3

Introduction to
Economics I

Editor

Assoc.Prof.Dr. Ahmet TİRYAKİ

Authors

CHAPTER 1, 2 Prof.Dr. Serdar SAYAN

CHAPTER 2 Assoc.Prof.Dr. Alper DUMAN

CHAPTER 3 Prof.Dr. Süleyman DEĞİRMEN

Assoc.Prof.Dr. Levent ERDOĞAN

CHAPTER 4 Asst.Prof.Dr. Havva Nesrin TİRYAKİ

CHAPTER 5, 6 Assoc.Prof.Dr. Kenan LOPCU

CHAPTER 7 Assoc.Prof.Dr. Çağla ÖKTEN

Asst.Prof.Dr. Yavuz YILDIRIM

CHAPTER 8 Asst.Prof.Dr. Nazmi Yükselen YAĞANOĞLU
 T.C. ANADOLU UNIVERSITY PUBLICATION NO: 3569
OPEN EDUCATION FACULTY PUBLICATION NO: 2403

Copyright © 2017 by Anadolu University

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INTRODUCTION TO ECONOMICS I

E-ISBN
978-975-06-2433-9

All rights of this book belong to Anadolu University.

ESKİŞEHİR, August 2018
3182-0-0-0-2009-V01
 Contents
Basic Concepts,
Scope and
CHAPTER 1
Methodology of
Economics
Introduction ................................................... 3
What is Economics? ...................................... 3
Choices ................................................... 3
Scarcity of Resources ............................ 4
Balancing Choices and Scarcity: Subject
Matter of Economics ..................................... 4
Basic Concepts ............................................... 5
Tradeoffs and Opportunity Cost .......... 5
Production Possibilities Frontier
and Opportunity Cost ........................... 6
Efficiency and Equity ............................ 8
Marginal Changes ................................. 8
Supremacy of Markets ......................... 9
How Markets
Work? Market
CHAPTER 2 Forces and
Equilibrium
Introduction ................................................... 25
Market Forces and Competition .................. 25
Markets .................................................. 25
Perfect Competition ............................. 26
Imperfect Competition ......................... 26
Demand and Demand Curve ........................ 27
The Law of Demand .............................. 27
Market Demand Versus Individual
Demand .................................................. 29
Determinants of Demand .................... 30
Changes or Shifts in Demand Curve .... 31
Market Failures and Externalities ....... 10
Trade as a Positive-sum Game ............. 11
Economywide Outcomes and the
Difference Between Microeconomics
and Macroeconomics .................................... 12
Standards of Living ............................... 12
Methodology of Economics ......................... 14
Scientific Method .................................. 14
Economics as a (Mostly)
Non-experimental Discipline ............... 15
The Role of Assumptions ...................... 16
Positive versus Normative Analysis .... 16
Changes in Demand Versus Changes in
Quantity Demanded ............................. 33
Supply and Supply Curve .............................. 33
Market Equilibrium: Demand and Supply  ... 37
Equilibrium ............................................ 37
Markets in Equilibrium ......................... 38
Markets Not in Equilibrium ................. 38
Changes in Market Equilibrium ................... 39
Changes in Demand .............................. 39
Changes in Supply ................................. 39
Shifts in Both Supply and Demand ...... 40
Prices and Allocation of Resources .............. 41
iii
 The Theory of
CHAPTER 3
Consumer Choice
Introduction ................................................... 51
Budget Constraint  ........................................ 51
Consumer Preferences .................................. 54
Indifference Curves ............................... 57
Properties of Indifference Curves ........ 59
Optimization: Optimal Choices for
Individual Consumers .................................... 65
Changes in Consumer Choices ...................... 67
Changes in Income ................................ 67
Elasticity,
Government
CHAPTER 4 Policies and
Market Efficiency
Introduction ................................................... 83
Elasticity and its Applications ...................... 83
Elasticity in General .............................. 84
Elasticity of Demand ..................................... 84
Price Elasticity of Demand ................... 85
Computing the Price Elasticity of
Demand .................................................. 85
Mid-point Approach ............................. 86
Determinants of Price Elasticity of
Demand .................................................. 87
The Importance of Being Unimportant ... 87
Time Horizon ......................................... 88
Shape of Demand Curves and Elasticity... 88
Perfectly Elastic Demand Curve .......... 90
Relationship Between Total Revenue
and Price Elasticity of Demand  ........... 90
Price Elasticity-Total Revenue Relationship
With a Linear Demand Curve ......................... 91
The Income Elasticity of Demand ....... 92
The Cross-Price Elasticity of Demand ..... 93
iv
Changes in Prices ................................... 68
Derivation of Demand Curve ............... 69
Positively Sloped Demand Curve? ............... 70
Giffen Good ........................................... 70
Applications ................................................... 71
How Real Wage Changes Affect
Labor Supply? ........................................ 71
How Real Interest Rate Changes
Affect Individual Savings? .................... 74
Elasticity of Supply ........................................ 94
The Price Elasticity of Supply ............... 94
Determinants of Price Elasticity of
Supply ..................................................... 95
Supply Curves and Price Elasticity ....... 95
Government Policies and Their Effect on
Market Outcomes ......................................... 96
Price Ceiling as a Price Control ............ 97
Minimum Wage as a Price Floor ......... 98
Taxation and Its Effects on Market
Outcomes ............................................... 98
The Relationship between the Tax
Incidence and Elasticity ........................ 100
Benefits to Participants and Market
Efficiency ........................................................ 101
Consumer Surplus ................................. 101
Producer Surplus ................................... 103
Total Surplus .......................................... 104
Market Efficiency .................................. 105
 The Firm and the
CHAPTER 5
Cost of Production
Introduction.................................................... 117
Production, Cost and Profit........................... 117
What is Cost?......................................... 118
Total Revenue........................................ 118
Total Cost................................................ 119
Profit....................................................... 119
Opportunity Costs.................................. 120
The Difference Between Economic
and Accounting Profit........................... 121
Production and Costs..................................... 121
Short Run Production Function............ 122
Average Product of Labor..................... 125
Different Types of Costs................................ 126
The Firm in Perfectly
CHAPTER 6 Competitive Markets
Introduction ................................................... 143
Market and Market Structure ...................... 143
What is a Competitive Market? ................... 144
A Representative Competitive Firm .... 146
Revenues and Revenue Curves of Competitive
Firms ............................................................... 147
Profit Maximization  ..................................... 149
The Short-Run Supply Curve ................ 151
Total Cost................................................ 126
Fixed Costs.............................................. 126
Variable Costs......................................... 126
Average Costs......................................... 126
Average Fixed Cost................................ 127
Average Variable Cost .......................... 127
Marginal Cost......................................... 127
Shapes of Typical Cost Curves............... 128
The Short Run and the Long Run
in Production.................................................. 130
Costs in the Short Run .......................... 131
Costs in the Long Run............................ 132
Scale Economies..................................... 133
The Short-Run Shutdown Decision
of the Firm: A Numerical Example ..... 152
Supply Curve in the Competitive
Market ................................................... 153
Why do Competitive Firms Make Zero
Economic Profit in the Long Run? ............... 155
Efficiency of Competition ............................. 157
v
 Monopoly
CHAPTER 7 and Imperfect
Competition
Introduction.................................................... 167
Monopoly........................................................ 167
The Sources of Monopoly..................... 168
Profit Maximization for a Monopoly..... 171
The Welfare Cost of Monopolies.................. 172
Types of Price Discrimination Under
Monopoly........................................................ 173
Examples of Price Discrimination......... 173
Oligopoly......................................................... 173
Factors of
CHAPTER 8 Production and
Factor Markets
Introduction ................................................... 187
The Labor Market .......................................... 187
Demand for Labor ................................. 187
Market Demand for Labor ................... 190
The Determinants of Labor Demand ...... 190
Supply of Labor ..................................... 192
The Determinants of Labor Supply ......... 193
Equilibrium in Labor Market ........................ 194
Changes in Equilibrium ......................... 194
The Capital Market  ....................................... 195
The Demand for Capital ....................... 196
Capital and Net Present Value ............. 196
vi
Using Game Theory to Analyze
Oligopoly................................................ 175
A Duopoly Game: Quantity
Competition Between Two Firms........ 175
Monopolistic Competition............................. 177
The Monopolistic Competitors
in the Short Run..................................... 177
The Monopolistic Competitors in
the Long Run (LR).......................................... 178
The Demand Curve for Capital ............ 197
Factors Affecting Demand for Capital .... 198
The Market for Loanable Funds ................... 199
The Demand for Loanable Funds ........ 200
The Supply of Loanable Funds ............. 200
Capital and the Loanable Funds Market .... 201
The Land Market ........................................... 202
Perfectly Inelastic Supply ..................... 203
Changes in Demand .............................. 204
Factors Affecting Demand ................... 204
Alternative Uses of Land ...................... 204
Preface
Dear students and readers,
Welcome to the world of economics and
welcome to the text of Introduction to
Economics-I, a resource book which is
prepared to be used in the open and distance
education programs of Anadolu University.
The students will find out that this textbook
offers a strong foundation in introductory
economics in an accessible format. The text
has been developed to meet the scope and
sequence of most introductory courses in
economics.
The Introduction to Economics-I textbook
is designed for a one-semester economics
course. It is traditional in coverage of
introductory economics content, especially
in microeconomics’ topics. At the same time,
the book includes a number of innovative
and interactive features designed to enhance
student learning in introductory economics.
Instructors can also customize the book,
adapting it to the approach that works best in
their classroom.
The book is organized into four main parts:
• What is Economics? The first chapters
introduce students with the study of the
main concepts, scope, methodology and
principles of economics, with a focus
on making choices in a world of scarce
resources.
• Supply, Demand and Elasticity, Chapters
2, 4 and 8, introduce and explain the first
analytical model in economics: supply,
demand and equilibrium and also the
types of elasticity concepts before showing
applications in the markets for factors of
production, such as the labor and finance.
• The Fundamentals of Microeconomic
Theory, Chapters 3, 5, 6 and 7 start the
microeconomics portion of economic
theory, presenting the theories of consumer
behavior, production and costs, and the
different models of market structure, such
as the competitive market, monopoly and
the other imperfect competitive market
structures.
• Microeconomic Policy Issues, Chapters
4 and 8 also cover the range of topics in
applied microeconomics, organized around
the concepts of public goods and positive
and negative externalities, taxation and the
issues with regards to welfare economics.
Throughout the textbook of Introduction to
Economics-I, you will find new features that
engage you in economic inquiry by taking
selected topics a step further. The features
include:
• Learning Outcomes,
• Test yourself,
• Your turn questions and
• Important notifications.
I hope you will benefit from the knowledge
and experience that you will acquire from the
Introduction to Economics-I book, not only
during your education in school years but also
in your professional life. I wish you all the
success.
Editor
Assoc.Prof.Dr. Ahmet TİRYAKİ
vii
 Basic Concepts, Scope and
Chapter 1 Methodology of Economics
After completing this chapter, you will be able to:

1 2
Learning Outcomes

Understand the meaning of scarcity and Learn the concepts of opportunity cost and
resource allocation tradeoffs that people face

3 Learn and apply the meaning of thinking at the

margin 4 Learn the effects of incentives on people’s
behavior

5 Distinguish the difference between

microeconomics and macroeconomics
6 Understand why trade makes everyone better
off

7 Learn the basics of scientific methodology

used in economics 8 Define the concepts of market failure and
market power

Key Terms
Economics
Externality
Scarcity
Market Power
Chapter Outline Opportunity Cost
Introduction
Microeconomics
What is Economics?
Efficiency
Basic Concepts
Macroeconomics
Economywide Outcomes and the Difference
Equity
Between Microeconomics and Macroeconomics
Standards of Living
Methodology of Economics
Incentives
Scientific Method
Thinking at the Margin
Positive versus Normative Analysis
Market Failure
Methodology of Economics

2
Introduction to Economics I
INTRODUCTION
The purpose of this chapter is to introduce
some of the basic and commonly used concepts in
economic analysis. Also, to familiarize the reader
with some of the methodological issues. The
resources that we can use to satisfy our needs and
desires are available only in limited quantities. They
fall short of the amounts required to fully satisfy
all our needs and desires. This is true not only
for individuals but also for all societies. Scarcity
refers to society’s inability to produce all the goods
and services people desire to have due to resource
limitations. This give rise to a choice problem:
How should individuals and societies decide on
their priorities and manage their scarce resources
accordingly with the priorities they set.
Economics studies how individuals and societies
prioritize their needs and choose to use scarce
resources at their disposal. Satisfying unlimited needs
and desires requires production of goods and services.
Scarcity follows from the scarcity of resources we use
to produce them. Notice that if scarcity of resources
were not a problem, it would be possible to produce
all goods and services in sufficiently large quantities
to make them available to everyone for free. The
economic problem arises because of this scarcity.
Economists study human behavior as a
relationship between unlimited ends and scarce
means with alternative uses. Thus, economics
could also be defined as the study of how society
sets priorities in managing its scarce resources.
Main problems that economics addresses
include what to produce, how to produce and for
whom to produce?
Given the choice problem that arises because of the
scarcity of resources relative to their needs and desires,
human beings are forced to give up one thing every time
they choose to obtain another thing. The opportunity
cost of a desired item or outcome to a person is what
that person has to give up to get that item or to achieve
that outcome. Everyone in the society faces tradeoffs.
A student who chooses to prepare for an economics
exam on a certain night may be giving up his chance
of watching a championship match on TV, some of his
sleep time, or his chances to prepare for a mathematics
exam. Likewise, a household may have to decide
whether to change the car or furniture at home. The
state may have to decide whether it should spend more
on education and health services or should spend on to
increase its military might instead.
In economics, decision makers make decisions
by thinking at the margin. Thinking at the margin
requires recognizing the need to make decisions
by evaluating the costs and benefits of marginal
changes. It means that a decision maker should
compare his/her action’ marginal benefit and
marginal cost. Any action should be undertaken
only if the benefit is greater than the cost.
If people make choices by comparing cost and
benefits, then their decisions may be altered by
altering the cost or benefits of their actions. People
do respond to positive and negative incentives.
When there is a significant increase in the price
of gasoline, for instance, demand for public
transportation and the demand for smaller, more
fuel-efficient cars increase.
These concepts are key to the study of economics
which has two major branches: microeconomics and
macroeconomics. Microeconomics is the branch
of economics that examines the decision making
behavior of the smallest decision-making units such
as the individuals, or households and the business
firms. Macroeconomics is the branch of economics
that examines the aggregate behavior of economic
agents and the government on a national scale.
The rest of the chapter introduces more concepts
to briefly discuss methodology of economics
and the difference between microeconomics and
macroeconomics in greater detail.
WHAT IS ECONOMICS?
Choices
Do you ever wonder why people do the things
that they do? People do whatever they do basically
for two reasons. They do something either because
they like (or enjoy) doing it, or because they need
to (or have to) do it. Things they need to do rarely
match with the things they like to do. A factory
worker living in Istanbul, for example, may like to
spend weekday afternoons by fishing by the Bosp-
horus, but instead he will typically be seen while
working hard on an assembly line in a Gebze fac-
tory. A teenager who enjoys listening to music all
day is sometimes caught cleaning up her room, or
helping her mother carry shopping bags. A student
who is a big football fan could be doing homework,
instead of watching Fenerbahçe-Galatasaray soccer
game on TV. Many students even cut their sleeping
hours when they need to prepare for an exam.
3
 Basic Concepts, Scope and Methodology of Economics
As these examples show, we all sometimes give
up doing things that we like in order to do things
we do not like. Stated alternatively, we all do what
we need to do sometimes by sacrificing activities
we enjoy. Why do we do that? Why don’t we spend
more time on fun activities? The reason is actually
obvious. We often avoid doing more of the things
we like to do because we have limited time. In other
words, we don’t have enough time to do everything
we need to (or have to) do without sacrificing some
of the activities we enjoy more than others. We have
to sleep and eat, take care of our bodies and homes,
study or work, assume various responsibilities within
our households and societies, etc. Given the limited
number of hours on a day, days in a year and years
in a lifetime, all these activities leave us with only
limited time to do other things.
Scarcity of Resources
Time is a limited or scarce resource, keeping
us from doing more in life. But it’s not the only
limited resource. We also have limited budgets. We
cannot buy everything we want, anytime we want.
All things that we want/desire or need to have but
cannot be obtained without cost are scarce relative
to our endowments or budgets. The worker in the
example above has to work at that Gebze factory to
buy food and other things that he and his family
need. No matter how many fishing trips to the
Bosphorus he gives up, his earnings from work
will not allow him to buy everything he and his
family would desire to consume. He will therefore
be forced to prioritize his purchases to live on his
limited budget–just like he gave a higher priority
to his job than fishing trips while allocating his
limited time between different activities. Likewise,
that football loving student prioritizes homework
over the game on TV.
Life is all about setting priorities. We all have
too many needs, wants and desires and we cannot
have everything we want because of the scarcity of
our resources. We therefore have to make choices
regarding how to use our scarce resources. Whether
it is money or time, scarcity of resources forces us
to decide on a list of priorities regarding things to
be done or purchased before others. Buying food
or paying rent will obviously be a higher priority
than booking a balloon ride in Göreme if the
person who wants the Göreme vacation does not
4
have enough money left from food, rent and other
necessities (or time left from work and other more
essential activities).
Scarcity arises from the limited nature of
society’s resources compared to unlimited
needs and desires.
Our resources are limited relative to our needs,
and this is true not only for individuals but also for
societies. Scarcity refers to the society’s inability to
produce all the goods and services people desire to
have because of deficiency of resources. Societies
therefore must also decide on their priorities
and manage their resources accordingly with the
priorities they set.
Balancing Choices and Scarcity:
Subject Matter of Economics
Economics is the study of how individuals
and societies choose to use scarce resources at
their disposal. The needs and desires of individuals
are unlimited. Satisfying those needs and desires
requires the production of goods and services. All
the goods that are not sufficiently abundant to be
available to everyone for free are said to be scarce.
Their scarcity follows from the scarcity of resources
we use to produce them. If scarcity of resources were
not a problem, it would be possible to produce all
goods and services in sufficiently large quantities
to make them available to everyone for free. This
is not possible because material inputs and factors
of production needed to produce goods are not
available in unlimited quantities.1 The economic
problem arises because of this scarcity.
Famaus British economist Lionel Robbins views
economics as a discipline studying human behavior
as a relationship between ends and scarce means
with alternative uses. Thus, economics could also
be defined as the study of how society sets priorities
in managing its scarce resources. In today’s
societies, resources are typically allocated through
the interactions among the millions of consumers
1
Factors of production are land, labor, capital and entrepreneurial
skills. These factors, together with material inputs (raw materials
and semi-processed or intermediate inputs) are used in
production. What sets factors of production apart from other
inputs is their durability: While material inputs disappear at the
end of the production of a batch, factors of production may
depreciate but do not disappear, and continue to be used in the
production of next batch.
Introduction to Economics I
and tens of thousands of producers. Economics
examines how these actors prioritize their needs in
light of the scarcity of resources at their disposal
and how their priorities interact collectively.
Economics is the study of how society sets
its priorities in managing its scarce reso-
urces.
This collective interaction is what determines the
prices of various goods and services, and how much
of each will be produced and sold. Determination
of prices and quantities is a complex process where
millions of economic actors interact while trying
to make the best out of limited resources that they
have. The process gets further
complicated by the actions of
governments that levy/charge
taxes on the income of consumers
and producers, provide public
services, regulate markets, and etc.
Economists therefore study the
whole process of the allocation of
society’s scarce resources between
different goods and services
needed by different sections of the
society, and examine the effects of
the government’s actions on the
economy as a whole. They also
analyze changes in economywide
indicators that affect the whole
society such as growth rate of
total income, unemployment rate and inflation rate
over time. In addition to these three critical “rates”,
economists study the determination of exchange
rates at which national currencies of trading nations
are exchanged, and interest rates that lenders get in
return on funds they lend to borrowers.
As shown even by this brief discussion, a wide
range of complex economic phenomena fall into
the subject area of economics. There are several
subfields of economics covering different types
of phenomena. While each of these is a different
area of specialization, there are a number of
ideas and key concepts commonly known to all
economists no matter what their particular areas
of specialization are. Economists widely use these
basic ideas that can be applied in many different
situations.
BASIC CONCEPTS
Tradeoffs and Opportunity Cost
Economists often say “there is no such thing as
a free lunch.” This expression is closely related in
meaning to “her seçiş bir vazgeçiştir,” a saying in
Turkish. Thus, everyone has to give up something
in order to get one thing that he or she wants. In
other words, there is a “price” for everything we get
even when no money changes hands.
The opportunity cost of a desired item or
outcome to a person is what that person has to give
up to get that item or to achieve that outcome. When
making decisions, individuals should recognize the
opportunity costs of each action that they can take.
Picture 1.1
When you decide to watch a movie on TV,
you may be missing a basketball game shown on
another channel. A student who chooses to prepare
for an economics exam on a certain night may
be giving up some sleeping hours or her chances
of preparing for a mathematics exam. Buying
that handbag may leave Ayşe with no money to
buy the shoes she has long wanted. Sometimes
opportunity costs have longer time horizons. If
Mehmet decides to complete his military service
right after graduation, he essentially postpones
earning money from work until after the military
service. Marrying Atacan keeps Pelinsu from
marrying Berke. In other cases, the nature of
opportunity costs may change over time or
depending upon alternative outcomes resulting
from an action. For example, going to a vocational
5
 Basic Concepts, Scope and Methodology of Economics
or technical high school eliminates the individual’s
chances of getting a general high school or lycée
diploma, but it endows him with technical skills
that could provide a higher income now. Yet, a
lycée diploma may imply higher chances of getting
a better score on LYS, and hence a higher income
after graduating from the university.
The opportunity cost of a desired item or
outcome is what you give up to get that
item or to achieve that outcome.
Scarcity of resources makes it necessary to choose
one goal over the other. This need is true not only
for individuals, but also for societies or nations
because they also have limited resources to give every
one of their members or citizens what they want.
The society may, for example, face a choice between
dedicating the olive fields along the Aegean coast
to mining and manufacturing activities, or to olive
and olive oil production and tourism. Increasing the
mining and manufacturing activity in the fields will
require cutting down more olive trees, and hence
imply a drop in olive trees and olive oil production.
There is also a tradeoff between environmental
quality and income to be generated by mining
and manufacturing activities. This is an important
tradeoff for modern societies in general.
Regulations that require firms to reduce the
pollution resulting from the production of goods
and services increase the cost of production. Thus,
even though environmental
regulations contribute to a Wheel-chairs
cleaner environment and
improved health outcomes,
they reduce the incomes of
the shareholders of firms, and 450 A B
their employees. They also
increase the cost to customers
and negatively affect their
purchasing power. Lower
environmental quality due
to increased mining and
manufacturing activity in
olive fields may have other
effects such as a reduction in
tourism income –once again
proving that there really is “no 150 200
free lunch.” Figure 1.1 Production Possibilities Frontier for Çiftteker
6
Production Possibilities Frontier and
Opportunity Cost
Consider the case of Çiftteker, a firm that
employs 50 workers to produce two goods: Bicycles
and wheel-chairs. The production takes place
in a factory with two assembly lines. Alternative
combinations of bicycles and wheel-chairs that
this firm can produce within a week (or month,
year etc.) can be captured by the production
possibilities frontier of this firm shown in Figure
1.1. The production possibilities frontier or PPF,
as it is shortly called, is a graph that shows various
combinations of output (in this case, bicycles and
wheel-chairs) that the firm can produce in its factory
with the available workforce and other inputs by
using the available production technology.
Production Possibilities Frontier is a
graph that shows the combinations of out-
put that a firm or a society can possibly pro-
duce using the available production techno-
logy and the given amount of inputs.
Stated alternatively, the PPF is the locus of
all output pairs that could be produced with the
available production technology when the firm
uses all its scarce resources fully and efficiently.
Efficiency refers to the ability to put a given
amount of scarce resources into use in such a way
to produce the highest level of output that could be
produced with the available production technology.
G
C
D
F
Bicycles
450 500 600
Introduction to Economics I
Figure 1.1 is a typical example of PPFs that
is frequently used in economic analyses. It shows
that if Çiftteker uses all its resources in bicycle
production, it can produce 600 bicycles a week
and no wheel-chairs. Alternatively, if the firm
devotes all its resources to wheel-chair production,
it can produce 450 wheel-chairs and no bicycles.
The two intercepts on the graph represent these
extreme production possibilities. The firm may
obviously choose any combination in between
as well, depending upon, for example, demand
conditions. Points A through G exemplify choices
available to the firm. Points A through D are
alternative bicycles/wheel-chairs pairs that can be
produced when the firm uses all its resources fully
and efficiently. The firm would typically avoid
producing at an internal point like F because that
would imply that Çiftteker is either using its scarce
resources fully but inefficiently, or it is leaving
some of the resources idle. Since doing so would
be costly, the firm would not prefer to produce at
any point inside the PPF. A point like G might be
desirable but it would be impossible to reach there
with given available resources and technology.
It must be noted that the PPF shown in the figure
is concave to the origin or bowed outward. This
curvature implies that the number of wheel-chairs
that the firm has to give up to be able to increase
the number of bicycles produced vary as more
and more bicycles are produced (i.e., as increasing
amounts of resources are shifted away from bicycle
production towards wheel-chair
production). In other words, the Wheel-chairs
opportunity cost of bicycles in
terms of wheel-chairs depends on 490
how much of each good the firm is
producing. For example, when the 450
firm is producing at a point like
A by using most of its resources
to make wheel-chairs, increasing
the weekly bicycle production
by 50 (from 150 to 200) so as
to move to point B does not
cause a large reduction in wheel-
chair production. That’s because
at point A, almost all workers
including the most skilled bicycle
makers as well as the machines
best suited to making bicycles are
Figure 1.2 Production Possibilities Frontier for Çiftteker after the Purchase
allocated to making wheel-chairs.
So, the firm gets a slight decrease in the number
of chairs for each additional bicycle it produces,
as it moves towards point B pulls resources away
from wheel-chairs toward bicycles. By contrast,
when Çiftteker is already producing many more
bicycles such as at point C, further increasing the
bicycle production by the same amount (from 450
to 500 this time) requires that a lot more wheel-
chairs be given up, as the colored arrows indicate.
In this case, the resources best suited to wheel-chair
production are already used to make wheel-chairs
and moving them to bicycle production creates a
much larger cost in terms of the number of wheel-
chairs given up. That means opportunity cost of
increasing bicycle production in terms of wheel-
chairs increases, as one moves to the right along
the horizontal axis, since this reflects shifting of
resources most suitable for making wheel-chairs
away from production of that good.
If Çiftteker purchases a new machine that could be
used to sew leather parts together, the PPF will shift
outward, possibly making the pair of production
amounts characterized by point G feasible to reach
as well. This is shown in Figure 1.2. The asymmetric
nature of the shift hints that the newly purchased
machine has a greater potential to increase wheel-
chair production (from the maximum possible level
of 450 to 490) than to increase bicycle production
(from the maximum possible level of 600 to 610),
as wheel-chairs presumably have more leather-
covered parts than bicycles.
A B G
C
D
F
Bicycles
150 200 450 500 600 610
of New Machine
7
 Basic Concepts, Scope and Methodology of Economics
The same ideas are perfectly applicable to whole
economies. However, economies in real life produce
thousands of goods and services rather than just two.
It is always possible to simplify real life as if there
are only industries where all resources available to
the economy are used. For example, the horizontal
axis may represent all agricultural products and the
vertical axis may represent all manufactured goods
produced by an economy. The same arguments
about the increasing opportunity cost (this time, of
agricultural goods in terms of manufactured goods)
could be made in the context of a whole economy.
The PPF is a very useful analytical tool to
illustrate the basic economic concepts such as
scarcity, efficiency, tradeoffs and opportunity cost.
It could even be used to illustrate economic growth,
another frequently used economic concept, in the
form of an expansion in the production possibility
set of an economy, just as the shifting PPF in
Figure 1.2 shows. You will be coming across these
concepts and ideas over and over again in various
forms in the following chapters of this book, as
well as in other economics courses you may be
taking in the future. The production possibilities
frontier provides a very useful pedagogical tool to
think about them.
1 it”; “eat meat or go vegetarian” point to binary
Suppose that a society wants to produce and
consume at point G in Figure 1.1. Is it possible?
If it is, how? If it is not, why not?
Efficiency and Equity
Sometimes the tradeoff facing the society is
between more abstract goals or targets such as
the tradeoff between equity and efficiency. As
described above, efficiency is getting more from
a given amount of scarce resources. If production
technique A allows for production of more goods
than technique B without increasing the amount
of inputs and energy used, for example, technique
A is said to be more efficient than technique B.
Equity, on the other hand, refers to distribution
of resources fairly among members of the society.
To use the well-known cliché, efficiency is about
increasing the size of the economic “pie”, and
equity is about how that pie is divided into slices.
8
Efficiency refers to the ability of a firm or
society to get the most out of a given level
of inputs.
Equity refers to the distribution of resources
fairly among members of the society.
These two goals are often in conflict.
Government policies designed to improve equity,
for example, may reduce efficiency or vice-versa.
When the government sets unemployment
insurance payments too generously, for instance,
it reduces the rewards for hard work, and may
demotivate job seekers as a result. Consequently,
society may produce fewer goods and services.
Obviously, this is not to say that the unemployed
people should be driven into poverty just because
unemployment benefits reduces work incentives.
The government that faces a tradeoff here should
set its priorities by giving the proper weights to
these two goals that sometimes conflict.
Marginal Changes
Decisions involving only two alternatives are
called binary decisions. For example, statements
like “buy that shirt or not”; “sell your house or keep
decisions. Many of our decisions in life are not
binary. We rarely meet people who eat nothing but
meat. Likewise, most people are not vegetarians.
Majority of people tend to avoid the risk of getting
gout disease from overconsumption of meat, as
well as the other health risks they face when they
deprive themselves of animal fat and proteins.
That’s why they eat meat, as well as vegetables,
fruits, etc., all in moderation. For these people, the
question is not whether to eat meat at all or not.
The question rather is how much meat to eat. Each
individual decides on the amount of meat he or
she will consume based on his or her income, meat
prices, health concerns etc. and his or her tastes.
Similarly, the choice facing most students during
exam weeks is not between completely ignoring the
subject material or studying day and night without
eating or sleeping. The rational choice is to allocate
an extra hour to review exam materials instead of
hanging out on Instagram or Facebook.
Introduction to Economics I
The term marginal is used frequently in
economics to refer to small incremental adjustments
made on an existing plan of action. The term
“margin” means “edge,” so marginal changes are
adjustments made to add to the total (the amount
at the edge) achieved thus far. Eating one more
meatball at dinner (increasing the total number
of meatballs eaten from 3 to 4), or drinking one
more cup of tea at breakfast (increasing the total
cups drunk from 2 to 3) are examples of marginal
additions. Similarly, studying one more hour for an
exam (increasing the total hours studied from 10
to 11) represents a marginal increase in study time.
Likewise, adding one more shovelful of fertilizer to
the flower bed in the backyard would be a marginal
adjustment, if the flower bed has already received
20 shovelfuls of fertilizer. That last meatball, cup of
tea, hour or shovel are all called marginal as they
are additions at the edge.
The term marginal is used frequently in
economics to refer to small incremental
adjustments made on an existing plan of
action.
Making the best decision sometimes requires
thinking at the margin. Consider the decision
of a newly graduated student of economics to
apply for a one-year master’s program in business
administration (or an MBA degree). To make an
informed decision, the graduate needs to know the
additional benefits of an extra year in school (in
terms of higher wages throughout her career, for
example) and the additional costs that she would
face (tuition she will have to pay for enrolling in the
MBA program and the wages she will forgo while
she’s in the program). She can decide whether an
extra year is worth spending for an MBA degree,
by comparing these marginal costs and marginal
benefits (extra income she will earn as an MBA
graduate beyond the amount she will get as the
holder of a 4-year economics degree).
Now consider the owner of a 10-room boutique
hotel who rented out 9 of the rooms for a given
night at an average rate of 150 liras per night as
another example. Late at night, a young passenger
arrives and asks about the availability of a room
for 75 liras for that night. The rational choice for
the hotel keeper would be to rent out that last
room as long as the marginal cost of letting that
passenger sleep in the room is lower than 75 liras.
(Think about it: What would be the marginal cost
of renting out that additional room for that night?)
Thinking at the margin while taking an action
indicates that the rational decision makers such
as individuals, firms, and students, take an action
if and only if the marginal benefit of the action
is greater than the marginal cost. Thus, we make
decisions based on the criteria of comparing the
marginal benefit and marginal costs of our actions
and if the expected marginal benefit exceeds the
expected marginal cost we take the action.
2
Suppose that you want to buy a brand name
t-shirt and your willingness to pay for that
t-shirt is 125 TL. You went to the store where
the t-shirt is sold and found out that the price
is just 100 TL. You bought one and wore it
right away. Unfortunately, a big chunk of paint
spilled all over the new t-shirt and you cannot
wear it again. The question is whether or not
you go to the same store and buy another t-shirt
by paying 100 TL again. Why? Why not?
Supremacy of Markets
If people make choices by comparing costs and
benefits, their decisions may be altered by changing
costs or benefits. That means people respond to
incentives. When there is a significant increase in
the price of gasoline increases, for instance, demand
for public transportation as well as the demand
for smaller, more fuel-efficient cars increase. This
increases demand for buses and mini buses while it
leads to a drop in the gasoline for larger cars, especially
4x4’s. As a result, automotive manufacturers begin
to produce more buses and mini buses and fewer
cars, and 4x4’s. This tends to relieve traffic jams and
may have positive effects on environmental quality
as CO2 emissions from cars will be reduced. As
the following chapters of this book will also show,
understanding the effect of price changes on the
behavior of buyers and sellers in a market —in this
case, the market for gasoline— and related markets
is critically important for understanding how the
economy works as a whole.
9
 Basic Concepts, Scope and Methodology of Economics
There is continuous interaction between the
actions of firms and households in a market
economy. These actions affect (even determine)
market prices, and get affected by changes in those
prices. Prices are the best and most effective signals
guiding the decisions of households (or consumers)
and firms (or producers). Firms decide whom to
employ and what to produce by looking at prices.
Households decide which firms to work for and
what to buy with their earnings from work again
by looking at prices. All of them are interested
in improving their own well-being. Even though
the actions of these self-interested actors are often
completely uncoordinated, market economies
have proven remarkably successful in matching
what consumers want with what producers are
willing to supply in such a way to promote overall
economic well-being of the society. In 1776, Adam
Smith, the founder of modern economics, made
the best known remark in economics of all times:
Consumers and producers act as if their actions
are guided by an “invisible hand” leading them
to desirable market outcomes. As all students of
economics eventually learn, the actual instruments
that do what Adam Smith thought the invisible
hand does are prices.
A Market Economy allocates resources
through the decentralized decisions of many
producers and households that interact in
various markets.
Prices drive economic activity by reflecting
both the value to society of a product and the cost
of making that good to society. Since households
and firms make their consumption and production
decisions by looking at prices, they indirectly “talk to
each other” through prices and unknowingly take into
account the social benefits and costs of their actions.
As a result, prices guide market actors to reach
outcomes that, in many cases, maximize the welfare
of the entire society. It must be noted, however,
that government interventions sometimes prevent
prices from responding naturally to changes in
supply and demand. In other words, the government
intervention often impedes the ability of the invisible
hand to coordinate the millions of households and
firms. Taxes on purchases, for example, distort prices
and may change the incentives of economic actors,
10
as noted above. Such price distortions may lead to
misallocation of scarce resources and they may inflict
negative effects on social welfare.
In the absence of interventions, markets
usually work in a way to improve social welfare.
Still, governments sometimes prefer to intervene
to achieve certain social or policy goals. Different
instruments, particularly taxes may be used to
change incentives, and thus people’s behavior.
A hike in gasoline prices, for instance, may be
induced through an increase in taxes on gasoline, if
the government wants to fight air pollution caused
by toxic emissions from cars. More generally,
government interventions in the economy aims to
promote either efficiency or equity.
Market Failures and Externalities
While the market mechanism generally leads
to an efficient allocation of resources, markets
sometimes fail to achieve that. Economists call it a
market failure when the market itself falls short of
allocating resources efficiently. One possible cause
of such failures is the presence of externalities. An
externality is the one that has often unintended
impact that an economic actor’s actions has on
the well-being of another actor who stands by.
The best known example of an external cost (or
negative externality) is pollution generated as a
byproduct during a production process. If a factory
is not held accountable for the entire cost of the
pollutants it generates during production, it will
probably generate too much pollution. Chemicals
that the factory releases into a nearby river, for
example, may not only cause the environment to
stink, but they may also kill the fish in the river.
This will create a negative externality for everyone
living near the river, in the form of increased health
care costs perhaps. The fishermen who make their
living by selling the fish they catch in the river will
also face losses. Unless the government introduces
environmental regulations, however, neither
cost will be born by the factory. Thus, water
pollution will continue to reduce social welfare
and economic well-being. As for external benefits
(or positive externalities) the classic example is
R&D (research and development) activities that
lead to productivity-enhancing inventions. In this
case, the government can raise social welfare by
providing incentives to support R&D activities.
Introduction to Economics I
A market failure occurs when the market falls
short of allocating resources efficiently.
An externality is the one that often has uninten-
ded impact that an economic actor’s actions on
the well-being of another actor who stands by.
Picture 1.2
A second possible cause of market failure
is market power. Market power is the ability
of a single actor (or a few actors) to control or
substantially influence market prices. For example,
there are only three GSM operators in Turkey and
the cell phone service industry is not competitive
enough to keep the existing firms’ greed in check.
That’s why there is room for regulating the price
these firms charge to protect consumers.
Market power is the ability of a single actor
(or a few actors) to control or substantially
influence market prices.
The market mechanism is also difficult to
rely on to distribute economic prosperity fairly.
A market economy rewards individuals by their
ability to produce things that others are willing to
purchase but this does not necessarily imply that
every member of the society will have enough food
to eat, a decent shelter, and access to health care.
Many public policies, such as the tax and the social
assistance policies, aim to create a more equitable
distribution of economic well-being.
Trade as a Positive-sum Game
Just like other voluntary exchanges such as those
between individuals, trade between two nations make
(citizens in) each country better off. Trade between
Spain and Turkey, for example, improves social
welfare in both countries, not just in Spain, nor in
Turkey alone. So, unlike a basketball match where one
party wins and the other loses, both parties
are winners in international trade. In other
words, international trade is a positive-sum
game, not a zero sum-game. Notice, however,
that trade is actually carried out typically
by the private firms of each country. In that
sense, international trade is like a basketball
match between Fenerbahçe and Real Madrid
(the champion and finalist, respectively,
of Euroleague 2017), rather than a match
between national teams of Turkey and Spain.
In a sense, nations are like households
that want to obtain the highest quality
products at the lowest possible cost. That
would be impossible if a household isolated
itself from the other households around.
Doing so would require that the household
do everything by itself: grow its own food,
make its own clothes, build its own houses and
provide its own transportation. If you compare what
your own household could achieve under those
circumstances to its actual achievements, you can
see how beneficial trade is to the well-being of the
trading parties. Trade, whether it involves agriculture,
tailoring, or construction work, allows everybody to
specialize in what they produce with less effort. By
exchanging what they produce most efficiently for
what they cannot produce as efficiently people can
enjoy larger amounts of a greater variety of goods
and services at lower cost.
Picture 1.3
11
 Basic Concepts, Scope and Methodology of Economics
Trade, regardless of whether it is domestic
or international, makes all participants bet-
ter off.
Likewise, countries benefit from trade as it
allows them to exchange what they produce most
efficiently for what they cannot produce quite
as efficiently. Since this will help put the scarce
resources of each trading country into their best
use, citizens of both countries will be able to
consume larger amounts of a greater variety of
goods and services at lower cost.
ECONOMYWIDE OUTCOMES
AND THE DIFFERENCE BETWEEN
MICROECONOMICS AND
MACROECONOMICS
All these decisions made by economic actors
and their interactions in the markets, as well as the
linkages between these markets, produce economy
wide outcomes. Most of the concepts and ideas
introduced so far are essentially microeconomic
in nature. Microeconomics is the sub-field of
economics that studies the behavior and decisions
of the smallest decision units such as individuals or
households and firms. Individuals and households
make choices about how much labor to supply,
what goods to purchase, how much to save and
what assets to buy or sell, etc. accordingly with
their self-interest. Likewise, firms make choices
about how much to produce or sell, how many
workers to hire, etc. in pursuit of profits (a self-
interest indicator for firms). When these smallest
decision units in the economy take the type of
decisions they do, their collective behavior produces
economywide outcomes. These economywide
outcomes and how they come to be make up the
subject matter of macroeconomics, another sub-
field of economics. Macroeconomists study how
a country’s economy as a whole works, by paying
special attention to the effects of various policies
pursued by the government. Of particular interest
to macroeconomists are problems like inflation and
unemployment not covered in microeconomics.
For reasons beyond the scope of this book,
problems like inflation and unemployment are not
dealt with at all by the microeconomists, and they
discuss some other macroeconomic issues such as
economic growth only indirectly at best.
12
Microeconomics is the a main branch of
economics that studies the behavior and de-
cisions of the smallest decision units such as
individuals or households and firms.
Macroeconomists study how a country’s
economy as a whole is structured and works,
by paying particular attention to the effects
of monetary and fiscal policies pursued by
the government.
The ultimate measure of how well a country’s
economy works as a whole is the standard of living
that citizens of that country achieve. This is a
widely discussed topic in macroeconomics.
Standards of Living
A country’s standard of living depends on the
economy’s ability to produce goods and services.
Since this ability displays great variation across
countries, there are huge differences in the living
standards of countries around the world. By the
World Bank figures, the average individual in the
world in 2015 had an annual income of 10,112 US
dollars (USD) as measured in that year’s prices (or
in current USD). This average was in sharp contrast
with per capita income of Luxembourg that stood at
USD 99,718 the same year. While the average world
citizen’s income was about 10 percent of that of an
average Luxembourger, yearly per capita income in
Burundi, a country in Africa, was just 277 dollars.
In other words, an income of the average Burundian
earned about 3 percent of the average world citizen
and only 0,3 percent (or 3‰) of the income of the
average Luxembourger in 2015. Per capita income of
USD 9,125 in Turkey was below the world average
and ranked the country in the 83rd row in the world
in 2015. By comparison, our neighbors had per
capita income levels ranging from USD 3,489 in
Armenia to USD 18,007 in Greece the same year.
As would be expected, this large discrepancy in
average income levels across countries is reflected
in various measures of the quality of life. Citizens
of richer countries have more cell phones and
computers, more TVs and cars; receive better health
care and better nutrition; and are naturally expected
to live longer than citizens of poorer countries. Not
counting the rich oil exporters in the Middle East
Introduction to Economics I
and Latin America, richer countries have also higher
democratic standards, greater freedom of press, less
corruption and they spend more on culture and arts
than lower-income countries.
Evolution of the improvement in the standards
of living over time has also occurred at different
speeds. In the United States of America, for
example, real incomes (that is, incomes adjusted for
inflation) have grown at about 2 percent per year
historically. Over the 50-year period between 1966
and 2015, per capita income in the USA increased
2.4 times, whereas that in Turkey increased 3.1
times. So, from 1966 to 2015, Turkey slightly
increased its per capita real income relative to the
USA’s from 17 percent to 22 percent of the per
capita real income in the USA. In other words,
Turkey’s per capita income slightly converged to
the USA’s. Over the same period, there was a 3.6
times rise in Luxembourg’s per capita real income,
whereas there was no increase in real per capita
income in Burundi. As a matter of fact, per capita
real income in Burundi decreased by about 4
percent in 50 years from 1966 to 2015.
These large differences in living standards among
countries are due, to a large extent, to the differences
in worker productivity across countries. In countries
where workers can produce a larger quantity of goods
and services per hour or per day, people enjoy a higher
standard of living. By contrast, the less productive
workers in a country are, the lower the standards
of living in that country will be. An important
question then is what determines the productivity
level of a country? The short answer is investment.
Investment in physical capital (all machinery and
equipment used in production) and human capital
(improvement of people’s productive skills through
education and training) is indeed the recipe for
increasing economywide productivity levels.
3 quantity of money in circulation. When large
Can you list the factors that determine the
productivity level of a country?
Economywide productivity level has obviously a
huge effect on living standards of citizens through its
effect on their incomes. But prices also have direct
bearing on living standards since prices determine the
actual purchasing power of a given level of income.
In 1950, a loaf of bread weighing 900 grams was
sold for 30 kuruş or 0,3 liras in Turkey. In 1960, the
price doubled and a loaf weighing 860 grams (or 40
gr. less than before) began to be sold for 70 kr., more
than double the price in 1950. As of January 1974,
the price of an 830 gram-loaf rose to 200 kr. or 2
liras. By the 1980s, breads got smaller and smaller
and began to weigh around 400 grams. Price per
loaf increased to 12.6 liras in 1982; 27.3 liras in
1984 and 80 liras in 1987. The next year in 1988,
the price more than doubled again and increased to
200 liras. The same 400 gram-loaf cost 2,500 (two
thousand five hundred) liras, just four years later in
1992; 3,750 liras in 1993, and 5,625 liras in 1994.
By 1997, the weight had been halved to 200 grams
and the price had reached 28,000 liras. It went up
to 60,000 liras in 1998 and 100,000 (one hundred
thousand) liras in the year 2000. In 2004, the price
of a 200-gram loaf hit 300,000 liras.
Prices of the other goods and services rose
by similar amounts. This path that prices in the
Turkish economy followed from the late-1970s to
the early-2000s marks the high inflation episode of
Turkey’s economic history. Defined as an increase
in the general price level (or overall level of prices) in
the economy, inflation forced the Turkish Central
Bank to drop 6 zeros from the currency in 2005.
Since high inflation imposes various social and
economic costs on society, inflation must be kept
under control.
Inflation is the increase in the general price
level (or overall level of prices) in the eco-
nomy within a given period of time.
Underlying causes of inflation must be
identified to control it. In the overwhelming
majority of cases, persistently high inflation
is caused by similarly persistent growth in the
quantities of the national currency are put in
circulation, the value (or purchasing power) of the
money falls: With 100,000 liras, one could buy
more than exactly 100,000 of those 400-gram
loaves of bread in Turkey in 1974. The number
of 400-gram loaves that could be purchased with
100,000 liras dropped to almost 8,000 in 1982,
to 3,663 in 1984, and to just 500 in 1988. The
same amount of money could only buy 40 breads
13
 Basic Concepts, Scope and Methodology of Economics
in 1992, 18 breads in 1994 and less than 2 breads
weighing 400 grams in 1997. As of 1998, it
was impossible to buy 400 grams of bread with
100,000: 100,000 liras could buy only a half of a
400 gram-loaf in the year 2000!
The reduction in the number of bread loaves
that could be purchased with 100 thousand liras
from one hundred thousand (100,000) in 1974 to a
mere half (1/2) loaf in the year 2000 well illustrates
the loss in the purchasing power of Turkish lira
during the high inflation episode between the
late-1970s and the early-2000s. These high rates
of inflation in Turkey were also associated with
rapid money growth. By contrast, relatively lower
rates of inflation after the late 2000s went hand in
hand with slow growth in the quantity of money
in circulation. If the underlying cause of inflation
and its harmful effects are so well-known, why
do policymakers not stop it? One reason behind
this failure is that cutting money supply to reduce
inflation is often thought to raise unemployment.
This tradeoff between inflation and unemployment
is sometimes illustrated by a curve called the
Phillips curve. While this relationship examined
first by the British economist William Phillips has
raised much controversy in economics in the past,
most economists today recognize the possibility of
the presence of a tradeoff between inflation and
unemployment at least in the short-run. In other
words, in relatively short periods of one to two
years, economic policies introduced to control
inflation may lead to an increase in unemployment
or vice-versa.
Economic policy choices often produce
similarly conflicting outcomes. Policymakers
must therefore prioritize economic policy goals,
or attribute different weights to desirable and
undesirable outcomes from the introduction of
various policies. In the case of the Phillips curve,
for example, policymakers can tackle this tradeoff
using various policy instruments: By changing the
level of government spending or tax collection,
and the quantity of money put in circulation,
policymakers can, in the short run, influence the
inflation and unemployment rate pairs. Since
these fiscal and monetary policy instruments are
powerful tools that could significantly affect the
living standards of different sections of the society,
economists study how they could be used to
achieve different goals.
14
METHODOLOGY OF ECONOMICS
Each scientific discipline has its own vocabulary
and terminology. While biologists deal with cells,
organisms and species, mathematicians use limits,
derivatives, logarithms and matrices. (Astro)
physicists talk about electrons and protons, nuclear
fusion, Big Bang, galaxies and nebulae, whereas
psychologists refer to ego, superego, id, and
depressions. Economics is no different. Concepts
like opportunity cost, supply, demand, marginal
revenue, inflation and unemployment make up the
economist’s vocabulary.
The primary goal of any introductory course
in economics (and hence the textbook used in
that course) is to help students understand how
economists think about and approach the problems
around them. One cannot be expected to become
a biologist, astrophysicist, mathematician or
psychologist overnight: Similarly, grasping an
economist’s way of thinking will take time. This
course is a first step in that long journey and this
book is designed to guide the reader in that process.
For that purpose, the book introduces the main
concepts commonly used in economics and builds a
simple theoretical framework around those concepts
to analyze various economic problems. The book
also offers plenty of examples from case studies, the
news, outcomes of economic policies, etc. to help the
readers develop their analytical skills in economics.
Before proceeding to the topics covered in the
following chapters, it is instructive to begin with a
discussion on the methodology of economics.
Scientific Method
Professional economists view the economy
much the same way as physicists view subatomic
particles or states of the matter, or as biologists
view the cells and organisms: They build theories
to explain relevant phenomena, and to make
accurate predictions about those phenomena. They
then collect and analyze data to verify or refute
their theories.
Even though economists do not walk around
in white lab coats using microscopes (or telescopes
for that matter), they employ basically the same
scientific method involving the development of
theories after careful observation of the relevant
behavior and real world phenomena, and putting
those theories to test by using data. This is the
Introduction to Economics I
same method of inquiry as the one employed in
studying the meteorological phenomena or testing
the theories about ‘survival of the fittest.’
Scientific method involves the development
of theories after careful observation of the re-
levant behavior of economic agents and real
world phenomena, and then putting those
theories to test by using data.
The scientific method follows a sequence starting
and ending with observations. In between, a theory
is formulated to explain those initial observations,
and the validity of that theory is continuously
tested through additional observations.
You must have heard the famous story about
the ancient Greek polymath Archimedes. Hiero,
the local tyrant, allegedly asked Archimedes, the
local genius, to test if the goldsmith cheated while
manufacturing the golden crown he ordered.
Hiero suspected that his goldsmith kept a certain
amount of gold to himself and replaced it with
silver without changing the weight of the crown.
Archimedes got to thinking about possible ways
to detect fraud. He was still thinking about them
when he went to the public baths. He realized there
that the deeper his body sank into the water, the
more water overflowed from the tub. Upon careful
measurement, he realized that the displaced water
was an exact measure of his body’s volume under
water. He then reasoned, since gold is heavier than
silver, a crown with a given weight would have to
be larger in volume when it contained silver than
when it was composed only of gold. Therefore a
crown made with silver mixed into gold would
displace more water when it sank. Realizing that
he found the solution to the problem in hand,
Archimedes rushed out of the bath and ran home
naked shouting “Eureka! Eureka!” (“I’ve found it!
I’ve found it!”)
The observation of water overflow led
Archimedes to develop a theory about buoyancy. An
object in a fluid experiences an upward (buoyancy)
force equal to the weight of the displaced volume
of liquid. This applies not only to the golden crown
sinking into water but any object in the universe
including huge cargo ships. Archimedes’ theory has
successfully explained observation indeed, and it is
still taught today in physics courses all around the
world as one of the basic laws of physics.
A similar interaction also occurs between
theory and observation in economics. An
economist living in a high-inflation country
could be inspired by this observation and end
up developing a theory of inflation. The theory
might assert that high inflation results from large
budget deficits the government runs (with excess
government spending over tax collection leading
to an abundance of money in circulation). The
economist could test this theory by collecting and
analyzing data on price levels and budget deficits
from different countries. If levels or growth rates of
budget deficits that different country governments
run were disconnected from the rate of inflation
(or the rate at which general price level is rising) in
those countries, the economist would need to be
concerned about the validity of her theory. If these
two indicators (or variables) of the countries in the
sample were strongly correlated in the data, as we
would expect, the economist would have higher
confidence in her theory.
Economics as a (Mostly)
Non-experimental Discipline
Still economists face an obstacle that scientists
in many other fields do not face: Experiments are
often difficult to conduct in economics. A physicist
studying buoyancy can sink many different objects
into water in the lab and generate data to test his
theory. By contrast, an economist is not allowed
to change the budget deficit of his and/or other
people’s country just to generate data to test his
theory of inflation. Economists, like astronomers,
evolutionary biologists or paleontologists, and ge-
ologists usually have to live with whatever data the
universe happens to supply them.
In order to substitute for the lack of laboratory
experiments, economists study history or closely
watch current developments in the world to identify
natural experiments that might have occurred.
When unemployment in the USA increases, for
example, investors in other countries begin to
expect the Fed to cut interest rates. This typically
leads to an increase in short-term financial capital
flowing into emerging market economies, causing
the national currencies of these countries to
appreciate against the US dollar. This appreciation,
15
 Basic Concepts, Scope and Methodology of Economics
in turn, affects the international competitiveness of
these countries negatively, and lowers their exports.
As a result, unemployment among workers in the
export sectors of emerging economies may increase
by pushing down their living standards. While it
poses a difficult choice about what the best policy
response would be for economic policymakers, it
provides an opportunity for economics scholars to
study the effects of the state of economic activity
in the USA on the other economies. When the
episodes of rising unemployment or rate cuts by the
Fed in the USA get repeated a sufficient number of
times in history, economists get access to data they
need to analyze the effects of these on emerging
market economies.
The Role of Assumptions
Physicists base a lot of predictions on Newton’s
law of gravity. The law states that a free-falling
object accelerates at the rate of 9.8 m/s2, downward
on Earth. That acceleration constant is valid under
the assumption that the object falls in a vacuum.
This assumption is obviously false. In reality,
the air surrounding the earth exerts friction on
falling objects (objects attracted by the earth’s
gravitational power) and slows it down. Yet the
physicists safely ignore the friction on the falling
object on account of its small effect. Assuming that
the free fall happens in vacuum greatly simplifies
solutions of many problems without substantially
affecting the answer. In economics, assumptions are
made for the same reason: Assumptions simplify
the real world that is too complicated to fully
understand. While studying international trade,
for example, economists often assume a world
made up of only two countries (or regions), each
producing only two goods by using only physical
capital and labor. Obviously, this assumption is
not consistent with real life observations. In the
real world, there are more than 200 countries, each
producing thousands of different products. Raw
materials, energy and intermediate inputs are also
used in production in addition to physical capital
and labor. We simplify this world by assuming
that there are only two countries and two goods
to better understand the fundamental forces driving
international trade. Once we understand the basics
of international trade in that hypothetical world
with two countries and two goods, we can better
grasp the mechanisms of international trade in the
16
real world that is a lot more complex. Economists
use different assumptions to answer different
questions, but they are all intended to simplify
the analysis by highlighting the most fundamental
forces underlying the phenomena studied.
For purposes of analysis, economists often
build mathematical models. These models are
made up of mathematical equations that capture
or represent the essential elements of the behavior
and responses of key economic actors to changes
in various economic indicators. Such a model is
deliberately built to assume away certain features of
the economy, so as to make it tractable or to keep it
solvable or statistically estimable. Different models
are used in different disciplines from physics and
biology to architecture and engineering but all
models essentially simplify reality in order to
enhance our understanding of it.
Positive Versus Normative Analysis
A primary task of economists is to offer
solutions to economic problems. To be able to offer
recipes, economists need to explain the causes of
economic events by answering questions like why,
for example, are rates of youth unemployment
or inflation rates in some countries are so high?
Only after fully understanding the causes of such
economic outcomes, can they recommend policies
to fix those outcomes. What, for instance, should
the government do to improve the economic well-
being of the younger people? When economists
try to understand and explain the workings of an
economy, they must act like scientists. When they
provide support to policymakers to choose policies
that will lead to a “better society” or a “better world”,
they act like policy advisers (or voters).
When an economist says raising the minimum
wage by X percent will cause unemployment to
increase by Y percentage points, she speaks like
a scientist. When someone says the government
should raise the minimum wage to assure that
every working individual will have ‘decent’
standards of living, he speaks like a policy adviser,
activist or voter. Regardless of whether one agrees
with them, these two statements are different in
nature. The first statement is a claim about how the
economy (or labor markets, to be more specific)
works. The second statement, on the other hand,
is a prescriptive statement like the ones expected
Introduction to Economics I

to be made by a policy adviser, and involves normative

judgements. It is a claim about how the person making
Positive statements in economics are state-
it would like to change the world. In general, statements
ments that intend to describe how things are
about the world are of two types. Statements like the first
and how things actually work.
one above are positive statements. These are descriptive
statements, describing how the world is. The second type A normative statement is a prescriptive sta-
of statements, such as the latter of the two above, are tement, like the ones expected to be made
normative statements. These statements are prescriptive, by a policy adviser, involving normative jud-
making a claim about how the world ought to be. A crucial gements and prescriptions about how the
difference between positive and normative statements world should be.
concerns how we judge their validity. It is, in principle,
possible to confirm or refute positive statements based
on available evidence. An economist might analyze data on changes in minimum wages and changes in
unemployment over time. By contrast, validity of normative statements cannot be decided using data
alone. Deciding what is good policy and what is bad also involves ethical judgements, religious or political
views.
Obviously, positive and normative statements may be linked. Our positive views about how the world
works affect our normative views about the desirability of various policies. Availability of empirical support
to the first statement that increasing the minimum wage pushes the unemployment up, might lead to the
rejection of the normative statement that the government should raise the minimum wage. Still, normative
conclusions cannot be based on positive analyses alone. They also require value judgments. While much
of economics just tries to explain how the economy works, the goal of economics is often to improve the
way the economy works. So when economists begin to make normative statements, they start acting as
policy advisers, not scientists.

17
 Basic Concepts, Scope and Methodology of Economics

Understand the meaning of

LO 1 scarcity and resource allocation

Our resources are limited relative to our needs, and this is true not only for individuals but also for
societies. Scarcity refers to society’s inability to produce all the goods and services people desire to
have because of limited resources. Societies therefore must decide on their priorities and manage their
resources accordingly with the priorities they set.
Economics is the study of how individuals and societies choose to use scarce resources at their disposal,
Summary

with the understanding that the needs and desires of individuals are unlimited. Satisfying those needs
and desires requires production of goods and services. All the goods that are not sufficiently abundant
to be available to everyone for free are characterized as scarce. Their scarcity follows from the scarcity
of resources we use to produce them. If scarcity of resources were not a problem, it would be possible
to produce all goods and services in sufficiently large quantities to make them available to everyone for
free. This is not possible because material inputs and factors of production needed to produce goods are
not available in unlimited quantities. The economic problem arises because of this scarcity.
Economics is a discipline studying human behavior as a relationship between ends and scarce means
with alternative uses. Thus, economics could also be defined as the study of how society sets priorities
in managing its scarce resources. In today’s societies, resources are typically allocated through the
interactions among the millions of consumers and tens of thousands of producers. Economics examines
how these actors prioritize their needs in light of the scarcity of resources at their disposal and how their
priorities interact collectively.
Fundamental problems economics addresses are:
What to produce? This question involves the decision on the quantity and range of goods to be
produced. Since resources are limited, we must choose between alternative sets of goods and services to
be produced. That is, we cannot produce and consume all the goods that we want.
How to produce? Once the decision on what to produce has been made, one must decide how these
goods are going to be produced. This question is about choosing the best technique of production from
the set of labor intensive and capital intensive techniques available.
For whom to produce? Because of the scarcity problem, it is impossible to fully satisfy everybody’s
needs and desires. So, this question is essentially about how the national product of a country needs to
be distributed or who should get how much of the output of each commodity.

18
Introduction to Economics I

Learn the concepts of

LO 2 opportunity cost and tradeoffs
that people face

Everyone in the society faces tradeoffs. A student who chooses to prepare for an economics exam on
a certain night may be giving up his chance of watching a championship match on TV, some of his
sleep time, or his chances to prepare for a mathematics exam. Likewise, a household may have to decide
whether to change the car or furniture at home. The government may have to decide whether it should
spend more on education and health services or should choose to increase its military might instead.

Summary
Learn and apply the meaning of
LO 3 thinking at the margin

Thinking at the margin requires recognizing the need to make decisions by evaluating the costs and
benefits of marginal changes. It means that a decision maker should compare the marginal benefit and
the marginal cost of his/her actions. Any action should be undertaken only if the benefit is greater than
the cost. For example, the decision concerning whether to go to a university for an advanced degree or
not must be made by comparing the costs (the fees and foregone wages) with the expected benefit (the
extra income you could earn with the extra year of education).

Learn the effects of incentives on

LO 4 people’s behavior

Rational people respond to positive and negative incentives. An incentive is something that induces
an action or greater effort to produce a desirable outcome or to avoid an undesirable outcome. For
example, a worker who is paid well in the job by the boss exerts more effort. When gasoline prices rise,
consumers buy more hybrid cars and fewer gas guzzling SUVs, and the environmental damage resulting
from gasoline consumption declines.

Distinguish the difference

LO 5 between microeconomics and
macroeconomics

Microeconomics is the branch of economics that examines the decision making behavior of the smallest
decision-making units such as the individuals or households households and the business firms.
Macroeconomics is the branch of economics that examines the aggregate behavior of economic agents
and the government on a national scale. The basic study concerns of macroeconomics include the
structure and the performance of national economies and how the government policies adopted affect
this performance.

19
 Basic Concepts, Scope and Methodology of Economics

Understand why trade makes

LO 6 everyone better off

Just like other voluntary exchanges such as those between individuals, trade between two nations make
(citizens in) each country better off or equivalently, it improves social welfare in both countries. In other
words, international trade is a positive-sum game that is actually carried out typically between the private
firms of the participant countries.
In a sense, nations are like households that want to obtain the highest quality products at the lowest
Summary

possible cost. That would not be possible if a household isolated itself from the other households
around. Doing so would require that the household do everything by itself: grow its own food, make its
own clothes, build its own houses and provide its own transportation. If you compare what your own
household could have achieved under those circumstances to its actual achievements, you can see how
beneficial trade is to the well-being of the trading parties.
Trade, whether it involves agriculture, tailoring, or construction work, allows everybody to specialize in
what they produce with less effort than the others. By exchanging what they produce most efficiently
for what they cannot produce as efficiently people can enjoy larger amounts of a greater variety of goods
and services at lower cost.
Likewise, countries benefit from trade, as it allows them to exchange what they produce most efficiently
for what they cannot produce quite as efficiently. Since this will help put the scarce resources of each
trading country into their best use, citizens of both countries will be able to consume larger amounts of
a greater variety of goods and services at lower cost.

Learn the basics of scientific

LO 7 methodology used in economics

Professional economists view the economy much the same way as natural scientists. They build theories
to explain relevant phenomena, and to make accurate predictions about those phenomena. They then
collect and analyze data to verify or refute their theories about economic phenomena.
Economists employ basically the same scientific method involving the development of theories after
careful observation of relevant behavior and real world phenomena, and putting those theories to test
by using data. Scientific method involves the development of theories after careful observation of
relevant behavior of economic agents and real world phenomena, and then putting those theories to
test by using data.

Define the concepts of market

LO 8 failure and market power

Market failures occur when the market fails to allocate society’s scarce resources efficiently to the best
uses. It occurs because of the existence of externalities and market power to name a few. Externalities
occur when the production or consumption of a good affects bystanders positively or negatively, e.g.
pollution due to the production or second hand smoking due to the consumption of tobacco products.
Market power refers to a situation in any market which take place when a single buyer or seller has
substantial influence on market price (e.g. monopoly).

20
Introduction to Economics I
1 Which of the following definitions refers
to society’s inability to produce all the goods and
services that people desire to have because of
limited amounts of resources available?
A. Equity B. Efficiency
C. Externality D. Utility
E. Scarcity
2 Which of the following statements describes
the production possibilities frontier?
A. Shows the distribution of resources fairly
among members of the society.
B. Shows the various combinations of output
produced with the available production
technology when the firm uses all its scarce
resources efficiently.
C. Shows small incremental adjustments made on
an existing plan of action.
D. Shows the instances market itself falls short of
when allocating resources efficiently.
E. Shows the best and most effective signals
guiding the decisions of producers.
3 The opportunity cost is defined as:
A. The tradeoff between inflation and unemployment
B. How society sets priorities in managing its
scarce resources
C. What a person has to give up to get a desired
item
D. The allocation of resources as achieved by the
invisible hand
E. The ultimate measure of how well a country’s
economy works as a whole
4 What type of statement is the one below?
“The government should raise the minimum wage
to assure that every working individual will have
‘decent’ standards of living.”
A. Normative statement
B. Positive statement
C. Biased statement
D. Realistic statement
E. Negative statement
5 Which of the following concepts explains
the ability of a single actor or actors to control or
substantially influence market prices?
A. Efficiency
Test Yourself
B. Standards of living
C. Inflation
D. Market power
E. Market failure
6 Which of the following is an issue in
microeconomics?
A. High inflation rates
B. Low unemployment rates
C. Increasing Total Debt/GDP ratio
D. The equilibrium in consumer durables market
E. The size of aggregate money stock
7 What is the main reason behind our need to
continuously make choices?
A. Scarcity B. Price
C. Opportunity cost D. Externalities
E. Efficiency
8 What is the best alternative of a decision for
an economist?
A. Externality B. Opportunity cost
C. Utility D. Profit
E. Loss
9 What does production possibilities frontier
implement?
A. The path the economy grows
B. The expected trend of growth rate
C. The limit that an economy could produce
D. The factor quantity of an economy
E. The factor productivity of an economy
10 Which of the following is not based on
marginal thinking?
A. All you can eat restaurants
B. Unlimited night usage on cell phones
C. Discounted rides for senior citizens
D. Discounts in fairs on last days
E. A 200 percent tip
21
 Basic Concepts, Scope and Methodology of Economics

If your answer is wrong, please review

1. E If your answer is wrong, please review the 6. D the “Economywide Outcomes and The
“Scarcity of Resources” section. Difference Between Microeconomics and
Answer Key for “Test Yourself”

Macroeconomics” section.
If your answer is wrong, please review
2. B 7. A If your answer is wrong, please review the
the “Production Possibilities Frontier and
“Tradeoffs and Opportunity Cost” section.
Opportunity Cost” section.

3. C If your answer is wrong, please review the 8. B If your answer is wrong, please review the
“Tradeoffs and Opportunity Cost” section. “Tradeoffs and Opportunity Cost” section.

4. A If your answer is wrong, please review the 9. C If your answer is wrong, please review the
“Positive versus Normative Analysis” section. “Production Possibilities Frontier” section.

5. D If your answer is wrong, please review the 10. E If your answer is wrong, please review the
“Market Failures and Externalities” section. “Thinking at the margin” section.

Suppose that a society wants to produce and

consume at point G in Figure 1.1. Is it possible?
Suggested answers for “Your turn”

If it is, how? If it is not, why not?

Any point on the PPF curve represents the combinations of good X and
good Y that can possibly be produced with the given technology and factors
of production available to society. So, points on the PPF shows the output
combinations that can be produced with full and efficient use of inputs. That
your turn 1 indicates that with the given technology and factors of production available to
society, production of an output combination, like G is impossible. To be able
to reach that point, either the production technology or the amount of factors
of production available to the society has to increase. Either way, the economy
grows, by enabling the society to produce and consume more.

Suppose that you want to buy a brand name t-shirt and your
willingness to pay for that t-shirt is 125 TL. You went to the store
where the t-shirt is sold and found out that the price is just 100
TL. You bought one and wore it right away. Unfortunately, a big
chunk of paint spilled all over the new t-shirt and you cannot
wear it again. The question is whether or not you go to the same
store and buy another t-shirt by paying 100 TL again. Would
you? Why? Why not?

We should make our decisions by thinking at the margin. Rational decision

makers take an action if and only if the marginal benefit of the action is greater
than the marginal cost. Thus, we make decisions based on a comparison of
the marginal benefits and costs of our actions and proceed only when the
expected marginal benefit exceeds the expected marginal cost.
your turn 2
In this example, the person buys the t-shirt since the marginal benefit, which
is equal to the consumer’s willingness to pay is greater than the price the
person pays. So the marginal benefit exceeds the cost. When the t-shirt is
stained, he should buy the second one since the marginal benefit still exceeds
the cost. We make decisions at the margin not at the total or at the average.

22
Introduction to Economics I

Can you list the factors that determine the

productivity level of a country?

Suggested answers for “Your turn”

The primary determinant of productivity is the level of investment in physical
capital (all machinery and equipment used in production), and investment in
your turn 3 human capital (improvement of people’s productive skills through education
and training). Thus, investment is the recipe for increasing economywide
productivity levels.

References
Acemoğlu, D., D. Laibson. and J.A. List (2015).
Economics, Global Edition, Pearson Education, Inc.
Bade, R. and M. Parkin (2015). Foundations
of Microeconomics, 7th US Edition, Pearson
Education Inc..
Case, K.E., and R.C. Fair (2007). Principles of
Microeconomics, 8th edition, Pearson/Prentice Hall.
Case, K.E., R.C. and S. Oster, S., (2012). Principles
of Economics, 10th Edition, Prentice Hall.
Mankiw, N. G. and M.P. Taylor (2011). Economics,
2nd edition, South Western College Publishing.
Mankiw, N. G. (2003). Principles of Economics, 5th
edition, South-Western College Publishing.
McConnel, C. R. and S. L. Brue (2005).
Microeconomics: Principles, Problems and
Policies, 16th edition, McGraw-Hill Companies,
Inc.
Nicholson, W. (1995). Microeconomic Theory: Basic
Principles and Extensions, 6th Edition, Harper
Collins College Publishers.
Parkin, M. (2012). Economics, 10th Edition, Pearson.

23
 How Markets Work? Market
Chapter 2 Forces and Equilibrium
After completing this chapter, you will be able to:

1 Define what a market is according to

2 Differentiate between perfect and imperfect

Learning Outcomes

economic theory competition

3 Explain the Law of Demand

4 Distinguish the shifts in the demand curve
and the movements along the demand curve

5 Explain the Law of Supply

6 Distinguish the shifts in the supply curve and
the movements along the supply curve

7 Define the market equilibrium

8 Explain excess demand and excess supply

Chapter Outline Key Terms

Introduction Market
Market Forces and Competition Excess Demand and Supply
Demand and Demand Curve Competition
Supply and Supply Curve Market Equilibrium
Market Equilibrium: Demand and Supply Monopoly
Changes in Market Equilibrium Technology
Prices and Allocation of Resources Demand
Input Prices
The Law of Demand
The law of supply
Price
Supply
Income
Substitutes and complements
Normal and Inferior goods
Price of related goods

24
Introduction to Economics I
INTRODUCTION
Does your family own their house? Are you a
tenant, do you pay rent? Will you be able to find
a job when you graduate? Will you be able to
buy a car when you have found a job? All these
questions are centrally important for your life
standards. The answers, however, depend not only
on you but also on the workings of the particular
markets in question: the real estate market, the
job market and the car market, respectively.
Consumers (households) and producers (firms) are
the main players in the markets. The households
are the consuming units in a market and also in an
economy. On the production side, the firms are the
organizations that transform inputs into outputs.
Firms are the primary producing units in a market
economy and they are led by entrepreneurs. An
entrepreneur is a person who organizes, manages,
and takes the risks of a firm, by blending the inputs
to transform them into a new product.
The decisions of these actors interact in complex
patterns. However, we simplify these by focusing
on essentially two mechanisms: (1) demand and
(2) supply. In this chapter of your textbook, we will
discuss how interactions between market actors
affect these mechanisms under certain assumptions
and in certain economic environments.
This chapter explains how the market forces
of demand and supply interact to determine
equilibrium prices and equilibrium quantities of
goods and services. We will see how prices and
quantities adjust in response to changes in demand
and supply and how changes in prices in turn serve
as signals to buyers and sellers.
MARKET FORCES AND
COMPETITION
Markets
In economics, a market is where consumers
and producers meet to carry out an economic
transaction. Markets may be physical places
where goods or services are exchanged for money.
The Grand Bazaar in Istanbul or your weekly
neighborhood market can be given examples of
these physical places.
A market is a place where a group of buyers
and sellers of a particular good or service
meet.
But there are other venues for markets as
well. For example, Gittigidiyor or N11 are also
platforms on which such economic transactions
can be made. Online markets where products
are sold with credit cards or money transfers
flourish day by day. Alibaba, one of these firms
headquartered in China provides such a platform
and it is a world giant.
Broadly speaking, there are two types of
markets: Product markets and factor markets. In
the first one, all sorts of goods and services from
cars to movie tickets are bought and sold. The
other one involves factors of production such as
land, labor and capital. When you are offered a
consumer loan, you are in a capital market. When
you try to get a job, you are in a labor market. If
you want to buy a piece of land or house by the
Aegean coast for your retirement, then you are a
participant in the land market or real estate market.
Probably, the most famous markets are stock
markets and foreign exchange markets. In stock
markets such as the Turkey’s BIST (Borsa İstanbul),
shares of companies are bought and sold. In foreign
exchange markets, international currencies are
traded.
Demand and supply are the building blocks of
economic theory. They are essentially forces that
work in such concrete markets as well as in certain
abstract markets that we will discuss in the book.
Markets work as the way they do because of
market competition. Consumers compete to buy
a particular good and producers compete to sell
it. Especially, the behavior of individual producers
strategically depends on other producers’ behavior.
The central information channel in a market is the
price signal. Competition asserts its pressure through
these price signals. Markets can be classified into two
depending on the intensity of competitive forces: In
some markets perfect competition prevails. Others,
are imperfectly competitive. Markets for all goods
and services are scattered on a continuum ranging
from perfectly competitive markets at the one end to
monopolistic markets, the least competitive example
to imperfect competition, at the other end.
25
 How Markets Work? Market Forces and Equilibrium
A competitive market is a type of market
in which there are many buyers and sellers
so that the effect of each one on market
price is negligible.
Perfect Competition
Both the producers and the consumers would
like to know what the price and quantity will be
at a given market in a given time period and space.
In order to simplify and model the interactions in
the market, the economists use an ideal model of a
market. By using the ideal models, economists can
answer the questions of producers and consumers.
The conventional ideal market model represents
perfect competition. This is a hypothetical market
in which:
• The good or service being exchanged is the
same across all sellers; the quality or the
characteristics of it do not change from one
seller to another 

• There is a high number of potential
buyers and sellers of this good; and all act
independently from each other
• Entry of new sellers into the market is not
restricted by any means
• Buyers and sellers readily and freely have
access to information with regards to the
prices at which other buyers and sellers are
exchanging the good. 
 could be offered by a single seller. There are a
The underlying assumptions play critical roles
in the analysis of perfectly competitive markets.
Homogeneity of products is assumed to make sure
that consumers cannot differentiate the products
produced by different firms so that all sellers charge
the same price in the market. Large number of
producers and consumers guarantee that no single
consumer or producer has the power to alter the
market price individually. Information is freely
available so that consumers and producers can
instantly change their behavior -if doing so will
improve their welfare.
26
1
Did you buy anything yesterday?
Did you check whether you paid
the lowest price possible? Were
there many sellers and buyers for
the good you bought? Do you
think that market is perfectly
competitive?
Imperfect Competition
Most of the markets are imperfectly competitive.
The extreme cases of imperfect competition are
monopoly and monopsony. Monopoly is a market
where there is only one seller.
A monopoly is a market where there is
only one seller of the product and this
seller sets the price alone.
The Türk Telekom, for example, is a monopoly
in internet infrastructure. All the other internet
providers have to use Telekom’s infrastructure.
Likewise, TCDDY is a state owned monopoly
in railway transportation. There are also local
monopolies. Many cities in Turkey are served by
a single airline (typically THY subsidiary Anadolu
Jet). In smaller towns, many goods and services
few worldwide monopolies as well: SpaceX, for
example, is the only company selling touristic trips
to the space. The pricing behavior of a monopoly
is totally different than the behavior of firms
operating in a competitive market.
Monopsonist markets are the ones in which
there exist only one buyer and many sellers. The
relatively high agricultural prices in Turkey might
be attributed to near monopsonist local markets
where there are only a few merchants buying the
farmers’ products. For example, larger milk and
dairy product firms generally act as monopsonist
buying wholesale milk from cow owners in many
towns around Turkey.
Introduction to Economics I
2 individuals are willing and able to buy at each of
In which type of market,
monopolistic or competitive
market, is the equilibrium
market price lower? Why?
DEMAND AND DEMAND CURVE
Demand is the quantity of a good or service
that consumers are willing and able to purchase
at a given price in a given time period at any
given market. The important terms here are
the “willingness and ability” of buyers. It is not
sufficient for potential buyers to be willing to
purchase a good or a service, they must also be
able to purchase it. That is, they must have the
financial means to buy the product. This is known
as the ability to buy. For example, you may wish
to buy a Ferrari, but as long as it is beyond reach
with your budget, your desire does not count as
demand. This is known as effective demand and it
is what we show on a demand curve.
Suppose that as an individual you went to a
market and you want to buy a good. Which factors
affect or determine the quantity of the good you
purchase for a specific time period, say, for a week?
An individual’s or a household’s decision about the
quantity of a particular good to demand depends
on many factors including: the price of the good
in question, the current income and accumulated
wealth available to the individual or the household,
the prices of related goods, the tastes and preferences
of the individual, and the individual’s expectations
about the future income, wealth, and prices.
A demand curve or a demand schedule for a
good or service is a plot on the quantity-price (Q-
P) plane. A demand schedule is a table showing
how much of a given product an individual or a
household would be willing to buy at different
prices. Demand curves are usually derived from
the given information of demand schedules. On a
demand schedule, there is information about the
price and quantities demanded at each different
price. The quantity demanded is the amount of a
good that an individual or a household would buy
in a given time period at the current market price.
It maps alternative price levels to different
quantities that an individual or a group of
those price levels, when income level and other
factors affecting demand are held constant. In
other words, a demand curve shows how much
more of a product an individual is willing to buy
when its price falls in the absence of a change in
that individual’s income, tastes, etc.
A demand curve is a graph that illustrates
how much of a specific good an individual
or household would be willing to buy at
different prices.
A demand schedule is a table that shows
the relationship between the price and
quantity demanded of a product.
If we had unlimited resources, or if things
we wanted to have were free of charge, then the
demand as a concept would be meaningless. We
would then get as much goods as we desired
without really having to consider their prices, or
our budget. In other words, we would not have to
face any tradeoffs. The reality of scarcity underlines
the logic and the significance of demand. Demand
curves are downward sloping to reflect the negative
relationship between the price and quantity
demanded. Moreover, they are normally convex
to the origin. However, economists usually draw
them as straight lines. It is ironic that these lines
are still called curves, but we will follow the same
convention and call them demand curves whether
they are really curves or are lines.
3
If the demand curve were
positively sloped, what would it
indicate?
The Law of Demand
Economists often use the term “law” to refer to
frequently observed regularities. This particular law
simply indicates that when the price of a product
falls, under the assumption of ceteris paribus, the
quantity demanded of the product will usually
27
 How Markets Work? Market Forces and Equilibrium

increase. The law of demand states that there is a

negative, or inverse, relationship between the price
of a good and the quantity of that good demanded.
This inverse relationship indicates that the demand
curves slope downward.

The law of demand states that, other things

equal, when the price of a good rises, the
quantity demanded of that good falls.

The Latin term ceteris paribus describes an

assumption which allows for a change in only one
variable at a time. In other words, when there is
a number of different factors that determine an
outcome, we assume that only one can change and Picture 2.1
all the others are held constant. Thus, in this case,
the price is changing while the other determinants
of demand are assumed to be unchanging.
Let us illustrate the Law of Demand by an example.
Table 2.1 illustrates the different quantities of meatballs
Ceteris Paribus is a Latin phrase, which demanded at each price by the students dining at a
means “other things being equal.” It is used university cafeteria. Depending on the price of meatballs
in economics to state that all variables other per plate the following schedule illustrates the quantities
than the one studied are assumed to be demanded by the students who are willing and able to pay
constant or fixed. to enjoy meatballs.

Table 2.1 Demand Schedule for Meatballs

Quantity Demanded
Price of Meatballs per plate
(Number of plates ordered)

35 TL 100

20 TL 200

10 TL 300

5 TL 500

The same information can be also represented by a demand curve. In Figure 2.1 we have the demand
curve for meatballs as presented. A change in the price of the product itself will lead to a change in the
quantity demanded of the product, as represented by a movement along the existing demand curve.
The phrase “change in the quantity demanded” is important since it differentiates the change in price
from the effect of a change in any of the other determinants of demand. In Figure 2.1, a change in the
price of meatballs from 20 TL to 10 TL leads to an increase in the quantity demanded of the meatballs
from 200 plates to 300 plates.

28
Introduction to Economics I

40

35

30
Price of Meatballs (TL)
25

20

15

10

5
0
0 100 200 300 400 500 600
Quantity (Plates of Meatballs)
Figure 2.1 Demand Curve for Meatballs

The quantity demanded is the amount of
good that the buyers are willing and able
to buy.
Market Demand Versus Individual
Demand
The individual demand is derived from the
solution of a personal utility maximization
problem -which will be discussed in more advanced
economics courses. Utility that the individual
obtains from each additional or marginal unit
consumed of a good declines, as more and more of
that good is consumed. The consumer is said to be
satiated after consuming a large enough quantity.
Before the point of satiation, the individual tries to
equate the marginal utility for every TL spent on
each good in her consumption basket. That way,
she makes sure that each TL she spends will give her
equal satisfaction at the margin. This provides the
maximum total utility to the consumer indeed: If
the last unit of a good X in the consumption basket
provided more marginal utility MUx per lira than
the other goods, the consumer would obviously
want to consume more of that good. But then,
MUx MU
MUx would fall equating to for
Px Pi
all other goods indexed by i. Adding the individual
demand curves horizontally, the market demand
curve can be derived. In other words, the market
demand curve shows the sum of the quantities that
each consumer would be willing to consume at any
given price, for all conceivable prices.
Market demand is the sum of all the
quantities of a product demanded per
period by all the buyers in the market.
Assume that the market in question consists of
three individuals. Let’s call them A, B and C. Each
individual has a distinct individual demand curve
for a particular product, say, for tea. Figure 2.2
shows the demand curves for individuals A, B and
C. The demand curves for each individual shows
that there is a negative relationship between the
price of a cup of tea and the quantity demanded of
the tea. Even though the relationship is negative,
the quantities at the same price range for each
individual is different. The difference results from
the variables found in the individual characteristics
such as the income level as well as the tastes and
preferences towards tea.

29
 How Markets Work? Market Forces and Equilibrium

A’s Individual Demand Curve for Tea B’s Individual Demand Curve for Tea
6 6

5 5
Price of tea (TL)

Price of tea (TL)

4 4

3 3

2 2
1 1
0 0
0 5 10 15 0 5 10
Cups of Tea Cups of Tea

C’s Individual Demand Curve for Tea

6
The Market Demand Curve for Tea
5 6
Price of tea (TL)

5
4 Price of Tea (TL)

4
3
3
2
2
1
1
0 0
0 2 4 6 0 5 10 15 20 25
Cups of Tea Cups of Tea

Figure 2.2 Derivation of Market Demand Curve for Tea

Consider the case in which the price of tea PT is Income Effect: When the price of a product, say,
3 TL per cup. Individual A’s quantity demanded is product Y, falls, people consuming the product will
5 cups, individual B’s quantity demanded is 6 cups, experience an increase in their purchasing power or
and individual C’s quantity demanded is 3 cups. “real income,” which reflects the amount of diffe-
Summing up all the quantities demanded at the rent products that they can buy with their incomes.
price of 3 TL, we arrive at the quantity demanded With this increase in real income, the people will
(14 cups) for PT = 3 TL in the market. Replicating be able to buy more of product Y whose price has
the procedure for all prices, we derive the market declined, or more of the other products. Please no-
demand curve for the market. The market demand tice that they will be left with more money in their
is the sum of individual demands. The market pockets, if they continue to buy the same amount of
demand curve is found by adding horizontally product Y after the price of good Y, (Py) goes down.
the individual demand curves at all prices. This is
illustared by the market demand curve for tea in Substitution effect: When the price of product
Figure 2.2. MUy MU
Y, (Py) falls, ratio will go up, exceeding
Py P
ratio of all other products in the consumption
Determinants of Demand basket. This will make product Y relatively more
The nature, the slope and the position of the attractive than other products, whose prices have
demand curve are determined by different factors. stayed unchanged. As a result, consumers will
The slope and the curvature of the demand curve
want to purchase more Y, while lowering the
are the consequences of consumer responses to the
changes in prices under ceteris paribus conditions. consumption of some of the other products until
There are two channels in which these responses are MU
they equate ratios of all products once
shaped: Income effect and substitution effect. P
again. The positioning of the demand curve on
the Quantity-Price plane is influenced by non-

30
Introduction to Economics I
price factors such tastes and preferences, income,
prices of related goods, population, seasons and
expectations.
Changes or Shifts in Demand Curve
Tastes and Preferences
As some of you might remember, Nokia cellular
phones were once very popular in Turkey. Almost
everybody had one back then, but currently only
few people have a Nokia. The company went
bankrupt. However, no one would be interested
in buying a Nokia even if it survived. Apple and
Samsung have become the popular suppliers of
cell phones today. Tastes and preferences of the
consumers had totally changed when smartphones
began to dominate the cellular phone market in
the mid-2000s. That shifted down the demand
curve for Nokia in the Turkish market, implying
that Turkish consumers would be willing to buy
fewer Nokias at every conceivable price.
Consider another example. Once an exotic
fruit, avocados have become widespread in
the fruit stalls in Turkey in recent years. (See
http://www.haberturk.com/ekonomi/is-yasam/
haber/1486545-avakadoya-talep-patladi).As many
more consumers prefer avocados, demand curve
for avocados shifts to the right. That is, consumers
are now willing to buy more avocados at every
conceivable price. For any given amount of supply,
the outcome of this increase in demand will be
higher prices at equilibrium, ceteris-paribus. The
shift in consumer preferences toward avocados
translates into higher market prices which, in
turn, provide incentives for new sellers to enter the
market. This will eventually lead to an increase the
quantity supplied as well.
Income
If income of the society increases for whatever
reason, the demand for most products also go up.
When a change in income affects the demand for a
good positively or in the same direction, that good
is called a normal good. The exceptions are called
inferior goods.
Normal Goods
For most products, an increase in income leads
to an increase in demand. Such goods and services
are known as normal goods. As income rises, the
demand curve for a normal good will shift up to
the right. The exact size of the shift in demand
will depend upon the good itself. An increase in
income may cause a small shift to the right in the
demand curve for salt, but a larger increase in the
demand for cinema tickets.
Normal goods are the goods for which
the demand increases when income is
higher and decreases when income is
lower.
The demand curve for air travel is shown in
Figure 2.3. In this case, an increase in income
shifts the demand curve for air travel to the right,
so more air travel is demanded at every price.
Price (TL)
D1
D0
Number of Airline Tickets Sold
Figure 2.3 Demand for Air Travel
Inferior Goods
A product is said to be inferior if the demand
for that product goes down when the income of the
consumers increases. Consumers prefer to buy higher
priced substitutes in place of the inferior goods when
their income rises. Examples of inferior goods may
be ordinary (white) bread, cheap cheese (“lor”) or
fake brand (imitation) jeans. If
income increases, the
demand curve for the inferior good will shift down
to the
left. When income reaches a certain level, the
consumer buys only the higher quality goods and the
demand for the inferior
good will become zero.
31
 How Markets Work? Market Forces and Equilibrium
Inferior goods are the goods for which the
demand falls when the income goes up.
Prices of Related Goods
All or most of your consumption decisions
involve tradeoffs and require making choices among
different products. Changes in the prices of certain
products definitely influence your purchasing
decisions about other products. If meatballs get
very expensive, then you will probably switch to
pizza, as pizzas are substitutes for meatballs. If prices
of CDs/DVDs increase sharply, the demand for
CD/DVD players is expected to decline, as CDs/
DVDs and players are complements.
4
As the diesel prices have almost
caught up the gasoline prices,
the market for diesel cars has
responded. What do you expect?
The Substitute Goods
If two products are substitutes for each other,
a change in the price of one product will change
the demand for the other product in the opposite
direction. For example, if the price of chicken goes
down, the demand for beef will shift down to the
left. As chicken is a substitute product for beef, a fall
in the price of chicken will increase the consumption
of chicken and the quantity demanded in the beef
market will fall for all possible levels of price.
Substitute goods serve as replacements for
one another. When the price of one rises,
the demand for the other increases.
The Complementary Goods
Two goods are said to be complements if they are
generally or necessarily consumed together, such as
tea and sugar cubes or printers and ink cartridges.
32
If products are complements to each other, then a
rise in the price of one of the products will decrease
the demand for the other product. For example, if
there is a fall in the price of tea then the demand
for sugar cubes will go up. In other words, demand
curve for sugar will shift to the right.
Complements are the goods that go toget-
her. A decrease in the price of one causes
an increase in the demand for the other.
Expectations
If consumers expect that the price of a certain
good will go up in the near future, their current
demand curve shifts upwards as they rush to
purchase that good before it gets expensive.
Number of Buyers
Turkey has experienced a large wave of internal
migration during the last couple of decades.
Therefore, urbanization rate increased. More people
live in urban areas now. These people demanded
housing services and the demand for apartments in
urban areas shifted upwards.
In the past, most families in Turkey preferred
bigger houses (i.e., 3 + 1 bedrooms) as people used
to live in traditional, extended families. As the
nuclear family became more dominant than the
traditional type, the demand for smaller houses
surpassed the demand for bigger houses. The rise
in prices of 2 + 1 and 1 + 1 houses exceeded the
rise in the prices of bigger houses, as more people
demanded them. The Figure 2.4 shows the effect
of the change in the number of buyers in Turkey.
In the figure, the demand curve D0, is the initial
market demand curve for housing in Turkey.
With the increase of the number of buyers due to
migration from rural areas to cities and increase in
population, the market demand curve shifts to the
right and becomes D1. The Shift of the demand
curve to the right indicates an increase in demand.
Introduction to Economics I
House Price (TL)
D1
D0
Number of Houses
Figure 2.4 Demand for Housing in Turkey
Changes in Demand Versus Changes
in Quantity Demanded
The foregoing discussion showed that sometimes
there are movements along an existing demand
curve and sometimes the demand curve actually
shifts to the left or to the right. Distinguishing
one from the other is very simple. A change in
demand is not the same as a change in the quantity
demanded. A change in the price of a good causes
a change in the quantity demanded. For example, a
higher price causes a lower quantity demanded for
the good considered. On the other hand, change in
demand or a shift of demand occurs when there is a
change in the determinants of demand, other than
the price. Changes in the determinants of demand,
other than price cause a change in demand, or a
shift of the entire demand curve from, say, D0 to
D1, as it is seen in figure 2.2.
A change in the price of the good itself leads to
a movement along the existing demand curve since
the price of the good is on one of the axes, typically,
the vertical X axis. A change in any of the other
determinants of demand will always lead to a shift
of the demand curve to either the left or the right.
A movement along the demand curve
occurs when the price of the good changes.
Because a change in price causes quantity
demanded to change in opposite direction.
A change or shift of a demand curve
occurs when the other factors, other than
the price, such as the income changes,
happens. Any change that increases the
quantity that buyers wish to buy at a given
price causes a shift of the demand curve
to the right.
When demand increases, the demand curve
shifts to the right. This shift causes the quantity
demanded to be greater than it was prior to the
shift, for each and every price level. In contrast,
when demand decreases, the demand curve shifts
to the left causing the quantity demanded to be
smaller than it was prior to the shift, for each and
every price level.
SUPPLY AND SUPPLY CURVE
Supply is the willingness and the ability of
producers to produce a quantity of a good or a
service at a given price in a given time period. For
example, a restaurant may produce 300 plates of
meatballs per week, at a price of 10 TL per plate.
We would say that their supply of meatballs at a
price of 10 TL would be 300 plates each week.
Just as the case with demand, the important
phrase here is “willingness and ability.” It is not
enough for producers to be willing to produce
a good or a service; they must also be able to
produce it, i.e. they must have the ability to supply
a product as well as the technical and financial
means to supply that product. This is known as
the effective supply and this is what is shown on a
supply curve. For example, Turkish firms say that
they are willing to supply an all-Turkish car but
it seems that they lack the ability to supply such
a product.
Supply Curve
For a perfectly competitive firm, the curvature
and the slope of the supply curve follow the
marginal cost (MC) curve of the producers. By
marginal cost, we mean the additional cost that
the producers have to incur when they increase
the production of a certain product by one unit.
Marginal cost tends to increase as production
33
 How Markets Work? Market Forces and Equilibrium

increases. In other words, each additional unit the quantity supplied. When the input prices rise,
produced will cost more to the firm to produce the cost of production rises and leads to a decrease in
than the previous unit. If the MC of the last unit to supply. Improvements in the production technology
be produced will be higher than the price it can be lead to an increase in the supply of goods by causing
sold for, the rational thing to do would obviously the cost of production per unit to decrease.
be not to produce that last unit. If the MC of
producing the last unit is lower than the market
price, then the firm would increase its profits by
producing the additional units of the product. This Profit is the difference between the total
should continue until the MC catches the market revenue and total cost.
price. In other words, a perfectly competitive firm
stops increasing the production when the MC gets
equal to price. If there is a sudden ceteris paribus Quantity Supplied
increase in the market price of the product when The quantities that the producers are willing
the firm is producing just as much, the MC of and able to supply at every given prices are called
the last unit falls below this new price. Then, it quantity supplied. The quantity supplied represents
will be meaningful and profitable for the firm to the number of units of a good that a firm would be
increase the production in response to the rise in willing and able to offer for sale at a particular price
the market price, until the MC of additional units during a given period of time. In a supply curve,
produced becomes equal to the (higher) market all quantities corresponding to different price levels
price again. This is the underlying reason behind make up the set of quantities supplied.
the producer’s incentive to increase the quantity
supplied as the price increases. The Law of Supply
The Law of Supply states that, under the
A supply curve is a graph which illustrates
assumption of ceteris paribus, an increase in the price
of a product leads to an increase in the quantity
how much of a good a firm is willing to
supplied. In other words, The law of supply states
sell at different prices.
that there exists a positive relationship between the
price and the quantity supplied of a good, implying
that the supply curves normally slope upwards.
Determinants of Supply
Producers of goods and services are in the business
to make profits. They have to take into account
their unit cost as well as the price at which they can
sell. They try to maximize their profits given the
technological and market demand constraints. Their
supply curve depends on not only the market price
but also all the factors affecting the costs, technology
and the market demand constraints. For example, if
corporate tax rates are increased ceteris paribus, the
Picture 2.2
profits will go down. Thus, the supply curves will
shift to the left. The factors that affect or determine
the amount of good supplied in a given period of The law of supply refers the fact that there
time by the producers/sellers are the price of the exist a positive relationship between the price
good, the cost of producing the good, which in turn and the quantity supplied of a particular
depends on the price of required inputs and the good. It indicates that when the price of a
technologies that can be used to produce the good, good goes up, the sellers’ quantity supplied
expectations and the prices of related products. There also goes up, and vice-versa.
exists a positive relationship between the price and

34
 Introduction to Economics I

Again think about the restaurants across the city you live in. Depending on the level of the price that
they can charge for each plate of meatballs, they will decide how many plates they will be serving or the
quantity supplied at that price. Figure 2.5 shows the supply curve for meatballs, which indicates that as
the price goes up, the quantity of meatballs plates also goes up.

25
Price of Meatballs (TL)
20

15

10

0
0 100 200 300 400 500 600
Quantity (Plates of Meatballs)

Figure 2.5 Supply of Meatballs

Market Supply Versus Individual Firm’s Supply

The market supply curve is a horizontal aggregation of the individual supply curves. Let’s say there are
three (3) restaurants that serve meatballs in a city and each has a different supply curve. At every price
level, the market aggregates the quantity supplied and arrives at the market supply curve. Figure 2.6 shows
the derivation of the Market Supply Curve for meatballs in a town by horizontally adding the quantity
supplied at each price.

Supply Curve of Restaurant A Supply Curve of Restaurant B

35 35
30 30
25
25
Price

20
Price

15 20
10 15
5
10
0
0 10 20 30 40 50 5
Quantity 0
0 5 10 15 20 25 30 35
Quantity

Supply Curve of Restaurant C Market Supply of Meatballs

35 35
30 30
25 25
20 20
Price

Price

15 15
10 10
5 5
0 0
0 10 20 30 40 0 20 40 60 80 100 120
Quantity Quantity

Figure 2.6 Derivation of the Market Supply Curve

35
 How Markets Work? Market Forces and Equilibrium
As you may notice, individual supply curves start
at a positive point on the y-axis. This is generally
considered to be the reservation price. At that price
level and below, producers can at best cover their
opportunity costs and they will not be willing to
supply a positive quantity. Only when the market
price exceeds their respective reservation prices,
will the firms be able to start supplying increasingly
more as prices go up.
Shifts in Supply Curve
There are a number of non-price factors that
determine supply and that lead to an actual shift of the
supply curve to either the right or the left. Whenever
we look at a change in one of the determinants, we
always make the ceteris paribus assumption. If we do
not, then the analysis becomes too complicated and
it will be almost impossible to identify the effect of
a change on any one of the determinants. Some of
these determinants are listed below.
Input Prices
Producers maximize profits. Profits are influenced
by prices and costs. The main deriving factor for the
costs is the input prices. When the input prices are
changed, the profits of the producers also change in
the opposite direction, ceteris paribus. If there is an
increase in the cost of an input, such
as the price of
cotton used as an input by a firm producing textiles,
then this will increase the firm’s costs. This, ceteris
paribus, implies a reduction in the firm’s profits.
Then, the firm will no longer be willing to supply
the product in the same amount as before. At every
possible price, it will supply less, shifting the supply
curve up to the left, as illustrated in Figure 2.7, by
the shift of the supply curve from S0 to S1.
Prise of T-shirts
S1
S0
Quantity of T-shirts
Figure 2.7 Shift in the Supply Curve for T-shirts
36
The effects of rising energy costs, for example,
will also be similar. (Since energy is used as an input
in all production processes, the supply curves of all
products will be affected by an increase in the cost
of electricity per kWh.
Technology
An improvement in production technology
enables the producer to produce more products
with the same level of inputs. Conversely, a better
technology means using less of inputs in producing
the same level of quantity. Either way, at all price
levels quantity supplied will go up, hence the
supply curve will shift down to the right.
Technology tends to improve across time in
almost all economies but natural disasters or large-
scale wars can cut access to critical inputs or destroy
current technology, thereby forcing firms to adopt
less efficient techniques. In such a case, there will
be leftward shifts in supply curves.
Expectations
Producers and sellers look out for current prices.
But they also make estimates of future prices based
on their expectations. Producers who expect the
demand for their product to rise in the future may
assume that the higher demand will lead to a higher
price. In order to enjoy higher prices in the future,
they may choose to use input stocks later and cut,
instead, the quantity supplied at every price level
now, thus shifting the supply curve to the left.
In general, the expectations and confidence
of the producers with regards to market booms
or busts in the future may influence their current
production decisions.
Number of Sellers
The number of sellers also
determines the quantity supplied at given market
prices. If new entrants increase the number of
sellers for every price level, the total quantity
supplied will be higher, thus the supply curve will
shift to the right.
Introduction to Economics I

MARKET EQUILIBRIUM: DEMAND

AND SUPPLY
5 As they say, it takes two to tango. So, the
What will happen to the market demand and supply aspects of the markets
price/s of a product when a should meet in order to determine the prices and
country liberalizes its international quantities at market equilibrium. Note that in real
trade and allows the producers of life, it’s the people who meet at the markets, not
imported products to compete the curves. People agree or disagree on the prices.
with the domestic firms? Sometimes they bargain. In theory, economists use
the abstract and simplified representations of the
Changes in Supply Curve Versus bargaining process via the meeting of the demand
Changes in Quantity Supplied and the supply curves in a given market.
As in the case of demand, there appear
sometimes movements along and sometimes shifts Equilibrium
in the supply curve. A change in supply is not the
same as a change in the quantity supplied. Changes The concept of equilibrium is central in
in price causes a change in the quantity supplied. economics. Equilibrium may be defined as a state of
For example, a higher price causes the quantity rest: It’s a state which will not be disturbed by itself
supplied to increase, which, in turn, indicates a unless there is an external intervention or shock.
movement along the supply curve. On the other A sleigh can be said to be in equilibrium if it is
hand, changes in the determinants of supply, other standing still on a flat area on top of a snow covered
than the price of the good, cause an increase in hill. If someone pushes it down the hill, then it will
supply, or a shift of the entire supply curve to the be in a disequilibrium state until it reaches a flat
right or left. area at the base of the hill. When it stops there, it is
said to have reached a new equilibrium.
When supply increases, the supply curve
shifts to the right. This shift causes the quantity
supplied to be greater than before, for each and
every price level. When supply decreases, the
supply curve shifts to the left causing the quantity
supplied to be smaller than before for each and
every price level.
Distinguishing between the change in supply
and the change in the quantity supplied is very
easy. A change in any of the determinants of supply
other than the price will always lead to a shift of
the supply curve to either the left or the right. For
example, an increase in the cost of the rent of the
office space used by a law firm will have the effect
of shifting the supply curve to the left. Thus, the
lawyers at the firm will be asking for higher fees for
any given number of cases.
Picture 2.3

6
The price of green plums generally decline from
Equilibrium is a situation in which the
May to June in your local neighborhood bazaars as
supply and demand equals to each other.
the sellers supply greater amounts in each week. Is
this a case of movement along the supply curve or a
shift in the supply curve? Explain why.

37
 How Markets Work? Market Forces and Equilibrium
Economists evaluate changes in equilibria. They
study forces or factors which cause the changes
triggering the movements out of equilibria and
they compare various equilibria. The relevant
knowledge of these factors is used to predict the
changes in equilibrium states, and exactly where
the new equilibrium will be reached. These
predictions are really important as they can be the
basis of economic policies.
Markets in Equilibrium
By market equilibrium, economists think of the
price level at which demand and supply curves meet.
At that price level the quantity demanded will be equal
to the quantity supplied. Figure 2.8 shows how a
market reaches equilibrium. In the figure, the market
supply curve is positively sloped and the demand
curve is negatively sloped. The curves intersect at
point E, at the price of 20 TL. At this price, the
quantity demanded of meatballs, (QD=200 Plates)
and the quantity supplied of meatballs, (QS=200
Plates) are equal to each other. The equilibrium in
any market requires the equality of QD and QS. Any
price above or below 20 TL, will create a situation of
either excess supply or excess demand.
Price (TL)
Supply
20 TL E
Demand
200 Plates Quantity of Meatballs
Figure 2.8 Equilibrium in the Meatball market
In a competitive market, equilibrium prices and
quantities characterize the so called Pareto-efficient
matching which represents the best outcome for both
buyers and sellers under the relevant constraints
they face. It is the best outcome in the sense of
maximizing the welfare of both the consumer and
the producer under given conditions.
38
Markets Not in Equilibrium
Assume that the market equilibrium price of
meat is 40 TL per kg in Turkey. What happens if
the government imposes a price ceiling of 32 TL
per kg? Obviously, the market would deviate from
equilibrium.
internet
http://www.hurriyetdailynews.com/ministry-
to-impose-price-ceiling-to-control-turkeys-
rising-meat-prices-.aspx?pageID=238&nID=
95023&NewsCatID=345
At the ceiling price of 32 TL, there will be
excess demand. Figure 2.9 shows the effect of
a price ceiling policy. At this price, the quantity
demanded of meat is greater than the quantity
supplied, so there is excess demand for meat. Some
of the buyers will not be able to buy meat, as the
quantity supplied will be lower than what it has
been at market equilibrium. Both the sellers and
buyers will be worse off.
Price (TL)
Supply
Price
40 TL E ceiling
32 TL
Excess
Demand
Demand
Quantity of Meatballs (Kg)
Figure 2.9 The effect of Price Ceiling on the Meat
Market Equilibrium
Sometimes the intervention appears in the form
of a minimum price set by the government such as
the introduction of a minimum wage legislation.
Once a minimum wage is set by law, employers are
forced to pay that wage, even if the equilibrium
wage is lower than that (just as in the Turkish labor
market). In this case, there will be excess supply of
Introduction to Economics I
the good or service whose equilibrium price is lower
than the minimum price set. Figure 2.10 illustrates
the effect of minimum wage legislation on the
labor market if the minimum wage is binding.
Minumum
Wage (TL) Wage
Excess
Supply Supply
1500 TL
1200 TL E supply. Figure 2.11 illustrates the change in market
Demand
Number of Workers
Figure 2.10 The effect of Minimum Wage Laws on the
Labor Market
CHANGES IN MARKET
EQUILIBRIUM
All equilibrium points are transitory. At a given
time interval, the quantity demanded may match
with the quantity supplied but both demand and
supply (and hence the relevant) curves could easily
change due to the changes in underlying factors
and conditions in the next period. Indeed, there
are many factors that cause shifts in the demand
or supply curves. All such shifts will disturb the
existing equilibrium and move the market to a new
equilibrium.
Changes in Demand
As we know, the equilibrium may be moved by
any “outside disturbance”. In the case of demand
and supply, this would be a change in one of the
determinants of demand or supply, other than the
price of the product, which would lead to a shift of
either one of the curves.
Consider the effects of an increase in the income
of the consumers on the demand for vacations
abroad. Vacationing abroad is a “normal good”:
When income increases, ceteris paribus, there will be
an increase in their demand and the demand
curve
for vacations abroad will shift to the right.
When the demand curve shifts to the right,
an excess demand arises at the initial price. As
consumers who fail to book vacations at that price
begin offering higher prices to be able to go on a
vacation, the market price increases along the new
demand curve. This process will continue until
the excess demand gets eliminated. Only then, the
price will have increased just enough to make the
quantity demanded equal to the quantity supplied
once again. There, the market will reach the new
equilibrium characterized by a new price and
a new quantity representing both demand and
equilibrium when the demand shifts. The figure
shows that the market is initially in equilibrium
at point E with the equilibrium price of P0 and
equilibrium quantity of Q0. When the demand
increases, say, as a result of an income increase,
the demand curve shifts to the right and a new
equilibrium is established in the intersection of the
new demand curve and supply curve at point F.
So the change in demand causes both the
equilibrium price and the equilibrium quantity
to increase. The new equilibrium price and
equilibrium quantity will be P1 and Q1, respectively.
Whenever there is a shift of the demand or
supply curves, the market will, if left to act alone,
adjust to a new equilibrium or market-clearing
price.
Price
S1
P1 F
P0
E
D1
D0
Q0 Q1 Quantity
Figure 2.11 Changes in market equilibrium when the
demand shifts.
Changes in Supply
Information technologies enable more effective
coordination of taxi services. Companies like Uber
and Lift emerged as big players in taxi markets
of many cities around the world. Adoption of
39
 How Markets Work? Market Forces and Equilibrium

such technologies will shift the supply curve for
taxi services down to the right. Keeping demand
curve constant, the entrance of new suppliers,
ceteris paribus, will give rise to an excess supply at
the going price. As taxi companies face difficulty
finding cab riders (customers), they will be forced
to cut down prices along the new supply curve.
Eventually, buyers and sellers meet at the new
market equilibrium at which quantity demanded
matches the quantity supplied again. At this
new equilibrium, the price will be lower and the
quantity will be higher.
Price
Shifts in Both Supply and Demand
So far we have evaluated each shift in demand
or supply curves in isolation. What will happen to
the equilibrium market price and quantity if both
curves shift? Since each curve can shift either to
the right or to the left, there exist four different
combinations of simultaneous shifts. The effects
of these shifts on the prices and quantities at new
market equilibrium points may be determinate or
indeterminate as shown in the table below.
Price

S0
S1
S1
F S0
P1

P0 E

P1 E
F P0
D1

D0 D0

Q0 Q1 Quantity
Q0 Q1 Quantity
Figure 2.13 Shifts of supply and demand
Figure 2.12 Changes in market equilibrium when the
simultaneously
supply shifts.

The Figure 2.12 above shows the changes in Price

market equilibrium when the supply changes. S1

Adoption of new technologies will increase the

supply, causing a shift of the supply curve for
S0
taxi services down to the right from S0 to S1. The
figure 2.12 shows that the market is initially in P1 F
equilibrium at point E with the equilibrium price
of P0 and equilibrium quantity of Q0. When the
supply increases, the supply curve shifts to the
P0 E
right and a new equilibrium is established in the
D1
intersection of new supply curve (S1) and demand
D0
curve (D0) at point F.

Q1 Q0 Quantity
7
Figure 2.14 Shifts of supply and demand
What will happen to the taxi simultaneously
market if the government
imposes a surcharge to allow for
entrance to the city center, as is
the case in London?

40
Introduction to Economics I

Table 2.2 Simultaneous Shifts in Demand and Supply

Supply Shifts to the

LEFT RIGHT
Equilibrium Price: Equilibrium Price:
Lower/Higher? UNCERTAIN Lower/Higher? LOWER
LEFT
Equilibrium Quantity: Equilibrium Quantity:
Lower/Higher? LOWER Lower/Higher? UNCERTAIN
Demand curve shifts to the
Equilibrium Price: Equilibrium Price:
Lower/Higher? HIGHER Lower/Higher? UNCERTAIN
RIGHT
Equilibrium Quantity: Equilibrium Quantity:
Lower/Higher? UNCERTAIN Lower/Higher? HIGHER

Figures 2.13 and 2.14 illustrate the changes
in market equilibrium when both the supply and
demand change simultaneously. The effect of
the shifts of both the supply and demand curves
simultaneously on the market equilibrium price
and quantity is explained in table 2.2. For each
case, you should check the relative shifts of the
demand and supply curves to figure out the effects
on prices and quantities.
8 behavior is not to increase the well-being of the
In Ramadan the demand and
supply of dates (hurma) increase
seasonally. What will happen
to the equilibrium price and
quantity?
PRICES AND ALLOCATION OF
RESOURCES
We have seen how supply and demand, as
key components of the “price mechanism”, lead
markets to equilibrium. It is critical to understand
how this price mechanism manages to allocate
scarce resources. Scarce resources are allocated
efficiently as market prices adjust to various changes
which affect demand and/or supply. Since changes
in demand and supply affect relative scarcity of
resources, prices respond accordingly. If there is an
increase in the price of a good, say, due to a switch
in buyers’ preferences or tastes towards the good,
then this signals to producers that consumers wish
to buy this good at greater amounts. As producers
are rational and wish to maximize their profits, a
higher price will give producers an incentive to
produce more of a good. Therefore, producers will
allocate more resources towards the production of
those goods whose demand increases. It must be
noted that the true motivation behind producers’
consumers or to make them happy. They increase
production demanded more by consumers to
increase profits.
The crucial point is that there is no need for a
central coordinating agency, i.e. a government, to
instruct producers to produce more of the good.
The rise in prices serves as a signal to producers.
Higher prices create the incentive for producers in
terms of higher profits to convince them to produce
more of the good. As Adam Smith imagined, it is
as if there is an “invisible hand” in the economy
manipulating around the factors of production
to produce the goods and services wanted by the
buyers in the economy. Markets satisfy collective
needs and desires through adjustments in prices.
In other words, the market price is the tool that
reconciles the goals of consumers and producers.

41
 How Markets Work? Market Forces and Equilibrium

Define what a market is

LO 1 according to economic theory

Market: In economics, a market is where consumers and produ-

cers meet to carry out an economic transaction. Markets may
be physical places where goods or services are exchanged for
money (such as the neighborhood farmers’ markets or second-
hand car markets) or just platforms where purchase offers and
Summary

bids are made (like BIST, the stock exchange, or e-Bay).

Differentiate between perfect

LO 2 and imperfect competition

Perfect Competition: It is a (hypothetical) market in which

(1) the good or service being exchanged has exactly the same
qualities no matter who the seller is; (2) there are a high number
of potential buyers and sellers, all of whom act independently
of each other, and (3) buyers and sellers readily and freely have
access to information with regards to the prices at which other
buyers and sellers are exchanging the good. 


Differentiate between perfect

LO 3 and imperfect competition

The Law of Demand states that a fall in the price of a product,

ceteris paribus, typically increases the quantity demanded of
that product. Even a shorter statement of the law says: the de-
mand curve slopes downwards.

Distinguish the shifts in the

LO 4 demand curve and the movements
along the demand curve

Movements along and shifts in the demand curve: A change in the

price of the good itself leads to a movement along
the existing
demand curve since the price of the good is on one of
the axes.
A change in any of the other determinants of demand will ca-
use the demand curve to shift either to the left or to the right.

42
Introduction to Economics I

LO 5 Explain the Law of Supply

The Law of Supply states that, ceteris paribus, an increase in the

price of a product causes the total quantity supplied to also
increase. It is even simpler to state it by noting that the supply
curve normally slopes upwards.

Summary
Distinguish the shifts of the supply
LO 6 curve and the movements along the
supply curve

Movements along versus Shifts in the Supply curve: A change in

the price of the good itself leads to a movement along
the exis-
ting supply curve since the price of the good is on one of
the
axes
. A change in any of the other determinants of supply will
always shift the supply curve either to the left or to the right.

LO 7 Define market equilibrium

The market equilibrium refers to the quantity-price combinati-

on demand and supply curves meet. At the relevant price level,
quantity demanded will be equal to the quantity supplied.

LO 8 Explain excess demand and excess

supply

Resource Allocation: Scarce resources are allocated in response to

changes in price. If there is an increase in the price of a good,
say, due a switch in preferences or tastes of the buyers towards
the good, then this signals to producers that consumers wish to
buy this good at greater amounts. This will lead to an upward
shift in the demand curve and raise the equilibrium price. As
producers are rational and wish to maximize their profits, the
higher price will provide the incentive needed to convince pro-
ducers to produce more of the good.

43
 How Markets Work? Market Forces and Equilibrium
1 In a market system, prices are determined by:
A. Corporate executives
B. Government bureaucrats
C. Supply and demand
Test Yourself
D. Total market demand
E. Production costs
2 According to the law of demand:
A. There is a positive relationship between the
quantity demanded and price
B. As the price rises, the demand will shift to the left
C. There is a negative relationship between the
quantity demanded and price
D. As the price rises, the demand will shift to the right
E. As the price rises, consumers switch their
purchases to substitute goods
3 A decrease in the price of a particular good,
with all other variables constant, causes:
A. A shift to a different demand schedule with
higher quantities demanded
B. A shift to a different demand schedule with
lower quantities demanded
C. A movement along a given demand curve to a
lower quantity demanded
D. A movement along a given demand curve to a
higher quantity demanded
E. No movement along a given demand curve
unless the supply also changes
4 If automobiles are a normal good and the
price of automobiles rises, then holding all else
constant, the
A. Demand for automobiles will rise
B. Quantity demanded of automobiles will fall
C. Demand for automobiles will fall
D. Quantity demanded of automobiles will rise
E. Supply of automobiles will fall
5 An increase in the number of fast-food
restaurants:
A. Increases the demand for substitutes for fast-
food meals.
B. Raises the price of fast-food meals.
C. Increases the supply of fast-food meals.
D. Increases the demand for fast-food meals.
E. Decreases the demand for fast-food meals.
44
6 If both demand and supply increase
simultaneously due to external factors, what will
be the effect on the equilibrium price and quantity?
A. The price will rise but the quantity could either
increase, decrease, or remain the same.
B. The quantity will increase but the price could
either rise, fall, or remain the same.
C. Both the price and the quantity will increase.
D. The price will fall but the quantity will increase.
E. Both the price and the quantity will fall.
7 A shortage occurs when there is:
A. Excess supply
B. Excess demand
C. Price is higher
D. At market equilibrium
E. A Tax on the good.
8 In the market system, resource allocation
occurs via:
A. Price mechanism
B. Power
C. Central directives
D. A first-come-first-served system
E. Financial market signals
9 Assuming that tea and sugar cubes are
complements, what happens when tea prices go
up?
A. Demand curve for tea shifts to the left
B. Demand curve for tea shifts to the right
C. Demand curve for sugar shifts to the left
D. Demand curve for sugar shifts to the right
E. There will be no change in both demand curves
10 In a particular market, such as house rentals,
if supply is fixed, the price will be determined by:
A. Income
B. Demand curve
C. Location
D. Supply curve
E. Expectations
Introduction to Economics I

1. C If your answer is not correct, review the 6. B If your answer is not correct, review “Chan-

Answer Key for “Test Yourself”

“Market Equilibrium: Demand and Supply”. ges in Market Equilibrium”.

2. C If your answer is not correct, review “De- 7. B If your answer is not correct, review “Chan-
mand and Demand Curve”. ges in Market Equilibrium”.

3. D If your answer is not correct, review “De- 8. A If your answer is not correct, review “Prices
mand and Demand Curve”. and Allocation of Resources”.

4. B If your answer is not correct, review “De- 9. C If your answer is not correct, review “Comp-
mand and Demand Curve”. lements”.

5. C If your answer is not correct, review “Supply 10. B If your answer is not correct, review “Market
and Supply Curve”. Equilibrium: Demand and Supply”.

Did you buy anything yesterday? Did you check

whether you paid the lowest price possible? Were there

Suggested answers for “Your turn”

many sellers and buyers for the good you bought? Do
you think that market is perfectly competitive?

The consumers try to pay the lowest price for a good that they purchase. If
a specific good is produced in a competitive market rather than a monopoly,
certainly the price you pay will be lower than the case that the market is mo-
your turn 1 nopoly. A market is called a competitive market if there are many buyers and
sellers in that market. As a result, the effect of buyers and sellers on the market
price is negligible.

In which type of market, monopolistic or

competitive market, is the equilibrium market price
lower? Why?

If a specific good is produced in a competitive market rather than a mono-

poly, certainly the price you pay will be lower than the case that the market
is monopoly. A market is called competitive if there are many buyers and
sellers in the market and as a result of it the effect of each buyer and seller’s
your turn 2 on market price is negligible. A monopoly is a market where there are many
buyers but there is only single producer/seller of the product. Different than
the competitive market, in monopoly, the monopolist has effect on the price
determination.

45
 How Markets Work? Market Forces and Equilibrium

If the demand curve were positively sloped, what

Suggested answers for “Your turn”

would it indicate?

A positively sloped demand curve implies that the buyers are willing to pay for
your turn 3 a good if the price is higher. This is against the rationality assumption.

As the diesel prices have almost caught up the gasoline

prices, the market for diesel cars has responded. What
do you expect?

Goods are either substitutes or complements to each other. The Diesel and
diesel cars are the complementary goods. When the price of diesel goes up, the
your turn 4 demand for diesel cars goes down. So, we should expect the demand for diesel
cars to decrease, leading to a price decrease in the diesel car market.

What will happen to the market price/prices of a product

when a country liberalizes its international trade and
allows the producers of imported products to compete
with the domestic firms?

When a country liberalizes its international trade and allows the producers
of imported products to compete with the domestic firms, the supply of that
your turn 5 product increases and the price of the product falls as a result. Some of the
domestic firms that have higher costs of production relative to the foreign
firms will have to leave the market in the long run.

46
Introduction to Economics I

The price of green plums generally decline from May to June in

your local neighborhood bazaars as the sellers supply greater

Suggested answers for “Your turn”

amounts in each week. Is this a case of movement along the
supply curve or a shift in the supply curve? Explain why.

This represents a change in the supply of plums in the indicated period and it
causes a shift of the supply curve to the right, which results in lower market
your turn 6
prices and higher market equilibrium quantities.

What will happen to the taxi market if the government

imposes a surcharge to allow for entrance to the city
center, as is the case in London?

If the government imposes a surcharge to the taxi market to allow for entrance
your turn 7 to the city center, the supply curve will shift to the left, causing the equilib-
rium quantity of taxi services to decrease. After that, the market equilibrium
price will go up.

In Ramadan the demand and supply of dates (hurma)

increase seasonally. What will happen to the equilibrium
price and quantity?

When the demand and supply of dates (hurma) increase seasonally during the
Ramadan, what happens to the equilibrium price is uncertain but the equi-
your turn 8
librium quantity will certainly be higher as a result of the shift of both curves
to the right. Whether the price will increase or decrease will be determined
by the relative changes in the demand and supply curves. If the change in
demand is more than the change in supply, we can say that the equilibrium
price goes up.

47
 How Markets Work? Market Forces and Equilibrium
References
Acemoğlu, D., Laibson, D. and List, J.A. (2015),
Economics, Global Edition, Pearson Education,
Inc.
Bade, R. and Parkin, M. (2015), Foundations of
Microeconomics, 7th Edition, Pearson Education
Inc., USA.
Browning, E. K. and Zupan, M.A. (1999),
Microeconomic Theory and Applications, 6th
Edition, Addison-Wesley, USA
Case, K., Fair, R. and Oster, S., (2012), Principles of
Economics, 10th Edition, Prentice Hall, NY, USA
Goodwin, N., Nelson, J., Ackerman, F. and Weisskopf,
T., (2014), Principles of Economics in Context,
M.E. Sharpe, NY:USA
Gwartney, J. D., Stroup, R. L. and Sobel, R. S. (2000),
Microeconomics: Private and Public Choice, 9th
Edition, The Dryden Press, New York.
Hirshleifer, J. and Hirshleifer, D. (1998), Price Theory
and Applications, 6th Edition, Prentice Hall, NJ,
USA.
Hubbard, R. G. and O’Brien, A. P. (2012), Economics,
Pearson, 4th edition.
Mankiw, N. G. and Taylor, M. P. (2011) Economics.
2nd edition, South Western, Cengage Learning.
Mankiw, N. G. (1998), Principles of Microeconomics.
Harcourt Brace College Publishers.
48
Mankiw N. G. (2003), Principles of Economics,
South-Western College Publishing, USA, 5th
edition.
Mansfield, E. (1998), Microeconomics, Shorter
7th Edition, W. W. Norton & Company, Inc.,
London and New York.
McEachern, W. A. (2015), ECON Microeconomics,
4th Student Edition, Cengage Learning, Uni. Of
Connecticut, USA
McConnel, C. R. and Brue, S. L. (2005),
Microeconomics: Principles, Problems and
Policies, 16th edition, McGraw-Hill Companies,
Inc.
Miller, R. L. (1994), Economics Today: The Micro
View, 18th Edition, Harper Collins College
Publishers.
Nicholson, W. (1995), Microeconomic Theory: Basic
Principles and Extensions, 6th Edition, Harper
Collins College Publishers.
Rittenberg, L. and Tregarthen, T. (2009), Principles of
Microeconomics, Ingram Publishers.
Robert S. Pindyck and Daniel L. Rubinfeld (2008),
Microeconomics, 6th international edition,
Pearson Education International.
Parkin, M. (2012), Economics, 10th Edition, Pearson,
NY, USA
 The Theory of
Chapter 3 Consumer Choice
After completing this chapter, you will be able to:
Deal with questions such as
Learning Outcomes

“How does a consumer decide what to buy?”

“What are the trade-offs faced by him while
making such decisions?”

1 “How do the decisions change with changes in

factors such as price, incomes, interest rates, etc.?”
2
Understand the concepts of affordability and
budget constraint
Understand and interpret the impact of

3 Derive indifference curves and explain how

they depict consumer preferences
4 the changes in income and price on the
consumer’s choice
Derive demand curves, and apply the theory

5 Identify the income and substitution effects

6 of consumer choice to a few implications
about household behavior

Key Terms
Chapter Outline Utility
Introduction
Total Utility
The Budget Constraint Marginal Utility
Consumer Preferences Law of Diminishing Marginal Utility
Optimization: Optimal Choices for Individual Preferences
Consumers Commodity Bundles
Changes in Consumer Choices Indifference Curve
Positively Sloped Demand Curve? Marginal Rate of Substitution
Applications: Budget Constraint
How Real Wage Changes Affect Labor Supply? Relative Prices
Consumer Choice
How Real Interest Rate Changes Affect Individual
Utility Maximization
Saving? Income Effect
Substitution Effect
Normal Good
Inferior Good
Giffen Good
Rational Behavior
Utility-Maximizing Rule

50
Introduction to Economics I
INTRODUCTION
This chapter builds a usefull base for deriving
the demand curve at the end of this chapter, which
enables us to take another step to discuss further
the demand curve in the next chapter. In essence,
this chapter goes “behind” the market demad
curve to see it is made up of individual consumer
demands, and to see what factors determine
the choices of individual consumers (Gwartney
et. al, 2000, p.170). In order to understand
demand theory after the theory of consumer
choice, students must have a firm grasp of budget
constraints, indifference curves, the marginal rate
of substitution, and optimal consumer choice and
related topics, respectively.
Consumer choice is related to the behavior of
consumers. In theory, there is an assumption that
the behaviors can be rational or irrational1. There
is an implicit assumption here that individuals
and/or households as consumers behave rationally
since each of us must decide how to allocate
our limited income (and of course, our time)
among the many possible commodities or things
we can purchase. The price of goods, relative to
each other, is a very important determing factor
for our demand. If your favorite tea doubled in
price, how would you change your preference
or taste to another brand of tea? Would your
decison be different if all teas doubled in price?
As a consumer, your choice between different
brands of tea will be affected only by the change
in relative prices (when we consider the prices
of other goods as well). Let’s assume that all tea
prices rose. This will be a case in which you may
switch your tastes or preferences to buy another
goods, for instance coffee or something different
thing. In this sense, the relative price helps us
to measure the opportunity cost of our behavior
in the economic aspect of our daily lives. Thus,
consumer behavior will enable us to predict
how much of a particular commodity-bread,
paint, housing, etc.-a consumer buys during a
particular period of time. Clearly, one of the
most important determinants of a consumer’s
behavior is his or her tastes or preferences. Since
there are so many consumers with different
1
Rational Choice Theory is an approach used by social scientists
to understand human behavior. The approach has long been
the dominant paradigm in economics, but in recent decades
it has become more widely used in other disciplines such as
Sociology, Political Science, and Anthropology.
preferences in each society, these differences
in tastes or preferences result in quite different
decisions by consumers as to what commodities
or things to purchase. According to recent data,
there have been some changes during the past
few years in the way Turkish consumers allocate
their income.2
This chapter also discusses consumer choice
without going into extensive detail on utility
theory since consumers must measure which choice
of consuming a good or a bundle of goods brings
more utiliy for satisfaction than the other good or
other bundle of goods, and thus, must reach their
aim of utility maximization (for given preferences
and restrictions) at the end of their behavior. In
this way, we will show how this body of theory has
been applied to help solve very important practical
problems related to the effects of real wage changes
on labor supply and those of real interest rates
changes on individual saving over substitution and
income effects.
BUDGET CONSTRAINT
We begin our study of consumption choices
by learning about the limits of what a person can
afford to buy. Consumption choices are limited
by income and prices. We summarize these
influences on buying plans in a budget line or
constraint. Given his or her tastes or preferences,
along with the assumption of rationality of
consumers, he or she tries to get on the highest
possible indeference curve. To do so, the consumer
must consider factors other than his or her own
tastes or preferences or choices. These factors,
such as prices of commodities and the level of
the consumer’s income, can limit or constrain the
nature and size of the market basket that he or
she can buy.
Let’s consider the budget constraint facing an
individual who has a fixed level of income (I) that
can be used to buy two goods (X and Y) at fixed
prices (PX and Py). The budget constraint facing
this individual can be expressed as:
Px.X + Py.Y = I (3.1)
2
Please see http://www.tuik.gov.tr/PreHaberBultenleri.
do?id=18630.
51
 The Theory of Consumer Choice

For instance, if the price of good X is $1 a unit and the price of Y is $2 a unit and consumer income
is $80, it must be true that X+ 2Y= 80. Please note that we realistically assume that the consumer takes
prices of goods or commodities as given. A graph of this budget constraint appears below. The intercepts
of this budget constraint on each axis equals income divided by the price of the good represented on the
axis. This can be demonstrated quite easily using basic algebra as follows:

X = 1 − Py Y
Px Px (3.2)

In Equation (3.2) which is represented by the straight line in Figure 3.1, the first term on the right is
the intercept of the line on the horizontal axis: it is the amount of good X that could be bought by the
consumer if he or she spent all his or her income on good X. In other words, if the consumer expends all
her or his income just for good X, Equation 3.2 provides the answer. Similar logic is supposed to apply
for the maximum consumed amount of good Y, as well. Or, if the consumer spends all his or her income
just for consuming good Y, intersection on Y axis will be equal to I/Py. When we combine these two
intersection points on both axis, we find the budget line or constraint and its slope is equal to the negative
of price ratios, Px/Py which is the result of (I/Py)/(I/Px). Thus, the slope equals the relative price of the two
goods, that is, the price of one good compared to the price of the other (i.e., -1/2).

Table 3.1 Budget Constraints

Good Bundle or Total Spending
Good X; Px=$1 Good Y; Py=$2
Market Basket X+ 2Y= 80
A 0 40 80
B 20 30 80
C 40 20 80
D 60 10 80
E 80 0 80

A Budget constraint is “the combinations

/Py 40
of quantities of X and Y that a consumer
can purchase with certain amount of inco-
30
slope = tan me or earning”.
10
20

As illustrated in Figure 3.1, the

10
budget line shows all of the combinations
X of quantities of X and Y that a consumer
20 40 60 80
/Px
can purchase. In the following figures,
we are interested in how changes in
Figure 3.1 Budget Constraint or Line: The budget line shows all
(money) income3 and prices of goods X
of the combinations of the quantities of goods X and Y that the
and Y affect the behavior of preferences
consumers can buy. The slope of the budget line equals –Px/Py= -1/2.
of consumers. These changes are reflected
by the changes in the budget line. An
increase in income (from 80$ to 160$) causes the budget line to shift outward, parallel to the original line
(holding prices of goods constant as Px=1$ and Py=2$) as indicated in Equation 3.2. This means that these
changes will leave unaffected the slope (β) of the budget line (Figure 3.2). And, the consumer will have a
3
Money income means “parasal gelir” in Turkish, and refers nominal or current income in the context.

52
Introduction to Economics I

chance to consume more of both good X and Y. Conversely, a decrease in income (from 80$ to 40$) lowers
the intercepts of the budget line which cause a paralel backward shift. Backward changes will lead to less
consumption of both goods when compared to the original consumption basket.
Important

In the Table 3.1, when income goes up,

1 it will double all the figures in the second
and third columns. Conversely, when in-
Fill out Table 3.1 considering an
come goes down, all figures in second and
increase in income.
third columns will be in half.

/PY 80

60
Budget Lines:
B1, B2, B3
ec e
e
in com
as
re

40
cr eIn
de com
se

20
ea
In

X
40 80 120 160
/PX
Figure 3.2 Effect of Change in Income on Budget Line: Increases in money income increase the intercept of the
budget line, but do not affect its slope.

However, changes in prices of goods will result in a parallel shift in the budget constraint while
changes in the prices of goods X and Y will affect the slope of the budget constraint. Equation 3.2 also
shows what happens to the budget line if the price of good X changes as income level and Py remains
constant (ceteris paribus assumption). With the assumption that income and Py remain constant, an
inrease in Px from 1$ to 2$ increases the absoluate value of
the slope of the budget line—leading to an inward tilt or Important
getting steeper; a decrease in Px from 1$ to ½$ decreases
the absolute value of the slope of the budget line—leading The slope indicates the rate at which the
to an outward tilt or getting flatter (from Bo toward B2). The two goods can be substituted without
main point here is that the vertical intercept of the line is changing the amount of money spent.
unaffected. This means that the point where the budget line The vertical intercept (I/PC), illustrates
cuts the X axis at a point closer to (farther from) the origin the maximum amount of C that can be
indicates the minimum (maximum) number of unit of good purchased with income I. The horizontal
X that the consumer can buy with his or her fixed money intercept (I/PF), illustrates the maximum
income and Py, and this number obviously is inversely amount of F that can be purchased with
related to the price of good X (Figure 3.3). income I.

53
 The Theory of Consumer Choice

40

B0 B1 B2

40 80 160 X
PX=2 PX=1 PX=0.5
Figure 3.3 Effect of Change in the Price of Good X on Budget Line: If the original budget line is in the middle, an
increase in the price of good X shifts the budget line inward and a decrease in the price of good X shifts it outward.

Important

If the price of one good increases, the budget line shifts inward, pivoting from the other good’s inter-
cept. If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s
intercept.

CONSUMER PREFERENCES
As we mentioned at the outset of this unit, consumer preferences or choices have changed from time-
to-time and to understand what accounts for these changes, as well as consumer choice or preferences
more generally, it is important to outline several fundamental principles underlying consumer behavior.
We also mentioned that these changes find their reflection through an indifference curve that measures the
satisfaction of consumers via utility. Moreover, we, as consumers, have a goal in life, which is to maximize
our utility subject to our budget constraint. When we go to the store, we pick the basket that we like best
and that stays within our budget. Therefore, this section underlies the basic assumptions4 that economists
make about the nature of the consumer’s tastes or preferences.

Important

Given the limited budget available to them, consumers choose a combination of goods that will
maximize the satisfaction they can achieve.
The maximizing market basket must satisfy two conditions:
It must be located on the budget line.
Must give the consumer the most preferred combination of goods and services.
Recall, the slope of an indifference curve is: MRS = – (ΔY / ΔX)
The slope of the budget line is Px/Py
Therefore, it can be said that satisfaction is maximized where:
MRS = – (ΔY / ΔX) = Px/Py
It can be said that satisfaction is maximized when the marginal rate of substitution (of good X and Y) is
equal to the ratio of the prices (of X and Y).

4
It is cited from Edwin Mansfield (1998) Microeconomics, W. W. Norton & Company, Inc., p.50. The author of this chapter edited
the acknowledged parts according to the subject of the section and the content of the section.

54
Introduction to Economics I
1. Preferences are complete: this means that
the consumer is able to compare and rank
all possible baskets. Suppose the consumer
confronts with any two market baskets,
each containing various quantities of
commodities or goods. For example,
market basket or goods bundle might
contain 1 jean and 3 hamburgers, while
the other bundle contains 1 ticket to
a soccer match and 3 chocolate bars.
Economists assume that consumers may
choose the first basket to the second one,
the second one to the first one, or they
may just choose to be indifferent between
them.
2
When these baskets have the
same price, what do you think
would determine the the custo-
mer’ s choice/preference of one
basket over the other?
Important
Consumers can be indifferent between
these baskets if they provide equal units
of utility. Otherwise, consumers will cho-
ose the basket with the higher utility.
2. Consumer’s preferences are transitive.
For example, a person can prefer Coca-
Cola to Pepsi Cola, Pepsi Cola to Sprite
(a soft drink), or Coca-Cola to Sprite.
Otherwise, his or her preferences would
not be transitive; hence, would be
contradictory or inconsistent. He or she is
indifferent between Coca-Cola and Pepsi,
and Pepsi and Sprite soft drink, he or she
must be indifferent between Coca-Cola
and Sprite. This case is out of economic
analysis. Although not all consumers may
exhibit preferences that are transitive,
this assumption certainly seems to be a
plausible basis for a model of consumer
behavior.
3. Consumers always prefer more of a commodity
to less (i.e., non-satiation). If, for example,
one market basket (a very big one) contains
15 Coca-Cola cans and 2 hamburgers,
whereas another basket (also big) contains
15 Coca-Cola cans and 1 hamburger,
we assume that the first market basket,
which unambiguously contains more
commodities, is preferred. Otherwise,
his or her preferences would not be
transitive; hence, would be contradictory
or inconsistent.
4. A diminishing marginal rate of substitution
(i.e., convexity): Indifference curves are
convex, and the slope of the indifference
curve increases (becomes less negative) as we
move down along the curve. As a consumer
moves down along his or her indifference
curve he or she is willing to give up fewer
units of the good on the vertical axis in
exchange for one more unit of the good
on the horizontal axis. This assumption
also means that balanced market baskets
are preferred to baskets that have a lot of
one good and very little of the other good
(McEachern, 2015: 86) This is very suitable
situation with third one just above. All these
three assumptions seem quite plausible.
A diminishing marginal rate of
substitution is exhibited when indifference
curves are convex, and the slope of the
indifference curve increases (becomes less
negative) as we move down along the curve.
Important
As a consumer moves down along his or
her indifference curve, he or she is wil-
ling to give up fewer units of the good on
the vertical axis in exchange for one more
unit of the good on the horizontal axis.
This assumption also means that balanced
market baskets are preferred to baskets
that have a lot of one good and very little
of the other good.
55

Along with these four basic assumptions, there
are several fundamental principles5 underlying
consumer behavior as follows:
Rationality requires cost and benefit
comparisons when making all decisions
even in daily life.
3. One good can be substituted for another.
Picture 3.1
1. Limited income necessitates choice. The main
assumption of scarcity in economic theory
states that we all have limited incomes.
Limited income forces us to make choices
about which goods we will and will not
purchase. This will keep us within our
budget. When more of one good or service
is purchased, we must purchase less of some
4. Consumers must make decisions without
other good. The third assumption above is
also in accordance with this principle. This
principle also explains why we cannot go
above the budget constraint or the line in
Figure 3.1. Moreover, this is the “cost” of
purchasing something.
2. Consumers make their decisions purposefully.
If two products have the same cost, a
consumer would choose to purchase the
one expected to have the higher benefit. On
the other hand, if two products yield equal
benefits, the consumer would choose to
purchase the cheaper one. At the beginning
of this chapter, we assumed that consumers
are rational—they are able to weigh the
costs and benefits of their choices. The first
assumption above is also in accordance with
this principle.
5
It is cited from James D. Gwartney, Richard L. Stroup and
Russel S. Sobel (2000) Microeconomics: Private and Public
Choice, The Dryden Press, pp.170-172. The author of this
chapter edited the acknowledged parts according to the subject
of the section and the content of the section.
56
The Theory of Consumer Choice
Important
Consumers can achieve utility—that
is satisfaction—from many different
alternatives. This is very suitable with
transitive assumption mentioned above.
With 300$, you might either buy a new
TV set or take a vacation. There are many
alternative ways to satisfy consumers’ wants.
“Wants” and “needs” are different. Wants
are unlimited but as we explained earlier,
budget constraint turn “some wants” in to
“a need” with the provision of purchasing
power. By doing so, the need of a person
for an item (a good or commodity) is
closely related to its cost—what must be
given up to obtain the item (i.e., alternative
cost). This principle reveals that if the price
of a good increases, it will always have a
substitute.
perfect information, but knowledge and past
experiences will help. As explained in earlier
chapters, information is costly to acquire.
The likelihood that a consumer will spend the
necessary time, effort, and money to gather
information (about items or goods he or she
wants to buy) is directly related to its value
to the consumer. Many people or consumers
will collect this information when deciding
on the purchase of a new automobile [which
has a very high value], but very few customers
would do the same when purchasing a pencil
or a roll of paper towels [which have a low
value]. When making a bad decision has a
low cost, consumers will rationally choose to
be less informed. They are supposed behave
conversely when consumers value goods
relatively more. Not all consumers have
perfect foresight; hence, they will not always
correctly anticipate the consequences of their
choices. Finally, being a good consumer is a
process of learning through previous choices
or preferences.
Introduction to Economics I

5. The law of diminishing marginal utility
applies: as the rate of consumption
increases, the total utility will increase at
decreasing rate or marginal utility derived
from consuming additional units of a
good will decline. To predict consumer
behavior, we need to develop a consistent
way of viewing utility. [According to
Cardinal utility approach], utility is a term
economists use to describe the subjective
personal benefits that result from an
action. By attaching a numerical measure
to utility, we can compare the total
utility a particular consumer gets from
different goods and the marginal utility
that the consumer gets from additional
consumption (McEachern, 2015:87).
Thus, we can employ units of utility to
evaluate a consumer’s preferences. Note,
however, that we cannot compare utility
levels across all consumers. The law of
diminishing marginal utility states that
the marginal (or additional) utility derived
from consuming successive units of a
product will eventually decline as the rate
of consumption increases. For example,
even though you might like ice cream in
summer time, your marginal satisfaction
from additional ice cream consumption
will decline. If you consume ice cream
at lunch, dinnertime, and as a snack at
midnight, you will have less satisfaction
at each consumption level. This situation
perfectly fits in with the definition of the
law of diminishing marginal utility.
The law of diminishing marginal utility
is that the marginal (or additional) utility
derived from consuming successive units
of a product will eventually decline as the
rate of consumption increases.

Important

“Each person has a uniquely subjective utility scale.”

“The utility you derive from a particular good, service, or activity depends on your tastes and preferences.”
William A. McEachern, (2015) ECON Microeconomics Fourth (Student) Edition, Cengage Learning,
Uni. Of Connecticut, USA, pp.87 and 88.
According to Cardinal utility approach, the utility is measurable and can be expressed in quantitative
terms. Cardinal utility approach is also known as classical approach because it was presented by classical
economists. (please see http://www.managedstudy.com/micro/cardinal_utility_approach.htm)
Ordinal Versus Cardinal Utility
Ordinal Utility Function: places market baskets in the order of most preferred to least preferred, but it
does not indicate how much one market basket is preferred to another.
Cardinal Utility Function: utility function describing the extent to which one market basket is preferred
to another.

The law of diminishing marginal utility Indifference Curves

explains why you would not spend the entire
money in your budget on certain products, goods
or items even if you really like them. Consumers
will continue to consume goods until they reach
the point where additional units provide less and
less marginal utility--finally reaching the point of
MU=0.
If the assumptions and fundamental principles
in the previous section hold, we can represent
the consumer’s tastes or preferences by a set of
indifference curves. On an indifference curve,
the locus of points represent market baskets (or
consumption bundles), in which among the
bundles the consumer is indifferent.

57
 The Theory of Consumer Choice

Table 3.2 Alternative Market Baskets (or Consumption Bundle)

Market Basket
Units of Good X Units of Good Y
(Consumption Bundle)
A 20 30
B 10 50
C 40 20
D 30 40
E 10 20
G 10 40

For example, suppose we confine Y B

our attention to the six market baskes 50
in Table 3.2, in which the first market
E
basket contains 20 units of good X and H
40
30 units of good Y, and so on (see also
Figure 3.4). Suppose the consumer is A
asked to choose between various pairs of 30
these market baskets and that he or she is
indifferent between some of these market G D
20
baskets. For instance, he or she does
not care about consuming what is the
consumption bundle A and D. According 10
to Figure 3.4, all points in the mustard X
10 20 30 40
yellow area are preferred to A and all
Figure 3.4 Consumer Preferences
points in the blue area are inferior to A.
Following Figure 3.4, we plot each of Y
the market baskets as in Figure 3.5 and
draw an indifference curve (U0), which
involves a set of points representing
B
the market baskets among which the E
consumer indifferent. Any two points on
an indifference curve generate the same
H
level of utility. Thus, Figure 3.5 indicates
that this person would be indifferent A
if faced with a choice between the
G D
combinations of the goods represented U0
by points X and Y. Points that lie above
and to the right of an indifference curve
X
provide a higher level of consumption
Figure 3.5 Indifference Curve for two goods, X and Y
of each good than the points on that
indifference curve. Because of this, such
points provide a higher level of utility than points on the indifference curve. Thus, point E would be
preferred to either point A, B or D (or any other point on the indifference curve U0). Points that lie
below and to the left of the indifference curve (such as points H and G) provide a lower level of utility.
Therefore, this consumer would prefer the bundle of goods represented by point A if faced with a choice
between the bundles of goods represented by points G and A.

58
Introduction to Economics I
An indifference curve can be derived
when there are two elements in every
choice: (1) preferences (the desirability of
various goods) and (2) opportunities (the
attainability of various goods). It is related
to the former: preferences. It separates
better (more preffered) bundles of goods
from inferior (less preferred) bundles,
providing a diagrammatic picture of how an
individual ranks alternative consumption
bundles. (Gwartney et al., 2000: 194-195).
Important
Total utility: The total satisfaction you
derive from consumption; this could refer
to either your total utility of consuming a
particular good or your total utility from
all consumption.
Marginal utility: The change in your
total utility from a one-unit change in
your consumption of a good .
Law of diminishing marginal utility:
The more of a good a person consumes
per period, the smaller the increase in
total utility from consuming one more
unit, other things constant.
Y
C
A
D U0
Figure 3.6 Indifference Map
Properties of Indifference Curves
In consumer theory, economists assume that
the preferences of consumers exhibit certain
properties or characteristics. These properties
enable us to make statements about the general
pattern of indifference curves. What are these
properties, and what do they imply about the
characteristics of indifference curves? These are
important questions to be answered to grasp how
consumers reach their final decision to consume
any combinations of consumption bundles. (see
Figure 3.6).
First, more goods are preferrable to fewer goods—
thus, bundles on indifference curves lying farthest
to the northeast of a diagram are always preferred.
Lets assume, a consumer consumes only two
commodities, X and Y, that are both desired, the
individual will always prefer a bundle with more
of one good (without loss of the other) to the
original bundle. In Figure 3.6, bundle point C is
preferrable to A, B or of course, to D. This means
that combinations to the northeast of a point on
the diagram will always be preferred to point s lying
to the southwest. In other words, it is assumed that
individuals attempt to place themselves on the
highest level of utility that they can achieve, given
the constraints that they face. Any market basket
lying above and to the right of an indifference
curve is preferred to any market basket that lies on
the indifference curve.
B
X
59

Second, goods are substitutable—therefore,
indifference curves slope downward to the right.
Given the fact (noted in the last section) that every
commodity is defined so that more of it is preferred
to less, indifference curves slope downward to the
right or it follows that indifference curves must
have a negative slope. According to the shape of
the indifference curve in Figure 3.5 (also consider
Figure 3.4), if the consumer moves along the curve
from B to A, he or she will be willing to give up 20
units of good Y to consume 10 units more of good
X. However, moving from A to D requires giving
up 10 units good Y to consume 20 units of good X.
This definition is about the slope of indifference curve,
which also indicates the alternative or opportunity
cost of consuming good X more in terms of good
Y. Moving along the indifference curve does not
change the utility.
Y Third, indifference curves cannot cross eachother,
A
Figure 3.7 Intersecting Indifference Curves: A Contradiction to the Assumptions
If the indifferent curves U1 and U2 that have
different utility levels were to intersect, the consumer
would be indifferent between market baskets C
and B, which is impossible since market basket B
contains more of both goods X and Y (according to
the Figure, same amount of X but more of Y) than
market basket C. However, this cannot be, since
market basket B contains more of both goods X
and Y (according to the Figure, same amount of X
but more of Y) than market basket C, and goods X
and Y are defined so that more of them is preferred
to less. If the consumer’s preferences or tastes are
transitive, as we assume in this section, there cannot
be an intersection of indifference curves.
60
The Theory of Consumer Choice
3
What would happen if the indifference
curve had a positive slope?
Important
If two market baskets are to be equivalent
[in utility units], and if one market basket
contains more of both commodities, it
would mean that one or the other of the
commodities is not defined so that more of
it is preferred to less. If it sloped upward, it
would violate the assumption that more of
any commodity is preferred to less.
if they did, the rational ordering among preferences
would be violated. As indicated in Figure 3.7,
on the indifference curve U1, market basket A is
equivalent to market basket C in terms of utility.
On the difference curve U2, market basket A is also
equivalent to market basket B in terms of utility.
B
U2
U1
C
X
Fourth, indifference curves are everywhere dense.
We can draw an indifference curve trough any
point on the diagram. This simply means that
any two bundles of goods (commodity bundle)
can be compared by the consumers. Considering
Figure 3.4 and Figure 3.5, we can draw various
indifference curves with different points of
coordination.
Fifth, the valuation of a good declines as it is
consumed more intensively—therefore, indifference
curves are always convex. As we noted above, the
slope of the indifference curve represents the
willingness of the individual to substitute one
Introduction to Economics I
good for the other. This is also defined as the
marginal rate of substitution (MRS), which refers
to the amount of good X that is just sufficient
to compensate the consumer for the loss of a
unit of the good Y. Reflecting the principle of
diminishing marginal utility, MRS of a good
Y will decline as the good X is consumed more
intensively relative to other goods Y. This means
that as his or her consumption of good X increases
(and his or her consumption of good Y declines),
his or her valuation of good X relative to good Y
will decline, and vice versa. Therefore, since the
valuation of each good declines as it is consumed
more intensively, indifference curves must be
convex to the origin.
Marginal Rate of Substitution (MRS)
As noted in the fifth property of indifference
curves above, consumers differ in the importance
that they attach to an extra unit of a particular
good. This is useful in getting a measure of the
relative importance attached by the consumer
to the acquisition of another unit of a particular
good. This means that whereas a consumer’s
consumption of good X increases (and his or
her consumption of good Y declines), his or
her valuation of good X relative to good Y will
decline. Besides, MRS is defined as the number
of units of good Y that must be given up if the
consumer, after receiving an extra unit of good
X, is to maintain a constant level of satisfaction
or utility (Mansfield, 1988: 54). For instance,
in Figure 3.5 (also consider Figure 3.4), if the
consumer moves along with it from B to A, this
means that he or she is giving up 20 units of good
Y to consume 10 units more of good X. However,
moving from A to D requires giving up 10 units of
good Y to consume 20 units of good X. Therefore,
MRS is decreasing along with indifference curve.
The MRS of good X for good Y gets smaller as the
consumer has more of good X and less of good
Y. This means that this trade-off between good
X and Y leaves him or her no better or no worse
off—maintaining a constant level of satisfaction
or utility (see also Figure 3.8).
The marginal rate of substitution (MRS)
is defined as the number of units of good
Y that must be given up if the consumer,
after receiving an extra unit of good X, is
to maintain a constant level of satisfaction
or utility.
To understand MRS in detail, as noted in
previous sections, we have stressed that the
consumer’s indifference map is a representation
of his or her tastes or preferences. Given the
indifference map of a particular consumer, we can
attach a number, a utility, to each of the market
baskets that might confront this consumer.
This utility indicates the level of enjoyment or
preference attached by this consumer to this
market basket. The economic theory of choice
is based on the concept of utility. Utility is
defined as the level of happiness or satisfaction
associated with alternative choices. Economists
assume that when individuals are faced with a
choice of feasible alternatives, they will always
select the alternative that provides the highest
level of utility.
U = f (X, Y) (3.3)
By using utility over the economic theory of
choice, we can calculate MRS value. The total uti-
lity associated with a good is the level of happiness
derived from consuming that good. Marginal uti-
lity is a measure of the additional utility that is re-
ceived when an additional unit of the good is con-
sumed. The table below illustrates the relationship
between the total and marginal utility associated
with an individual’s consumption of pizza (in a gi-
ven time period).
61
 The Theory of Consumer Choice

Table 3.3 Total Utility and Marginal Utility

# of pizza slices (Good X) Total utility Marginal utility

0 0 -
1 20 20
2 35 15
3 45 10
4 50 5
5 50 0
6 45 -5
7 35 -10

As the table above indicates, the marginal utility associated with an additional slice of pizza (good X)
is just the change in the level of total utility that occurs when one more slice of pizza is consumed. Note,
for example, that the marginal utility of the third slice of pizza is 20 since the total utility increases by 20
units (from 110 to 130) when the third slice of pizza is consumed. More generally, the marginal utility
can be defined as:

changeintotal utility of good X ΔTUx
Marginal Utility, (MUx) = = (3.4)
changein quantity of good X ΔX

The table above also illustrates a phenomenon known as the law of diminishing marginal utility. This
law states that marginal utility declines as more of a particular good (here, X) is consumed in a given time
period, ceteris paribus. In the example above, the marginal utility of the additional slices of pizza (good
X) declines as more pizza is consumed (in this time period). The marginal utility of pizza consumption
becomes negative when the 6th slice of pizza is consumed. Note, though, that even though the marginal
utility from pizza consumption declines, the total utility still increases at decreasing rate as long as the
marginal utility is positive. The total utility will decline only if the marginal utility is negative.

Total and Marginal Utility Curves

60
50 50
50
45 45
40
35 35
30
Total utility
20 20
20
15 Marginal utility
10 10
5
0 0 0
0 1 2 3 4 5 6 -5 7
-10 -10
-20
Figure 3.8 Total and Marginal Utility Curves

62
Introduction to Economics I
This law of diminishing marginal utility is believed to occur for virtually all commodities. A bit of introspection
should confirm the general applicability of this principle. Finally, we repeat the same procedure for computing
the marginal utility for good Y, (MUy) and then, can reach MRS(x for y) = −
180
-30
150
1
-10
140
1 -5
135
QX1=2 QX2=4 QX3=6
Figure 3.9a Marginal Rate of Substitution
The marginal utility theory examines the
increase in the satisfaction a consumer gains from
consuming an extra unit of a good in a market
or a consumption basket. In addition, there is a
close relationship between marginal utility and
consumer choice. Marginal utility measures the
additional satisfaction obtained from consuming
one additional unit of a good. The principle of
diminishing marginal utility states that as more
and more of a good is consumed, consuming
additional amounts will yield smaller and smaller
additions to utility. If consumption moves along
an indifference curve, the additional utility
derived from an increase in the consumption of
one good, good X, must balance the loss of utility
from the decrease in the consumption of the
other good, good Y. This means that individuals
chooses to have more food and less protection via
clothing—if the season is summer. In the winter
season, individuals may prefer having less food,
more clothing or more in both.
ΔY MUx
= , (Figure 3.9).
ΔX MUy
1
QX4=8 X
Perfect Substitute
Two goods are perfect substitutes when the
marginal rate of substitution of one good for the
other is constant. In Figure 3.9, the consumer
can perfectly substitute the apple juice with the
orange juice. This means that a perfect substitute
is a good that functions just the same as the good
it is being compared to. Some examples are:
Coke vs Pepsi, BP Oil vs Exxon Oil, etc. The
indifference curve for a perfect substitute would
have no convexity because it makes no difference
for consumers. If you were offered BP petroleum
or Exxon petroleum, and you thought that all
petroleum was the same, then you wouldn’t care
about the trade-off between these two goods. For
a perfect substitute, the MRS of the indifference
curve is 1--a straight line. (See more at: https://
www.subjectmoney.com/definitiondisplay.
php?word=A%20Perfect%20Substitute#sthash.
izZv4voD.dpuf ) When the price increases for
one good, the demand for the substitute will also
increase (more at http://www.econogist.com/
home/complements-and-substitutes).
63
 The Theory of Consumer Choice

X
1 2 3 4
Figure 3.9b: Indifference Curves for Perfect Substitute Goods

Perfect Complements
Two goods with right-angle indifference curves are perfect complements such as left and right shoes.
Complementary goods are items that go together, so if the price of one increases the demand for the other
will decrease. On the other hand, if the price of cars increases, demand for gas may decrease—you cannot
use one item without the other, so the demand is tightly intertwined (more details at http://www.econo-
gist.com/home/complements-and-substitutes).

1 2 3 4 X
Figure 3.9c Indifference Curves for Perfect Complementary Goods

64
Introduction to Economics I
OPTIMIZATION: OPTIMAL
CHOICES FOR INDIVIDUAL
CONSUMERS
Individuals maximizing utility subject to their
budget constraint attain the highest possible level
of utility at a point of tangency between their
budget constraint and an indifference curve. This
occurs in the diagram below when the individual
consumes X* units of good X and Y* units of good
Y. While other points on the budget constraint,
such as point A, are feasible, they provide a lower
E B
Y*
X*
Figure 3.10 Equilibrium of Consumer The market basket that will maximize the consumer’s utility is the tangent
point of Uo, the one on the budget line that is on his or her highest indifference curve.
A consumer optimum occurs at the point where
the highest indifference curve and the budget cons-
traint are tangent. Therefore, the tangent point of
Uo indifference curve (point E) indicates consumer
equilibrium indicating the optimal choices for an
individual consumer. Suppose that an individual
has a given income that can be spent on alternative
combinations of goods and services. A utility ma-
ximizing consumer will select the bundle of goods
(or commodity bundle) at which the following two
conditions are satisfied:
1. MUA/PA = MUB/PB = ... = MUZ/PZ, for all
commodities (A-Z), and
2. All income is spent.
level of utility (since MRS is smaller than the ratio
of the prices of goods X and Y, -1/2). Points such
as point B provide a higher level of utility, but are
not feasible (since MRS is greater than the ratio of
the prices of goods X and Y, -1/2); however, this
condition vialotes the budget constraint which
means that there are laws that prevent people
from acquiring more goods than they can pay for.
To reach point B is not possible to attain, which
provides a higher level of utility than Uo without
violating the budget constraint (Figure 3.10).
U’’
U’
U0
X
4
Explain the Consumer’s optimal
choice.
Important
The consumer chooses between the con-
sumption of the two goods so that the
marginal rate of substitution equals the
relative price. At the consumer’s opti-
mum, the consumer’s valuation of the
two goods equals the market’s valuation.
65

The first of these conditions requires that the
marginal utility per dollar spent be equated for all
commodities (i.e., utility maximizing rule). To see
why this condition must be satisfied, suppose that
the condition is violated. In particular, let’s assume
that the marginal utility resulting from the last
dollar spent on good X equals 10 while the marginal
utility received from the last dollar spent on good Y
equals 5 (i.e., (MUx/Px) > (MUy/Py) or (10/1$)>
(5/1$)) Since an additional dollar spent on good X
provides more additional utility than the last dollar
spent on good Y, a utility-maximizing individual
would spend more on good X and less on good Y.
Spending $1 less on good Y lowers the utility by
5 units, but an additional dollar spent on good X
raises the utility by 10 units in this example. Thus,
the transfer of $1 in spending from good Y to good
X provides this person with a net gain of 10 units
of utility. As more is spent on good Y and less on
good X, though, the marginal utility of good Y will
fall relative to the marginal utility of good X. This
person will keep spending more on good Y and less
on good X, though, until the marginal utility of
the last dollar spent on good Y is the same as the
marginal utility of the last dollar spent on good X
(i.e., MUx/Px = MUy/Py). The first condition listed
above is sometimes referred to as the “equimarginal
or marginal principle.” In sum, we can make a
connection between MRS (slope of indifference
curve), Px/Py (slope of budget line) and marginal
principle as shown by the formulas below.
0 = MUx·(ΔX) + MUy·(ΔY) (3.5)
MRS(x, y) = MUx / MUy (3.6)
When consumers maximize his or her
satisfaction or utility:
MRS(x, y) = Px / Py (3.7)
MUx / MUy = Px / Py (3.8)
The reason for the assumption that all income
is spent is because this relatively simple model is a
single-period model in which there is no possibility
of saving or borrowing (since there are no future
periods in this simple model). Of course, a more
detailed model can be constructed which includes
such possibilities, but that is a topic left for more
advanced microeconomics classes.
66
The Theory of Consumer Choice
When the two conditions above are satisfied,
a state of consumer equilibrium is said to occur.
This is an equilibrium because the individual
consumer has no reason to change the mix of
goods and services consumed once this outcome
is achieved. (Unless, of course, there is a change in
tastes, income, or relative prices.) Moreover, the
marginal principle can also be used to derive the
law of demand-as the price of good X increases,
the consumer will purchase less and vice versa.
This will help us to derive the demand curve in
related section.
5
Is there a highest indifference
curve that the budget line can
reach on the X or Y axis?
Important
A corner solution exists in a situation
in which the budget line reaches the
highest achievable indifference curve
along an axis (the vertical axis). For
example, a consumer may choose
to spend all his or her income just
on one good X. Of course, it is also
possible to spend that income just on
good Y. In this situation, the corner
solution will be on highest achievable
indifference curve along the horizontal
axis. In non-technical terms, a corner
solution is available when the chooser
is either unwilling or unable to make
a tradeoff. It holds true if there is a
higher preference vs. a lower preference
and a perfect substitution between two
goods. (for more information please
see https://micrograndma.wordpress.
com/2013/02/04/closer-look-corner-
solutions/ and https://www.youtube.
com/watch?v=-ZvkM6Sm8HM)
Introduction to Economics I

CHANGES IN CONSUMER CHOICES

Building on the results of the previous chapters
and sections, we show how the consumer responds to
changes in his or her money income and to changes
in the prices of commodities. For example, suppose
that the consumer is a student and that the amount
of money he or she earns/receives from his or her
family increases from 1000$ to 1500$ per month.
What effect will this have on his or her purchases?
How much of the extra money income will he or she
spend on books? Entertainment? Clothes? Food?

Changes in Income Picture 3.2

In the previous section (please see Figure 3.2), we saw that an increase (decrease) in money income results
in an increase (decrease) in the intercept of the budget line, but leaves unaffected the slope of the budget line
(as long as the prices of goods remain constant). An increase in income shifts the budget constraint outward.
The consumer is able to choose a better combination of goods on a higher indifference curve.
Y

2/PY

Income-Consumption
Line/Curve
(ICL-ICC)

1/PY
Q3

Q2 U3
Q1
U2

U1

X
I1/PX 2/PX
Figure 3.11 Effects of Changes in Money Income on Consumer Equilibrium: The income-consumption curve (ICC)
connects points (like Q1, Q2 and Q3) representing the equilibrium market baskets corresponding to all possible levels
of money income.

In Figure 3.11, the consumer reacts in regard to
his or her purchases of the goods when his or her
money income changes, prices of the goods and his
or her tastes and preferences remaining unchanged.
Of course, Px/Py ratio is held constant when we
analyze the effects of changes in money income on
consumer behavior. For example, the equilibrium
market baskets corresponding to four income levels
are represented by points Q1, Q2 and Q3 in Figure
3.11. These points represent more consumption
of both goods that are normal goods. When we
connect all of points representing the equilibrium
market baskets corresponding to all possible levels
of money income, the resulting curve is called the
income-consumption curve (ICC).
Important
For more information about the shape
of ICC curves: http://www.economics-
discussion.net/notes/income-effect-
income-consumption-curve-with-curve-
diagram/1026

67
 The Theory of Consumer Choice

Normal Good Y
If a consumer buys more of a good 2/PY
Income-Consumption Curve
when his or her income rises, the good is
called a normal good. Figure 3.11 shows
that when consumer has higher income
levels, he or she is capable of consuming U3
more on both goods.
1/PY
U2

Inferior Good
If a consumer buys less of a good when
his or her income rises, the good is called U1
an inferior good. In other words, inferior
goods will have better quality alternatives.
Therefore, when income rises, people
Q3 Q2 Q1 1/PX 2/PX X
can afford to forego the cheap alternative
and buy the higher quality good instead
(Figure 3.12). When there is an increase in Inferior Good “Y”
income, it shifts the budget line outward. Figure 3.12 Effects of Changes in Money Income on Consumer
However, the consumption of the soft Equilibrium
drink Pepsi (good Y) falls (making Pepsi
an inferior good) and the consumption of pizaa (good X) rises (making pizza a normal good). In this case,
ICC will have a downward slope when we connect the initial optimum point with the new optimum one.
Important
Changes in Prices
A fall in the price of any good rotates the budget constraint For more information about inferior
outward and changes the slope of the budget constraint. goods: http://www.economicshelp.org/
concepts/inferior-good/
Income and Substitution Effect
The substitution effect is the change in Y
consumption that results when a price
change moves the consumer along an
I/Pb
indifference curve to a point with a different
marginal rate of substitution. When the
I*/Pb
price of good Y declines, consumers will
substitute cheaper goods for expensive ones. A
Therefore, he or she consumes more good Y
and less of good X. The income effect is the B
C
change in consumption that results when
U2
a price change moves the consumer to a U1

higher or lower indifference curve. In the

Figure 3.13, if price of good Y falls in budget
Qx1 Qx1* I/Px Qx2 X
constraint, considering Equation 3.1, will I*/Px I/Px’
increase purchasing power of same level of Subst
Income Effect
Effect
income and thus, will provide consumers to
Total Effect
purchase more of both goods X and Y.
Thus, a price change causes the consumer
to move from one point to another on a Figure 3.13 Effects of Changes in Prices of Good Y on Consumer
indifference curve to, which is illustrated by a Equilibrium Income and Substitution Effect

68
Introduction to Economics I

movement from point A to point B. After moving from one point to another on the same curve, the consumer
will move to another indifference curve. It is illustrated by movement from point B to point C. We assume
here that both goods are normal. However, the net effect will be ambiguous as indicated in following table.

Important Important

For more information about the net effects
of substitution and income effects: http://
www.economicsdiscussion.net/cardinal-
utility-analysis/price-demand-relationship-
normal-inferior-and-giffen-goods/1069
The substitution effect will always work in
this direction. The income effect, however,
may work in reverse direction for some
types of goods known as inferior goods.

Table 3.4 Summary of Income and Substitution Effect

Good Income Effect Substitution Effect Total Effect

The consumer is richer,
Pepsi
so he buys more Pepsi.
The consumer is richer,
Pizza
so he buys more Pizza.
Pepsi is relatively The income and
cheaper, so the substitution effects act
consumer buys more in same direction, so
Pepsi. consumer buys more Pepsi.
The income and
substitution effects act
Pizza is relatively more
in opposite directions,
expensive, so the
so the to tal effect on
consumer buys less pizza.
pizza consumption is
ambiguous.

Derivation of Demand Curve

The demand curve for a good can be derived by varying the price
of the good and using the marginal utility theory to determine how 6
the quantity demanded changes. When the price of a good rises, the
How are the Marginal Utility
marginal utility per dollar spent on the good falls, so to maximize the
and the Elasticity of Demand
utility, the consumer buys less of the good. Conventional curves are
related to each other?
well-known in microeconomic theory. A conventional demand curve is
is easy to draw from a given price demand schedule for a commodity,
whereas the drawing of a demand curve from the Price Consumption Curve (PCC) is somewhat compli-
cated. The derivation of demand curve from the PCC also explains the income and substitution effects of
a given fall or rise in the price of a good, which the Marshallian demand curves fail to explain. Thus, the
ordinal technique of deriving a demand curve is better than the Marshallian method. Therefore, demand
curve will be driven via price-consumption curve as well. In this section, as noted in the previous section,
we will benefit from Figure 3.14, that is a continuation of Figure 3.13, to derive demand curve as below.
Important

When the marginal utility decreases quickly as more of a good is consumed, a fall in the good’s price requires only
a small change in consumption to equate the marginal utility per dollar spent on it with the marginal utility per
dollar spent on other goods. As a result, the quantity demanded increases very little and so demand is inelastic.
When the marginal utility decreases slowly as more of a good is consumed, a fall in the good’s price requires a
large change in consumption to equate the marginal utility per dollar spent on it with the marginal utility per
dollar spent on other goods. As a result, the quantity demanded increases significantly and so demand is elastic.

69
 The Theory of Consumer Choice

Important

For futher information about the derivation of a

Conventional demand curve is that the
demand curve, see: http://www.yourarticlelibrary.
lower the price, the higher the quantity
com/economics/how-to-derive-demand-curve-
demanded. This relationship follows the law
from-price-consumption-curve-economics/10692/.
of demand. It  states that the quantity
The drawing of a demand curve from the Price
demanded will drop as the price rises, ceteris
Consumption Curve (PCC) has an edge over the
paribus, or  “all other things being equal.”
former (from a given price demand schedule for a
The relationship between quantity and
commodity). It arrives at the same results without
price will follow the demand curve as long
making the dubious assumptions of measurability
as the four  determinants of demand  don’t
of utility and constant marginal utility of money.
change  These determinants are:
PCC assumes that:
1. Price of related goods or services. 
(a) The money to be spent by consumer is given
2. Income of the buyer.
and constant.
3. Tastes or preferences of the buyer,
(b) The price of good X falls.
4. Expectation of the buyer, especially
(c) Prices of other related goods do not change.
about future prices.
(d) Consumer’s tastes and preferences remain
constant.
As A. Marshall referred in his “The Good Y
Principle of Economics”, the law of
demand indicates that for the normal
/Po
goods ther is a negative slope parameter
or as generally named “marginal
propensity of consumption”. We
call this type of demand functions as
“Marshalian demand functions”. An PCC
example of this type of equation is
given below: U0 U1 U2

Dx = a0 - bPx Qb1 /Pb Qb2 Qb3 /Pb’ /Pb” Good X

POSITIVELY SLOPED Price of

Good X
DEMAND CURVE?
Even though the law of demand states
that the demand curve has a negative
slope, there is an exceptional situation
for some goods which may indicate a
P1
positive demand curve opposite to the
conventional demand curve.
P2
Demand Curve
P3 Good X
Giffen Good
In the 19th century, R. Giffen Qb1 Qb2 Qb3 Quantity of Good X
observed that, especially, during the
famine periods of the economies, some Figure 3.14 Effects of Changes in Prices of Good Y on Consumer
of the certain goods are not line with Equilibrium: Price-Consumption Curve to derive Demand Curve for
the law of demand. In most of the Normal Goods
studies, as a general case study for this

70
Introduction to Economics I

paradox is referred to Irish potato famine. Within APPLICATIONS

that period, the prices of potato were in an upward
trend in Ireland and the demand for it increased.
We can explain this paradox as following: if we
decompose price and income effects of (Slutsky
and Hicksian Demand Function), when the price of
a potato (inferior goods or low quality of nutrition
goods) decrease, income effects avoid substitution
effect, then the positively increased effective
demand of society tends to consume more qualified
nutrition goods (ex: beef, salmon and etc). Here,
we can formulate a simple (ceteris paribus) demand
function for the Giffen paradox:
Dx = a0 + bPx
So far, we have analyzed the behavior of
consumers in many aspects. We have seen
that consumers must measure which choice of
consuming a good or a bundle of goods brings
more utiliy for satisfaction and thus, must reach
their aim of utility maximization (for given
preferences and restrictions) at the end of their
behavior. By using the details of these analyses,
we will now show how this body of theory
has been applied to help solve very important
practical problems concerning those of real wage
changes on labor supply and the effect of real
interest rate changes on individual savings over
substitution and income effects.

Here, a hypotetical example and its templates

are given for normal goods with the Marshalian How Real Wage Changes Affect
demand function and the Giffen Paradox. Labor Supply?
In an economy, the real changes in the
Table 3.5 Marshalian Demand Function vs. Giffen wages of individuals are crucial while they are
Demand Function thinking to decide whether to work or not (i.e.,
more leisure time). For some people, working
Marshalian Giffen Type activity may not be attractive. To understand
Price
Demand Demand the behavior of this kind of people under the
100 25 9 analysis of consumer behavior in this chapter so
far, we can talk about the certain existence of
110 23 11
a threshold wage for these kind of people that
120 21 13
may cause in changes in his or her decision for
130 19 15 between working and having more leisure time.
140 17 17 Beyond this threshold wage, these individuals
150 15 19 prefer not to work and try to be socially more
160 13 21 active by using more leisure time. However, in
170 11 23 this analysis, it is vital to indicate that wages are
considered in terms of real terms. It means we
180 9 25
need to decompose the price level by dividing
Giffen Goods and Giffen Paradox wages by prices. Such real wage
30
changes will help these individuals
25 25
make their decisions and in the
25
23 21 21 23 end, we will have a labor demand
20 19 19
15 15
17
15 and labor supply curve. After the
13 13 threshold wage level, the labor
10 11 11
9 9
5 supply curve tends to move with
0 a backward rotation that is a
100 110 120 130 140 150 160 170 180
validity of indication of Engel
Marshalian Demand Giffen Type Demand Curve (Figure 3.16).
Figure 3.15 Marshalian Demand Function vs. Giffen Demand Function

71
 The Theory of Consumer Choice

Real Wage
(Wage / )

SL

Waget Threshold Wage

Wageb Balanced Wage and

Labor
DL

of Total Employed
Et Eb Labor ( Ei )

Figure 3.16 the Effects of Real Wage Changes on Labor Supply Substitution Effect and Income Effect

In Figure 3.16, the substitution effect dominates
the labor supply, and the quantity of labor supply
will continue to increase due to the substitution effect.
According to the substitution effect, an increase in
real wages cause in substitution for employed workers
to work more but to have less leisure time. Until the
threshold wage line, the substitution effect is larger
than the income effect. Therefore, as in our example,
the domination of the substitution effect stops at
the threshold wage level. After this level, the income
effect comes into play. Following the income effect,
employed workers or individuals will work less and
have more leisure time since he or she will have a
higher standard of living due to higher wage level.
Therefore, there will be a negative relationship between
the supply of labor and wage rate. This means that
individuals will prefer to spend more leisure time after
this threshold level. Upper part of the SL curve has a
negative slope, which means that the income effect
of a real wage increase is greater than the substitution
effect of a real wage increase. Here, the total effect of
an increase in real wage on Ls is ambiguous since the
substitution effect may be greater or smaller than the
income effect (Figure 3.17 and 3.18).

Real Wage
(Wage / )
SL

Wage1

Waget

Wageb

Wage0

of Total Employed
E0 Eb E1 Et Labor ( Ei )

Figure 3.17 The Labor Supply Curve and the Engel Curve: the Income Effect surpassing the Substitution Effect

72
Introduction to Economics I

If we brush up of the utility theory, for a moment we should acknowledge the existence of a benefit-
cost relationship between working and spending leisure time. Then, we should analyze this scene via
Cartesian Plane, which sometimes referred to as the x and y plane or the coordinate plane.

Engel curves, named after 19th Century German statistician Ernst Engel, illustrate the
relationship between consumer demand and household income.
Engel curves for normal goods slope upwards – the flatter the slope the more luxurious
the good, and the greater the income elasticity. In contrast, Engel curves for inferior goods
have a negative slope.
Income Demand for the three
(Y) goods, shown here, all
Normal respond very differently to
Good
the same change in income,
Y to Y1. Demand for the
Luxury normal good increases from
Y1
Q to Q1, demand for the
Y luxury good rises much
more, to Q2, and demand
for the inferior good falls
from Q to Q3.
h t t p : / / w w w .
Inferior
Good economicsonline.co.uk/
C o m p e t i t i ve _ m a rk e t s /
Q3 Q Q1 Q2 Quantity
Demand_and_income.
Demanded html

Real Wage
(Wage / )

Wage2

Wage1

Waget

35H 40H 45H of Weekly Working

Hours (Wi) and Spending
More working hours Leisure Time ( Li )

More social activities

Figure 3.18 Cartesian Plane for Working Time and Leisure Time

73

How Real Interest Rate Changes
Affect Individual Savings?
Now we have another real life case to analyze
the behavior of consumer: if real interest rates
increases or decreases, how these changes affect the
decisions of individuals to save more or less, which
also means to consume less and more, respectively.
We can define real interest rate as the subtraction of
the price level from the nominal interest rate. This
methodology helps us to purify and observe the
meaningful effect of change of interest rate on micro
and macroeconomic variables that may also affect
millions’ decision to save, invest and consume, etc.
When the real interest rate starts to decline, because
of the lower level of opportunity cost of holding
money, individuals become more willing to spend
money for goods and services, instead of saving. This
negative effect of the real interest rate on the saving
rate is called the “Substitution Effect”. This effect
indicates that there is a trade-off between saving
and spending for consumption goods in regard to
changes in real interest rates. Then we can formulize
a simple and positively related functional equation
for the relationship between real interest rate and
saving rates for the “Substitution Effect”:
Saving Rate = s0 + β1r
In this formulation, the first term on the right,
s0, represents the autonom saving rate, β1 is the
marginality or slope coefficient, and represents the
real interest rate.
If interest rates fall, the reward from saving
falls. It becomes relatively more attractive
to hold cash and / or spend. This is the
substitution effect – with lower interest rates,
consumers substitute saving for spending.
Here, it is important to talk about another effect
of real interest rate decline. Some research studies
have come up with a number of findings that have
reduced the effect of this slope parameter in practice.
Some middle-income individuals (like pensions and
underpaid workers) tend to save more (i.e., less
demand) at the new level of interest rate in order
to be able to compensate for the negative effect
downward movements of the real interest rate. This
counter-tendency is called the “Income Effect”.
74
The Theory of Consumer Choice
Important
However, if interest rates fall, savers see
a decline in income because they receive
lower income payments. A pensioner
relying on interest payments from
savings may feel he needs to save more
in order to maintain the income from
savings. Usually, the substitution effect
dominates. Lower interest rates make
saving less attractive. But, for some, the
income effect may dominate, and people
may respond to lower interest rates by
saving more in order to maintain their
standard of living.
Most of the studies show that usually the
“substitution effect” dominate the “income effect”, so
with the fall of interest rate, the “total effect” will be
negative because of this dominance.
For the case of the effects of higher interest
rates, higher interest rates increase the income from
saving. Therefore, this gives consumers more income
to spend, and spending may rise (income effect).
Higher interest rates make saving more attractive than
spending, reducing consumer spending (substitution
effect). Therefore, total effect again is depends on
whether or not the income or the substitution effects
are greater or smaller than one another.
Of course, these situations will have different ef-
fects if the individual is a net-saver or net-borrower
in real life as explained in below.
An increase in the interest rate will cause a
clockwise rotation in the budget line as shown in
the Figure 3.19. This increase makes savers better
off (they will be on a higher indifference curve) and
borrowers worse off. When the interest rate increases,
the current consumption becomes relatively more
expensive (the interest rate represents the “price” of
current consumption) thus the individual will tend
to substitute away from the current consumption.
This movement is known as the substitution effect
(Co’-Co). However, assuming that present and future
consumption are both normal goods, an increase
in the interest rate will increase the relative income
leading to what is known as the income effect (Co’-Yo)
For a net-saver, this increase in the relative income will
thus induce him to “buy” more current consumption
(i.e., the net effect is Co-Yo).
Introduction to Economics I

The opposite is true for Y (Future

the borrower where the Consumption)
reduction in relative income
leads to the “purchase”
of less consumption in
the present time period.
Therefore, the income A
effect will be positive for a Cf’
net-saver and be negative
for the net-borrower in
contrast to the substitution
effect which is negative for C U1
f
both. The substitution and B
the income effects work B(Yf) U0
C
in opposite directions for
the net-saver. Therefore,
the effect of changes in
the interest rate on savings
behavior depends on the
relative size of the two X (Current
C0’ C0 Y0 Consumption)
effects. If the income
effect is greater than the Figure 3.19 The Effect of An increase in the interest rate (r) on Future and Current
substitution effect (i.e., the Consumption
individual has a strong reaction to the increase in purchasing power), then an increase in the interest rate
will lead to an increase in current consumption and a reduction in savings. If the income effect is less than
the substitution effect (the individual reacts strongly to an increase in the price of current consumption),
the opposite will be true. For a net borrower, the two effects complement each other. An increase in the interest
rate will always lead to a reduction in present consumption as borrowing from the future become more
expensive. Total effects will depend on the type of individuals as net borrowers or savers (for details, http://
www.digitaleconomist.org/tpc_4020.html ).

Further Reading

Books: Economist Magazine,

N. Gregory Mankiw and Mark P. Taylor, EconomicsUK.com
(2011) Economics. Second edition, SouthWes- Federal Reserve
tern, Cengage Learning.
European Central Bank
Robert S. Pindyck and Daniel L. Rubinfeld
FT.com
(2008) Microeconomics, sixth international edi-
tion, Pearson Education International. Bloomberg
Magazines: https://www.sheffield.ac.uk/library/subjects/
econir (Useful websites for economists)
Business Week
From Turkey:
Economist
Turkish Republic Central Bank
Forbes
State Planning Organization (Turkey)
Fortune
State Statistical Institute (Turkey)
Other resources:
Top 10 economic web sites:

75
 The Theory of Consumer Choice

Dealing with questions such as, “How does a consumer decide what to buy?”
“What are the trade-offs faced by him while making such decisions?”
LO 1 “How do the decisions change with changes in factors such as price,
incomes, interest rates?”

People behave rationally in an attempt to maximize satisfaction from a particular combination of goods
and services. Consumer choice has two related parts: the consumer’s utility (total utility, marginal utility,
and the law of diminishing marginal utility) and the budget line.
Summary

Consumers maximize satisfaction subject to budget constraints. The rational consumer will choose in
equilibrium to allocate his or her income between two goods (X and Y) at the point that the MRS x for
y =Px/Py.
Because of the scarcity issue in economy, consumers have to make choices by comparing market baskets or
bundles of commodities. With a given income, choosing more of from one good reqires giving up another.
Price changes, with a given income, couses two effects: The substitution and income effects on the
decision of the buyers. Normally, an increase in the price of one good causes that good’s quantity
consumed to decreas and another goods’ consumption to increase. Income changes affects the budget
line and cuses the budget line to shift. For normal goods, an ancrease in income causes both goods’
demand (consumption) to increase.

LO 2 Understanding the concepts of

affordability and budget constraint.

Indifference curves are downward sloping and cannot intersect one another. Consumer preferences
can be completely described by an indifference map. The marginal rate of substitution of good X for
good Y is the maximum amount of Y that a person is willing to give up obtaining one additional unit
of X. Budget lines represent all combinations of goods for which consumers expend all their income.
Consumers maximize satisfaction subject to budget constraints.

Deriving indifference curves and explaining how they

LO 3 depict consumer preferences,

Indifference curves are downward sloping and cannot intersect one another. Consumer preferences can
be completely described by an indifference map. The marginal rate of substitution of good X for good Y
is the maximum amount of Y that a person is willing to give up to obtaining one additional unit of X.

76
Introduction to Economics I

Understanding and interpreting the impact of the

LO 4 changes in income and price on the consumer’s choice.

Consumers maximize satisfaction subject to budget constraints. The rational consumer will choose
in equilibrium to allocate his or her income between two goods (X and Y) at the point that the MRS
x for y =Px/Py.
If we hold commodity prices constant, each level of money income results in an equilibrium market
basket for the consumer. This analysis gives us the income-consumption curve.

Summary
Holding constant the consumer’s money income as well as the prices of other goods, we can
determine the relationship between the price of a good and the amount of this good that a consumer
will consume. This analysis gives us the price-consumption curve, which is a usefull tool to derive
the individual demand curve.
The total effect of a price change on the quantity demanded can be divided into two parts: the
substitution effect and the income effect.

LO 5 Identifying the income and substitution effects.

If we hold commodity prices constant, each level of money income results in an equilibrium market
basket for the consumer. This analyze gives us income-consumption curve.
Holding constant the consumer’s money income as well as the prices of other goods, we can determine
the relationship between the price of a good and the amount of this good that a consumer will
consume. This analyzes gives us price-consumption curve, which is usefull tool to derive individual
demand curve.
Total effect of a price change on the quantity demanded can be divided into two parts: substitution
effect and the income effect.

Deriving demand curves, and applying the theory of consumer

LO 6 choice to a few implications about household behavior.

Let’s expalin the marginal utility theory and use it to derive a consumer’s demand curve. The marginal
utility theory implies the law of demand. That is, other things remaining the same, the higher the
price of a good, the smaller is the quantity demanded of that good.
An illustration of how this model of consumer behavior has been used to help solve some practical
problems is provided by the study on the effects of a real wage increase and of interest rate changes.

77

1 The theory of consumer behavior is based
on certain assumptions. It includes at least the
assumption(s) that preferences are:
A. complete B. transitive
C. intransitive D. both (a) and (b) are correct
Test Yourself
E. both (a) and (c) are correct
2 The assumption of transitive preferences
implies that indifference curves must:
A. not cross one another
B. have a positive slope
C. be L-shaped
D. be convex to the origin
E. all of the above
3 If a market basket is changed by adding more
of at least one good, then rational consumers will:
A. Rank the market basket more highly after the
change.
B. More likely prefer a different market basket.
C. Rank the market basket as being just as desirab-
le as before.
D. Be unable to decide whether the first market
basket is preferred to the second or vice versa.
E. Have indifference curves that cross.
4
The slope of an indifference curve reveals:
A. that preferences are complete.
B. the marginal rate of substitution of one good
for another good.
C. the ratio of market prices.
D. that preferences are transitive.
E. none of the above.
5 Indifference curves are convex to the origin
because of:
A. the transitivity of consumer preferences.
B. the assumption of a diminishing marginal rate
of substitution.
C. the assumption that more is preferred to less.
D. the assumption of completeness.
E. none of the above.
Consider the following three market baskets:
Table
Food Clothing
A 6 3 D. will be right angles whose corners occur on a
B 8 5
C 5 8 ray from the origin with a slope of +2.
78
The Theory of Consumer Choice
6 Refer to the table above, if preferences satisfy
all four of the usual assumptions:
A. A is on the same indifference curve as B.
B. B is on the same indifference curve as C.
C. A is preferred to C.
D. B is preferred to A
E. both (a) and (b) are correct.
7 Mikey is very picky and insists that his mom
make his breakfast with equal parts of cereal and
apple juice – any other combination and it ends
up on the floor. Cereal costs 4 cents per tablespo-
on and apple juice costs cents per tablespoon. If
Mikey’s mom budgets $8 per month for Mikey’s
breakfast, how much cereal and juice does she buy?
A. 40 tablespoons each of cereal and juice.
B. 80 tablespoons each of cereal and juice.
C. 40 tablespoons of cereal and 75 tablespoons of
juice.
D. 100 tablespoons of cereal and 67 tablespoons
of juice.
E. None of the above.
8 If Px = Py, then when the consumer maximi-
zes utility,
A. X must equal Y.
B. MU(X) must equal MU(Y).
C. MU(X) may equal MU(Y), but it is not neces-
sarily so.
D. X and Y must be substitutes.
E. None of the above.
9 Mustafa consumes only two goods, X and Y.
Assume that Mustafa is not at a corner solution,
but he is maximizing utility. Which of the follo-
wing is NOT necessarily true?
A. MRSxy = Px/Py.
B. MUx/MUy = Px/Py.
C. Px/Py = money income.
D. Px/Py = slope of the indifference curve at the
optimal choice.
E. MUx/Px = MUy/Py.
10 If a consumer is always indifferent between
an additional one grapefruit or an additional two
oranges, then when oranges are on the horizontal
axis the indifference curves:
A. will be straight lines with a slope of -1/2.
B. will be straight lines with a slope of -1.
C. will be straight lines with a slope of +1/2.
E. None of the above.
Introduction to Economics I

If your answer is wrong, please review the

1. D If your answer is wrong, please review the 6. D
“Consumer Preferences and Indifference

Answer Key for “Test Yourself”

“Consumer Preferences” section.
Curves” section.

If your answer is wrong, please review

2. A If your answer is wrong, please review the 7. B
the “Optimization: Optimal Choices for
“Consumer Preferences” section.
Individual Consumers” section.

If your answer is wrong, please review

3. A If your answer is wrong, please review the 8. B
the “Optimization: Optimal Choices for
“Consumer Preferences” section.
Individual Consumers” section.

If your answer is wrong, please review the If your answer is wrong, please review
4. B 9. C
“Consumer Preferences and Indifference the “Optimization: Optimal Choices for
Curves” section. Individual Consumers” section.

If your answer is wrong, please review the If your answer is wrong, please review
5. B 10. A
“Consumer Preferences and Indifference the “Optimization: Optimal Choices for
Curves” section. Individual Consumers” section.

Fill out Table 3.1 considering an increase in income.

Suggested answers for “Your turn”

In Table 3.1, when income goes up, it will double all the figures in the second
your turn 1 and third columns. Conversely, when income goes down, all the figures in the
second and third columns will be in half.

When these baskets have the same price, what do you think would
determine the customer’ s choice/preference of one basket over the other?

Consumers can be indifferent between them if these baskets privide equal units
your turn 2 of utility. Otherwise, consumers will choose the basket with the higher utility.

What would happen if the indifference curve

had a positive slope?

If two market baskets are to be equivalent [in utility units], and if one market basket
contains more of both commodities, it would mean that one or the other of the
your turn 3 commodities is not defined so that more of it is preferred to less. If it sloped upward
it would violate the assumption that more of any commodity is preferred to less.

79
 The Theory of Consumer Choice

Explain the Consumer’s optimal choice.

The consumer chooses between the consumption of the two goods so that
Suggested answers for “Your turn”

the marginal rate of substitution equals the relative price. At the consumer’s
your turn 4 optimum, the consumer’s valuation of the two goods equals the market’s va-
luation.

Is there a highest indifference curve that the budget line can reach
on the X or Y axis?

A corner solution exists in a situation in which the budget line reaches the
highest achievable indifference curve along an axis (the vertical axis). For
example, the consumer may choose to spend all his or her income just on one
good, good X. Of course, it is possible to spend all his or her income just on
your turn 5 good Y. In this situation, the corner solution will be on the highest achievable
indifference curve along the horizontal axis. In non-technical terms, a corner
solution is possible when the chooser is either unwilling or unable to make a
tradeoff. It holds if there is a higher vs. lower preference between, and a per-
fect substition for two goods.

How are the Marginal Utility and the Elasticity

of Demand related to each other?

When the marginal utility decreases quickly as more of a good is consumed, a

fall in the price of that good requires only a small change in consumption to
equate the marginal utility per dollar spent on it with the marginal utility per
dollar spent on other goods. As a result, the quantity demanded increases very
little and so demand is inelastic.
your turn 6
When the marginal utility decreases slowly as more of a good is consumed, a
fall in the good’s price requires a large change in consumption to equate the
marginal utility per dollar spent on it with the marginal utility per dollar spent
on other goods. As a result, the quantity demanded increases significantly and
so demand is elastic.

80
Introduction to Economics I

References
Bade, R. and Parkin, M. (2015) Foundations http://www.economicsdiscussion.net/notes/income-
of Microeconomics, (7th Edition), Pearson effect-income-consumption-curve-with-curve-
Education Inc., USA. diagram/1026
Gwartney, J. D., Stroup, R. L. and Sobel, R. S. http://www.economicshelp.org/concepts/inferior-
(2000) Microeconomics: Private and Public good/
Choice, (Nineth Edition), The Dryden Press,
https://www.subjectmoney.com/definitiondisplay.
New York.
php?word=A%20Perfect%20Substitute#sthash.
Mansfield, E. (1998) Microeconomics, (Shorter izZv4voD.dpuf
7th Edition), W. W. Norton & Company, Inc.,
http://www.econogist.com/home/complements-and-
London and New York.
substitutes
McEachern, W. A. (2015) ECON-Microeconomics
http://www.economicsdiscussion.net/cardinal-utility-
Fourth (Student) Edition, Cengage Learning,
analysis/price-demand-relationship-normal-
Uni. Of Connecticut, USA
inferior-and-giffen-goods/1069
http://www.tuik.gov.tr/PreHaberBultenleri.
http://www.economicsonline.co.uk/Competitive_
do?id=18630.
markets/Demand_and_income.html
http://www.managedstudy.com/micro/cardinal_
http://www.digitaleconomist.org/tpc_4020.html
utility_approach.htm)
https://micrograndma.wordpress.com/2013/02/04/
closer-look-corner-solutions/

81
 Elasticity, Government
Chapter 4 Policies and Market Efficiency
After completing this chapter, you will be able to:

1 The meaning of the demand elasticities

2 The determinants of the price elasticity of
demand

3 The relationship between the elasticity and

the total revenue
4 The determinants of the price elasticity of
supply
Learning Outcomes

5 The meaning of price controls

6 The effect of the taxation on the market

7 And analyze the tax burden based on the

elasticities
8 The meaning of the consumer and the
producer surpluses

Chapter Outline Key Terms

Introduction Elasticity
Elasticity and its Applications Tax burden
Elasticity of Demand
Price elasticity of demand
Elasticity of Supply
Government Policies and Their Effects on Market Tax incidence
Outcomes Income elasticity of demand
Benefits to Participants and Market Efficiency Consumer surplus
Cross-price elasticity of demand
Producer surplus
Price elasticity of supply
Total surplus
Price ceiling
Efficiency
Price floor

82
Introduction to Economics I
INTRODUCTION
Market theory, especially the demand and
supply theories, analyzes how changes in the
determinants of demand and supply affect the
behavior of buyers and sellers in market place and
simply show the direction of the change in the
quantity demanded and/or quantity supplied in
response to, say, in change in price or income of
the consumer.
In this chapter, what is going to be analyzed is how
much the buyers and sellers respond to changes in
market conditions. Hence, the concepts of elasticity of
demand and supply, the effects of taxation and issues
of welfare economics will be developed, analyzed and
their applications will be discussed.
The concepts that will be developed in relation
to demand are the price elasticity of demand,
income elasticity of demand and the cross-price
elasticity of demand. Related to supply, the price
elasticity of supply will be introduced. Also, the
shapes and slopes of demand and supply curves
will be introduced based on the elasticities and
their meaning will be explained with the real life
examples.
The price elasticity of demand measures the
price-sensitivity or responsiveness of consumers.
It is calculated as the percentage change in the
quantity demanded divided by the percentage
change in price. The income elasticity of demand
measures the response of the quantity demanded to
a change in consumer income and is computed as
the percentage change in the quantity demanded
divided by the percentage change in income. Most
of the goods and services we consume are normal
goods. For normal goods, the income elasticity is
positive and for inferior goods, the income elasticity
is negative. The third type of demand elasticity is
the cross-price elasticity of demand. Two goods
are either substitute to each other or they are
complement to each other. The cross-price elasticity
of demand measures the response of demand for one
good (good Y) to changes in the price of another
good (good X). For substitute goods, the cross-
price elasticity of demand is positive since the price
increase of good X causes the quantity demanded
of good Y to increase. For complement goods, the
cross-price elasticity of demand is negative because
a price increase in good X causes the quantity
demanded of good Y to decrease.
The price elasticity of demand for a good or
service depends on many factors such as whether
close substitutes are available, the good is of
necessity or luxury for the consumer, share (weight)
of the good’s cost in the consumers’ budget, and
the time period.
What happens to total revenue from sales
if the price of goods changes? The answer of
this question is related to the price elasticity of
demand. If demand is elastic, an increase in price
causes total revenue to decrease. A decrease in
price, in contrast, causes total revenue to increase.
On the other hand, when demand is inelastic, an
increase in price causes total revenue to increase.
With an inelastic demand curve, the reason that
total revenue increases with price increase since
the increase in price leads to a decrease in quantity
demanded that is proportionally smaller.
The applications of elasticities to real life
examples are important to understand the market
behavior of buyers and sellers. The concept of
elasticity is important since the buyers and sellers
can use the concepts to understand and decide
what kind of strategies they are going to follow.
Besides the elasticity issue, the effect of taxation
and its relationship with elasticity will also be
introduced in this chapter. Other concepts are
related to welfare economics, namely the consumer
and producer surpluses.
ELASTICITY AND ITS
APPLICATIONS
In the previous chapters of 2 and 3, the
determinants of both the individual and market
demand and supply are analyzed. When there is
a change in one of the determinants of demand
or supply, how market equilibrium price and
quantity change is also explained. The theory of
demand indicates that an individual’s decision
about what quantity of a specific good to demand
is determined by factors such as the tastes and
preferences of the individual, the price of the good,
the income of the individual, the price of related
goods and services, the individual’s expectations
about the future income, wealth, and prices, etc.
Also, when the market demand is considered, the
number of buyers in the market is added to the
determinants of the demand of the specific good.
83
 Elasticity, Government Policies and Market Efficiency
The law of demand indicates that when the price
of a good increases, the quantity demanded of that
good decreases. Also, it tells us that for the normal
goods an increase in income causes individuals to
buy more of that good.
On the supply side of the market, the
determinants of the supply of a good or service
involve the price of the good, the input prices,
technology available to production and the number
of sellers/suppliers of the good. The law of supply
tells us that there is a positive relationship between
the price of a good and the quantity produced and
supplied of that good.
The principles of market theory and especially
the theory of demand and supply allows us to make
certain predictions about how individuals and firms
behave in a market when there is a change in one
of the determinants of demand or supply. In case
of price changes, for example, the demand theory
enables us to predict that an increase in the price
of a good leads consumers to reduce the amount
of that good that they demand. Hence, this theory
allows us to predict the direction of the change but
does not allow us to know how much change occurs
in the quantity of demand when there is a change
in price. So, we need to develop another useful
measure to predict the effect of changes in, say,
price on quantity demanded in both direction and
quantitative change. That measure or concept in
economics is called elasticity. In general, elasticity
is a measure that shows how much buyers and
sellers respond to changes in market conditions,
which is represented by the changes in variables
that determine demand and supply.
Elasticity in General
In general, elasticity can be defined as a measure
that shows how much one variable responds to
changes in another variable. So, elasticity shows
not only the direction of the relationship between
two variables, but also the quantitative response
of one variable to another. Thus, elasticity is
a numerical measure of the responsiveness of
quantity demanded (Qd) or quantity supplied (QS)
to one of its determinants.
84
Picture 4.1
Elasticity, in general, is used to quantify
the response of one variable when another
variable changes.
Economists compute elasticity as the percentage
change in, say, variable A, divided by the percentage
change in variable B. That is,
%ΔA
Elasticity of A with Respect to B=
%ΔB
In order to measure the quantitative response of
one variable to another, elasticity measures related
to demand and supply are going to be developed
in this chapter. On the demand side, to show
the quantitative response of consumers to price,
income and related goods price changes, the price
elasticity of demand, income elasticity of demand
and cross-price elasticity of demand concepts will
be introduced and analyzed. On the supply side,
to represent the quantitative response of producers
to price changes, the concept of price elasticity of
supply will be introduced.
ELASTICITY OF DEMAND
In order to measure how much consumers
respond to changes in the determinants of demand
such as, changes in price of the good, their income,
or price of the related goods, in the market place
the concept of elasticity is used. In this section,
the price elasticity of demand, income elasticity
of demand and cross-price elasticity of demand
concepts will be introduced by showing how
each elasticity measure is computed, what are the
determinants and implication of each concept for
the consumers and producers/sellers.
Introduction to Economics I

Price Elasticity of Demand

The law of demand indicates that there is an inverse relationship between the price of a good and
the quantity demanded of that good. The law states that
when the price of a good increases the quantity demanded
of that good falls. The price elasticity of demand measures The price elasticity of demand measures
how much the quantity demanded (Qd) of a good changes the responsiveness of demand to changes
when there is a change in the price of that good (P) Hence, in price.
the price elasticity of demand measures the price-sensitivity
or responsiveness of consumers.
It is calculated as the percentage change in the quantity demanded of the good divided by the percentage
of change in the price of that good as shown below:
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price

%ΔQ d
ε Pd = (1)
%ΔP

In equation 1, ε Pd represents the price elasticity of demand, Qd represents the quantity of demand and
P represents the price of the good. For example, assume that a 10 percent increase in the price of bananas
causes a 15 percent decrease in the quantity demanded for bananas. In order to calculate the price elasticity
of demand for bananas by using the equation (1), we can calculate the price elasticity of demand as:

%ΔQ d 15%
ε Pd =
= = 1.5
%ΔP 10%

The elasticity measure we calculated, which is 1.5, states that consumers’ response to price changes by
changing their quantity demanded is more than proportional in percentage.
The sign of the price elasticity of demand is always negative because of the law of demand. As you
remember, the law of demand states that an increase in the price of a good causes the quantity demanded of
the good to fall. In the example above, the sign of the elasticity is shown with plus sign due to the common
practice of dropping the negative sign in economics. This
practice is called absolute value by mathematicians. From
this point on, the sign of the price elasticity of demand The sign of the price elasticity of
will be presented with the plus sign following the common demand is always negative because of the
practice but the students should know that because of the law of demand.
law of demand the sign is always negative.

Computing the Price Elasticity of Demand

Assume that we have a demand curve, like the one in Figure 4.1, and we would like to compute the price
elasticity of demand between any two points in that figure by using the equation in (1). If we try to calculate
the price elasticity of demand between two points, such as point A, (Q1, P1) and point B, (Q2, P2) on the
demand curve, then calculating the price elasticity of demand going from point A to B or from point B to
A, gives us different measures and creates a problem. Let us consider these numbers for point A and point B:
Point A Price 1 = 6 TL, Quantity 1 = 150
Point B Price 2 = 9 TL, Quantity 2 = 100

Moving from point A to point B, the price rises by 50 percent and in response to this price change the
33%
quantity demanded falls by 33 percent, resulting that the price elasticity of demand is, = .66 . On
50%

85
 Elasticity, Government Policies and Market Efficiency

the other side, if the elasticity is measured by starting from point B and moving to point A, this gives us

an elasticity measure which is equal to, 50% = 1.5 . This is because the percentage change in price from
33%
9 TL to 6 TL is a 33 percent change and the response of consumers to this price change in the quantity
demanded is 50 percent. Computing these two different elasticity measures on the same demand curve
from two different points shows that using this price elasticity calculation method is not without problems.
In order to avoid these measurement problems, the best way in economics is to use the mid-point method.
Price (TL)

B
9

6 A

Demand

Quantity
100 150
Figure 4.1 Measuring Price Elasticity

Mid-point Approach
When we take two points such as points A and B, on the demand curve, then calculating the price
elasticity of demand moving from point A to B or B to A and have the same elasticity measure requires the
following equation. Different than the standard way to compute price elasticity of demand, the mid-point
method calculates the percentage change by dividing the change by the average of the initial and final levels
of price and quantities.
(Q2 − Q1 )
(Q2 + Q1 )
2
Price elasticity of demand= (P − P ) (2)
2 1
(P2 + P1 )
2
For example, if we use the same values for point A and point B and then try to calculate the price
elasticity of demand by using the mid-point method, we get:

(100 −150) (−50)

(100 +150) (250) −50 −2
d
Going from point A to B: ε P = 2 = 2 = 125 = 5 = −1
(9 − 6) (3) 3 2
(9 + 6) (15) 7.5 5
2 2

86
Introduction to Economics I
(150 −100) (50)
(150 +100) (250) 50
d
Going from point B to A: ε P = 2 = 2 = 125 = 5 = −1
(6 − 9) (−3) −3 −2
(6 + 9) (15) 7.5 5
2 2
The results of the computations by using the
mid-point approach give the same values and avoid
the problems involved when the standard method
is used. Hence, after this point on in this book,
otherwise indicated, the mid-point method is going
to be used in elasticities are measured.
Determinants of Price Elasticity of
Demand
As indicated before, the price elasticity of
demand is a measure that shows how much quantity
demanded changes in response to price changes
and the measure has a minus sign due to the law
of demand. The price elasticity of demand can take
values between zero (0) to minus infinite (–∞).
The demand for a good is said to be inelastic if the
percentage change in quantity demanded is smaller
than the percentage change in the price of a good.
The demand for a good is said to be elastic if the
percentage change of quantity demanded is greater
than the percentage change in the price of a good.
For example, if consumers respond to a 10% increase
in the price of a good with a less than 10% decrease in
their quantity demanded, it is said that the demand
for this good is inelastic. In contrast, if the response
of consumers to a 10% increase in price is more
than 10% decrease in the quantity demanded, then
the demand is said to be elastic. The price elasticity
of demand shows the willingness of consumers to
move away from a good in case the price of that
good increases. Hence, the price elasticity reflects the
economic, social, and psychological forces that shape
the tastes of consumers.
The price elasticity of demand for a good or
service depends on many factors such as whether
close substitutes are available, the good is necessity of
luxury for the consumer, share (weight) of the good’s
cost in the consumers’ budget, and the time period.
Are Close Substitutes of the Good
Available to Consumers?
Price changes affect the consumer behavior
by changing their quantity demanded in the
2
opposite direction. How much consumers change
their quantity demanded is mostly affected by the
availability of close substitutes of the good. Goods
with close substitutes tend to have more elastic
demand than goods without close substitutes since
it is easier for consumers to give up that good and
switch to its substitutes. For example, apple and
orange or pears are easily substitutable.
The Good is a Necessity or a Luxury
For The Consumers?
Price elasticity of demand is also affected by how
the consumers view a good or service a necessity
or luxury for themselves. Necessities tend to have
inelastic demand and luxuries tend to have elastic
demand. Education and health services (doctor
visits), heating in the winter, gasoline for car owners
are considered necessities for consumers and these
items have inelastic demand since the case of price
increases in these items gets small reactions from
consumers to cut their quantity demanded. On
the other hand, for the items that is considered as
luxury for the consumers, a price increase gets a
substantial response from the consumers’ demand.
Please notice that whether a good or service is a
necessity or luxury is determined by the tastes and
preferences of the consumer.
The Importance of Being Unimportant
Another factor that affects the price elasticity is
the share (weight) of a good’s cost in the consumers’
budget. When a good or service represents a relatively
small portion of our total budget, we tend to pay little
attention to its price. The price hikes in this kind of
goods do not create substantial responses from the
consumers in terms of cutting their quantities. Thus,
we can say that goods that represent a relatively small
portion of our total budget (Importance of Being
Unimportant) tends to have inelastic demand. For
example, for the wealthy, the cost of bread represents
a relatively small portion of their total budget and
they tend to pay little attention to its price. Thus,
the price increases does not create substantial cuts in
bread consumption.
87
 Elasticity, Government Policies and Market Efficiency
Time Horizon
Goods tend to have more elastic demand in the
long-run than the short-run because in the long-run
availability of substitutes for buyers is higher than
the short-run. For example, when the gasoline prices
increase by 30% and the car users cannot respond to
this price hike by cutting their car use too much in
the short-run but in the long-run the consumers can
find alternatives by switching to other energy uses.
Thus, we can say that the price elasticity of demand
is higher in the long-run than it is in the short-run.
1 The first part of this equation is equal to the
Which one do you expect to
have more elastic demand: the
food market in general or the
hamburger market in particular?
Shape of Demand Curves and
Elasticity
Demand curves are classified by economists
according to their price elasticity. The demand of a
good is said to be inelastic if the price elasticity
of demand is smaller than 1 (between 0 and -1),
so the quantity changes proportionally less than
price. Demand is elastic when the price elasticity of
demand is greater than 1 (between -1 and - ∞), so
that the quantity moves proportionally more than
the price. Demand is unit elastic if the elasticity
is equal to 1 (-1) indicating that the quantity
moves proportional to price. The price elasticity
of demand is closely related to the slope of the
demand curve but the slope of a demand curve is
different from its price elasticity of demand.
Demand is inelastic when the percentage
change in quantity demanded is smaller
than the percentage change in price.
Inelastic demand always takes a value
between zero and -1.
Demand is elastic when the percentage
change (decrease) in quantity demanded
is larger than the percentage change
(increase) in price. Elastic demand has an
absolute value greater than 1.
88
It is important to understand the difference
between the slope of the demand curve and its price
elasticity. Generally, it is thought that the price elasticity
of demand can be understood by simply looking at
the slope of a demand curve, that is, the flatter the
demand curve is, the higher the price elasticity and
the steeper the demand curve is, the lower the price
elasticity of demand. The slope of a demand curve is
different from its price elasticity of demand. In order
to understand the difference between the two, let us
look at the formula for price elasticity of demand.
ΔQ P
ε Pd = x
ΔP Q
slope of the demand curve, and the second part is
the ratio of the price to quantity. The slope of a
demand curve, whether it is flat or steep, is based
on absolute changes in price and quantity, that is:
ΔP 1
Slope of demand curve= x
ΔQ ΔQ
ΔP
On the other hand, the price elasticity of
demand is concerned with relative changes in price
and quantity, that is:
ΔQ
Q
ε Pd =
ΔP
P
Thus the slope of the demand curve and its
price elasticity are different because:
ΔQ
1 Q
≠
ΔQ ΔP
ΔP P
However, there are exceptions in which the
price elasticity of demand can be understood by
looking at the slope of the demand curve. These
cases are: (i) when price and quantity are identical,
by looking at the slopes of the two intersecting
demand curves it can be said which one is more
elastic than the other. (ii) If the demand curve is
vertical, its slope and its price elasticity is zero, and
(iii) If the demand curve is horizontal, its slope and
the price elasticity would be infinite.
Introduction to Economics I

Thus, it can be concluded that the price elasticity
is closely related to the slope of the demand curve
but the slope of a demand curve is different than
its price elasticity. Also, as a rule of thumb, it can
be said that; the flatter the demand curve is, the
bigger the price elasticity of demand, the steeper
the demand curve is, the smaller the price elasticity.
In Figure 4.2, all calculations are made by using
the mid-point method. By taking the initial price
as 2TL and initial quantity as 100 Units, in Figure
4.2.a, and going to price of 3 TL is a 40 % change in
price. In response to this price increase, the quantity
demanded does not change. So, the response is
equal to zero. As a result, we say the demand is
perfectly inelastic since the elasticity is equal to zero.
(a) Perfectly Inelastic Demand:
Elasticity Equals to Zero (0)
Price (TL)
Demand
In Figure 4.2.b, a 40 percent increase in price creates
a 22 percent decrease in quantity demanded. So, the
elasticity is smaller than -1, indicating an inelastic
demand. In Figure 4.2.c., a 40 percent increase
in price creates a 40 percent decrease in quantity
demanded. So, the elasticity is equal to -1 which
means that the demand is unit elastic. In Figure
4.2.d., a 40 percent increase in price creates a 66.6
percent decrease in quantity demanded. Elasticity is
greater than the absolute value 1 indicating that the
demand is elastic. In Figure 4.2.e., at any price above
2 TL, quantity demanded will be zero since there are
other sellers that sell the identical good for the price
of 2 TL. At the price of 2 TL, the consumers will
buy any quantity. So, the elasticity is infinite means
we face a perfectly elastic demand curve.
(b) Inelastic Demand: Elasticity
Smaller than One (1)
Price (TL)

3 B
3
2 A
2
Demand

100 Quantity 80 100 Quantity

(c) Unit Elastic Demand: (d) Elastic Demand: Elaticity
Elaticity Equals to One (1) Greater than One (1)

Price (TL) Price (TL)

B 3 B
3

2 A A
Demand 2
Demand

66,6 100 Quantity 50 100 Quantity

(e) Perfectly Elastic Demand

Elaticity Equals to Infinity,

Price (TL)

2 Demand

Quantity
Figure 4.2 Demand Curves with Different Elasticities
89
 Elasticity, Government Policies and Market Efficiency

reason why competitive firms face a perfectly elastic

demand curve is that elasticity is greater when there
2 are lots of close substitutes available. In this case, the
competitive firm is selling a product that has many
What is the price elasticity of
perfect substitutes since in the competitive markets,
demand? Is it related to the
by definition, there are many sellers and all sellers sell
demand curve?
identical products.
Exceptional Cases: Zero Elastic Demand Curve
For a good, if the quantity demanded (Qd) does Relationship Between Total Revenue
not change in response to price changes, then the and Price Elasticity of Demand
percentage change in quantity equals to zero, and In any market, for any firm that wants to
thus price elasticity of demand would be equal maximize its profit, the amount of revenue that
to zero. When price elasticity of demand is zero, it earns is important. Total revenue is the amount
the demand curve is vertical. It is hard to think paid by buyers and received by the sellers of a
of a good for which the price elasticity of demand good or service. For a firm in any market, the total
is zero but in general insulin is given as a good revenue is equal to the price of the good times the
example for this. However, a large price increase amount (quantity) of the good sold, which can be
in insulin would probably reduce the demand for expressed with the equation: TR=PxQ . For any
insulin a little for people with very low incomes demand curve, the total revenue, which is shown
and no health insurance. Still, the price elasticity graphically in figure 4.3, is the colored area of the
can be accepted as zero. box under the demand curve, P1xQ1 . The height of
the box under the demand curve is P, and the width
of the box is Q.
Perfectly Elastic Demand Curve
A perfectly elastic demand curve which would have
a horizontal shape indicates “extreme price sensitivity” Total revenue is computed as the
which means that the tiniest price increase causes the price of a good times the quantity
demand to fall to zero for the analyzed good. If we sold.
can consider the perfectly inelastic demand curve as
one extreme, the perfectly elastic demand curve Price (TL)
would be the other extreme case. In economic
theory, a good example of a perfectly elastic
demand curve is the demand curve that firms
face in competitive markets. In competitive
markets, the competitive firm is the price taker,
which means that the price at which that firm
P
sells its product is determined by the market and 1
each firm has to sell its product for this price.
Assume that the market price for a product, say
it is wheat, is 5 TL per unit and consider the
P1 x Q1 Demand
demand curve facing the individual firm. If the
firm charges a price of 5TL, the firm can sell as
much as it wants. If it charges a price even just
a little higher than 5 TL, the demand for the
firm will fall to zero. The reason for this is that Q1 Quantity
buyers would not be willing to pay more than
5TL when they could get the same wheat elsewhere
Figure 4.3 Total Revenue
for 5TL. Similarly, if the firm drops its price to below
5TL, then the demand for the product will become
huge, “almost infinite”. Please remember that the

90
Introduction to Economics I

What is important for the sellers of any good is
to understand what happens to the total revenue
from sales if the price of that good is changed.
The answer to this question is related to the price
elasticity of demand of the good that the firm sales.
If the demand is elastic, an increase in the price
causes the total revenue to decrease. A decrease in
price, in contrast, causes total revenue to increase.
On the other side, when the demand is inelastic, an
increase in price causes the total revenue to increase.
With an inelastic demand curve, the reason why
total revenue increases with price increase is that
the increase in price leads to a decrease in quantity
demanded that is proportionally smaller.
3 is shown in Figure 4.4. By using the price and
If the demand of a good is
inelastic, what would be the
pricing strategy to increase the
total revenue from the sales?
Price Elasticity-Total Revenue
Relationship With a Linear Demand
Curve
As shown above, some demand curves have
price elasticity that is the same along the whole
demand curve, a fact which is not always the case
for linear demand curves. Non-linear demand
curves mostly have a different price elasticity along
the entire curve since the slope changes as you
move along the demand curve. On the other hand,
the linear demand curves have a constant slope. As
you move down a linear demand curve, the slope
which is equal to the ratio of the absolute change in
price to that in quantity, remains constant. As you
recall, the slope is not equal to the price elasticity of
demand. Thus, a constant slope does not indicate
a constant elasticity for the linear demand curves.
For the linear demand curves, price elasticity of
demand falls as you move downward along the
demand curve. This fact can be seen by looking
at Table 4.1. The table which shows the demand
schedule for the special case linear demand curve,
quantity values from Table 4.1, the price elasticity is
calculated by using the mid-point approach shows
that at points on the demand curve with low price
and high quantity, the portion of demand curve
is inelastic (elasticity is less than 1) and at points
with high price and low quantities the portion of
demand curve is elastic (elasticity is greater than
1). At the mid-point of the curve, the elasticity is
equal to 1 indicating the unit elastic point of the
demand curve.

Table 4.1 Calculation of Price Elasticity of a Linear Demand Curve

Percentage Change in Percentage Change in

Price Quantity Total Revenue Elasticity
Price Quantity Description
(P) (Q) (P x Q) ε Pd ( )
9 0 0
8 2 16 11.76 200 17 Elastic
7 4 28 13.30 66.70 5 Elastic
6 6 36 15.40 40 2.60 Elastic
5 8 40 18.20 28.60 1.57 Elastic
4 10 40 22.20 22.20 1 Unit Elastic
3 12 36 28.60 18.20 0.64 Inelastic
2 14 28 40 15.40 0.385 Inelastic
1 16 16 66.60 13.30 0.20 Inelastic
0 18 0 200 5.90 0.02 Inelastic

91
 Elasticity, Government Policies and Market Efficiency

Price (TL) Now the question is which

of these two effects is bigger?
9 A
The answer depends on the price
8 Elastic Demand elasticity of demand for the good
d
>1 that the firm sells.
7 p
Elasticity equals to 1 When the demand is elastic
6
d
=1
(If we are on the elastic portion of
p
5 B
demand curve), then
4 Inelastic Demand
Price elasticity of demand is
d
<1
greater than 1 (ε P > 1)
d
3 p

2 Percentage
1 The decrease in total revenue
C from
0 2 4 6 8 10 12 14 16 18
Figure 4.4 Linear Demand Curve and Price Elasticity
On the linear demand curves, price
elasticity of demand falls as you move
downward along the demand curve.
As table 4.1 shows, on the inelastic portion of
the demand curve, an increase in price causes the
total revenue to increase. On the other hand, on the
elastic portion of the demand curve, a reduction in
the price causes the total revenue to increase. These
relationships between elasticity and total revenue
indicate that while firms that face elastic demand
can increase their revenues by cutting their prices,
the firms that produce goods with inelastic demand
should follow the price increase strategy to increase
their sales revenues. Students also should notice
that the revenue is maximum when the demand
is unit elastic where it shows the mid-point of the
linear demand curve.
Total Revenue = PxQ
change in
Quantity>Percentage change in Price
Demand
lower Quantity is greater
Quantity than the increase in total revenue
from higher Price, so total revenue
from sales falls.
• If the demand is inelastic (If we are on the
inelastic portion of demand curve), then
Price elasticity of demand is less than 1 (ε P < 1)
d
Percentagechange in Quantity <Percentage change
in Price
The decrease in total revenue from lower
Quantity is smaller than the increase in total revenue
from higher Price, so the total revenue rises.
• In the case of unit elastic demand, which
is the case of mid-point of linear demand
curve, an increase in price leaves total rev-
enue unchanged: the increase in the total
revenue from higher Price exactly offsets
the reduction of the total revenue due to
lower Quantity.
4
When the seller increases the price
of his/her product, what happens
to revenue? Does it rise or fall?

A price increase has two effects on revenue:

The Income Elasticity of Demand
1. Higher Price means more revenue on each
unit the firm sells. Other than the price of a good changes, one
of the most important factor that determines the
2. But higher price means that the firm sells
quantity demanded of the consumer is the income
fewer units (lower Q), due to the Law of
of the individuals. As you recall from the previous
Demand.
chapters that for the normal goods, an increase in
income causes an increase in demand and that for

92
Introduction to Economics I

the inferior goods, an increase in income causes a decrease in demand. If we like to measure how much the
consumers respond to income changes, the measure we need to use is the income elasticity of demand. The
income elasticity of demand (Qd) measures the response of quantity demanded to a change in consumer
income (I) and is computed as the percentage change in quantity demanded divided by the percentage
change in income.

PercentageChangeinQuantity Demanded
Income Elasticity of Demand (ε Id ) =
PercentageChangein Income

Most of the goods and services we consume are normal

goods. Since an increase in income causes an increase in
Income elasticity of demand measures
demand for a normal good, then for normal goods, the
the responsiveness of demand to income
income elasticity is positive, greater than zero. On the
changes.
other hand, since an increase in income causes a decrease in
demand for the inferior good, then for the inferior goods,
the income elasticity is negative, smaller than zero.
Then, in general, we can say that:
For normal goods,the income elasticity is greater than zero (ε Id > 0 )
For inferior goods,the income elasticity is less than zero (ε I < 0 )
d

Even though the sign is positive, the size of the income elasticity of demand for normal goods varies
depending on whether the good is a luxury or necessity good for the consumer. Necessities, such as food,
clothing, health services and gasoline tend to have small income elasticities since consumers, regardless of their
income levels, chose to buy these items. Luxuries on the other hand tend to have large income elasticities.

The Cross-Price Elasticity of Demand

As you recall from chapters 2 and 3, when the price of a good changes, the quantity demanded of related
goods also changes. Two goods are either substitute to each other or they are complement each other. If the
price increase in one good (good X) causes consumers to use other good (good Y) in place of this good, we
say that these two goods (X and Y) are substitutes for each other. Substitutes are goods that are generally used
in place of one another. Concerning the substitute goods, a
price increase in good X leads to quantity demanded of good
Y to increase. Goods have also complementary relationship. The cross-price elasticity of demand is
Complements are goods that are typically used together. One a measure of how much the quantity de-
good or service cannot be used without the other. Concerning manded of one good responds to a change
the complements, price increase of good X causes quantity in the price of another good.
demanded in good Y to decrease.
When we want to learn how much the quantity demanded of one good changes in response to a change
in the price of a related good, we consider the cross-price elasticity of demand. The cross-price elasticity
of demand measures the response of the demand for one good (good Y) to changes in the price of another
good (good X).
PercentageChangeinQuantity Demanded of goodY
Cross − price Elasticity of Demand (ε yxd ) =
PercentageChangein Pr iceof X

For Substitute goods, the cross-price elasticity of demand is positive since the price increase of good X
causes the quantity demanded of good Y to increase.

For substitutes, Cross-price elasticity of demand is greater than zero (ε d

yx > 0)

93
 Elasticity, Government Policies and Market Efficiency

For example, beef and chicken are substitute goods. An increase in the price of beef causes an increase in the
quantity demanded for chicken.
For complement goods, the cross-price elasticity of demand is negative because a price increase in good
X causes the quantity demanded of good Y to decrease.
For complements,Cross-price elasticity of demand is less than zero (ε yx < 0 )
d

For example, computers and software products are complements since one cannot be used without the
other. An increase in the price of computers causes a decrease in the quantity demanded for software products.

ELASTICITY OF SUPPLY
The amount that producers bring to market at any point in time is determined by many factors
including the price of the good, technology and input prices. The law of supply indicates that an increase
in the price of a good leads producers to produce more quantity of that good and, in turn, bring more of
that good to market for sales. So the law indicates a positive relationship between the price and quantity
supplied of a good. When we want to learn how much the suppliers respond to price changes, we need to
take into consideration the concept of price elasticity of supply.

The Price Elasticity of Supply

The law of supply states that with higher prices the
producers increase the quantity supplied. Price elasticity of
The price elasticity of supply is a measure
supply measures how much quantity supplied responds (Qs)
of the response of quantity supplied of a
to a change in price (P). Loosely speaking, the price elasticity
good to a change in price.
of supply measures the price-sensitivity of sellers’ supply.
The price elasticity of supply is computed as the
percentage change in quantity supplied divided by the percentage change in price. That is;

PercentageChangeinQuantity Supplied
Pr ice Elasticity of Supply (ε PS ) =
PercentageChangein Pr ice

For example, suppose that an increase in ice cream prices from 30 TL/Kg to 40 TL/Kg increases the
daily ice cream production in a small town from 100 Kg to 120 Kg. Using the mid-point approach, we
calculate the price elasticity of supply as:

20
PercentageChangeinQuantity Supplied 110 18%
ε Ps = = = = 0.63
PercentageChangein Pr ice 10 29%
35
Q2 − Q1 120 −100 120 −100
ε S = (Q2 + Q1 ) / 2 = (120 +100) / 2 = 110
P
P2 − P1 40 − 30 40 − 30
(P2 + P1 ) / 2 (40 + 30) / 2 35
⎛ 20 ⎞
⎜ ⎟
⎝ 110 ⎠ 0,1818
S
εP = = = 0,63
⎛ 10 ⎞ 0,2857
⎜ ⎟
⎝ 35 ⎠

94
Introduction to Economics I
Because of the law of supply, the price elasticity
of supply has always a positive sign. An increase in
price causes the quantity supplied to increase. The
supply of a good is said to be elastic if the quantity
supplied changes more than the price changes. For
example, if a 10 percent increase in the price of
good X leads to more than 10 percent increase in
the quantity supplied of good X, we say good X has
elastic supply. Supply is said to be inelastic if the
quantity supplied responds only slightly to price
changes. For example, if a 10 percent increase in
the price of good X leads to only 5 percent increase
in the quantity supplied of good X, we say good X
has inelastic supply. Hence, we can say that if the
price elasticity of supply takes the value between 0
and 1, the good has inelastic supply. If the value is
larger than 1, we say the good has elastic supply.
Determinants of Price Elasticity of
Supply
The price elasticity of supply is determined
by the flexibility of producers/sellers to change
the amount of the good or service they produce
in response to price changes. The flexibility of
producers depends on two important factors. These
factors are the availability of inputs to producers
and the time horizon.
The higher the availability of inputs for
production, the higher the elasticity of supply.
For example, the supply of beachfront property
in Istanbul Bosporus or Mediterranean coasts is
harder to vary and thus less elastic than the supply
of new cars or computers.
Supply is more elastic in the long-run than
in the short-run. Over the short-run, the firms
cannot easily change their plant size or factory size
to change their production in response to price
changes. However, in the long-run change in the
plant size and as a result change in the quantity
supplied to price changes are both possible.
Thus, we can say that, the more easily sellers can
change the quantity they produce due to availability
of inputs, the greater the price elasticity of supply.
Also, the price elasticity of supply is greater in the
long-run than in the short-run, because firms can
build new factories to extend their plant size, or
new firms may be able to enter the market.
Supply Curves and Price Elasticity
Since elasticity of supply measures the price
sensitivity of producers’ quantity supplied, the
price elasticity of supply mostly can be understood
from the shape of supply curves. Supply curves
can be classified based on their elasticity. As was
the case in the discussion of price elasticity of
demand, the slope of the supply curve is closely
related to the price elasticity of supply. As a
rule of thumb, it can be said that the flatter the
supply curve, the larger the price elasticity and
the steeper the supply curve, the smaller the price
elasticity of supply.
Figure 4.5 shows different shaped supply curves
and explains the price elasticity of supply based
on the types. In extreme cases, the figure shows
zero (0) and infinite (∞) elastic supply curves in
figures (a) and (e). The perfectly inelastic supply
curve has a vertical shape and the slope and the
price elasticity of vertical supply curve is equal to
zero. It indicates that any increase in price does not
cause any increase in the quantity supplied of the
good or service. Beachfront properties/lands can
be given as examples for zero elastic supply curves.
Any increase in the price of this type of land does
not lead to an increase in the acre of that land.
Another extreme example of the supply curve is
the infinite elastic supply curve shown in figure
4.5.e. The figure shows that the elasticity of supply
is infinite indicating that at any price above 2 TL,
the quantity supplied is infinite and at any price
below that price, the quantity supplied is equal
to zero. For the supply curves starting from the
origin and having the 45 degree line from then on
the elasticity is equal to one. That means that the
percentage change in quantity is always equal to
the percentage change in price along the supply
curve. This curve is shown in figure 4.5.c.
5
Suppose that for a good market,
the demand for the good is ine-
lastic and the supply is elastic.
What happens to the producers’
revenue if the supply increases
because of the technological
improvements?
95
 Elasticity, Government Policies and Market Efficiency

(a) Perfectly Inelastic Supply: (b) Inelastic Supply: Elasticity

Elasticity Equals to Zero (0) Smaller than One (1)
Price (TL) Price (TL)
Supply
Supply

3 B
3
2 A
2

100 Quantity 100 120 Quantity

(c) Unit Elastic Supply: (d) Elastic Supply: Elaticity
Elaticity Equals to One (1) Greater than One (1)

Price (TL) Price (TL)

3 B
3 B
2
A 2 A

100 150 Quantity 100 200 Quantity

(e) Perfectly Elastic Supply:

Elaticity Equals to Infinity,
Price (TL)

2 Demand

Quantity

Figure 4.5 The Price Elasticity of Supply

GOVERNMENT POLICIES AND Examples of price controls in reality include

THEIR EFFECT ON MARKET
OUTCOMES
So far, we have seen how unregulated
markets work and how without the government
intervention the demand and supply and price
mechanism bring the markets into equilibrium. In
this section of the chapter, we are going to see how
government policies such as price controls as price
ceiling and price floor and government tax policies
impact the market outcomes. Also, as an extension,
the section will look at the interaction between tax
policies and elasticities of demand and supply.
the rent controls and the minimum wage laws
dictated by the governments. The use of price
ceiling policy is a legal maximum on the price of
a good or service and the rent control is the best
example for the regulation. Another price control
mechanism in reality is the price floor which sets
a legal minimum on the price of a good or service
is applied. The minimum wage laws are cited as
the most well-known examples of this kind of price
control. Price controls are generally applied when
decision makers believe that market prices, either
rental prices or wages, are unfair to users of rental

96
Introduction to Economics I

places or workers. In tax applications, the local or central governments make buyers or sellers pay a specific
amount on each unit bought or sold in the market of a good or service.

Price Ceiling as a Price Control

Price ceiling is a legal maximum on the price at
which a good can be sold. As indicated before, the
most well-known price ceiling policy is conducted by
the rent controls in real life. Without the government
intervention, the market equilibrium price and quantity
for rental places will be determined by the demand and
supply. Assume that in a town, the unregulated rental
market price is 1000 TL and with this price 1000
apartments are rented out. If the policymakers think
that this market price is unfair and the fair rental price
should be 750 TL and imposes this price for rental
places, the market outcome will be altered.
First of all, imposing a price ceiling above the Picture 4.2
equilibrium price is not binding and it has no effect
on the market outcome. For example, as it can be seen
from Figure 4.6.a., imposing a price ceiling of 1200 Price ceiling is a legal maximum on the price
TL will not be binding and will not affect the free at which a good or a service can be sold.
market outcome.
Imposing a price ceiling of 750 TL which is smaller than the free market equilibrium price is binding
and will alter the free market outcome. With the price ceiling, the equilibrium price (1000 TL) is above
the imposed ceiling (750 TL) and will, therefore, be illegal. As it can be seen from Figure 4.6.b, the ceiling
is now a binding constraint on the price, and it causes a shortage in the rental market. A binding price
ceiling creates shortage in the market since at imposed price the quantity supplied (750 units) is smaller
than the quantity demanded (1250). So, the price ceiling will create a shortage of 500 units of apartments
for rent in the town.

Price a) Price ceiling that is not Price b) Price ceiling that is

(TL) binding (TL) binding
Supply Supply

1200
Price Ceiling

1000 E 1000 A

Price Ceiling
750
Shortage
Demand Demand

1000 Quantity 750 1000 1250 Quantity

Figure 4.6 Price Ceiling

It should also be noted that in the long-run, since the supply and demand are more price-elastic, the
shortage in the market will be larger.

97
 Elasticity, Government Policies and Market Efficiency

In order to see the effect of price floor and

6 assume initially that the labor market is free from
How an application of binding
price ceiling policy on gasoline
market affects the market
outcome?
Minimum Wage as a Price Floor
As a social policy, the minimum wage laws
are imposed to create a fair minimum wage floor
to protect workers in the job market. While the
intention of the policymakers is to protect the
workers, the imposition of minimum wage laws
creates unemployment for especially unskilled
labors.
Price floor is a legal minimum on the
price at which a good or service can be
sold.
especially the effect of minimum wage laws, let’s
regulation and it is in equilibrium as it is seen in
figure 4.7.(a). The market equilibrium wage and
the quantity is determined by the labor supply
and demand. Assume that the equilibrium wage
level is 10 TL per hour and at this wage level the
equilibrium quantity (employment) is 10000
labor. The imposition of a minimum wage floor
which is below the equilibrium price, say, 8 TL
per hour, is not binding since it is lower than the
already established market wage level and it has no
effect on the market outcome. On the other hand,
when a wage, say, 12 TL per hour, which is higher
than the equilibrium wage level is imposed, the
equilibrium wage (10 TL per hour) is below the
floor. Therefore, the initial free market wage level
will be illegal and the floor is a binding constraint
on the wage, and causes a surplus in the labor
market. This will result in unemployment. This
impact of the minimum wage law on labor market
can be seen from figure 4.7. (b)

Wage (a) Price (b)

(TL/Hour) (TL)

Labor Labor
Unemployment
Supply Supply
Wmin
Minimum Wage

10 E 10 E

Labor Labor
Demand Demand

10000 Quantity of Labor 8000 10000 12000 Quantity of Labor

Figure 4.7 The Minimum Wage and Price Floor

Minimum wage laws generally do not affect highly skilled workers since the free labor market
equilibrium is mostly above the imposed price floor. However, the imposition of the law mostly do affects
the unskilled labor and teen workers in the market. Thus, even though the intention of the policymaker
is to protect the labor from unfair wages, the law negatively effects especially the intended labor groups by
creating unemployment. Studies in the USA show that a 10% increase in the minimum wage raises teen
unemployment by 1-3%.

Taxation and Its Effects on Market Outcomes

Governments generally levy taxes on many goods and services to raise revenue to pay for expenditures
such as national defense, public schools, etc. Taxes may be imposed on the market transactions, institutions,

98
Introduction to Economics I

property, meals, and other things, but in the final

analysis is that they are paid by individuals or
households. The government can choose and make
buyers or sellers to pay the tax. The tax can be a
percentage of the good’s price, or a specific amount
for each unit sold or bought in the market. In order
to analyze the effects of taxation on a market and
market participants, and to make a comparison
between a market equilibrium with and without
tax, we are going to analyze the effect of only per-
unit taxes for simplicity.
In a market without taxation, the market
equilibrium will be established at the intersection
of demand (D0) and supply (S0) and equilibrium
price will be P0 and equilibrium quantity will
be Q0, as it can be seen from figure 4.8. At this
Picture 4.3
equilibrium, the price that buyers pay is equal to
the price sellers receive, that is P0 The government When a tax is levied on sellers, on the other hand,
can choose and make buyers or sellers pay the causes the shift of the Supply curve up left from
tax. Suppose that the government levied a tax on S0 to S1 by the amount of the tax as if the cost of
buyers in the amount of T. When the government production for the sellers/producers increased. With
levies a tax on buyers, the tax causes the shift of the imposition of the tax on the per unit that the
the Demand curve down left from D0 to D1 by the seller supply, the price that buyers pay rises from P0
amount of the tax. The new equilibrium will be at to PB, the price sellers receive falls from P0 to PS, and
the intersection of the new demand curve D1 and equilibrium Quantity falls from Q0 to QT again. This
S0 . With the imposition of the tax on per unit that effect can be seen from figure 4.8. (b). A tax levied
the buyers buy, the price that buyers pay rises from on buyers means that the buyers will have to pay
P0 to PB, the price sellers receive falls from P0 to more, which causes their demand to fall. The fall in
PS , and the equilibrium Quantity falls from Q0 to demand also hurts sellers, by forcing them to reduce
QT. The effect of a tax levied on buyers can be seen their sale price. Similarly, a tax levied on sellers is like
from figure 4.8. (a). a cost of production increase, and sellers have to pass
along a portion of that cost increase to buyers in the
form of higher prices.

(a) Tax on Buyers (b) Tax on Sellers

Price (TL) Price (TL) S1

S0 S0

PB PB
P0 E P0 E
PS PS

D0 D0

D1
QT Q0 Quantity QT Q0 Quantity
Figure 4.8 The Effects of Taxation on market

99
 Elasticity, Government Policies and Market Efficiency
Tax incidence is the study of who bears
the burden of taxation.
As it can be seen from figure 4.8. the effects of
taxation on Prices (PB and PS), on quantity, and
on tax incidence are the same whether the tax is
imposed on buyers or sellers. The tax incidence is
the study of how the burden of taxation is shared
by buyers and sellers. The effects of taxation on
market can be summarized as follows: Firstly, a tax
creates a wedge between the price that buyers pay
and the price that sellers receive. The wedge is equal
to the tax. Secondly, regardless of whether the tax
is levied on buyers or sellers, the effects of taxation
are the same: the price that the buyers pay rises
from P0 to PB and the price that the sellers receive
falls from P0 to PS. Finally, the tax also reduces the
market size by reducing the equilibrium quantity
from Q0 to QT .
The Relationship between the Tax
Incidence and Elasticity
The tax incidence shows who pays the tax and
how the tax burden is shared among buyers and
sellers. As it is seen above the tax incidence is not
affected by whether the tax is levied on buyers
or sellers. It does not matter who pays the tax to
government, the burden is shared by buyers and
(a) Tax on Buyers
Price (TL)
S
PB
Burden fall
on buyers
P0
Burden fall E
PS on sellers
QT Q0 Quantity
Figure 4.9 The tax incidence: Who pays? The distribution of a tax burden.
The workers bear the bulk of the burden of a payroll tax if the labor supply is relatively inelastic than
the labor demand, and the firms bear the bulk of the burden of a payroll tax if the labor supply is relatively
elastic than the labor demand.
100
sellers. So, what determines the tax incidence?
How is the burden of tax shared? The answer to
this question is elasticity, specifically, the price
elasticities of demand and supply. In general, it
can be said that a tax burden goes more heavily on
the side of the market that is less price elastic. This
general conclusion indicates that the burden goes to
the side in the market that is less flexible to changes
in market conditions. For any market, when supply
is more price-elastic than the demand, sellers are
relatively more responsive to price changes, and the
supply curve is flatter than the demand curve. It
also indicates that the buyers have relatively fewer
alternatives, so they have to accept most of the
price increase and hence, the burden caused by the
imposition of the tax.
Suppose that there are two cases. In the first
case, the supply is more price-elastic than demand
and in the second case the demand is more price-
elastic than supply. Figure 4.9 shows how tax
incidence is shared by buyers and sellers when price
elasticities are different. When the supply is more
price elastic than the demand which is shown in
figure 4.9.(a), tax burden falls heavily on the buyers
since inelastic demand indicates that the buyers do
not have much alternatives to switch. When the
demand is more price elastic than the supply, then
the tax burden heavily falls on the sellers. This
situation is represented in figure 4.9.(b).
(b) Tax Burden
Price (TL)
S
PB Burden fall
P0 on buyers E
Burden fall
on sellers
PS
D
QT Q0 Quantity
Introduction to Economics I
7 answer the second question: “Who will produce
Who pays the burden of the
payroll tax? Workers or Emplo-
yers?
8
Who pays the luxury car and
yachts taxes? Workers or buyers
of the products?
BENEFITS TO PARTICIPANTS
AND MARKET EFFICIENCY
In chapters 2 and 3, when the market and
market equilibrium topics were covered, it is
analyzed how markets and market prices work in
an efficient way to allocate scarce resources to the
most efficient uses. The works of market system
and price mechanism not only allocate the scarce
resources to the most efficient uses, also benefit the
participants of the market, namely the buyers and
the sellers.
With the efficient allocation of resources, three
important questions find answers. These questions
are: i) What is going to be produced and how
much of each good is going to be produced? ii)
Which producers produce it and how is it produced?
iii) For whom is it going to be produced? In other
words, which consumers consume it?
As you recall from Chapter1, the needs and
desires of individuals are limitless but the resources
that we use to satisfy human needs are limited.
Because of the existence of limited resources,
production of all desired goods and services to
satisfy human needs is not possible. Scarcity
problem allows us to produce only a limited variety
and amount of goods and services. Thus, the first
question we need to answer is: “Which goods and
services are going to be produced and how much
of each good is going to be produced?” The answer
to this question is that scarce resources allocated in
a way to make us to choose which goods and what
amounts are going to be produced among the all
the desired ones.
Once the first question is answered, at the
same time the market and price mechanism also
it and how is it produced?” In production also
the requirement is the efficient use of resources
and efficient use of production requires the cost
minimization in production. So, the most efficient
firms will make the production. The answer to
the third question, “For whom is it going to be
produced?”, will be those who value the goods and
services the most and willing to pay that price.
Efficient resource allocation through the price
mechanism not only answers these questions,
but also tells us how the well-being of market
participants is affected by it. Welfare economics
is the study of how the efficient allocation of resources
affects the economic well-being of the buyers and
sellers. One of the economic principles is that trade
benefits all participants. The benefits of buyers gained
by taking part in the market activity is called consumer
surplus and the benefit that the producers/sellers get is
called producers surplus. Now, we should understand
the concepts of consumer and producer surpluses.
Consumer Surplus
Recall from chapter 2 that the behavior of the
buyers in the market place is represented by the
market demand function. Under the assumption of
ceteris-paribus, a market demand curve shows how
the quantity demanded of a good varies as the price
of that good varies. Also, each point on the market
demand curve for a good represents the marginal
valuation of each consumer. In other words, each
point on the demand curve represents the valuation
of consumers and at the same time the price that
each consumer is willing to pay most for the good.
Hence, the demand curve can also be called the
willingness to pay curve. Willingness to pay tells
us the maximum amount that a buyer will pay for
a good or service. Also it measures how much the
buyer values the good. In any market, there are
many buyers of a good and the market demand
curve then represents each buyer’s willingness to pay
for that good from the higher prices to the lowest.
Consumer surplus is the difference bet-
ween the maximum amount a person is
willing to pay for a good and the market
price.
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 Elasticity, Government Policies and Market Efficiency

Imagine a negatively sloped linear market
demand curve for a good, say for T-shirt. By moving
from the left top point to the right bottom point
of the demand curve, the prices decrease and the
quantity demanded of that good increases. Let‘s say
that the highest price that a consumer is willing to
pay for the T-shirt is 250 TL and the lowest price is
40 TL. Since there are many buyers in the market,
the demand curve indicates that the other buyers’
willingness to pay is between 250 and 40 TL. When
the T-shirt market reaches to equilibrium, we get an
equilibrium price and equilibrium quantity. Let’s
say that for the market the established equilibrium
price is 120 TL and the quantity is 200 units. The
equilibrium price leads us to many conclusions.
Firstly, those whose willingness to pay is lower
than the equilibrium price cannot buy the T-shirt.
Secondly, those whose willingness to pay is higher
P
P0=250
than the market equilibrium price get benefits from
the participation in the market. The benefit that the
buyers get is called consumer surplus. Consumer
surplus (CS) is the amount a buyer is willing to
pay minus the buyer actually pays. That is:
CS=WTP–P
The consumer surplus that each buyer gets is
different. For the highest bidder whose willingness
to pay is 250 TL, the consumer surplus is equal to
250 minus 120 TL; that is, 130 TL. Starting from
the highest price and moving downward on the
demand curve every buyer who bids a price which
is higher than the equilibrium price of 120 TL
gets the benefit of consumer surplus. The buyer,
whose willingness to pay is 120 TL, does not get
consumer surplus since his/her willingness to pay
is equal to what actually he/she pays.

Consumer
Surplus
a Consumer Surplus to
E0 New Consumers
PE=120
Additional Consumer Surplus
b c to Initial Consumers
P1=40 E1

200 400 Q
Figure 4.10 Consumer Surplus

Figure 4.10 shows the demand curve and equilibrium conditions for the imaginary T-shirt market.
Considering the equilibrium conditions, the total consumer surplus can be computed. The total consumer
surplus equals to the area below the demand curve and above the market equilibrium price, from zero to
equilibrium quantity. As it can be seen from figure 4.10, the consumer surplus area is a triangle , which is
equal to the half of the base times height of the triangle. The area of the triangle, which is represented by
the shaded area, can be calculated as:
1
CS = x(BasexHeight)
2
For the example, then the CS is;
CS = 1 x((250 −120)x(200 − 0)) = 1 x((130)x(200)) = 13000TL
2 2
The total consumer surplus that the buyers gain from the participation in the market changes with
price changes. Any development that reduces the equilibrium market price causes the total consumer
surplus to increase and any price increase causes the total surplus to decrease. This fact can be seen from the

102
Introduction to Economics I
figure 4.10 again. When the price decreases from
PE to P1 , the total consumer surplus increases from
the area of P0E0PE to P0E1P1, which is the sum of
the areas a, b, and c. With the price reduction, not
only the initial consumers get extra gains from the
market, but also the new consumers earn consumer
surplus. The extra consumer surplus that the initial
consumers get is the area b in the figure and the
consumer surplus that the new consumers gain is
the triangle c in the figure.
Producer Surplus
There are gains from trade to producers/sellers
also. The benefit the producers get from participating
in the market activity is called producer surplus
(PS). The production of goods and services requires
firms to bring all factors of production together
and convert inputs to output by taking the risk of
production and bringing into the market. Hence,
for the firms, the production of goods and services
requires bearing costs. In economics, the cost is
defined as the value of everything a seller must
give up to produce a good which is also called as
opportunity cost. The cost or the opportunity cost
includes the cost of all resources used to produce a
good, including the value of the seller’s time. A seller
will only produce and bring the good to the market
for sales if the price of the good in the market exceeds
his or her cost. In other words, a seller is only willing
to produce and willing to sell a good if the price is
at least equal or higher than the cost of production.
Thus, the cost or opportunity Price
cost is a measure of willingness
to sell for the producers.
A market supply
curve shows the positive P1
relationship between price
e f
and quantity supplied. Also
the supply curve shows the
P = 120
cost of production of firms. E
Specifically, every point on the
d
curve represents willingness
to sell of the firms at different
prices. Suppose that there
exists a market supply curve P0 = 30
such as the one shown in
figure 4.11 representing the
price and quantity supplied
combinations for T-shirts also.
The positively sloped supply curve shows that at
higher prices the firms are willing to supply more
of them. Since each firm’s cost of production is
different from each other, their willingness to sell
is also different. In figure 4.11, each point on the
supply curve represents firms’ willingness to sell
T-shirts. Since the supply curve starts from the
price of 30 TL per unit, it indicates that there is a
firm whose willingness to sell T-shirt to market is
30 TL. Let’s call this firm as firm A. Prices which
are above the starting price also represent each
firms’ willingness to sell.
Producer surplus is the difference in the
amounts that a seller is paid for a good minus the
cost to the seller. That is:
PS=Price–Cost
In order to compute and show the producer
surplus that each firm gets, we need to know the
market equilibrium price for the T-shirts. Let’s say
the equilibrium price is 120 TL and the equilibrium
quantity is 200 units. Since the first firms’ (Firm A)
willingness to sell its product is 30 TL but the price
at which the firm sells its product is 120 TL, the
calculated producer surplus for the firm will be 90
TL. The result of this calculation shows that, since
the producer surplus is equal to, PS=Price–Cost , every
firm in the market that its willingness to sell is lower
than the market price, will earn producer surplus.
The firm whose willingness to sell is equal to market
surplus will not gain producer surplus because of the
equality of price and its production costs.
Additional Producer Surplus
to Initial Producers
S
E1 Producer Surplus to
New Producers
E0
Producer
Surplus
200 Quantity
Figure 4.11 Producer Surplus
103
 Elasticity, Government Policies and Market Efficiency

The total producer surplus can be calculated from

the figure 4.11 also. Since the producer surplus (PS) is
Producer surplus is the difference betwe-
the amount a seller is paid for minus the seller’s cost, the
en the price at which a firm sells its pro-
total producer surplus equals to the area above-left of the
duct and the cost of production.
supply curve under the market equilibrium price. That
area is the triangle of P0E0PE . If we would like to calculate
the total producer surplus for the example, that is: since the PS is equal to,
PS=Price–Cost
The total Producer Surplus is the area between the equilibrium Price and the Supply curve, from zero to
equilibrium Quantity. From the area of triangle, which is:
1
PS = x(BasexHeight))
2
1 1
PS = x(200x(120 − 30)) = x(200x90) = 9000TL
2 2
The total producer surplus increases with the market price
increase and vice-versa. As it can be seen from figure 4.11, when
the market price increases for any reason, the higher price not only
9
increases the additional producer surplus to the initial producers,
area e, but it also brings extra gains to new producers, which is How does a decrease in price af-
area f in the figure, that are able to produce with higher prices. fect the total producer surplus?

Total Surplus
As you recall, one of the main principles of economics is that trade makes all participants better off.
From the above topics, it is seen that the buyers and sellers of the market make gains from trade. The sum
of the gains that the buyers and sellers of a market is called total surplus. Total surplus (TS) measures the
total gains from trade in a market. Total surplus from a market is the sum of consumer and producer
surpluses; that is, TS=CS+PS. Figure 4.12 represents the market equilibrium for a good, T-shirt market,
and also shows the total surplus area from the free market activity. That area in figure 4.12 is the sum of the
areas of a and b. By using the same equation used to calculate the areas of CS and PS, we can also calculate
the TS area. Based on figure 4.12, the total surplus is:
1
TS = x(BasexHeight))
2
1 1
TS = x(200x(250 − 30)) = x(200x220) = 22000TL
2 2

Total surplus is equal to the sum of areas of a and b. If you control the calculations made for CS and PS, the
computations were 13000 TL and 9000 TL.

104
Introduction to Economics I

Price

250

Supply

PE = 120 E

30 Demand

200 Quantity
Figure 4.12 Total Surplus

Market Efficiency
One of the fundamental questions in economics Efficiency is the property of a resource al-
is that whether the allocation of resources via free location of maximizing the total surplus
markets create a desired outcome for all individuals received by the society.
in the society. In other words, the question is
whether the allocation is efficient to maximize the Thus, the equilibrium in free markets is
well-being of all market participants. Efficiency in efficient because: i) The equilibrium quantity
this matter is a property of a resource allocation output maximizes total surplus received by the all
of maximizing the total surplus gained by all members of the society. ii) The goods are produced
individuals of society. Free market outcomes is by the producers with the lowest cost. iii) The
considered as efficient because an allocation of goods are consumed by the buyers who value them
resources is efficient if that resource allocation most highly.
maximizes the total surplus in any market. Free
market equilibrium outcome is efficient since this
equilibrium price and quantity indicate that the
goods are being produced by the producers with
the lowest cost, satisfying the cost minimization
and the goods are consumed by the buyers who
value them most highly, implying the utility
maximization.

105
 Elasticity, Government Policies and Market Efficiency

Knowing the meaning of the

LO 1 demand elasticities

There exists three types of elasticities of demand. The first one is the price elasticity of demand which
measures how much quantity demanded of a good changes when there is a change in the price of the
good. The price elasticity of demand measures the price-sensitivity or responsiveness of consumers. It
is calculated as the percentage change in quantity demanded divided by the percentage change in price.
That is:
Summary

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price

The second type of elasticity of demand is the income elasticity of demand. The income elasticity of
demand measures the response of quantity demanded to a change in consumer income and is computed
as the percentage change in quantity demanded divided by the percentage change in income.
Most of the goods and services we consume are normal goods. For normal goods, the income elasticity
is positive and for the inferior goods, the income elasticity is negative.
Then, in general, we can say that:

For normal goods,the income elasticity is greater than zero ( ε Id > 0 )

For inferior goods,the income elasticity is less than zero ( ε Id < 0 )

The third type of demand elasticity is the cross-price elasticity of demand. Two goods are either
substitute to each other or they are complement each other. If the price increase in one good (good
X) causes consumers to use the other good (good Y) in place of this good, we say that these two goods
(X and Y) are substitute to each other. For the substitute goods, a price increase of good X leads to
quantity demanded of good Y to increase. Complements are goods that are typically used together.
For the complements, a price increase in good X causes quantity demanded of good Y to decrease. The
cross-price elasticity of demand measures the response of demand for one good (good Y) to changes in
the price in another good (good X). For substitute goods, the cross-price elasticity of demand is positive
since the price increase of good X causes the quantity demanded of good Y to increase. For complement
goods, the cross-price elasticity of demand is negative because a price increase in good X causes the
quantity demanded of good Y to decrease.
d
For substitutes,cross-price elasticity is greater than zero ( ε yx > 0)
d
For complements,cross-price elasticity is less than zero ( ε yx <0)

106
Introduction to Economics I

Knowing the determinants of the

LO 2 price elasticity of demand

The price elasticity of demand for a good or service depends on many factors such as whether close
substitutes are available, the good is necessity of luxury for the consumer, share (weight) of the good’s
cost in the consumers’ budget, and the time period.
Are close substitutes of the good available to consumers? Goods with close substitutes tend to have
more elastic demand than goods without close substitutes since it is easier for consumers to give up that

Summary
good and switch to its substitutes.
The good is a necessity or a luxury for the consumers? Necessities tend to have inelastic demand
and luxuries tend to have elastic demand. Education and health services (doctor visits), heating in the
winter, gasoline for car owners are considered necessities for consumers and these items have inelastic
demand since the case of price increases in these items gets small reactions from consumers to cut their
quantity demanded.
The Importance of Being Unimportant. When a good or service represents a relatively small portion
of our total budget, we tend to pay little attention to its price and price hikes in this kind of goods do
not create a substantial response from the consumers in terms of cutting their quantities. Goods that
represent a relatively small portion of our total budget tends to have inelastic demand.
Time horizon. Goods tend to have more elastic demand in the long-run than in the short-run because
in the long run availability of substitutes for buyers is higher than the short run. we can say that the price
elasticity of demand is higher in the long-run than in the short-run.

Knowing the relationship

LO 3 between the elasticity and the
total revenue

What happens to total revenue from sales if the price of good changes? The answer to this question is
related to price elasticity of demand. If the demand is elastic, an increase in the price causes the total
revenue to decrease. A decrease in price, in contrast, causes the total revenue to increase. On the other
side, when the demand is inelastic, an increase in price causes the total revenue to increase. With an
inelastic demand curve, the reason that total revenue increase with price increase since the increase in
price leads to a decrease in quantity demanded that is proportionally smaller.

Knowing the determinants of the

LO 4 price elasticity of supply

Price elasticity of supply measures how much quantity supplied responds to a changes in price. It measures
the price-sensitivity of sellers’ supply. The price elasticity of supply is computed as the percentage change
in quantity supplied divided by the percentage change in price. Because of the law of supply, the price
elasticity of supply has always a positive sign. An increase in price causes the quantity supplied to increase.
The supply of a good is said to be elastic if the quantity supplied changes more than the price changes.
Supply is said to be inelastic if the quantity supplied responds only slightly to price changes
The price elasticity of supply is determined by the flexibility of producers/sellers to change in the amount
of the good or service they produce in response to price changes. The flexibility of producers depends
on two important factors. These factors are the availability of inputs to producers and the time horizon.
The higher the availability of inputs for production, the higher the elasticity of supply. Supply is more
elastic in the long run than in the short run. Over the short-run, the firms cannot easily change their
plant size or factory size to change their production in response to price changes. However, in the long-
run change in plant size and as a result change in quantity supplied to price changes are both possible.

107
 Elasticity, Government Policies and Market Efficiency

Knowing the meaning of price

LO 5 controls

Price controls are applied as price ceiling and price floor. Examples in reality are the rent controls and
the minimum wage laws dictated by the governments. The use of price ceiling policy is a legal maximum
on the price of a good or service and the rent control is the best example for the regulation. Another
price control mechanism in reality is the price floor in which a legal minimum on the price of a good or
service is applied. Most known example of this price control is the minimum wage laws. Price controls
Summary

generally applied when decision makers believe that the market prices, either rental prices or wages, is
unfair to users of rental places or workers.

Knowing the effect of the

LO 6 taxation on the market

The effects of taxation on market can be summarized as follows: Firstly, a tax creates a wedge between
the price that buyers pay and the price that the sellers receive. The wedge is equal to the tax. Secondly,
regardless of whether the tax is levied on buyers or sellers, the effects of taxation are the same: the price
that the buyers pay rises and the price that the sellers receive falls. Finally, the tax also reduces the
market size by reducing the equilibrium quantity. So, tax creates a dead-weight loss for the market.

To analyze tax burden based on

LO 7 elasticities

The tax incidence shows who pays the tax and how the tax burden is shared among the buyers and
sellers. The tax incidence is not affected by whether the tax is levied on buyers or sellers. Does not
matter who pays the tax to government, the burden is shared by buyers and sellers. How the burden of
tax is shared? The answer to this question is elasticity, specifically, the price elasticities of demand and
supply. In general, it can be said that a tax burden goes more heavily on the side of the market that is less
price elastic. This general conclusion indicates that the burden goes to the side in the market that is less
flexible to changes in market conditions. For any market, when the supply is more price-elastic than the
demand, sellers are relatively more responsive to price changes, and the supply curve is flatter than the
demand curve. It also indicates that the buyers have relatively fewer alternatives, so they have to accept
most of the price increase and hence burden caused by the imposition of the tax.

Knowing the meaning of

LO 8 consumer and the producer
surpluses

Consumer surplus shows the benefits the consumers gain from participating in the market activity. The
consumer surplus (CS) is the amount a buyer is willing to pay minus the buyer actually pays. That is,
CS=WTP-P. It increases with the fall of market price.
Producer surplus shows the benefits to sellers for participating in the market activity. Producer surplus
is the difference between the amounts that a seller is paid for a good minus the cost to seller. That is;
PS=Price-Cost. It increases with the rise of market price.

108
Introduction to Economics I

1 Which of the following statements is true if 4 Which of the following has a positive cross-
the demand for a good is elastic? price elasticity of demand?
A. The percentage change of quantity demanded is A. Giffen good
greater than the percentage change in price. B. Luxury good

B. The percentage change of quantity demanded is
smaller than the percentage change in price.
C. The percentage change of quantity demanded
does not change in response to price changes.
D. The percentage change of quantity supplied is
greater than the percentage change in price.
E. The percentage change of quantity supplied is
smaller than the percentage change in price.
2
Which of the following interpretations is true
when price elasticity of demand is equal to -5?
A. An increase in price by 20 percent will cause an
increase in demand by 100 percent.
B. A decrease in price by 20 percent will cause an
increase in demand by 100 percent.
C. A decrease in price by 10 percent will cause an
increase in demand by 2 percent.
D. A decrease in price by 10 percent will cause an
increase in demand by 20 percent.
E. A decrease in price by 10 percent will cause a
decrease in demand by 20 percent.
3 I- If the demand is elastic, an increase in the
price causes total revenue to decrease.
II- If the demand is elastic, a decrease in price
causes total revenue to decrease.
III- If the demand is inelastic, an increase in
price causes total revenue to increase.
IV- If the demand is inelastic, an decrease in
price causes total revenue to decrease.
Which one or more of the above expressions
correctly explains the relationship between the
total revenue and the price elasticity of demand?
A. I, II D. the price is equal to or higher than the cost of
B. II, III
C. II, IV E. the price is equal to or lower than the cost of
D. I, II and III
E. I, III and IV
Test Yourself
C. Substitute good
D. Complementary good
E. Unrelated good
5 Which of the following is not an example of
price control?
A. Government specifying a base level of wage
B. Government assurance for buying all the wheat
at a specific price
C. Government specifying the highest price for
meat
D. Government linking rent increases to inflation
rate
E. Government implementing tax amnesty
6 Which of the following is the definition of
the price ceiling?
A. The legal minimum on the price at which a
good or service can be sold.
B. The legal maximum on the price at which a
good or service can be sold.
C. The difference between price and the cost to
the sellers.
D. The difference between price and the cost to
the buyers.
E. The measure of willingness to sell for the
producers.
7 A producers willingness to sell a good reflects:
A. the equilibrium price of the good
B. the revenue earned from producing the good
C. the property of a resource allocation of
maximizing the total surplus received.
production
production

109
 Elasticity, Government Policies and Market Efficiency

8 I- The quantity output maximizes total 9 Who bears the tax burden if the demand is
surplus received by the all members of more price elastic than the supply?
the society. A. Buyers
Test Yourself

II- The goods are produced by the producers B. Sellers

with the lowest cost. C. Brokers
III- The goods are produced by the producers D. Society
with the highest cost. E. Government
III- The goods are consumed by the buyers
who value them most highly.
10 What will be the shape of the supply curve if
Which one or more of the above statements the price elasticity of supply is perfectly inelastic?
correctly explain the equilibrium market efficiency?
A. Negatively sloped
A. I, III B. Positively sloped
B. II, III C. Vertical
C. III, IV D. Horizontal
D. I, II and III E. Steep
E. I, II and IV

110
Introduction to Economics I

If your answer is wrong, please review the

1. A “Shape of Demand curves and Elasticity” 6. B If your answer is wrong, please review the

Answer Key for “Test Yourself”

“Price Ceiling as a Price Control” section.
section.

2. B If your answer is wrong, please review the 7. D If your answer is wrong, please review the
“The Price Elasticity of Demand” section. “Producer Surplus” section.

If your answer is wrong, please review the

3. E 8. E If your answer is wrong, please review the
“Relationship between Total Revenue and
“Market Efficiency” section.
Price Elasticity of Demand” section.
If your answer is wrong, please review the If your answer is wrong, please review the
4. C “The Cross-Price Elasticity of Demand” 9. B “The Relationship between the Tax Incidence
section. and Elasticity” section.
If your answer is wrong, please review the
5. E “Government Policies and their Effect on
10. C If your answer is wrong, please review the
“Supply Curves and Price Elasticity” section.
Market Outcomes” section.

Which one do you expect to have more elastic

demand: the food market in general or the
hamburger market in particular?
Goods with close substitutes tend to have more elastic demand than the goods
that don’t have close substitutes. Since the food market is defined in broad

Suggested answers for “Your turn”

your turn 1 sense, it does not have close substitutes compared to the hamburger market
which has many close substitutes. Thus, we expect hamburger market to have
more elastic demand than the food market.

What is the price elasticity of demand? Is it

related to the demand curve?

The price elasticity of demand measures how much quantity demanded of

a good changes when there is a change in the price of the good. It measures
the price-sensitivity or responsiveness of consumers and it is calculated as the
percentage change in quantity demanded divided by the percentage change
your turn 2 in price. Generally, it is thought that the price elasticity of demand can be
understood by simply looking at the slope of a demand curve. The flatter
the demand curve, the higher the price elasticity and the steeper the demand
curve, the lower the price elasticity of demand. It should be noticed that the
slope of a demand curve is different from its price elasticity of demand.

If the demand of a good is inelastic, what would be the

pricing strategy to increase the total revenue from the sales?

Whether or not a price hike causes the total revenue from sales to increase
is determined by the price elasticity of demand. If the demand is elastic, an
increase in the price causes the total revenue to decrease. A decrease in price,
in contrast, causes the total revenue to increase. On the other side, when the
demand is inelastic, an increase in price causes the total revenue to increase.
your turn 3 With an inelastic demand curve, the reason why the total revenue increases
with price increase is that the increase in price leads to a decrease in quantity
demanded that is proportionally smaller. So, if the demand of a good is inelastic,
the pricing strategy to increase the total revenue from the sales would be to
increase the price of the good. As a result, the total revenue increases.

111
 Elasticity, Government Policies and Market Efficiency

When the seller increases the price of his/her

product what happens to revenue? Does it rise
or fall?

Whether or not a price hike causes total revenue from sales to increase is
determined by the price elasticity of demand. If the demand of the good that
your turn 4 the seller sells is elastic, an increase in the price causes the total revenue to
decrease. A decrease in price, in contrast, causes the total revenue to increase.
On the other side, when the demand of the good is inelastic, an increase in
price causes the total revenue to increase.

Suppose that for a good market, the demand for the good is
inelastic and the supply is elastic. What happens to the producers’
revenue if the supply increases because of the technological
improvements?

Suppose that the market is a wheat market where the demand is inelastic since
it is a necessary good and its supply is relatively elastic. When this market is
initially in equilibrium, let’s say at price of P0 and quantity of Q0, an increase in
your turn 5 supply due to technological improvements would cause the supply curve to shift
to the right. As a result, the equilibrium price falls and the equilibrium quantity
goes up. Since there is a fall in price, the revenue from sales for the sellers goes
down since the demand for their product is inelastic. Recall that when the
demand of the good is inelastic, an increase in price causes the total revenue to
increase but in contrast a decrease in price causes the total revenue to decrease.
Result indicate that technological improvements in the agriculture sector for the
goods with inelastic demand cause the farmers’ income to decrease.

How an application of binding price ceiling

policy on gasoline market affects the market
outcome?

Imposing a binding price ceiling on gasoline prices which is smaller than the
free market equilibrium price alters the free market outcome. With the price
your turn 6 ceiling, the equilibrium price is above the imposed ceiling and therefore it will
be illegal. The ceiling is now a binding constraint on the price, and it causes
a shortage in the gasoline market. A binding price ceiling creates shortage in
the market since at imposed price, the quantity supplied of gasoline is smaller
than the quantity demanded. So, price ceiling will create a shortage.

112
Introduction to Economics I

Who pays the burden of the payroll tax?

Workers or Employers?

The tax incidence shows who pays the tax and how the tax burden is shared
among the buyers and sellers. Does not matter who pays the tax to government,
your turn 7 the burden is shared by buyers and sellers. How is the burden of tax is shared?
In general, it can be said that a tax burden goes more heavily on the side of
the market that is less price elastic. This general conclusion indicates that the
burden goes to the side in the market that is less flexible to changes in market
conditions. For any market, when supply is more price-elastic than the demand,
sellers are relatively more responsive to price changes, and the supply curve is
flatter than the demand curve. It also indicates that the buyers have relatively
fewer alternatives, so they have to accept most of the price increase and hence
the burden caused by the imposition of the tax. When supply is more price
elastic than the demand, tax burden falls heavily on the buyers since inelastic
demand indicates that the buyers do not have much alternatives to switch.
When the demand is more price elastic than the supply, then the tax burden
heavily falls on the sellers. In the labor market, who pays the payroll tax? That
depends on the elasticity of labor demand and labor supply. The workers bear
the bulk of the burden of a payroll tax if the labor supply is relatively inelastic
than the labor demand, and the firms bear the bulk of the burden of a payroll
tax if the labor supply is relatively elastic than the labor demand. Labor demand
is more elastic than the labor supply. Thus, it can be said that a tax burden goes
more heavily on the side of the market that is less price elastic which is labor
supply. So, labor pays more of the payroll tax than the employers.

Who pays the luxury car and yachts taxes?

Workers or buyers of the products?

In general, it can be said that a tax burden goes more heavily on the side of the
market that is less price elastic. This general conclusion indicates that the burden
your turn 8 goes to side in the market that is less flexible to changes in market conditions.
When the supply is more price elastic than the demand, tax burden falls heavily
on the buyers since inelastic demand indicates that the buyers do not have
much alternatives to switch. When the demand is more price elastic than the
supply, then the tax burden heavily falls on the sellers. In the luxury car and etc.
markets, how is the burden shared? That depends on the price elasticity of car
demand and elasticity of labor supply. Since the demand for yachts is elastic and
the labor supply is inelastic, it can be said that a tax burden goes more heavily
on the side of the market that is less price elastic which is labor supply. So, labor
pays more of the tax than the buyers of the luxury cars and yachts.

How does a decrease in price affect the total

producer surplus?

Producer surplus is the difference between the amounts that a seller is paid
for a good minus the cost of seller. That is; PS=Price-Cost. The total producer
your turn 9 surplus is the area between the equilibrium Price and the Supply curve, from
zero to equilibrium Quantity. The total producer surplus increases with the
market price increase and vice-versa. When the market price increases for any
reason, the higher price not only increases the additional producer surplus to
the initial producers, it also brings extra gains to new producers who are able
to produce with higher prices. On the other hand, a decrease in price causes
the total producer surplus to decrease.

113
 Elasticity, Government Policies and Market Efficiency
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Gwartney, J. D., Stroup, R. L. and Sobel, R. S. (2000),
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Hirshleifer, J. and Hirshleifer, D. (1998), Price Theory
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Mansfield, E. (1998), Microeconomics, Shorter
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Robert S. Pindyck and Daniel L. Rubinfeld (2008),
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Microeconomics, 7th edition, Mason, OH: South-
Western Cengage Learning.
 The Firm and the Cost of
Chapter 5 Production
After completing this chapter, you will be able to:
Learning Outcomes

1 Understand what is involved in the production

process of a firm 2 Explain total revenue, total cost and profit

3 Analyze the relationship among different types

of costs 4 Recognize and draw the shapes of typical cost
curves

5
Understand the relationship between the short-
run and the long-run costs and the economies
of scale

Chapter Outline Key Terms

Total Cost
Introduction
Marginal Cost
Production, Cost and Profit
Average Fixed Cost
Production and Costs
Average Variable Cost
Different Types of Costs
Average Total Cost
Shapes of Typical Cost Curves
Diminishing Marginal Returns
The Short Run and the Long Run in Production
Opportunity Cost
Scale Economies
Explicit Costs
Implicit Costs
Short Run
Long Run
Economies of Scale

116

Introduction to Economics I
INTRODUCTION
Understanding what is involved in the
production process of a firm in terms of output
produced and costs is very important for the
students of economics.
The production process converts resources
which are called inputs or factors of production into
new goods and services called outputs over a period
of time. The basic factors of production available
to a society are natural resources, labor, capital and
entrepreneurship. Production technology, i.e. how
much output is produced when given amounts
of labor and capital are used, is defined by a
production function.
The total revenue of a firm is the price times
the quantity sold by the firm. How does total
revenue change in response to changes in price
and quantity? That depends on the type of market
structure in which the firm operates and the price
elasticity of demand. If the firm is operating in a
perfectly competitive market, the price is given
from the firm’s perspective and the total revenue
increases both in price and quantity. The demand
for the firm’s product in this case is perfectly
horizontal and the price elasticity of demand is
infinite.
In a market characterized by imperfect
competition, what happens to total revenue when
the price increases depends on the price elasticity
of demand. In these types of markets, the quantity
demanded and the price affect each other inversely.
So, to increase the quantity sold, the firm must
decrease the price. If demand is elastic, that is,
elasticity is greater than unity in absolute value,
then a percentage increase in the price will decrease
the quantity sold more than a percentage and the
total revenue will fall. However, if the demand is
price inelastic, i.e., elasticity is less than the unity
in magnitude, then a percentage increase in the
price will decrease the quantity sold less than a
percentage and the total revenue will rise.
In order to produce output and supply
to market, a firm hires factors of production
from factor markets. Regarding the production
technology, we will assume that to increase output,
the firm must employ more labor and/or capital.
The price of labor is the wage rate. When the firm
hires more labor, it has to pay more in wages.
Similarly, the price of capital is interest, and the
5
firm has to pay more in interest when it hires more
capital. The total cost increases as more labor and/
or capital is used.
Profit is defined as the difference between
total revenue and total cost, and the objective of
a firm that produces a good or service to sell is to
maximize its profit.
Economists distinguish between the time
frames short run and long run when studying the
production and cost relationship. In the short run,
some factors of production cannot be changed. The
long run is a time frame in which a firm can adjust
the usage of all resources, if it deems necessary.
Given the fixed factor prices, when all inputs are
raised at the same time by the same percentage, if
output increases more than the percentage increase
in inputs, we call this increasing returns to scale. If
output increases by the same percentage as increase
in all inputs, this is named constant returns to scale.
If output increases less than the percentage increase
in inputs, then there are decreasing returns to scale.
PRODUCTION, COST AND
PROFIT
Production is one of the main economic
activities. The production process converts
resources which are called inputs or factors of
production into new goods and services called
output over a period of time. The basic factors
of production available to a society are natural
resources, labor, capital and entrepreneurship.
Natural resources are resources such as land, metals,
coal, oil, gas, etc. provided by nature. Labor is the
work time and physical and mental effort devoted
to producing goods and services in exchange for a
wage. Capital or capital goods are the goods such
as machinery, equipment, buildings, etc., that are
used in the production of other goods or services.
Entrepreneurship is a human resource that brings
together natural resources, labor and capital and
organizes them to produce new goods or services.
The exact way in which production comes about is
determined by the available technology used.
The objective of a firm that produces a good
or service is to maximize its profit, which is the
difference between total revenue and total cost.
For profit maximization, the firm has to decide
how much output to produce or supply along
117
5
The Firm and the Cost of Production

with the amount of each input needed to produce Total Revenue

that particular level of output. When producing a The total revenue of a firm is the price times the
given level of output, the firm chooses the amount quantity sold by the firm.
of different inputs in a way that minimizes the
production cost of that particular level of output. Total Revenue (TR) = Price (P) x Quantity (Q)
In this chapter, we will discuss the concepts that
are pertinent to the production process and explain How does total revenue change in response to
how a firm decides how much to produce and changes in price and quantity? Well, that depends
supply. To this end, we will start with the definition on the type of market structure in which the firm
of cost, introduce concepts such as total revenue operates and the price elasticity of demand (see Ch.
and total cost, and discuss the difference between 2 and Ch. 4). If the firm is operating in a perfectly
the economic and accounting profit. Then, we will competitive market, which we will discuss in
continue with the cost and production relationship, chapter 6, then the price is given from the firm’s
explain different types of costs and discussing the perspective and the total revenue increases both
shape of typical cost curves. Finally, we will compare in price and quantity. The demand for the firm’s
the production process in the short and long run product in this case is perfectly horizontal and the
and explain the economies of scale. price elasticity of demand is infinite. In perfectly
competitive markets, firms are price takers and
they just need to decide how much to produce in
What is Cost? order to maximize their profits.
Cost is ordinarily understood to be the amount
we pay or the price we are charged for a good or
service we get. However, economists’ definition of
Total Revenue: The amount of money a
cost is different than what the meaning of cost in
firm receives from the sale of output
daily use. When economists think of cost, they
add the opportunity cost, which is the next best
alternative given up, to the out-of-pocket costs or
The story is different, though, if the firm
explicit expenses. For example, to attend college,
is operating under the conditions of imperfect
you have to pay tuition and fees. These are explicit
competition (see Ch. 7), monopoly, for
expenses you have to incur. However, you also give
example. In a market characterized by imperfect
up a substantial amount of time to become a full-
competition what happens to total revenue when
time student. How much would your time be worth
the price increases depends on the price elasticity
in monetary value? Well, it is the sum of wages you
of demand. In these types of markets, the quantity
would have received if you worked full time instead
demanded and the price affect each other inversely.
of attending college. So, the overall or total cost
So, to increase the quantity sold, the firm must
of you attending college is the sum of the explicit
decrease the price. If demand is elastic, that is,
expenses you pay, such as tuition and fees, plus the
elasticity is greater than unity in absolute value,
wages you would have earned if you had chosen to
then a percentage increase in the price will decrease
work during the time you devote to being a student.
the quantity sold more than a percentage and the
Hence, from an economist’s point of view, the cost
total revenue will fall. However, if the demand is
includes not only the explicit expenses you must
price inelastic, i.e., elasticity is less than the unity
pay, but also the monetary value of time, effort and
in magnitude, then a percentage increase in the
other resources you have to give up. The sum of all
price will decrease the quantity sold less than a
these costs is called the economic cost.
percentage and the total revenue will rise.
So, to increase the total revenue, a firm must
decrease the price in the elastic portion of the demand
Opportunity Cost: The best alternative
curve and increase the price in the inelastic portion
that we give up when we make a choice or a
of the demand curve. For the sake of completeness,
decision
we should note that a firm achieves the maximum

118

Introduction to Economics I
revenue where the demand is unit elastic with respect
to price. This is also the point at which the ratio of
change in total revenue to a small change in quantity,
i.e. marginal revenue, is equal to zero. Formally:
ΔTR
MR = =0
ΔQ
At this point or portion of the demand curve,
the firm does not need to change the price to
increase the total revenue since it is already at its
maximum.
Total Cost
To produce and supply, a firm hires factors of
production from factor markets. To keep the analysis
simple, let us assume that the firm employs only two
factors, labor and capital, in the production process
and produces some type of gadget. The production
technology, i.e., how much output is produced
when given amounts of labor and capital are used, is
defined by a production function:
Q = f (L,K)
Regarding the production technology, we will
assume that to increase output, the firm must
employ more labor and/or capital. The price of labor
is the wage rate. When the firm hires more labor,
it has to pay more in wages. Similarly, the price of
capital is interest, and the firm has to pay more in
interest when it hires more capital. Denoting the
wage rate and interest by w and r, respectively, the
total cost of a firm is then given by:
Total Cost (TC) = Wage (w) x Labor (L) + Interest
(r) x Capital (K)
The total cost increases as more labor and/or
capital is used. A firm can increase the amount
of labor it uses quickly, if it needs to. Given the
production technology and the amount of capital,
the firm must figure out how much labor to hire
to produce a certain amount of output, Q. If the
time frame is long enough, the firm can change
the amount of capital it uses as well. In this case,
the firm needs to determine the combination of
two resources—how much of each resource to
use—that minimizes the cost of producing a given
amount of Q.
5
Profit
Profit is defined as the difference between total
revenue and total cost, and the objective of a firm
that produces a good or service to sell is to maximize
its profit. Letting π represent the firm’s profit,
Profit (π) = Total Revenue (TR) – Total Cost (TC)
In order to maximize the profit, the firm has
to decide how much output to produce and sell.
As discussed above, the total cost increases as the
firm produces more output, and hence, uses more
input. What happens to the total revenue as the
firm produces more, on the other hand, depends
on the elasticity of demand. Under imperfect
competition, the firm has to decrease the price to
sell more output. When the firm does so, the total
revenue increases, if demand is very responsive
to price changes. So, the firm has to compare the
increase in total revenue versus the increase in total
cost whether it should decrease the price. As long
as the change in total revenue exceeds the rise in
total cost when an extra output is produced and
sold, the firm will continue to cut the price.
The ratio of change in total revenue to a small
change in quantity, MR = ∆TR / ∆Q, is defined as
marginal revenue, above. Similarly, marginal cost is
defined as the ratio of change in total cost to a small
change in quantity, MC = ∆TC / ∆Q If the firm is
operating in a perfectly competitive market, then the
price is given from the firm’s perspective. The more
produced and sold, the higher the total revenue
in this case. Specifically, for each additional unit of
output produced and sold, the ratio of change in total
revenue to the change in quantity, MR, will always be
equal to price, P. Hence, the competitive firm has to
compare price with the change in total cost when one
more unit of output is produced and sold.
Marginal Revenue: The additional revenue
that a firm earns when it increases production
by one more unit
One of the first things you learned in Chapter
1 was to think and decide at the margin. If you
are trying to decide whether to purchase a certain
product and how many units to purchase if you
decide to, you compare the marginal value of
119
5
additional units to you and the additional cost
of that extra unit to you, i.e., the price you pay.
You continue to buy additional units until the
monetary value of the satisfaction you derive from
the last unit is equal to the price you pay for that
last unit.
So, a firm as well must decide at the margin
to maximize its profit. That is, the firm will
continue as long as the increase in total revenue by
producing and selling an extra unit exceeds the rise
in total cost. Once the increase in total revenue and
total cost from an extra unit produced are equal,
the firm can no longer increase its profit. More
formally, if a firm is producing, the firm’s profit
will be maximized when marginal revenue and
marginal cost are equalized or marginal profit is
equal to zero.
Δπ ΔTR ΔTC
= – = MR – MC =0→ MR = MC
ΔQ ΔQ ΔQ
If the firm is operating in a perfectly competitive
market, then the marginal revenue will be equal to
price. Hence, for a firm producing in a perfectly
competitive market, its profit will be maximized
when the price is equal to the marginal cost.
P = MC
Opportunity Costs
In Chapter 1, you learned the definition of
opportunity cost as the next best alternative that
is forgone when you make a choice. There is a
tradeoff between attending college and working
full time, leisure and work or more public services
and private goods that would have been consumed
if more taxes would not have been paid to finance
the additional public services. For each of the
choices above there is an alternative we give up, i.e.,
the opportunity cost.
As each choice we make involves an opportunity
cost, each input a firm employs also has an
opportunity cost. When an entrepreneur invests
in a business or purchases new equipment for the
existing business, she gives up the return she could
have earned if she instead invested in the stock
market or forgoes interest she could have earned if
the amount were deposited in an interest-bearing
account or used to purchase a coupon bond.
120
The Firm and the Cost of Production
Additionally, the entrepreneur forgoes the relatively
riskless salary she could have earned when she
decides to set up her own business. When a worker
decides to accept a job, she gives up not only her
free time but also the enjoyment of spending her
leisure time with her children and family.
So, when a decision is made to use a resource
in a particular production process, the opportunity
of using that resource in another production
process or for something else in general is forgone.
All production decisions involve such tradeoffs.
The next best alternative use of that resource is
the opportunity cost of that particular resource
and all the inputs used in the production have
an opportunity cost. They are different from
direct expenditures or the price paid explicitly for
the resource. They, nevertheless, need to be fully
accounted for when calculating economic costs.
Explicit Costs
Explicit costs are direct expenditures or the
price paid plainly for a project from an accountant’s
perspective. These costs are figured out in terms
of monetary outflows alone. They involve direct
monetary movements and comprise of wages,
the cost of raw materials, interest payments,
transportation, etc. These costs are sometimes
referred to as accounting costs as to how an
accountant would calculate them.
Explicit Costs Costs that are direct expenditures
or the price paid plainly for a project.
Implicit Costs
Implicit costs are costs for which no direct
payments are made but a firm incurs them when it
gives up the next best alternative action or project.
When a firm uses its own capital, it forgoes the
rental income it could have earned by renting the
capital to another firm. This rental income the firm
sacrifices is the opportunity cost of the firm for
using its own capital. This is also called the implicit
rental rate of capital and is comprised of economic
depreciation and the interest forgone. Economic
depreciation refers to a decrease in the market value

Introduction to Economics I
of capital over a particular period. This decrease is
the implicit cost of using the capital throughout
that period. Also, the funds spent to purchase the
capital could have been used for another purpose,
and in their next best usage they would have
yielded an interest income.
Implicit Costs Costs a firm incurs when it
gives up the next best alternative action or
project.
Another implicit cost incurred by the firm
when it forges the next best action is the use of
the owner’s time and monetary resources. The
owner provides the entrepreneurial skills that bring
together factors of production, organizes them and
makes production decisions and bears the risk of
the firm being unsuccessful This is part of a firm’s
opportunity cost because the owner could have run
another business and supplied her labor-and earned
wages- in addition to her entrepreneurial skills.
The Difference Between Economic
and Accounting Profit
Profit is simply the difference between total
revenue and total cost. However, in light of the
discussions above, it should be clear that “profit”
for an economist is not exactly the same as
calculated by an accountant because the concept
of cost is different. An accountant looks at
monetary revenues and explicit monetary outlays
and calculates profit according to the generally
accepted principles of accounting. That is, the
difference between total revenue and accounting
costs—explicit or out-of-pocket costs. The profit
that is calculated by an accountant is named the
accounting profit.
Accounting Profit = Total Revenue – Accounting Cost
Accounting costs in the equation above are the
explicit costs, based on direct monetary expenditures
alone, such as wages for labor, interest paid for
capital and monetary payments for other factors of
production. For an economist, on the other hand,
profit is the difference between total revenue and
total cost or more explicitly total economic cost,
which includes not only the accounting or explicit
5
cost but also the opportunity cost of all factors
of production. Hence, profit, from an economist’s
point of view, is:
Economic Profit = Total Revenue – Total
Economic Cost = Total Revenue – (Accounting Cost
+ Opportunity Cost)
It should be clear that the two definitions
of profit could differ significantly, depending
on the magnitude of the opportunity cost. For
clarification, we should note that from this point
on in the text, when we say “profit” and “total
cost” we mean “economic profit” and “total
economic cost.”
1
Suppose you are working 8 hours
per day and giving guitar lessons for
50 TL an hour. One day you spent
8 hours planting 200 TL worth
of seeds in your family farm. The
planting of seeds yield 300 TL worth
of crops. For planting seeds, what is
the opportunity cost you incurred?
Did you earn economic profit? Did
you earn accounting profit?
PRODUCTION AND COSTS
The objective of a firm that produces a good
or service is to maximize its profit, which is the
difference between total revenue and total cost.
For profit maximization, the firm has to decide
how much output to produce or supply along
with the amount of each input needed to produce
that particular level of output. When producing a
given level of output, the firm chooses the amount
of different inputs in a way that minimizes the
production cost of that particular level of output.
Unlike the output produced and the price charged
which depends on the type of market structure in
which the firm operates, how to minimize the cost
of production for a given level of output is the same
for all firms under all types of market structures.
However, we need to distinguish between the time
frames of short run and long run when studying
the relationship between production and costs.
121
5
The Short Run A time frame in which
certain inputs cannot be changed.
The Long Run A time frame in which a
firm can adjust the usage of all resources if it
deems necessary.
In the short run, some factors of production
cannot be changed. If the firm decides to upgrade
its technology, construct a new building, or expand
its machinery and equipment capacity today, it
would take quite some time to realize any of these
changes. So, a time frame in which certain inputs
cannot be changed is called the short run. These
inputs are fixed in the short run and therefore
called fixed inputs. The firm, however, can change
certain inputs rather quickly—in the short run—
and these inputs are called variable inputs.
To increase output in the short run, a firm
must use more variable inputs. Labor is a typical
variable input. Given a sufficiently long time frame,
however, a firm can change the amount of all the
factors of production it uses. In a long enough
time period, a firm can improve its production
technology, add new buildings, and expand its
machinery and equipment capacity. So, the long
run is a time frame in which a firm can adjust the
usage of all resources, if it deems necessary.
Short Run Production Function
Let’s go back to the production technology of a
firm we introduced earlier when we discussed total
cost. We described the production technology by
the production function:
Q = f (L,K)
Also, remember that when one or both inputs
are increased, output as well will increase. We
will further assume that when more and more of
the same input is used while the other input and
everything else is fixed, output will continue to
increase, but the increase in total output for each
additional unit of the same input will eventually
decrease. Capital, K, however, is fixed in the short
122
The Firm and the Cost of Production
run. So, the firm can only hire more labor if it
wants to increase output in the short run.
Picture 5.1
Total Product of Labor
Given the production technology and the level
of capital K, the amount of maximum output that
a firm can produce for different levels of labor is
known as total product of labor (TPL). We can
draw the graph of total product by joining together
the points that show the maximum output for
given levels of labor. Figure 1 below shows the total
product curve of a sample firm using the data in
Table 1. The table shows the level of capital which
is fixed at 1, and the various levels of labor the
firm can hire and the corresponding maximum
output that can be produced in a week. Assuming
that labor and capital are the only resources, a
firm producing, say, some type of gadget, can only
increase labor (the number of workers) to produce
more output.
Total Product of Labor The amount of
maximum output that a firm can produce
with different levels of labor for a given
capital amount used.
The total product curve of labor separates the
feasible amount of output levels that the firm
can produce in a week from those that are not
achievable. In that respect, it is like the production
possibilities frontier you studied in Chapter 1. All
of the points lying above the curve, are impossible
to attain. The points below the curve are within
reach, but they are inefficient because the points
 5
Introduction to Economics I

below the curve employ more labor than is needed to produce a given amount of output. So, only the
points anywhere on the total product curve represent the most effective use of labor, given the amount of
capital and the production technology. So, the total product curve shows the technologically efficient
points of producing the given the level of output.
Table 5.1 and Figure 5.1 clearly illustrate that as a firm uses more labor, the quantity of total output
produced increases. However, the response of total output to an increase in labor is different at different
levels of labor. Why does output increase by 10 (from 6 to 16) when the amount of labor increases from
1 to 2, yet it only increases by 2 (from 24 to 26) when the quantity of labor employed increases from 4 to
5? Notice that the change in labor is the same in both cases, though the rise in output differs dramatically.
To understand this relationship better, we need to introduce a concept called marginal product of labor.

Table 5.1 Total, Marginal and Average Products of Labor

Capital Labor Total Product (TPL) Marginal Product (MPL) Average Product (APL)
1 0 0
6
1 1 6 6
10
1 2 16 8
5
1 3 21 7
3
1 4 24 6
2
1 5 26 5.2

30
26
TPL
25 24
21
20
16
Output

15

10
6
5

0 1 2 3 4 5
Labor (workers per week)
Figure 5.1 Total Product of Labor

Marginal Product of Labor

Marginal Product of Labor (MPL) is the additional Marginal Product of Labor (MPL) The
output produced when a small amount of additional labor additional output produced when a small
is employed with all other inputs remaining the same. amount of additional labor is employed with
More formally, it is the ratio of change in total product to all other inputs remaining the same.
the change in the amount of labor used.
ΔTP ΔQ
MPL = =
ΔL ΔL

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The Firm and the Cost of Production

If a firm keeps increasing the amount of labor it uses, ceteris paribus, the total output will increase, as
mentioned above. However, if the additional labor is more productive than the previous one, the total output
will increase more; if not, it will increase less. Suppose that two workers can work effectively with one machine.
If you employ only one worker, she can still produce some output, but because she is the only worker,
she has to divide her time in between using the machine and doing other work necessary for production.
So, employing another worker can increase production greatly. If the firm employs more labor, the output
would still increase, but, given the single machine to work
with, the higher the number of workers, the more difficult
it will be for all of them to use the same machine effectively. Law of Diminishing Returns Decrease in the
Hence, as more and more labor is used, given that everything marginal product of a variable input. When
else is the same, the increase in the total output for each additional units of a variable input—typically
additional unit of labor input, i.e. marginal product, might labor—are added to fixed input—typically
at first increase. We will call this increasing marginal returns. capital— the marginal product of variable
However, as we continue to use more and more labor while input firstly increases and then finally decreases.
other inputs are fixed, the marginal product will eventually
become less and less. This is known as Total Product of Labor
diminishing marginal returns. The 30 26
above two facts will be evident in the 24
TPL
25 21
positive but eventually decreasing slope of
the total product curve against labor for a 20 16
Output

given amount of capital. The relationship 15

between the total and marginal product
10 6
curves, based on the data in Table 5.1,
is illustrated in Figure 5.2. If you look 5
at Figure 5.2 carefully, you can see the
patterns we have discussed above. 0 1 2 3 4 5
The upper portion of Figure 5.2 Labor (workers per week)
shows the total product curve with a
change in the output marked as the Marjinal Product of Labor
amount of the labor unit increases from 12 10
0 to 5. In our example above, labor 10
Output per worker

changes by one unit at a time. So, using

8
the change in the total product for each 6
5
unit of increase in labor, we can calculate 6
the marginal product of labor as shown 4 3
2
by the height of the rectangles placed on MPL
the total product curve. As can be seen 2

from Figure 5.2, the marginal product

increases at first and reaches its maximum 0 1 2 3 4 5
of 10 gadgets per worker per week when Labor (workers per week)
the amount of labor used increases from Figure 5.2 Total and Marginal Product Relationship
1 to 2. So that until this level of labor,
we have increasing marginal returns. Once the number of
workers employed passes this point, diminishing marginal
returns kick in, and the marginal product starts to decrease Total Cost (TC) The total fixed cost plus
fast and eventually goes to 2 when the amount of labor the total variable cost.
employed increases from 4 to 5. This fact is also illustrated
by the shape of the total product curve in the first one of the Average Cost (AC) The total cost divided
two figures in Figure 5.2. as it becomes steeper at first, and by the amount of output produced.
then flatter once the diminishing marginal returns sets in.

124
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Introduction to Economics I

The bottom part in figure 5.2 displays the marginal product curve or the change in the output for each
additional unit of labor employed. The change in output increases until 2 units of labor are used and then
it decreases. This is nothing but a manifestation of increasing versus diminishing marginal returns. So,
the graph of marginal product against the number of workers employed also clearly illustrates increasing
marginal returns at first, and then diminishing marginal returns.

Average Product of Labor

We can also look at how productive the labor is on average. To do that, we need to look at the average
output per worker or more formally the average product of labor (APL). It is equal to the division of the
total product by the quantity of labor employed.

TP Q
APL = =
L L

The average product of labor will follow the marginal product of labor. If the marginal product of
additional workers exceeds the average product of labor, the average product will increase since additional
workers will be more productive than the average productivity of previously employed workers. For the
additional workers at which marginal product of labor is less than the average product of labor, the average
product of labor will decrease. As a result, the average product is highest when the marginal product is
equal to the average product. That is, the marginal product curve will cut the average product curve at its
maximum.
There is a very tight relationship between the total, marginal, and average product curves. Specifically,
when the total product curve is steepest, the marginal product curve is at its highest. Where the total
product curve is the least steep (flattest), the marginal product is at its lowest. Similarly, the point on the total
product curve which is on the steepest line, starting from the origin, gives the maximum average product.
These situations are illustrated in
Total Product of Labor
Figure 5.3, using the sample firm
30
data from Table 5.1. In figure 26
25 24
5.3, the slopes of red and green 21 TPL
lines correspond to the highest 20 16
Output

and lowest marginal products, 15

respectively, while the slope of 10
6
the purple line represents the 5
maximum average product.
0
In the next section, we will 0 1 2 3 4 5
see how the shapes of the total, Labor (workers per week)
marginal and average product
curves affect a firm’s cost curves. Marjinal and Average Products of Labor
At which output levels would 12
certain costs be minimized? Would 10
Output per worker

an average cost be minimized 8

when the average product is at 6
its maximum? Would a change in APL
4
the total cost be the slowest when
the marginal product is at its 2 MPL
peak? The answer to the latter two 0
0 1 2 3 4 5
questions is indeed yes as we will
Labor (workers per week)
see in the next section.
Figure 5.3 Total Product, Average Product and Marginal Product Relationship

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5
DIFFERENT TYPES OF COSTS
To produce and supply more output in the
short run, a firm has no option other than hiring
more labor. But employing more labor means
a definite increase in the costs that a firm has to
bear. As a matter of fact, in the short run, even if a
firm produces nothing, it has to keep paying for its
fixed inputs. In this section, when discussing the
output and cost relationship, we will again use the
concepts of total, average and marginal as we did
when we discussed production.
Total Cost
The total cost is the economic cost of all the
resources, including the cost of entrepreneurship
which is called normal profit. To keep the analysis
simple, however, we have assumed the firm uses
only two resources, labor (L) and a given amount
of capital (K), in the short run. The production
technology is represented by the following
production function:
Q = f (L, K)
Total Cost (TC) The total fixed cost plus
the total variable cost.
The firm hires factors of production from
factor markets and pays the wage rate, w and the
interest rate, r, respectively for each unit of labor
and capital it employs. Then, the total cost (TC)
of production for a firm is given by:
Total Cost (TC) = Wage (w) x Labor (L) + Interest (r)
x Capital (K)
Though costs of inputs that are fixed in the
short run will remain the same, the total cost
will increase with the output since the firm has
to employ more labor and pay more in wages to
produce more output.
Fixed Costs
Recall that even if a firm produces nothing, it
has to keep paying for its fixed inputs in the short
run. So, the fixed costs a firm faces do not depend
126
The Firm and the Cost of Production
on the level of production. The sum of all the fixed
costs a firm has to pay for, fixed inputs, is called
the total fixed cost (TFC). The total fixed cost
does not vary with the level of output. Capital is
the only fixed cost for our sample firm. Hence, the
firm’s total fixed cost is given by the price of the
capital times the amount of fixed capital employed
in the short run, and it remains constant for all
levels of output.
Total Fixed Cost (TFC) = Interest (r) x Capital (K)
Variable Costs
Since a firm cannot change the amounts of its
fixed inputs used in the short run, it has to use
more of its variable inputs to increase production.
That means that the firm has to pay more for
variable inputs to increase output. The sum of
all variable costs a firm pays for variable inputs is
called the total variable cost (TVC). Since labor is
the only variable input for our representative firm,
its total variable cost will be the wage rate times the
amount of labor used. Because the firm can only
hire more labor to produce more output, the firm’s
total variable cost will grow as the output produced
increases.
Total Variable (TVC) = Wage (w) x Labor (L)
Average Costs
The Average cost (AC) tells us the cost per unit.
It is equal to the total cost divided by the amount
of output produced.
TC
AC =
Q
How average cost behaves is tightly linked to
how total cost behaves. It might decrease at first
but it will eventually increase as the level of output
produced keeps increasing and typically be U
shaped.
Average Cost (AC) The total cost divided
by the amount of output produced.
 5
Introduction to Economics I

Average Fixed Cost

The Average fixed cost (AFC) gives the fixed cost per output. It is calculated as the total fixed cost
divided by the quantity of output produced.

TFC
AFC =
Q

Because the total fixed cost remains constant, irrelevant of the level of output produced, the average
fixed cost will continuously decrease as the output produced increases.

Average Variable Cost

The Average variable cost (AC) measures the variable cost per unit of the output produced. Its behavior
is connected to the behavior of the total variable cost and is normally U shaped. The average variable cost
is calculated as the total variable cost divided by the quantity of the total output produced.

TVC
AVC =
Q

Marginal Cost
The Marginal cost (MC) is the cost of producing the
last unit of output. It tells us how the total cost (and the
Marginal Cost (MC) The cost of producing
total variable cost) changes as the output changes. The
the last unit of output.
marginal cost is calculated as the increase in the total cost
(or total variable cost) divided by the increase in the output.

ΔTC
MC =
ΔQ

To understand the changes in the pattern of total cost and total variable cost, we need to understand
and use the concept of marginal cost. Marginal cost measures how fast or slow the total cost and the total
variable cost increase. The slower the increase, the lower the marginal cost. Also, when the marginal cost
is lower than the average cost and the average variable cost, it pulls them down as the output increases.
Conversely, when the marginal cost is higher than both average costs, it pulls them up as the output
becomes larger. Hence, the marginal cost is responsible for the U shaped average cost and average variable
cost and goes through the minimum points of both curves.
What lies beneath the behavior of marginal cost? Suppose a firm hires one more unit of labor and pays
the wage rate, w. The change in total cost, ∆TC in this case is equal to w and the change in total output
produced, ∆Q is equal to the marginal product of the last unit of labor, MPL. Substituting w and MPL in
the marginal cost formula above gives:

w
MC =
MPL
Given the wage rate, this definition tells us that the marginal cost is changing inversely with the
marginal product of labor, MPL. From our discussion about MPL above, it tends to increase first, reach its
maximum, and eventually decrease as output increases. Given the behavior of MPL, the behavior of MC
will then be exactly the opposite. It will first decrease, reach its minimum when MPL is at its maximum,
and then start to rise as output continues to increase and MPL starts to decrease.

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The Firm and the Cost of Production

Shapes of Typical Cost Curves

In light of the discussion above, we now MPL, APL
learned that the behavior of TC and TVC
depends on MC, which in turn is linked to
the MPL. Similarly, AVC is at the end linked
to the average product of a variable input,
TVC APL
typically labor. Recall that AVC = . Since
Q MPL
TVC = wxL, substituting wxL for TVC and
rearranging yields:

TVC wxL w w 0
AVC =
Labor
= =
Q Q (Q / L) APL
MC, AVC

Remember that APL stands for average

product of labor. Hence, given the wage rate,
w, a higher APL implies a lower AVC and vice MC
AVC
versa. So, as APL increases, AVC decreases and
hits its minimum when APL is at its maximum.
Once APL starts to fall, AVC begins to rise and
generate a U shape. Figure 5.4 illustrates the
relationship between the typical marginal and
average product curves and the corresponding 0 Output
marginal and average variable cost curves. Figure 5.4 Average and Marginal Product Curves versus
Since MC is the cost of producing the last Average Variable and Marginal Cost Curves
unit of output, TC and TVC increase less for TVC
each additional unit of output when MC is
decreasing. The lower the MC is, the flatter the
TC and TVC curves become, and the higher the TVC
MC is, the steeper both curves turn out to be.
Also, when AVC and AC are above MC,
additional units of production continue to
decrease both averages. When they are below
MC, producing more increases both. So, the
MC curve cuts the AC and AVC curves at their
minimum. Figure 5.5 illustrates the relationship 0 Output
between the TVC, MC and AVC curves.
MC, AVC
The red line in the figure indicates where
the TVC is the least steep, i.e., where the MC MC
is minimum. The purple line, on the other
hand, shows the point where the average slope
of TVC, i.e., AVC, is at its lowest. Recall that
TC is the sum of TVC and TFC:
AVC
TC = TVC + TFC
Because TFC stays the same, independent
of the output produced, the shape of the TC
0 Output
curve is exactly the same as the TVC curve but
lies above it. Figure 5.6 shows the total cost Figure 5.5 Total Variable Cost, Marginal Cost and Average
Variable Cost

128
 5
Introduction to Economics I

curves using the production data in Table 1 for our 1200

TC
representative firm and assumes the price of capital,
r, is $100, and the price of labor, w, is $200. Notice 1000
TVC
that the difference between TC and TVC is exactly
equal to TFC everywhere. 800
Dividing the both sides of the TC equation given

Cost ($)
above yields: 600

TC TVC TFC
= + 400
Q Q Q
200
Observing that AC = TC , AVC = TVC and AFC = TFC
Q Q Q TFC

AC can be rewritten as the sum of AVC and AFC:

0 5 10 15 20 25 30
AC = AVC + AFC Output
Figure 5.6 Total Variable Cost, Marginal Cost and
So, the shape of the AC curve is determined by Average Variable Cost
the shapes of AVC and AFC. As output increases,
AFC keeps decreasing because the firm can spread its TFC to a higher number of output produced. Hence,
AFC is downward sloped and descending for all possible output levels.
AVC continues to fall as long as MC remains below it. However,
the MC curve eventually starts to increase because of diminishing 2
returns and goes through the minimum of the AVC curve pulling it
up. When AVC and AFC decrease, AC too decreases. Though the AFC What kind of relationship exists
curve continues to decrease, once the AVC curve slopes upward, it will between the AC and MC?
eventually outweigh the slope of the AFC curve and make the AC curve
upward sloping and hence U shaped. Figure 5.7 below illustrates the
relationship between the MC curve and all three average cost curves and the connection among the average
cost curves. We finish this section by presenting the cost calculations for our sample firm in Table 5.2.

Table 5.2 Total Output and Corresponding Costs

Total Fixed Total Total Marginal Average Average Average

Labor Output Cost Variable Cost Cost Fixed Cost Variable Cost
(TFC) Cost (TVC) (TC) (MC) (AFC) Cost (AVC) (AC)
0 0 100 0 100
33.33
1 6 100 200 300 16.67 33.33 50
20
2 16 100 400 500 6.25 25 31.25
40
3 21 100 600 700 4.76 28.57 33.33
66.67
4 24 100 800 900 4.17 33.33 37.5
100
5 26 100 1000 1100 3.85 38.46 42.31

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The Firm and the Cost of Production

THE SHORT RUN AND THE

LONG RUN IN PRODUCTION
Recall that we define the production technology
Cost ($) with a production function, which converts physical
MC inputs or factors of production to physical output
through a production process. Also remember that,
a firm has to use inputs (labor and capital) and use
more of them to increase production. In the short-
run, capital is fixed and the firm can only increase
labor to increase production but diminishing returns
sets in eventually as discussed earlier. However, in the
AC long run, the firm can change the amount of capital
AVC it uses as well. When more capital is used for a given
amount of labor employed, output will increase. That
is, the same amount of labor combined with a higher
AFC amount of capital will produce more output. Let’s go
back to our sample firm and see what happens if the
0 Output firm increases the plant size and doubles the amount
Figure 5.7 Marginal Cost Curve and Average Cost Curves of capital used in each capacity enlargement. That is,
the amount of the capital used increases from 1 to 2
at first, and then from 2 to 4 later. Table 5.3 presents
the production data and the average product of labor
(APL) and the capital (APK).

Table 5.3 Production at Different Plant Sizes, Average Product of Labor and Capital
Plant 1 Plant 2 Plant 3
Labor Output APL APK Output APL APK Output APL APK
1 6 6 6 16 16 8 24 24 6
2 16 8 16 24 12 12 34 17 8.5
3 21 7 21 29 8.67 14.5 39 13 9.75
4 24 6 24 32 8 16 42 10.5 10.5
5 26 5.2 26 34 6.8 17 44 8.8 11
Capital 1 2 4

The first thing to note from Table 5.3 is that for a given plant size, an increase in labor increases output.
Similarly, for a given amount of labor, an increase in capital used increases output. From the table, you can
also see that for each plant size, APL is decreasing as more labor is used. This is due to diminishing returns
to labor, i.e., diminishing MPL discussed earlier. If you look at the table carefully, you will see a similar
pattern for capital. That is, for any given labor level, when the amount of capital increases, you will notice
a decrease in the APK at the end. This is due to the existence of diminishing returns to capital, decreasing
MPK, at all three quantities of capital for a given amount of labor.
You can calculate MPK by dividing the change in the output by the change in the amount of the capital
used. For one worker, for example, MPK is equal to 10, when the amount of the capital used increases
ΔQ 24 − 6 8
from 1 to 2. And, it is equal to 4 when the capital amount increases from 2 to 4 MPK = ΔK = 4 − 2 = 2 = 4 .
Table 5.3 also indicates that when the amount of labor and capital employed are both equal to 1, the total
output is equal to 6. When both inputs are doubled, the output increases to 24. So, changing the plant

130
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Introduction to Economics I

size in the long run can have a very sizeable impact on output. For a given wage and interest rate, this
increase in output implies that the average cost is halved. Hence, the plant size has a big impact on how
short-run costs behave.

Costs in the Short Run

Now, for each plant size, when the firm TC1 TC2 TC3
increases the quantity of labor to increase Cost ($)
output, the total cost (TC) increases. So,
with three different plant sizes, we have
three different TC functions, each reflecting
the change in total cost as labor, and hence
output, increases. These are short-run total
cost functions at the given amount of capital.
Recall that in Table 5.3, when both labor
and capital doubled from 1 to 2, the output Output
increased from 6 to 24. The total cost borne
by the firms is multiplied by two, if the price Cost ($)
of labor and capital stay the same, but the
amount of output is multiplied by 4 and
the average cost is halved. What happens AC1 AC2
here? Well, a larger plant size requires the
AC3
use of larger fixed inputs or higher total fixed
costs, but decreases marginal costs and hence MC1 MC2 MC3
average costs at higher levels of output. That
is, a larger plant size increases the initial
cost, but the increase in total cost slows
down when compared to a smaller plant
size, hence, reducing the average cost at high
Output
levels of output. Figure 5.8 below illustrates Figure 5.8 Short Run Total and Average Cost Curves
the behavior of three different hypothetical
short run TC and associated AC curves.
The figure illustrates that the larger the plant size is, the lower the average cost is at higher output levels.
The rays starting from the origin indicate where the average cost is minimum for each of the TC curves. The
average minimum cost occurs where rays are tangent to the TC curves. Each average cost curve is U shaped,
indicating that there are increasing marginal returns to labor first, and then diminishing marginal returns.

Table 5.4 Total Cost (TC) and Average Cost (AC) with Different Plant Sizes
Plant 1 Plant 2 Plant 3
Labor Output TC AC Output TC AC Output TC AC
1 6 300 50 16 400 25 24 600 25
2 16 500 31.25 24 600 25 34 800 23.53
3 21 700 33.33 29 800 27.59 39 1000 25.64
4 24 900 37.5 32 1000 31.25 42 1200 28.57
5 26 1100 42.31 34 1200 35.29 44 1400 31.82
Capital 1 2 4

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The Firm and the Cost of Production

Continuing to assume that labor costs $200 and capital costs $100 per unit, Table 4 presents the total
and average costs for our sample firm for each plant size. Table 5.4 indicates lower average costs with larger
plant size as illustrated in Figure 5.8. Readers can easily verify the calculations in the table.

Costs in the Long Run

Figure 5.9 below shows the long-run total cost Cost ($) TC1 TC2 TC3

(LRTC) and long-run average cost (LRAC) curves.

The LRTC and LRAC curves are derived from the LRTC
short-run total cost and average cost curves. If you
look at Figure 5.9, plant size 1 represented by TC1
provides the lowest short-run total cost until the
output level q1. Between the quantities q1 and q2,
TC2 gives the lowest total cost. For output levels q1 q2
Output
exceeding q2, plant size 3 symbolized by TC3,
delivers the least short-run total cost. Investigating Cost ($)
the lower part of the figure, we can see that short-
run average cost curves, associated with the relevant
total cost curves, provide the lower most average AC1 AC2
costs in between the same quantities. AC3

If the firm is operating using plant 1, it cannot

change the plant size (capital) in the short run and
has to bear the higher cost represented by TC1, even
if its production exceeds q1. Similarly, if the firm is LRAC
operating with plant size 3 shown by TC3, and the
q1 q2 q3
output level is well below q2, it cannot reduce its Output
capital immediately and has to accept an excessive Figure 5.9 Long-Run Total and Average Cost Curves
total cost in the short run. However, in the long run,
the firm can change its capital as well. So, for output levels exceeding
q1 and q2, the firm can increase its plant size to the one described by
TC2 and TC3, respectively, and reduce its total cost. Hence, the long
3
run total cost curve, LRTC, is given by the lowest portions of the short-
run total cost curves. Similarly, because AC1, AC2, and AC3 represent What kind of relationship you
the lowest short-run average cost until q1, between q1 and q2, and expect between the productivity
beyond q2, respectively, the long-run average cost (LRAC) is derived by and cost of production?
joining the lowest portions of the short-run average cost curves. Both
the LRTC and LRAC curves are highlighted and marked in Figure 5.9.

Picture 5.2

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Introduction to Economics I

Scale Economies
In the short run, we assume at least one of the Constant Returns to Scale An increase in
factors of production is fixed, and if a firm keeps output by the same percentage as an increase
increasing the output level, diminishing returns in all inputs.
to other factors of production eventually set in,
hence, generating an increasingly steeper short-run
total cost curve and increasing average cost curves
beyond a certain level of output. In the long run, Typically, a firm experiences economies of scale
however, all resources used in production can up to a certain production level. After passing
change. A firm can set its plant size to the level it that particular level, the firm passes into constant
desires to increase production greatly or it can shut returns to scale or diseconomies of scale. If the
down completely and leave the industry. So, the firm continues to experience economies of scale,
LRTC and LRAC reflect how costs vary by scales its LRAC curve will be downward sloped. With
of production. diseconomies of scale setting in after economies
of scale, the LRAC curve will be U shaped. If
Given the fixed factor prices, when all inputs
we go back to Figure 5.9, LRAC decreases until
are raised at the same time by the same percentage,
the output level q3, and increases thereafter. So,
if the output increases more than the percentage
the firm experiences economies of scale until the
increase in inputs, we call this increasing returns to
output level q3 and diseconomies of scale beyond
scale. If the output increases by the same percentage
this point. The production level at which the
as the increase in all inputs, this is called constant
economies of scale die out and constant returns
returns to scale. If the output increases less than
to scale or diseconomies of scale set in, is called
the percentage increase in inputs, then there are
the minimum efficient scale (MES). This is the
decreasing returns to scale. If you go back to the
minimum output level or scale at which LRAC is
production data in Table 5.3, you can verify that
minimized. Figure 5.10 below illustrates all three
our sample firm is experiencing increasing returns
scale economies and the minimum efficient scale.
to scale when both labor and capital increase
from 1 to 2, soaring the total output from 6 to Cost ($)
24. However, when we increase both inputs from
2 to 4, the output only increases from 24 to 42.
Economies Constant Returns to Diseconomies
So, somewhere beyond the output level of 24 of Scale Scale of Scale
but before 42, decreasing returns to scale set in. If
there are increasing returns to scale or economies
LRAC
of scale, LRTC will increase slowly and become AC1 AC2 AC3
flatter and LRAC will decrease. If there are
decreasing returns to scale or diseconomies of
scale, LRTC will become steeper, and LRAC will
be increasing. LRTC will be linear and LRAC stays
q1 q2 q3
the same, if there exist constant returns to scale. Output
Minimum
Hence, scale economies refer to whether LRAC of Efficient Scale
a firm rises, falls or stays the same as the output
increases. Figure 5.10 Scale Economies and Minimum Efficient Scale

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The Firm and the Cost of Production

LO 1 Understanding what is involved in

the production process of a firm.

The Production process converts resources which are called inputs or factors of production into new
goods and services called outputs over a period of time. The basic factors of production available to a
society are natural resources, labor, capital and entrepreneurship.
Production technology, i.e. how much output is produced when given amounts of labor and capital are
used, is defined by a production function. Marginal Product of Labor (MPL) is the additional output
produced when a small amount of additional labor is employed with all other inputs remaining the same.
More formally, it is the ratio of the change in total product to the change in the amount of labor used.
Summary

As more and more labor is used, given everything else is the same, the change in total output for each
additional unit of labor input first increases , which is referred to as increasing marginal returns. If we
continue to add more and more labor, the marginal product will eventually become less and less, which
is referred to as diminishing marginal returns.

LO 2 Explaining total revenue, total cost

and profit.

The total revenue of a firm is the price times the quantity sold by the firm.
Total Revenue (TR) = Price(P) x Quantity(Q)
How does total revenue change in response to changes in price and quantity? Well, that depends on the
type of the market structure in which the firm operates and the price elasticity of demand. If the firm is
operating in a perfectly competitive market, the price is given from the firm’s perspective and the total
revenue increases both in price and quantity. The demand for the firm’s product in this case is perfectly
horizontal and the price elasticity of demand is infinite. In perfectly competitive markets, firms are price
takers and they just need to decide how much to produce in order to maximize their profits.
In a market characterized by imperfect competition, what happens to total revenue when the price
increases depends on the price elasticity of demand. In these types of markets, the quantity demanded
and the price affect each other inversely. So, to increase the quantity sold, the firm must decrease the
price. If demand is elastic, that is, elasticity is greater than unity in absolute value, then a percentage
increase in the price will decrease the quantity sold more than a percentage and the total revenue will
fall. However, if the demand is price inelastic, i.e., elasticity is less than the unity in magnitude, then
a percentage increase in the price will decrease the quantity sold less than a percentage and the total
revenue will rise.
So, to increase the total revenue, a firm must decrease the price in the elastic portion of the demand curve
and increase the price in the inelastic portion of the demand curve. For the sake of completeness, we should
note that a firm achieves the maximum revenue where the demand is unit elastic with respect to price.
Total Cost. To produce and supply, a firm hires factors of production from factor markets. Regarding the
production technology, we will assume that to increase output, the firm must employ more labor and/or
capital. The price of labor is the wage rate. When the firm hires more labor, it has to pay more in wages.
Similarly, the price of capital is interest, and the firm has to pay more in interest when it hires more capital.
Denoting the wage rate and interest by w and r, respectively, the total cost of a firm is then given by:
Total Cost (TC) = Wage(w) x Labor(L) + Interest(r) x Capital(K)
The total cost increases as more labor and/or capital is used.
Profit is defined as the difference between total revenue and total cost, and the objective of a firm that
produces a good or service to sell is to maximize its profit. Letting π represent the firm’s profit,
Profit (π) = Total Revenue (TR) – Total Cost(TC)

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Introduction to Economics I

LO 3 Analyzing the relationship among

different types of costs.

The sum of all the fixed costs a firm has to pay for fixed inputs is called the total fixed cost (TFC). The total
fixed cost does not vary with the level of output. The sum of all variable costs a firm pays for variable inputs
is called the total variable cost (TVC). The sum of TFC and TVC gives us the total cost (TC). The total cost
is the economic cost of all the resources, including the cost of entrepreneurship which is called normal profit.
The average cost (AC) tells us the cost per unit. The average fixed cost (AFC) gives the fixed cost per
output. The average fixed cost will continuously decrease as output produced increases. The average variable
cost (AVC) measures the variable cost per unit of the output produced. The behavior of the average cost is
determined by the behavior of the total variable cost and the average fixed cost, and is normally U shaped.

Summary
The marginal cost (MC) is the cost of producing the last unit of output. It tells us how the total cost
(and the total variable cost) changes as the output changes. The marginal cost is calculated as the increase
in the total cost (or total variable cost) divided by the increase in the output.

LO 4 Recognizing and drawing the

shapes of typical cost curves.

Given the wage rate, w, a higher average product of labor APL implies a lower AVC and vice versa. So,
as APL increases, AVC decreases and hits its minimum when APL is at its maximum. Once APL starts
to fall, AVC begins to rise and generate a U shape.
Since MC is the cost of producing the last unit of output, TC and TVC increase less for each additional
unit of output when MC is decreasing. The lower the MC is, the flatter the TC and TVC curves become,
and the higher the MC is, the steeper both curves turn out to be.
Also, when AVC and AC are above MC, additional units of production continue to decrease both
averages. When they are below MC, producing more increases both. So, the MC curve cuts the AC and
AVC curves at their minimum.
Because TFC stays the same, independent of the output produced, the shape of the TC curve is exactly
the same as the TVC curve but lies above it.
The shape of the AC curve is determined by the shapes of AVC and AFC. As output increases, AFC keeps
decreasing because the firm can spread its TFC to a higher number of output produced. Hence, AFC is
downward sloped and descending for all possible output levels.
AVC continues to fall as long as MC remains below it. However, the MC curve eventually starts to
increase because of diminishing returns and goes through the minimum of the AVC curve pulling it up.
When AVC and AFC decrease, AC too decreases. Though the AFC curve continues to decrease, once
the AVC curve slopes upward, it will eventually outweigh the slope of the AFC curve and make the AC
curve upward sloping and hence U shaped.

Understanding the relationship between

LO 5 the short-run and the long-run costs and
the economies of scale.

Economists distinguish between the time frames short run and long run when studying the production
and cost relationship. In the short run, some factors of production cannot be changed. The long run is
a time frame in which a firm can adjust the usage of all resources, if it deems necessary.
Given the fixed factor prices, when all inputs are raised at the same time by the same percentage, if the
output increases more than the percentage increase in inputs, we call this increasing returns to scale. If
the output increases by the same percentage as the increase in all inputs, this is named constant returns
to scale. If the output increases less than the percentage increase in inputs, then there are decreasing
returns to scale.

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5
1 Suppose a certain firm is able to produce 180
units of output per day when 10 workers are hired.
The firm is able to produce 190 units of output
per day when 11 workers are hired (holding other
inputs fixed). Then the marginal product of the
11th worker is
A. 10 units of output B. 12 units of output
Test Yourself
C. 18 units of output D. 19 units of output
E. 20 units of output
2 If marginal cost is declining,
A. average variable cost must be rising.
B. average fixed cost must be rising.
C. marginal product of labor must be rising.
D. average cost must be rising.
E. marjinal profit is increasing.
3
Marginal cost is equal to average variable cost
when
A. average fixed cost is rising.
B. average variable cost is at its minimum.
C. average cost is rising.
D. average variable cost is declining.
E. total cost is maximum.
4 In economics, the long run is a time period in
which
A. all factors of production are variable.
B. all factors of production are paid for.
C. all outputs are determined.
D. all loans are repaid.
E. all factors are fully employed.
5 Which of the following statements is true
regarding the difference between economic and
accounting profit?
A. Accounting profit includes all implicit and
explicit costs.
B. Economic profit includes implicit costs only.
C. Accounting profit equals economic profit in
the long run.
D. Accounting profit includes only explicit costs.
E. Economic profit is always greater than the
accounting profit.
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The Firm and the Cost of Production
6 When adding another unit of labor leads to
an increase in the output that is larger than the
increases in the output that result from adding
previous units of labor, we have the property of
A. Diminishing marginal product of labor.
B. Increasing marginal product of labor.
C. Negative marginal product of labor.
D. Diminishing output of labor.
E. Diminishing average product of labor.
7 Average productivity of labor can be defined as the:
A. Change in profit divided by the number of
labor employed.
B. Total product divided by the number of labor
employed.
C. Change in total product divided by the number
of labor employed.
D. Total cost divided by the number of labor
employed.
E. Total profit divided by the number of labor
employed.
8 When average productivity of labor is maximum
and equals the marginal productivity of labor,
A. Marginal cost intersects average variable cost at
its minimum.
B. Marginal cost is greater than average cost.
C. Marginal cost and average cost both are rising.
D. Marginal cost and average cost both are declining.
E. Marginal, average and total costs are equal.
9 Fixed costs can be defined as costs that
A. Vary inversely with production.
B. Vary in proportion with production.
C. Are incurred only when production is large
enough.
D. Are incurred even if nothing is produced.
E. Always equal to variable costs.
10 Which of the following is an implicit cost?
A. Salaries paid to workers who work for the firm.
B. Interest on money borrowed to finance
equipment purchases.
C. Cash payments for raw materials.
D. Foregone rent on office space owned and used
by the firm.
E. Cash payments for purchasing machines.
 5
Introduction to Economics I

1. A If your answer is not correct, review the topic 6. B If your answer is not correct, review
of “Production and Costs”. “Production, Cost and Profit”.

If your answer is not correct, review

Answer Key for “Test Yourself”

2. C If your answer is not correct, review 7. B
“Production and Costs”.
“Different types of Costs”

3. B If your answer is not correct, review 8. A If your answer is not correct, review
“Different types of Costs”. “Production and Costs”.

4. A If your answer is not correct, review “The 9. D If your answer is not correct, review
Short Run and the Long Run in Production”. “Different types of Costs”.

If your answer is not correct, review

5. D If your answer is not correct, review 10. D
“Different types of Costs”.
“Production, Cost and Profit”.

The marginal product of labor is the change in output that results from
employing one more labor. In this question, by employing an 11th worker, the
firm is able to increase its production by 10 units. The marginal product of hiring
answer 1 one additional worker is the physical enhancement in the quantity produced.
The firm increases the number of workers from 10 to 11 and produces 190
instead of 180 units. Then the marginal product of the 11th worker is 10 units
of output.

There is a negative relationship between MC and marginal product of labor

(MPL). The logic is that for a given wage rate, as MPL increases, an additional
answer 2 output costs less. You can also confirm this relationship by recalling that MC=w/
MPL. So, given the wage rate w, if MC is decreasing, MPL must be increasing.

MC always intersects AVC and AC at their minimum. When MC is less than

AVC, each additional unit of production lowers AVC. The logic is that if you
have an average and you add another number that is lower than the average,
answer 3 then the new average has to go down because the number that was added to the
average was lower. However, MC becomes upward sloping before it intersects
with AVC. This implies that at some point, MC rises to the point that is equal
to AVC, and the two curves intersect.

In the long run, a firm is able to adjust all inputs of production capacity,
whereas in the short run, the firm is only able to adjust variable inputs—which
answer 4 is generally labor—to change the production level. In the long run, a firm can
go beyond the established capacity and adjust all inputs to a new situation,
including the use of new production technology and enlarging the plant size.

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The Firm and the Cost of Production

The accounting profit is the difference between total revenue and accounting
answer 5 costs. So, it includes only explicit costs.

When the marginal product of labor is greater than the previous worker, i.e.,
when MPL is increasing, this is called increasing marginal returns. When
answer 6 increasing marginal returns prevail, additional labor will produce more than
the previous one.

total product of labor

answer 7 Average Productivity of Labor =
number of labor employed

Higher APL means lower AVC. So, when APL is maximum, AVC is at its
answer 8 minimum which is the point of intersection of AVC and MC (also, see answers
2 and 3).

Fixed costs are the costs that the firm has to bear even if there is no production,
answer 9 such as depreciation on machinery, salaries of permanent employees, etc.

Implicit cost can be defined as the opportunity cost or what a firm must give up
when it uses a resource. In order to use an office space which the firm already
answer 10 owns and thus does not pay rent for, it has to forego the rental income it could
have earned by renting the office space to others.

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Introduction to Economics I

Suppose you are working 8 hours per day and giving guitar
lessons for 50 TL an hour. One day you spent 8 hours
planting 200 TL worth of seeds in your family farm. The
planting of seeds yield 300 TL worth of crops. For planting

Suggested answers for “Your Turn”

seeds, what is the opportunity cost you incurred? Did you
earn economic profit? Did you earn accounting profit?

Profit is the difference between total revenue and total cost. Your total cost
which is equal to the opportunity cost is equal to 200 T from seeds plus the
opportunity cost of losing 400 T that you would have earned in case you had
given guitar lessons. The total revenue is 300 T.
your turn 1 The accounting profit = 300 T -200 =100 T
The economic profit = 300 – (200 + 400) = -300
So, you have positive accounting profit but negative economic profit as a
result of your activity in your parent’s farm.

What kind of relationship exists between the ATC and MC?

AC curve has a U-shape. The MC curve has a positive slope indicating that
the MC increases with the increase in production. When MC is smaller than
your turn 2
the AC, the average decreases. When MC is greater than the AC, the average
increases.

What kind of relationship you expect between the

productivity and cost of production?

When there is an increase in productivity in general or in the productivity of

an input, there will be increase in the total output produced. It means that
your turn 3 the cost of per unit produced decreases. So, there is an inverse relationship
between productivity and the cost. Increase in productivity reduces both the
marginal and average cost.

139
5
References
Bade, R. and Parkin, M. (2015), Foundations of
Microeconomics, 7th Edition, Pearson Education
Inc., USA.
Browning, E. K. and Zupan, M.A. (1999),
Microeconomic Theory and Applications, 6th
Edition, Addison-Wesley, USA.
Case, K., Fair, R. and Oster, S., (2012), Principles of
Economics, 10th Edition, Prentice Hall, NY, USA.
Hubbard, R. G. and O’Brien, A. P. (2012), Economics,
Pearson, 4th edition.
Mankiw, N. G. (1998), Principles of Microeconomics.
Harcourt Brace College Publishers.
Mankiw N. G. (2003), Principles of Economics,
South-Western College Publishing, USA, 5th
edition.
140
The Firm and the Cost of Production
McConnel, C. R. and Brue, S. L. (2005),
Microeconomics: Principles, Problems and
Policies, 16th edition, McGraw-Hill Companies,
Inc.
Miller, R. L. (1994), Economics Today: The Micro
View, 18th Edition, Harper Collins College
Publishers.
Parkin, M. (2012), Economics, 10th Edition, Pearson,
NY, USA.
Rittenberg, L. and Tregarthen, T. (2009), Principles of
Microeconomics, Ingram Publishers.
Robert S. Pindyck and Daniel L. Rubinfeld (2008),
Microeconomics, 6th international edition,
Pearson Education International.
 5
Introduction to Economics I

141
 The Firm in Perfectly
Chapter 6 Competitive Markets
After completing this chapter, you will be able to:

1 2
Learning Outcomes

Understand what a competitive market is Explain revenue curves of competitive firms

3 Analyze profit maximizing output decisions of

competitive firms 4 Measure the profit of perfectly competitive
firms

5 Understand why perfectly competitive firms

make zero economic profit in the long run

Key Terms
Market Structure
Chapter Outline Market Power
Introduction Perfect Competition
Market and Market Structure Total Revenue
What is a Competitive Market? Average Revenue
Revenues and Revenue Curves of Competitive Marginal Revenue
Firms Break-Even Point
Profit Maximization Shut-Down Point
Why Do Competitive Firms Make Zero Economic Short-Run Market Supply Curve
Profit In The Long Run? Profit Maximization
Efficiency of Competition Long-Run Market Supply Curve
Normal Economic Profit
External Economies
External Diseconomies

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Introduction to Economics I
INTRODUCTION
A market is an institution that facilitates and
structures economic interactions among the buyers
and sellers. Perfect competition is a market for the
exchange of identical products in which there are
many sellers and buyers, all of whom have perfect
information. In a perfectly competitive market,
firms are price-takers. A producer is a price-taker
when its decision cannot affect the market price. In
a perfectly competitive market, consumers are also
price takers; a single consumer`s decision cannot
influence the market price.
In perfect competition, a firm`s average
revenue (AR) and marginal revenue (MR) equals
the market price, i.e., the MR curve is also a
representative firm`s demand curve. The demand
curve that the competitive firms face is perfectly
elastic means that it is horizontal the market price.
Hence, the competitive firm’s AR and MR curves
are horizontal since P=AR=MR.
When MR=MC, profit is maximized. And in
perfect competition conditions MR=P, which
implies that the profit maximization condition is
MR=MC=P. Thus, a competitive firm produces an
output up to the point where MR=MC.
In the short-run, firms can make a profit or
suffer an economic loss. A positive economic profit
creates an incentive to enter the market whereas
an economic loss causes a firm to shut down and
exit in the long run. A perfectly competitive firm
makes zero economic profit in the long run.
Profit is equal to Total revenue minus Total
cost. When the price of each unit of output sold is
greater than the ATC, the competitive firm makes
positive economic profit.
In the short-run, firms can make a profit or
suffer an economic loss. A positive economic profit
creates an incentive to enter whereas an economic
loss causes a firm to shut down and exit in the
long run. A perfectly competitive firm makes
zero economic profit in the long run. In the long-
run, because of free entry and exit, all firms in a
particular industry make normal economic profit
and in the long-run equilibrium no producer has
an incentive to enter or exit.
MARKET AND MARKET
STRUCTURE
Traditionally, a market is defined as a physical
area, building, or event (festival) in which sellers
and buyers gather to buy and sell goods and
services. For example, the Second-Hand Book
Bazaar in Istanbul (which is known as Sahaflar
Carsisi) located next to Istanbul University has been
a place to buy and sell old books, documents and
manuscripts since Byzantine times. However, more
recently, people have started to buy and sell books
on the internet. Book dealers such as Idefix, D&R,
Nadirkitap and Hepsiburada have become more
popular, and the number of people who use Web
services to buy goods and services has increased
enormously. Following the increased popularity of
Internet use, virtual spaces where buyers and sellers
can come together have made purchasing online
fast and easy. Shortly, the term `market` should
be expanded to include not only the economic
activities that are confined to a physical place, but
also the ones that take place in a Web site.
A market, whether a physical place or a Web
site, not only brings people together but also
enables contact among people, thus creating a
social relation. A market structures and coordinates
participants’ interactions. Internet bookselling is
a type of market institution that facilitates and
paves the way for purchases when a consumer does
not have the opportunity to visit a book store.
For example, a professor who does not have easy
access to books published abroad can order a book
through the Internet. After buying and selling
through the Internet became popular, governments
started to regulate the Internet buying/selling
market to protect consumer and seller rights. These
laws constitute a market institution that defines
certain practices and bans unfair business practices.
Therefore, a market can be defined as an institution
that facilitates and structures interactions among
participants for buying and selling.
Market: an institution that facilitates economic
interactions among buyers and sellers.
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 The Firm in Perfectly Competitive Markets

Traditionally, four types of market structures have been defined based on the characteristics of the
market, the number of firms in the market, the degree of product differentiation and the ease of entry and
exit of firms into and out of the market. Table 6.1 illustrates that.
Table 6.1 Market Structure
Perfect Monopolistic
Characteristics Oligopoly Monopoly
Competition Competition
The Number of
Many Many Few One
Firms
Identical/ No Close
Product Identical Differentiated
Differentiated Substitute

Barriers to Entry None Moderate Considerable Considerable

Perfect competition is a market for the exchange
of identical products, in which an enormous
number of small firms serve many buyers, all of
whom are well informed. It is difficult to find a
pure case of perfect competition, but agricultural
markets, such as farmers markets, street food
vendors, and the market for unskilled labor
are very close approximations of competitive
markets. Monopolistic competition differs from
perfect competition because the products sold in
monopolistic competition are slightly differentiated.
The markets for cosmetics, restaurants, and
beverages are examples of monopolistic competition.
Oligopoly is a market structure in which a few large
firms compete. Computers, aircraft manufacturing,
the automobile industry and agro-businesses are
examples of oligopolistic markets. A monopoly
arises when there is only one firm which produces a
good or service with no close substitute. The State
Airports Authority, the Turkish State Railways and
the local water supplier are examples of monopolies.
WHAT IS A COMPETITIVE
MARKET?
When economists talk about perfectly
competitive markets, they define a situation in
which many firms produce and sell identical
products to many consumers. When there is a
competitive market, a single/representative firm
cannot affect the market price of the good or service
it produces and sells.
Imagine a local vegetable bazaar in which many
farmers offer pretty close quality tomatoes. In this
situation, a single farmer does not need to identify
his rivals; there are so many competitors. A single
farmer`s actions have no effect on the market price
of tomatoes. In this sense, a single farmer is a price-
taker. A producer is a price-taker when its decision
cannot affect the market price. Similarly, consider
a consumer in the same local vegetable bazaar who
wants to buy a certain amount of tomatoes. In a
perfectly competitive market, there are many buyers,
so a single consumer`s decision cannot influence the
market price. In this sense, in a perfectly competitive
market, consumers are also price takers.
Perfect Competition: a market for the exc-
hange of identical products, in which there
are many sellers and buyers, all of whom have
perfect information.
In a perfectly competitive market, all market
participants, both consumers and producers, are
price-takers. However, the numbers of participants
do not assure price-taking behavior. Thus, we need
to introduce more features to describe perfectly
competitive markets. Firstly, the market share
of a single producer—the fraction of the total
production in a particular industry accounted for by
a single producer`s output— must be small enough
that a single producer is unable to affect market
price. There are thousands of tomato farmers all
over Turkey, none of whom accounts for more than
a tiny fraction of total tomato sales. However, the
tomato paste industry is dominated by only a few
producers. If one of them were to try to sell more
tomato paste, its action would likely drive down the
market price of tomato paste. That is, the actions of
these big firms influence the market price because

144
Introduction to Economics I
they produce a large portion of the market and their production will significantly affect the total quantity
supplied. A price taker firm can`t influence the market price because its production is an insignificant part
of the total market.
Picture 6.1
Secondly, an industry can be defined as
competitive if consumers don`t attribute a
noteworthy value to the products of any one
producer. Consumers regard tomatoes of all
farmers as equivalent. In a perfectly competitive
market, a good is an identical good when
consumers regard the production of different firms
as the same good. Additionally, all producers and
consumers are supposed to be well informed about
the quality and price of the good in question.
Because a tomato is an identical product in a local
vegetable bazaar, consumers regard the output of
one tomato farmer as a perfect substitute for that
of another farmer. In this situation, consequently,
a representative farmer immediately realizes that
an increase in the price of his or her tomato above
the market price would result in losing all sales
to other tomato producers. Similarly, a consumer
who declines to pay the ongoing market price
for tomatoes is unable to buy any tomato. Thus,
we can define the necessary conditions for a
competitive industry as follows:
i) There are many firms; a single firm pro-
duces and sells a tiny fraction of the total
market sold to many consumers; a single
consumer`s purchase is also a tiny fraction
of the total market purchase.
ii) Producers and consumers are well informed
about the quality and price of the good in
question.
iii) Firms produce and sell an identical product.
iv) There are no restrictions on entry into (or
exit from) the market, and established firms
don`t have any specific advantage over new
firms.
Sunk Cost: an expenditure that was incurred
in the past and is irreversible in the short-run.
All perfectly competitive industries have many
well-informed producers with a small market share,
producing identical products.
We have evaluated these features. At the
same time, perfectly competitive industries are
characterized by free entry and exit. Because there
is no extra advantage for existing firms over new
ones, it is easy for a new firm to enter the industry.
Additionally, because of a lack of a sunk cost, it is
also easy for a firm that is currently in the industry
to leave. A sunk cost is a cost that has already been
incurred and thus cannot be recovered. Free entry
and exit is a key factor in the long-run outcomes
145
 The Firm in Perfectly Competitive Markets

of competitive market analysis. It ensures that a number of producers can adjust to eliminate any excess
profit and loss in an industry in the long-run. We will analyze this feature in detail at the end of the
chapter.

A Representative Competitive Firm

In a perfectly competitive market, a representative firm is fairly small, relative to total demand in the
market. The production of a representative firm is characterized by constant return to scale.
In a perfectly competitive market, firms are price takers, which means a representative firm has no
market power and the market price is determined by the interaction of the market supply and demand.
A price taker competitive firm faces a perfectly elastic demand curve which is horizontal. Remember
that we assume perfect competition in which many fairly small firms produce and sell almost identical
products for a large number of consumers. In this case, there are an infinite number of substitute goods
for a representative firm`s product, i.e., the price elasticity for an identical product is infinite. When
a representative firm charges a higher price, well informed consumers will prefer another firm’s almost
identical product. Therefore, a firm that charges a higher price than the prevailing market price will not be
able to sell any amount of its production.

Price Price

P* P* d

D
Q* Quantity Quantity
( a ) Market Equilibrium ( b ) Firm’s Demand Curve

Figure 6.1 Market Demand, Price and a Firm`s Demand Curve in Perfect Competition

In part (a) of Figure 6.1, the market demand
and market supply determine the equilibrium
market price and quantity. Part (b) shows the firm`s
demand curve. In a perfectly competitive market,
each firm can sell what quantity they want to sell
at the market equilibrium price. A firm`s demand
curve is perfectly elastic at the equilibrium market
price. This means that at any price higher than the
market equilibrium price, a firm is not able to sell
anything at all as buyers are well-informed and can
obtain the identical product for a lower price without
bearing extra search cost. One firm`s product is a
perfect substitute for any other firm’s product. But
the market demand curve is not perfectly elastic.
The elasticity of the market demand curve depends
on the substitutability of a product for other goods
and services.
The main aim of a perfectly competitive firm is to
maximize economic profit. A perfectly competitive
price-taker firm must decide which technology to
adopt and what quantity to produce in the short
run along with deciding whether to exit or stay in a
market in the long run. The first decision has been
analyzed in the previous chapter.
In this chapter, we will analyze what quantity to
produce and whether to exit or enter a market. Let’s
start by studying a firm`s output decision.

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Introduction to Economics I

REVENUES AND REVENUE CURVES OF COMPETITIVE FIRMS

In chapter 5, profit was defined as total revenue minus total cost. A perfectly competitive firm tries
to maximize profit. To see how a firm does this, we first need to examine the revenues of a competitive
firm. Table 6.2 shows the revenue for a representative firm. The first column shows the amount of product
the firm produces, and the second column shows the price at which the firm sells its product. The third
column displays the firm`s total revenue. The market price is supposed to equal $7 each per product, so
the firm`s total revenue equals the market price multiplied by the output produced and sold.

Total Revenue (TR)=Price (P) x quantity (q)

The total revenue curve is a positively sloped linear line

which shows the relationship between output and total
revenue. Since the price for each unit is given in a perfectly Total Revenue: the total amount of money
competitive market, TR increases linearly with the quantity received by a seller, which is equal to price
supplied. We can illustrate total revenues graphically, as times quantity sold.
shown in Figure 6.2.
The fourth column shows average revenue which tells us how much revenue a firm gets for each unit
sold. Average Revenue (AR) is calculated as follow;

Total Revenue (TR)

Average Revenue (AR) =
quantity (q)

In Table 6.2, we can see that the average revenue equals $7, which is the market equilibrium price.
Since total revenue is price times quantity (TR=Pxq) and average revenue is total revenue divided by the
quantity (AR=TR/q=pxq/q=P), the average revenue equals the price of the product not only for a perfectly
competitive firm but also for all types of firms.

Table 6.2 Total Product, Total Revenue, Average Revenue and Marginal Revenue for a Competitive Firm

Total product Price Total Revenue Average Revenue Marginal Revenue

(q) (P) (TR) (AR) (MR)
0 7 0
7
6 7 42 7
7
14 7 98 7
7
24 7 168 7
7
32 7 224 7
7
38 7 266 7
7
42 7 294 7

147
 The Firm in Perfectly Competitive Markets

The last column shows the marginal revenue (MR)

which tells us how total revenue changes as the quantity
Marginal Revenue: the additional revenue
changes. Marginal revenue (MR) is the additional revenue
obtained by selling one more unit.
that results from one more unit increase in the quantity
sold. It is calculated as follow:

ΔTotal Revenue ΔTR

Marginal Revenue(MR)= =
Δquantity Δq

Total Revenue Average Revenue, Marginal Revenue

$168

$98
$7 d=AR=MR

$42

6 14 24 Quantity Quantity
(a) Total Revenue (b) Firm’s AR and MR Curve

Figure 6.2 Total Revenue and Marginal Revenue Curves in Perfect Competition

The production and sale of one more unit increases the total revenue by $7. Therefore, the marginal
revenue is also $7. For example, when a firm produces and sells 6 units, the total revenue is $42. Now
suppose that that same firm increases production by one unit, from 6 to 7, then the total revenue increases
to $49. The additional revenue that results from the last unit equals $7, the equilibrium market price. To
sum up, in perfect competition, a firm`s AR and MR equal the market price, i.e., the MR curve is also a
representative firm`s demand curve (Figure 6.2, part b).

Picture 6.2

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Introduction to Economics I

PROFIT MAXIMIZATION
It is possible to analyze profit maximization and a firm`s supply decision in different ways. In this
section, we begin our analysis with Table 6.3 and Figure 6.3. In the first column of the table is the quantity
that the firm produces. The second column shows the total cost. The total cost includes fixed costs, which
are $10 in the table, and variable costs, which are the costs of variable inputs and which depend on the
quantity produced. The third and fourth columns show average costs and marginal costs, respectively. The
fifth column displays the total revenue, and the last column shows the firm`s profit, which is calculated
as the difference between the total revenue (column 5) and the total cost (column 2). The firm must bear
$10 as a fixed cost when it produces nothing. If it produces 6 units, it has an economic loss of $18. If it
increases production to 14 units, the loss decreases to $12. If the firm produces 24 units, the firm earns
a profit of $8. To maximize profit then, the firm chooses
the unit quantity that will yield the largest possible profit.
In Table 3, the profit maximizing production level is 32 In a perfectly competitive market, marginal
units. When the firm produces 32 units, the profit is $14. revenue equals price; P=MR
Expanding the production ahead of this level causes profits
to decrease.
Table 6.3 Profit Maximization Output Decisions in Perfect Competition

Quantity Total Cost Average Cost Marginal Cost Total Revenue Profit
(q) (TC) (AC) (MC) (TR) (π)
0 10 0 -10
8.3
6 60 10 42 -18
6.3
14 110 7.9 98 -12
5.0
24 160 6.7 168 8
6.3
32 210 6.6 224 14
8.3
38 260 6.8 266 6
12.5
42 310 7.4 294 -16

Figure 6.3 shows the total revenue and total cost curves for a representative perfectly competitive firm.
When the firm produces nothing, the total revenue is zero, but the total cost equals the total fixed cost
(TFC), so the profit is minus TFC. Between 0 and q0, the total cost (TC) is greater than the total revenue
(TR) so that in this area the firm suffers an economic loss. At production level q0, the total cost and total
revenue are equal to each other. This production level is called the break-even point. At the break-even
point, the total revenue exactly offsets the total cost. Between points q0 and q2, the total revenue is higher
than the total cost. In this area, the firm earns a positive profit. At production level q1, the vertical distance
between two curves becomes maximum. Expanding the production beyond this level causes profit to
decrease, and once again at production level q2, profit becomes zero. Point q2 also shows a break-even
point.

149

TR
TC TC
Profit
Loss
0 q0 q1 q2
Figure 6.3 Total Revenue, Total Cost and Profit
There are two other ways to look at a firm`s
decision: firstly, we can find the profit-maximizing
output level by comparing the price and average
cost for each unit produced. When we divide both
sides of this equation, the equality doesn`t change.
Let`s divide the two sides of this equation by the
production level.
π TR TC
= −
q q q additional unit cost $6.3 while the additional revenue
The first term represents the profit per production
unit, i.e., average profit (AP), the second term is the
average revenue which is equal to the price, and the
third term is the average cost, i.e.,
AP=P-AC
According to this equation, when the price
is greater than AC, the firm earns a positive
average profit. Therefore, it is rational to increase
production when the price increases faster than
the average cost. This last equation explains why
there is a positive relationship between the price
and the quantity supplied. According to Table
150
The Firm in Perfectly Competitive Markets
6.3, the difference between the price and
the average cost is at its maximum when
TR the firm chooses to produce and sell 32
units. At this production level, the average
profit is the highest and so is the total profit.
Secondly, by comparing the marginal revenue
and marginal cost, we can find the profit
maximizing output level. Profit is equal to
π=TR – TC. So, to analyse the relationship
between profit and output, we develop a new
concept: marginal profit. Marginal profit is
the additional profit that a firm earns when
it increases its output by one more unit.
The marginal profit is equal to the marginal
revenue minus marginal cost.
MP=MR–MC
q
Figure 6.4 shows the profit maximizing
output level for a perfectly competitive firm.
The firm observes a market price of $7 and
decides how much to produce. Remember that the
firm wants to maximize the difference between total
revenue and total cost, not the difference between
MR and MC. The profit is maximized when MR
equals MC. Let`s think about an output level of 24
units. Here, the marginal cost is minimum, and the
difference between MR and MC is maximum.
However, the firm earns only $8 profit. When the
firm increases the output level from 24 to 32, each
gained from producing one more unit is $7, i.e. MR
> MC which implies MP > 0. By expanding
production, the firm`s profit increases to $14. In this
situation, producing one more unit of output is
profitable for the firm. Thus, the firm will increase
the production level as the marginal revenue exceeds
the marginal cost.
Profit Maximization: a seller should incre-
ase production up to the point where MR =
MC. As MR = P under perfect competition,
we can also define the profit maximizing so-
lution by setting P = MC
Introduction to Economics I

Price MR and AC
MC
S AC

$8.3
$7 $7 P=MR=AR=$7
$6.6

32,000 Quantity 24 32 38 Quantity

Market Equilibrium Firm Equilibrium
Figure 6.4 Profit Maximizing Output Level
Notice that if the firm decided to produce more than 32 units, the marginal cost would be $8.3 which
is greater than the marginal revenue of $7, i.e., MR < MC which implies MP < 0. Thus, producing more
than 32 units would reduce profit. The profit maximizing output level not only for a perfectly competitive
firm but also for all firms is the output level where the marginal profit is zero, i.e. MR = MC. However, in
perfect competition, the marginal revenue equals the market price. Hence, for the perfectly competitive
firm, the profit maximizing condition can be written as follows:

MR = MC = P

The Short-Run Supply Curve

So far, we have concluded that when MR = MC, profit is maximized. And in perfect competition
conditions, MR = P, which implies that the profit maximization condition can be rewritten as MR = MC
= P. Figure 6.5 represents a representative firm`s supply curve.
Price MR and AC
MC
S AC

$8.3 $8.3 d1=MR1=$8.3

$7 $7 d0=MR0=$7

D1
D0

32,000 38,000 Quantity 32 38 Quantity

Market
Figure 6.5 The Short-Run Supply Curve
At a price of $7, the firm produces 32 units, and
the industry of 1000 firms produce in total 32000
units. Now, suppose that the market demand curve
shifts to D1 and the equilibrium price rises, then the
price (and marginal revenue) exceeds the marginal
cost. The firm, like all other firms in the industry,
finds it profitable to increase production. The profit
maximizing firm expands production as price exceeds
marginal cost. At a price of $8.3, the firm increases
Firm
its production from 32 units to 38 units. At this
new price level, the industry output also rises from
32000 to 38000. All points on the MC curve show
how much the firm would be willing to produce
and supply at each price. The marginal cost curve
determines the firm`s willingness to supply various
levels of output at each price level. In a perfectly
competitive market, the marginal cost curve is also
the supply curve of a representative firm, and the

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 The Firm in Perfectly Competitive Markets

industry supply curve is the horizontal sum of the
individual firm’s supply curves. However, the story
has not been completed yet, for we need to examine
a firm`s decision to shut down in the long run.
Picture 6.3
The Short-Run Shutdown Decision of
the Firm: A Numerical Example
Table 6.4 presents a numerical example
for a representative firm. The table shows the
production and cost structure of the firm. Assume
that the market price is $6 and the total revenue
is derived by multiplying quantity by the market
price of $6. The last column shows the profit
which is calculated by subtracting the total cost
from the total revenue. According to the profit
maximizing condition derived above, the firm
would choose to produce 50 units of output. At
this production level, the profit is maximum and
equals $15.

Table 6.4 Cost Minimizing in the Short Run

Total Total Average

Total Average Marginal Total Marginal
Quantity Fixed Variable Variable Profit
Cost Cost Cost Revenue Revenue
(q) Cost Cost Cost (π)
(TC) (AC) (MC) (TR) (MR)
(TFC) (TVC) (AVC)
0 50 0 50 0 -50
5.0 6
10 50 50 100 5.0 10.0 60 -40
3.6 6
20 50 86 136 4.3 6.8 120 -16
4.4 6
30 50 130 180 4.33 6 180 0
4.8 6
40 50 178 228 4.5 5.7 240 12
5.7 6
50 50 235 285 4.7 5.7 300 15
6.1 6
60 50 296 346 4.9 5.8 360 14
6.5 6
70 50 361 411 5.2 5.9 420 9

Figure 6.6 graphs the industry equilibrium and the representative firm`s output decision. The market
price is $6, and we assume that there are 1000 identical firms producing 50,000 units in a perfectly
competitive market. At a price of $6, each firm earns a positive economic profit. Each firm maximizes
its profit by producing up to a point where the marginal revenue equals the marginal cost. According to
Table 6.4, any units produced over 50 would add more to the cost than they would add to the revenue.
For example, if a firm decided to produce 60 units, it would make a profit of $14, which is less than the
maximum profit level. The main reason for this result is that to produce the 60th unit, the firm would bear
an additional $6.1 while it would earn only an additional $6, i.e. MC > MR.

152
Introduction to Economics I
Price
S
$6
$5.7
$4.3
D0
D1
D2
20,000 40,000 50,000 Quantity
Market
Figure 6.6 Short-run conditions and shut-down decision of the firm
What would happen if the demand for the
product in question shifted leftward? A fall in
demand would decrease the equilibrium price and
quantity. Suppose that the leftward shift in the
market demand curve caused the market price to
fall to $5.7. At this new price level, the firm would
earn a zero level of profit, i.e., price equals average
cost. The situation refers to a break-even point
where the firm earns a normal profit. However, a
firm may suffer an economic loss if the demand
curve shifts further leftward. If the market demand
curve shifted to D2, the price would not be enough
to cover the average cost. In this situation, the
firm has two options: (1) shut down the operation
immediately and bear the total fixed cost (in Table
6.4, TFC is $50), or (2) reduce the output level
to the lowest point on the average variable cost to
minimize losses (in Table 6.4, the production level
at the lowest point on AVC is 20, and the firm still
bears $50 of economic loss). However, at any price
above $4.3 and below $5.7, by producing where
MC=P, the firm will cover all variable costs and
part of the fixed costs and will reduce its losses.
If the price is less than the average variable cost
at its lowest point, the firm will not be able to
continue to produce. Any price level which is less
than $4.3 will not be enough to cover the average
variable cost. In this case, for example, the firm
cannot pay the wage rate to hire labor. The rational
strategy for the firm would be to shut down
operation, so the optimal output level at all price
levels below the lowest AVC is zero. The lowest
point on the AVC is called the shut-down point.
MR, AC and AVC
MC AC
AVC
$6 d0=MR0
$5.7 d1=MR1
$4.3 d2=MR2
20 40 50 Quantity
Firm
The lowest value of AVC shows the minimum price
at which a firm would be willing to supply.
However, at all prices above the shut-down
point, the firm will produce and sell output where
P=MC. The part of the marginal cost curve above
the shut-down point presents the profit maximizing
output level. Thus, we can conclude that the short-
run supply curve of a perfectly competitive firm
is the part of the MC curve that lies above the
minimum of its AVC curve.
1
During the winter time in Mediterranean
and Aegean coasts, we see some firms in the
tourism sector are closed and some are open
for services? How can you explain this fact?
Supply Curve in The Competitive
Market
The short-run market supply curve in a perfectly
competitive market is the horizontal sum of the
marginal cost curves (above the minimum of AVC)
of all the firms operating in an industry. Of course,
there are many firms in a perfectly competitive
market. However, for the purpose of illustration, in
Figure 6.7, we assume there are three identical firms
in the market. Figure 6.7 illustrates the derivation
of the market supply curve for an industry with
three identical firms. At the price of $4, each firm
produces 20 units, where P=MC=AVCmin. The
total output supplied in the market at a price of
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 The Firm in Perfectly Competitive Markets

$4 is 60 units. Below $4, all firms shut down, i.e. $4 is the minimum price at which firms are willing to
supply. At a price level above $4, firms expand production along the MC curve. As the price rises, the
quantity supplied also rises--the law of supply. For example, at a price of $5, each firm produces 30 units,
where P=MC. The total output supplied in the market at a price of $5 rises to 90 units.

Price
MC MC MC
S AVC AVC AVC

$5 $5 $5 $5
= + +
$4 $4 $4 $4

60 90 Quantity 20 30 q 20 30 q 20 30 q

Industry Firm A Firm B Firm C

Figure 6.7 The Market Supply Curve in A Perfectly Competitive Industry

The factors that shift the MC curve cause the market supply curve to shift. In the short run, basically
two factors can cause the market supply shifts to the rightward:
(i) A decrease in production costs shifts the market supply curve rightward. For example, a technolo-
gical innovation which leads to a rise in labor productivity decreases the unit labor cost and causes
the market supply curve to shift to the right.
(ii) In the long run, an increase in the number of firms, i.e., new firms entering the industry, shifts the
market supply curve rightward.

Table 6.5 Long-Run Firm Decisions in Perfect Competition

Case Condition Short-Run Decision Long-Run Decision
P=AC=MC Normal Economic Profit Profit Maximized; q=q* Long-Run Equilibrium
P>AC Excess Economic Profit Produce where P=MC; q>q* New Firms Enter
AVC<P<AC Economic Loss Produce where P=MC; q<q* Firms Leave Industry
P<AVC Economic Loss Shut-Down; q=0 Firms Leave Industry

A shift in the market demand leads the market
price to change. For example, a rise in the market price
creates a positive economic profit in the short run,
and a fall in the market price generates losses. Firms
respond to positive economic profit and economic
loss by either entering or exiting a market in the long
run. New firms enter a market (industry) in which
existing firms are making positive economic profit.
Firms exit a market in which they are incurring
an economic loss. Remember that market supply
depends on the number of firms in an industry.
Entry and exit change the market supply. When new
firms enter a market, the number of firms rise and
the supply curve shifts to the right (supply increases,
equilibrium quantity increases and the equilibrium
price falls). New firms continue to enter the market
until positive economic profits are eliminated. When
firms exit a market, the supply decreases and the
supply curve shifts to the left (equilibrium quantity
falls and equilibrium price rises). Firms continue
to exit until economic loss is eliminated. However,
the effect of entry or exit on the market price after
a change in the market demand is ambiguous. The
results depend on external economies and external
diseconomies. External economies refer to the
changing circumstances outside of a representative
firm that reduce the firm`s average profits as market
supply increases. For example, suppose that a new
firm enters an industry with a better transportation
network. Its investment in a better transport network

154
Introduction to Economics I

will result in a decrease in the cost for all firms
working within the industry. Another example is
the development of research and development
facilities in local universities that all firms in an area
can benefit from. External diseconomies are factors
outside the control of a firm that raise the firm`s
costs as the market output increases. For example,
suppose that a new firm`s entry increases the
demand for labor. The average wage level will rise
and existing firms must pay more in wages which
will increase the average cost. Another example for
external diseconomies is the pollution problem. The
localization of an industry in a particular area may
pollute the environment. The polluted environment
creates health problems for the laborers. Thus, the
average production cost rises. With no external
economies or diseconomies, a firm`s cost structure
remains constant as the market output changes.
Figure 6.8 illustrates these three cases and
introduces a long-run supply curve (LRS). The
LRS shows how the quantity supplied responds to
numerous factors including a change in each firm`s
size and the number of firms in the market. Figure
6.8, part (a) shows the case where no external
economies or diseconomies exist. In this case,
a shift in market demand from D0 to D1 has no
effect on the price in the long run. The increase in
demand brings a rise in price to $7 temporarily,
and in the short run the quantity increases from
10 units to 12 units. Existing firms start to make
a positive economic profit which creates an entry
incentive for new firms. The arrival of new firms
leads the market supply curve shift to the right
from S0 to S1, which reduces the price from $7 back
to $5 and increases the quantity from 12 units to
15 units. In this case, the LRS is perfectly elastic.
Part (b) shows the case of external economies.
Similarly, a rise in the market demand increases
the price in the short run, but the arrival of new
firms with positive external economies lowers the
market price in the long run, and the LRS curve
slopes downward. Finally, part (c) shows the case
of external diseconomies. The LRS curve slopes
upward because, following a rise in the market
demand that increases the price in the short run,
the entry of new firms with external diseconomies
raises the market price in the long run.

Price Price Price

S0 S1 S0 S0 S1
S1

$7 LRS
$7 $7
$6
$5 LRS $5 $5
$4
LRS

D1 D1 D1
D0 D0 D0

10 12 15 Quantity 10 12 20 Quantity 10 12 14 Quantity

(a) Constant-Cost Industry (b) Decreasing-Cost Industry (c) Increasing-Cost Industry

Figure 6.8 Long-Run Market Supply Curve

WHY DO COMPETITIVE FIRMS MAKE ZERO ECONOMIC PROFIT IN

THE LONG RUN?
In the short run, firms can make a profit or suffer an economic loss. A positive economic profit
creates an incentive to enter the market whereas an economic loss causes a firm to shut down and exit
in the long run. A perfectly competitive firm makes zero profit in the long run. Long-run equilibrium
can be defined as a case in which there is no incentive to enter or exit. Consider a competitive market in
which firms are producing as efficiently as possible, and the market supply equals the market demand.
Figure 6.9 shows this situation at a price of $10 and an output of 10,000 units. Now suppose that
market demand increases. An increase in market demand is shown by a shift of the market demand
curve from D0 to D1, and the equilibrium price rises to $12. At the new higher equilibrium price, it

155
 The Firm in Perfectly Competitive Markets

is profitable for a firm to increase output in the short

run, even if it is costly to do so. Short-run excess profit
is shown by the light orange-shaded rectangle in Figure
6.9. The firm is now operating on the rising part of the
AC curve; however, the price is greater than AC so the
firm earns a positive economic profit.
Perfectly competitive market equilibrium:
the market equilibrium in a perfectly
competitive market in which the economic
profit of each individual seller is zero, and
there is no incentive for entry or exit.

Price MC, AC and MR

S MC
AC

$12 $12 d1=MR1=12

Exess profit
$10 $10 d0=MR0=10

D1
D0

10,000 18,000 Quantity 100 120 Quantity

Market Equilibrium Firm Equilibrium

Figure 6.9 Industry and Firm Equilibrium after a Rise in Demand

The firm responds to the new higher demand by expanding the production capacity in the long run.
Other firms also observe the excess profits and enter in the long run. Existing firms build a new capacity
and the new entry to the market shifts the market supply curve to the right. Now more product is available.
As long as the price is above $10, all firms, both existing and new ones, make positive profit, and new
entry can continue until a new long-run equilibrium is achieved. Figure 6.10 shows the new long-run
equilibrium with normal economic profit. At this new long-run equilibrium, market supply has shifted
to the right to return the industry to the original price of $10 at a new quantity level. Once again, each
individual firm produces at the lowest point on the AC curve. This production level corresponds to the
lowest point on the long-run AC curve. Firms choose a production scale that minimizes their long-run
average cost. In the long-run equilibrium, each firm has:
P = MC = ACmin = LRACmin
Price MC, AC and MR
S0 MC
S1 AC LRAC

$12 $12 d1=MR1=12

$10 $10 d0=MR0=10

D1
D0

Quantity Quantity
10,000 18,000 20,000 140
Market Equilibrium Firm Equilibrium
Figure 6.10 New Long-Run Equilibrium with Normal Economic Profit

156
Introduction to Economics I

To sum up, in the long run, because of free entry
and exit, all firms in a particular industry make normal
economic profit and in the long-run equilibrium, no
producer has an incentive to enter or exit.
2 cost of production (MSC).
In the long run, competitive firms make zero
economic profit. Why do you think they still
stay in the market with zero economic profit?
EFFICIENCY OF COMPETITION
Economic efficiency is the use of scarce
resources—the labor force, natural resources
and land—that will yield the highest possible
amount of output or the production of what
people demand using the least amount of input.
In economics, efficiency means production
and allocation efficiency. Production efficiency
refers to a production level when it is produced
at the lowest point on the long run average cost
curve where marginal cost equals AC. Allocative
efficiency refers to a situation in which production
meets consumer preferences. Economic efficiency
is achieved when the marginal social benefit
(MSB) to consumers equals the marginal social
The market demand curve illustrates marginal
social benefit and the market supply curve
illustrates marginal social cost. In a perfectly
competitive market, firms produce at the lowest
possible long-run average cost. This means
consumers will pay the lowest possible price.
As analyzed in chapter 3, to maximize utility,
consumers make the best available choices and
the market demand curve represents utility-
maximizing choices of consumers. Therefore, the
long-run equilibrium in a perfectly competitive
market shows a point where the marginal social
benefit equals the marginal social cost, so resources
are used efficiently and they reflect consumers`
preferences.

Price MC, AC and MR

MC AC LRAC
S=MSC

Consumer
Surplus
P* P* d=MR=P*
Producer
Surplus

D=MBS

Q* Quantity q* Quantity
Market Equilibrium Firm Equilibrium

Figure 6.11 Efficiency of Perfect Competition

Figure 6.11 illustrates the efficiency of perfect competition in the long-run equilibrium. The equilibrium
market price is P* and the equilibrium market quantity is Q*. At that price, each firm makes normal
economic profit and each firm produces at the lowest possible average cost on the LRAC curve. Consumers
also benefit because the product cannot be purchased at a lower price.
The most important implication of the perfect competition analysis is that each firm acts in an
economically efficient manner. In the long run, inefficient firms will be forced to exit the market. In
theory, if there isn`t any exogenous obstacle that prevents a perfectly competitive firm from producing
at the lowest AVC, then the consumer surplus and producer surplus is maximized. However, in the real
world, inefficiencies are common, even in markets that approach the conditions of perfect competition.
These inefficiencies may arise because of externalities, path dependence, and existence of public goods.
Therefore, all theoretical inferences depend on some critical assumptions:

157

(i) There are no positive or negative
externalities. Externalities are side effects or
unintended consequences, either positive or
negative, that affect persons or entities, such
as the environment, that are not among the
economic actors directly involved in the
economic activity that caused the effect.
An example of a negative externality is a
fossil fuel plant which uses coal to produce
electricity and issues toxic gases that affects
the health of workers and nearby residents
negatively. The most common example
of a positive externality is education. The
increased education of individuals creates
social benefits, for example, in the form of
less crime or greater economic productivity.
(ii)
All buyers and sellers have perfect
information. However, in assessing their
options, economic actors make use of
their existing knowledge but often need to
collect additional information. Consider
the decision to purchase a new house. Many
factors go into such a decision. Should you
158
The Firm in Perfectly Competitive Markets
buy a newly constructed house or a used
one? What is the relative importance of
neighborhood, safety and luxury features?
What about resale value and maintenance
costs? Making a rational decision requires
obtaining information on several factors.
This information gathering process is time
consuming and costly.
(iii)
Consumer demand curves are based on
willingness to pay. The consumer demand
curve reflects the benefits consumers
obtain from their purchases. However,
consumers often fail to predict the benefits
of goods and services and economic actors
sometimes make emotional decisions
instead of rational choices.
Even a market that meets all the conditions of
perfect competition may fail to maximize social
welfare if these additional conditions are not
satisfied. Additionally, the analysis in this chapter
says nothing about whether the market outcome is
considered fair or not.
Introduction to Economics I

Understand what a competitive

LO 1 market is

A market is an institution that facilitates and structures economic interactions among participants
(buyers and sellers).
Perfect Competition is a market for the exchange of identical products in which there are many sellers
and buyers, all of whom have perfect information. In a perfectly competitive market, firms are price-
takers. A producer is a price-taker when its decision cannot affect the market price. In a perfectly

Summary
competitive market, consumers are also price takers; a single consumer`s decision cannot influence the
market price.
In perfect competition, a firm`s AR and MR equals the market price, i.e., the MR curve is also a
representative firm`s demand curve.

Explain revenue curves of

LO 2 competitive firms

In a perfectly competitive market firms are price-takers. A producer is a price-taker when its decision
cannot affect the market price. In a perfectly competitive market, consumers are also price takers; a
single consumer`s decision cannot influence at the market price.
In perfect competition, a firm`s AR and MR equals the market price, i.e., the MR curve is also a
representative firm`s demand curve. The demand curve that the competitive firms faces is perfectly
elastic means it is horizontal the market price. Hence, the competitive firm’s AR and MR curves are
horizontal since P=AR=MR.

Analyze profit maximizing output

LO 3 decisions of competitive firms

In perfect competition, a firm`s AR and MR equals the market price, i.e., the MR curve is also a
representative firm`s demand curve.
When MR = MC, profit is maximized. And in perfect competition conditions, MR = P which implies
that the profit maximization condition is MR = MC = P.
Thus, a competitive firm produces an output up to the point where MR = MC.

159
 The Firm in Perfectly Competitive Markets

Measure the profit of perfectly

LO 4 competitive firms

In the short-run, firms can make a profit or suffer an economic loss. A positive economic profit creates
an incentive to enter the market whereas an economic loss causes a firm to shut down and exit the
market in the long run. A perfectly competitive firm makes zero economic profit in the long run.
Profit is equal to Total revenue minus Total cost. That can be expressed as:
Profit = (P*Q) – (ATC*Q)
Summary

= (P-ATC)*Q
The equation indicates that when the price of each unit output sold is greater than the ATC, the
competitive firm makes positive economic profit.

Understand why perfectly

LO 5 competitive firms make zero
economic profit in the long run

In the short-run, firms can make a profit or suffer an economic loss. A positive economic profit creates
an incentive to enter the market, whereas an economic loss causes a firm to shut down and exit the
market in the long run. A perfectly competitive firm makes zero economic profit in the long run. In the
long-run, because of free entry and exit, all firms in a particular industry make normal economic profit
and in the long-run equilibrium no producer has an incentive to enter or exit.

160
Introduction to Economics I
1 Which of the following statements is not true
about a competitive market?
A. There are no barriers to entry.
B. A representative firm faces a perfectly elastic
demand curve.
C. Firms sell slightly differentiated products.
D. Firms in the industry have no market power.
E. There is a single seller in the market
2 For a profit-maximizing competitive firm:
A. P>MR=MC B. P=MR=MC
C. P=MR>MC D. MR=P<MC
E. P>MR>MC
3 Suppose firms in a perfectly competitive
market are making a positive economic profit.
As firms enter the market, the price____ and the
positive economic profit of established firms_____
A. falls; decrease. B. falls; increase.
C. rises; decrease. D. rises; increase.
E. Rises; rises.
4 If a perfectly competitive firm produces
where MR=MC=P is above AVC but below AC:
A. the firm suffers an economic loss and shuts
down immediately.
B. the firm suffers an economic loss less than the
total fixed cost and continues to produce where
MC=P in the short run.
C. the firm is still making a positive economic profit
because the price is enough to cover AVC.
D. the firm is making zero economic profit and
continues to produce where P=AVC.
E. The firm shuts down in the long run.
5 Of the following characteristics of competitive
markets, which are necessary for firms to make a
normal economic profit in the long run?
I. There are many sellers and buyers.
II. Firms produce an identical product.
III. Sellers and buyers are well informed.
IV. There is no restriction on entry or exit.
A. only I
B. only III
C. only IV
D. I and II
E. I, II and III
6 When a competitive industry is in its long-
run equilibrium:
A. economic profit is zero.
B. the market demand equals the market supply.
Test Yourself
C. there is no incentive to enter.
D. P=MR=AR=ATC
E. all of the above.
7 If a firm in a perfectly competitive market
doubles the quantity of output sold, then total
revenue will:
A. increase more than double.
B. exactly triple.
C. increase less than double.
D. exactly double.
E. Does not change
8 At the profit-maximizing level of output, the
marginal profit is:
A. Also, maximized. B. Zero.
C. Positive. D. Decreasing.
E. Equal to price.
9 The long run market supply curve will be:
A. horizontal for constant-cost industries.
B. upward sloping for decreasing cost industries.
C. downward sloping for increasing cost
industries.
D. horizontal in case of external diseconomies.
E. The same as the short run market supply curve.
10 In the long-run equilibrium of a perfectly
competitive market:
A. The value of marginal cost is the same for all
firms.
B. Without any restriction about entry and exit,
each firm will have normal economic profit.
C. The long-run equilibrium of a perfectly
competitive industry is efficient.
D. With external economies, the cost structure
of firms remain constant as the market
output changes.
E. Market output will be equal to the total
wants of households.
161
 The Firm in Perfectly Competitive Markets

1. C 6. E If your answer is wrong, please review the

If your answer is wrong, please review the
“Why competitive firms make zero economic
“What is a Competitive Market?” section.
Answer Key for “Test Yourself”

profit in the long run?” section.

If your answer is wrong, please review

2. B If your answer is wrong, please review the 7. D
the “Revenues and Revenue Curves of
“Profit maximizing output decision” section.
Competitive Firms” section.

If your answer is wrong, please review the If your answer is wrong, please review the
3. A “Why competitive firms make zero economic 8. B “Profit Maximization and Profit maximizing
profit in the long run?” section. output decision” section.

If your answer is wrong, please review the If your answer is wrong, please review the
4. B “Profit Maximization and Profit maximizing 9. A “Supply curve in the competitive market”
output decision” section. section.

If your answer is wrong, please review the If your answer is wrong, please review the
5. C 10. A “Why competitive firms make zero economic
“Why competitive firms make zero economic
profit in the long run?” section. profit in the long run?” section.

answer 1 In a perfectly competitive market, firms produce identical products.

For all firms, profit is maximized where MR equals MC; however, in perfect
answer 2 competition, MR equals market price. Thus, in perfect competition, the profit
maximization condition can be written as MR=MC=P.

As new firms enter, the market supply curve shifts to the right and market
answer 3 price falls. The entry of new firms continues until a positive economic profit
is eliminated.

162
Introduction to Economics I

Firms enter or exit in the long run. If price covers AVC, a perfectly competitive
answer 4 firm continues to operate in the short run.

Characteristics (i), (ii) and (iii) imply that sellers and buyers are both price-
answer 5 takers. Characteristic (iv) guarantees a normal economic profit in the long run.

In perfect competition, long-run equilibrium is defined as the situation in

answer 6 which firms earn a normal (zero) economic profit, market demand equals
market supply, there is no incentive to enter, and MR=MC=P=ATC.

Total revenue equals the price times the quantity. Price is determined by
market demand and market supply and firms take this price as a given and
answer 7
decide how much to produce. Because the price is fixed, when the quantity
sold doubles, total revenue also doubles.

MP = MR – MC and the profit maximization condition is MR = MC, so

answer 8 when profit is maximized MP = 0.

Long-run market supply curves are shown in Figure 8. LRS is horizontal for
answer 9 constant-cost industries.

Because MC=P and firms are price-takers, in perfect competition, the value of
answer 10 the marginal cost is the same for all firms.

163
 The Firm in Perfectly Competitive Markets

During the winter time in Mediterranean and Aegean

coasts, we see some firms in the tourism sector are
closed and some are open for services? How can you
Suggested answers for “Your turn”

explain this fact?

Winter is the off season in the tourism service sector in the Turkish coastal
areas since the demand is relatively lower due to weather conditions. In the
short run, firms operate if the revenue is greater than the total variable cost or
your turn 1 price is greater than the AVC. Closing down the doors to business indicates
that the firms shutdown in the winter because their Total revenue from the
service is smaller than the Total variable cost. In the short run, firms ignore
the fixed costs in making decision to produce or not.

In the long run, competitive firms make zero economic

profit. Why do you think they still stay in the market with
zero economic profit?

Accounting profit is always greater than the economic profit. By making zero
economic profit means that the competitive firms still make positive accoun-
ting profit in the long run. Zero economic profit includes all the opportunity
your turn 2 cost of firm owners and this indicates that this is the best that they can do.
Even if they leave the market, they can not do better than this. That’s the rea-
son they stay in the market while making zero economic profit.

References
Acemoğlu, D., Laibson, D. and List, J.A. (2015). Hubbard, R. G. and O’Brien, A. P. (2012), Economics,
Economics. (Global Edition). Pearson Education, Pearson, 4th edition.
Inc.
Mankiw, N. G. (1998). Principles of Microeconomics.
Bade, R. and Parkin, M. (2015) Foundations Harcourt Brac College Publishers.
of Microeconomics, (7th Edition), Pearson
Mankiw N. G. (2001) Principles of Economics,
Education Inc., USA.
Harcourt College Publishers, 2nd Edition.
Browning, E. K. and Zupan, M.A. (1999).
Mankiw N. G. (2003) Principles of Economics,
Microeconomic Theory and Applications, Sixth
South-Western College Publishing, USA, 5th
Edition, Addison_Wesley, USA
edition.
Case, K., Fair, R. and Oster, S., (2012), Principles of
Miller, R. L. (1994). Economics Today: The Micro
Economics, Tenth Edition, Prentice Hall, NY:
View. (18th Edition). Harper Collins College
USA
Publishers.
Goodwin, N., Nelson, J., Ackerman, F. and Weisskopf,
Parkin, M. (2012), Economics, Tenth Edition,
T., (2014), Principles of Economics in Context,
Pearson, NY: USA
M.E. Sharpe, NY: USA

164
 Monopoly and Imperfect
Chapter 7 Competition
After completing this chapter, you will be able to:

1 2 Learn how monopolies make pricing and

Learning Outcomes

Learn what a monopoly is and why it exists output decisions

3 Understand the welfare costs of monopolies 4 Learn what an oligopoly is and why oligopolies
exist

5 Learn possible pricing strategies and output

outcomes in an oligopoly 6 Understand the meaning of the Nash
equilibrium

7 Define the monopolistic competition

Chapter Outline Key Terms

Introduction Monopoly
Monopoly Natural Monopoly
The Welfare Cost of Monopolies Oligopoly
Monopolistic Competition
Types of Price Discrimination Under Monopoly
Price Discrimination
Oligopoly Dominant Strategy
Monopolistic Competition Nash Equilibrium
Cartel
Collusion
Differentiated Product
Game Theory

166

Introduction to Economics I
INTRODUCTION
In Chapter 6, we analyzed firms in perfectly
competitive markets. Perfectly competitive
markets are characterized with many sellers; each
seller producing a small quantity compared to the
total quantity produced in the market. Products
are identical and producers take the market price
as given. Producers can sell any quantity they want
at the market price but cannot increase the price
at all because if they do, their quantity demanded
drops to zero since consumers immediately switch
to other firms that sell the same product at the
market price.
In many markets, however, producers are not
price takers but they can influence the market
price. For example, monopoly is a market structure
with only one producer. Therefore, this producer
will not act as a price taker but will be a price setter.
The monopolist will face the market demand curve
and choose any price and quantity that it wants on
the market demand curve.
Monopoly is a market structure with only
one producer/seller of a good and it does not
act as a price taker but as a price setter.
Perfect competition and Monopoly are two
extreme forms of market structure. Most markets
in the economy include elements of both of these
cases and, therefore, are not completely described
by either of them. The typical firm in the economy
faces some competition, but the competition is
not so rigorous as to make the firm a price taker
like the firms analyzed in chapter 6. The typical
firm also has some degree of market power, but
its market power is not so great that the firm can
be described exactly by the monopoly model.
In other words, many industries fall somewhere
between the polar cases of perfect competition
and monopoly. Economists call this situation
imperfect competition.
One type of imperfectly competitive market
is an oligopoly, which is a market structure with
few firms. Each firm produces a large share of the
7
total market quantity and hence can influence
the market price through its choice of quantity.
A second type of imperfectly competitive market
is called monopolistic competition where there
are many firms that sell differentiated products.
In a monopolistically competitive market, each
firm has a monopoly over the product it makes,
but many other firms make similar products that
compete for the same customers.
Oligopoly is a market structure with few
firms. Each firm in the market produces a
large share of the total market quantity and
hence can influence the market price.
Monopolistic competition is a market
structure where there are many firms that
sell differentiated products. Each firm has
a monopoly over the product it sells, but
many other firms make similar products
that compete for the same customers.
In this chapter, we next analyze the different
market structures of Monopoly, Oligopoly and
Monopolistic Competition in more detail by
making comparisons.
MONOPOLY
A firm is a monopoly if it is the only producer
of a good or service and this good or service does
not have close substitutes. For example, if you
own a personal computer, it probably uses some
version of Windows, the operating system sold
by the Microsoft Corporation. The copyright
gives Microsoft the exclusive right to make and
sell copies of the Windows operating system.
In 2016, Turkey’s BOTAŞ pipeline corporation
imported about 80 percent of natural gas to
Turkey making BOTAŞ a near monopoly in the
supply of natural gas.
167
7
• Natural Monopoly: A natural monopoly
Picture 7.1
The Sources of Monopoly
A monopoly exists in a market when there are
barriers to entry.
Barriers to entry are:
• Government regulations: The government
may give one person or firm the exclusive
right to sell some good or service.
- Private or public (state-owned) monopolies
established by the government. For
example, in 1970, Turkish Electricity
Authority (TEK) was created by the
Turkish Government as a state owned
and operated monopoly responsible for
electricity generation, transmission and
distribution.
- Patents or copyrights. Governments
grant patents to firms that develop
new products. A patent essentially
makes the firm the only producer of its
product for a number of years (usually
20 years). Since a monopoly can charge
higher prices and have higher profits, a
patent with its promise of higher profits
encourages firms to invest in research
and development and come up with
new products, such as a new drug that
can cure a specific illness.
• Ownership of a key resource: A company
may rarely have control of a key resource.
For example, De Beers diamond mining
and marketing company of South Africa
controlled almost all of the diamond
production in the world for years. Only
168
Monopoly and Imperfect Competition
recently, the company’s share of the world
diamond market decreased to 40 percent.
occurs when economies of scale are so
large that one firm can supply the entire
market at a lower average cost than two
or more firms. For example consider the
following Total Cost function (in TL):
TC(Q)=16+2Q. This is a cost function
where the fixed cost is equal to 10 and
the marginal cost is constant and equal
to 2. (Total Cost is 16 when Q=0, To-
tal Cost is 18 when Q=1, Total Cost is
20 when Q=2 and so on…). Consider a
case where there is one firm in the mar-
ket and this firm produces 8 units. The
total cost of producing 8 units will be
TC(8)=16+2*8=32TL. Now suppose
there are two firms in the market, each
producing 4 units so that the total quan-
tity produced is still 8 units. The total cost
of each firm will be TC(4)=16+2*4=24TL.
Hence the total cost of producing 8 units
will be TC(4)+TC(4)=24+24=48TL
which is higher than 32 TL. This cost
function is an example for a natural mo-
nopoly market where there are very large
economies of scale. Note that average
cost of a firm when it produces 8 units
is ATC(8)=TC(8)/8=32/8=4TL and the
average cost of a firm when it produces
4 units is ATC(4)=TC(4)/4=24/4=6TL.
Hence the average cost decreases as the
quantity produced increases. When fixed
costs are large and marginal costs are small
or constant, as the firm increases its scale
of operation, those large fixed costs get dis-
tributed over more and more units, lower-
ing the average cost of producing. Lower
average costs as scale gets larger means that
one firm can supply the entire market at a
lower average cost than two or more firms.
A natural monopoly occurs when
economies of scale are so large that one
firm can supply the entire market at a lower
average cost than two or more firms.

Introduction to Economics I
Network Externalities. In some markets,
the usefulness of a product increases with the
number of consumers who use it. For example,
the usefulness of social media websites such as
Facebook and Tinder increases with the number of
their users. This makes it difficult for other firms to
enter into these markets and compete with existing
firms with a large network of customers.
1 The following example illustrates this point.
Consider the market for
natural gas where natural gas
is transmitted via gas pipelines.
What are the sources for
economies of scale in this
market? Is this market a natural
monopoly? Explain.
How do monopolies make output and pricing
decisions?
The monopoly is the only producer in the
market, and hence it faces the market demand
curve. Since the market curve is downward
sloping, the monopoly faces a trade-off: It can sell
at a higher price but a smaller quantity or sell a
larger quantity but at a lower price. The marginal
revenue of a monopolist is very different from
the marginal revenue of a perfectly competitive
firm. A perfectly competitive firm produces a
small portion of the market output and hence it
can sell any quantity it wants at the market price.
A monopolist on the other hand has to lower
price to sell more and hence move down on the
demand curve. When a monopoly increases the
amount it sells, this action has two effects on the
total revenue (P*Q):
7
The output effect: More output is sold, so Q is
higher, which tends to increase the total revenue.
The price effect: The price falls, so P is lower, this
tends to decrease the total revenue.
Since a competitive firm can sell all it wants
at the market price, there is no price effect. When
a monopoly increases production by one unit, it
must reduce the price it charges for every unit
it sells, and this cut in price reduces the revenue
on the units it was already selling. As a result, a
monopoly’s marginal revenue is less than its price.
A monopoly’s marginal revenue is less
than its price: In order to increase its
output by one unit, a monopoly must
reduce the price it charges for every unit
and this cut in price reduces the revenue on
the units it was already selling.
Example: Table 7.1 shows how the monopoly’s
revenue structure depends on the demand for
its product. The first two columns show the
monopolist’s demand schedule. The third column
shows the monopoly’s total revenue which is equal
to the price charged multiplied by quantity sold,
TR=PxQ. The fourth column shows the monopoly’s
marginal revenue which is equal to the change in
total revenue divided by the change in quantity
ΔTR
sold, MR = . The final column shows the
ΔQ
monopolist’s average revenue which is equal to
total revenue divided by quantity sold:
TR .
AR =
Q
169
7
Monopoly and Imperfect Competition

Table 7.1 A Monopolist’s Demand, Total, Average, and Marginal Revenue

Q P (TL) Total Revenue Marginal Revenue Average Revenue

Q P
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0 0
ΔTR TR
TR=P*Q MR = AR =
ΔQ Q
0
9 (9-0)/(1-0) =9 9/1 =9
16 (16-9)/(2-1) =7 16/2 =8
21 (21-16)/(3-2) =5 21/3 =7
24 (24-21)/(4-3) =3 24/4 =6
25 (25-24)/(5-4) =1 25/5 =5
24 (24-25)/(6-5) = -1 24/6 =4
21 (21-24)/(7-6) = -3 21/7 =3
16 (16-21)/(8-7) = -5 16/8 =2
9 (9-16)/(9-8) = -7 9/9 =1
(0-9)/(10-9) = -9 0/10 =0

In Table 7.1, similar to price, marginal revenue decreases as quantity demanded/sold increases.
However, marginal revenue is always less than price. If the monopolist produces 1 unit, it can sell that
unit for 9 TL, if it produces 2 units, it must lower price per
unit to 8 TL to sell both units. Hence lowering price from
9 TL to 8 TL has two effects on the monopoly: 1) It can The monopolist’s average revenue from sales
sell one more unit at a price of 8 TL; 2) It receives 1 TL less equals to the price.
revenue from the first unit, since its price decreases from 9
TL to 8 TL. As a result, marginal revenue from the second
unit is 8-1=7 (8TL from the second 11
unit minus 1TL loss in revenue from
the first unit). 10

In Table 7.1, average revenue in 9

the last column equals the price of the
8
good. This is true for monopolists as
well as for competitive firms. 7
Figure 7.1 shows the graph 6
of demand and marginal revenue
curves of this monopolist. As the 5
figure illustrates, different from the 4
competitive firm, the demand curve
the monopolist faces is the market 3
demand curve and it is negatively 2
sloped. The MR curve is also Marginal Demand
negative and it is smaller than the 1 Revenue
price. So, the MR curve is located on 0
the left of the demand curve that the 0 1 2 3 4 5 6 7 8 9 10 11
monopolist faces.
Figure 7.1 Monopoly’s Demand and Marginal Revenue

170
 7
Introduction to Economics I

Profit Maximization For a Monopoly

Profit of a firm is equal to the total revenue minus total cost, π=TR-TC. A firm’s objective is to maximize
its profits. The difference between total revenues minus total costs is maximized when for the last unit
produced, the marginal revenue of this last unit is exactly equal to its marginal cost. If marginal revenue
of the last unit produced is more than its marginal cost, this means that marginal profit (profit from an
additional unit) is positive. Therefore, the firm can increase its profits by increasing its quantity output.
Hence producing at a quantity 11
where marginal revenue of the last
unit produced is greater than its 10
marginal cost is not optimal for the 9
firm to maximize its profits; the firm
can increase its profits by producing 8
more. In Figure 7.1, marginal revenue 7
Average Cost
is greater than marginal cost when
the quantity is less than 3 units. So, 6
the firm can increase its profits by 5
increasing quantity when quantity
produced is less than 3 units. Marginal 4
revenue of the last unit is equal to its 3
marginal cost when quantity is equal
to 3 units. Hence, the firm maximizes 2
its profits when quantity is equal to 3 1 Marginal Marginal Demand
Cost Revenue
units. If the firm produces more than
3 units, marginal cost will be greater 0
0 1 2 3 4 5 6 7 8 9 10 11
than marginal revenue and the firm
will decrease its profits by producing Figure 7.2 Monopolist’s profit maximization
more than 3 units.
A monopoly charges the maximum price that it can when it produces and sells 3 units. Demand
curve shows the maximum price that the monopoly can charge when it sells 3 units of output. Hence the
monopolist sets its price equal to 7TL per unit. Note that this price is higher than the marginal cost. Profits
are equal to:
Price
Profits = Total revenues-Total costs; 11
This can be written as: 10
Profits=P*Q-Total Costs
9
Since Total costs=Average total costs*Q;
8
profits can be written as:
Profits=P*Q-Average total costs *Q 7 Average Cost
Taking the right hand side of this 6
equation in Q parenthesis 5 Monopoly Profit
Profits = (P-Average total costs)*Q 4
This is equal to the shaded area in
3
Figure 7.3.
2
A monopolist, just like a competitive
Marginal Marginal Demand
firm, maximizes its profits at a quantity 1 Cost Revenue
where the marginal revenue is equal to the 0
marginal cost for the last unit produced. 0 1 2 3 4 5 6 7 8 9 10 11
What is the difference? A competitive firm Quantity
is a small firm among many firms in the Figure 7.3 Monopolist’s profits

171
7
market. It takes the market price as given and can sell
any quantity it wants at the market price. Hence, its
marginal revenue is constant and equal to the market
equilibrium price. A monopolist, on the other hand,
is the only producer in the market. It faces the market
demand curve and hence has to reduce price to sell
more units. As a result; its marginal revenue from the
last unit sold is less than the price of that unit. These
differences between the competitive firm and the
monopolist can be summarized as follows:
For a Perfectly Competitive Firm: P=MR=MC
For a Monopolist: P>MR=MC
Profit maximizing level of output for a
monopolist is the output level where the
MR is equal to MC.
THE WELFARE COST OF
MONOPOLIES
A monopoly, in contrast to a competitive firm,
charges a price above the marginal cost. The high price
is undesirable for consumers since it reduces their
consumer surplus. However, we have shown that the
monopoly maximizes its profits by charging this high
price. Is it possible that the benefits to the firm exceed the
loss in consumer surplus, making monopoly desirable
from the standpoint of society as a whole? We need to
find economic surplus when there is a monopoly and
compare it to maximum economic surplus that can be
achieved when there is perfect competition.
Price
11
10
7
Monopoly
Price 6
DWL
5
2
Marginal
1 Cost
0
0 1 2 3
Monopoly Efficient
Quantity Quantity
Figure 7.4 The Inefficiency of Monopoly
172
Monopoly and Imperfect Competition
A demand curve represents the maximum
willingness of consumers to pay the price for each
additional unit. A consumer’s willingness to pay the
price for an additional unit is at most her marginal
benefit from that unit. Hence, the demand curve is
also the marginal benefit curve of consumers. Marginal
benefit of the last unit is equal to its marginal cost at
the quantity where demand and marginal cost curves
intersect. This quantity is the socially efficient quantity
that maximizes economic surplus. Below this quantity,
the benefit of an additional unit to consumers exceeds
the cost of providing it, so increasing output would
increase economic surplus. Above this quantity, the
cost of producing an extra unit exceeds the benefit of
that unit to consumers, so decreasing output would
raise economic surplus. At the socially efficient
quantity, the benefit of an additional unit to consumers
(marginal benefit) exactly equals the marginal cost
of production. In Figure 7.4, the socially efficient
quantity is between 4 and 5. The monopoly produces
less than the socially efficient quantity and creates a
deadweight loss. The deadweight loss is represented by
the area of the triangle to the left of the intersection of
marginal cost and demand curves.
Compared to a perfectly competitive
market, a monopoly produces less than
the socially efficient quantity of output
and charges a relatively higher price, hence
creates a deadweight loss.
Marginal Demand
Revenue
4 5 6 7 8 9 10 11
Quantity
 7
Introduction to Economics I

TYPES OF PRICE price discrimination is mostly a theoretical concept,

DISCRIMINATION UNDER we observe many examples of price discrimination
where firms use information on age, job etc. as
MONOPOLY
a signal of income in order to price discriminate
In this chapter, we assumed that the monopolist among consumers. For example, in movie theaters
charges the same price for each unit sold to each low-income students buy tickets at a lower price
consumer. This is called uniform pricing. However, than wage earners. There are also discounts for
in many cases, firms sell the same good to different senior citizens who live on a pension income and
customers at different prices. This practice is called hence are on a more limited budget.
price discrimination. Consider the monopolist’s
Producers also recognize that willingness to
demand schedule in Table 7.1. According to Table
pay decreases for additional units for the same
7.1, a monopolist can sell the first unit at a price of
consumer. For example, a pricing strategy where the
9, the second unit at a price of 8, the third unit at
first T-shirt is sold at a regular price and the second
a price of 7 and so on.
one is sold at a discount -such as 30 percent off the
What if the monopolist can lower the price only regular price- is an example of price discrimination
for the additional unit sold without lowering the where each unit is sold at a different price.
price of previous units? In other words, what if the
Producers can also offer slightly different versions
monopolist can sell the first unit for 9TL, the second
of the same product at different prices. For example,
unites’ price for 8 TL and the third units’ for 7 TL?
business class and economy class airplane tickets are
Each consumer, who values the good at more than the
two different versions of the same product. In terms
marginal cost of the production, buys the good and
of travel time and safety standards, both business
he/she is charged the price equal to his/her willingness
class and economy class passengers are buying
to pay. What will be the total quantity sold and the
the same product. Business class passengers have
price of the last unit sold? The monopolist will sell an
slightly larger seats and better food and beverage
additional unit as long as the price of that unit is greater
service. Typically the price differential between
than or equal to the cost of that unit. The monopolist
business class and economy class is very large, a
will not sell an additional unit if the price of that unit
lot larger than the cost of extra space and food and
is less than the cost of that unit. Hence, the price of
beverages. The airline companies can charge a much
the last unit sold will be equal to its marginal cost.
higher price to business class tickets because of the
In Figure 7.3, this is where Q=4.5 and P=5.5. If the
customers’ high willingness to pay for air travel.
good is a discrete good such that decimal quantities
By offering them a slightly better product they are
are not possible to sell (for example the good is a TV
able to identify these customers and lure them into
or a dishwasher), then the monopolist will sell the 4th
buying business class tickets and hence charge them
unit at a price of 6 and the marginal cost of the 4th
a much higher price.
unit will be 5 and hence less than the price, but it will
not sell the 5th unit at a price of 5 because its marginal
cost will be 6 and it will be greater than the price.
This practice of charging the maximum price for each
unit sold is called perfect price discrimination. Note
2
that it eliminates the deadweight loss associated with
uniform price monopoly since the price of the last unit A perfectly competitive firm
sold is equal to the marginal cost of that unit. But it has a supply curve. Does a
also eliminates consumer surplus since each consumer monopolist have a supply curve?
pays her exact maximum willingness to pay.

Examples of Price Discrimination OLIGOPOLY

Perfect price discrimination is difficult to do Oligopoly is a market structure where there are
for the monopolist because the monopolist needs only a few firms in the market due to barriers to
to know maximum willingness to pay of each entry. For example, the GSM market in Turkey
consumer for each unit purchased. While perfect is composed of three firms: Turkcell, Avea and

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Monopoly and Imperfect Competition

Vodafone. This industry is characterized with large economies of scale due to fixed costs and small
and constant marginal costs. Hence large firms have an advantage over small firms and the industry is
characterized with few large firms rather than many small firms. There are two outcomes that are possible
in an oligopoly:
1. Collusion: Collusion is an agreement among firms to charge the same price or decide on quantities
in cooperation with each other. Unfortunately for Turkcell and Avea---but fortunately for their
customers, collusion is against the law in Turkey. The Turkish Competition Authority investigates
claims of collusion among producers. However, there are examples of collusive behavior in the
world. For example, Organization of Petrol Exporting Countries (OPEC) is a cartel and members
of this cartel are major petrol producing countries in the world. These producers decide on their
petrol quotas in cooperation with each other. By restricting their output through collusion, they
aim to keep the price of petrol at a high level.
2. Competition: Competition occurs when each producer maximizes its profits by choosing its own price
or quantity without consulting other firms. Since there are only few firms, we cannot assume that each
firm takes the market price as given as we have assumed in perfect competition. In oligopoly, each firm
takes the other firm’s strategy as given and chooses the best response strategy. The best response strategy
is a strategy that maximizes the firm’s profits given strategies chosen by other firms. Nash equilibrium
is a situation in which each firm chooses the best response strategy given the strategies chosen by other
firms. This equilibrium concept is named after the economist and Nobel laureate John Nash. Note
that this is a non-cooperative equilibrium concept, in the sense that firms are acting independently
and not in cooperation with
each other.
Oligopolists would like to
form cartels and earn monopoly
profits. Arguments among cartel
members over how to divide the
profits in the market can make
agreement among them difficult. In
addition, antitrust laws in Turkey,
USA, and Europe prohibit explicit
collusion and cartel formation
among oligopolists, because cartels
just like monopolies lead to high
prices, low consumer surplus and
deadweight loss. Luckily, for the
society, in the absence of a binding
cartel agreement, cartel agreement is
difficult to sustain. Each firm has an
incentive to increase quantity and
sell more when the market price is
high due to restrictions of output
by other firms. We will see this
dynamic between collusive (cartel)
outcome and competition within Picture 7.2
the context of a duopoly example.

Example: There are two firms in a market. We will assume that their costs are equal to zero to keep
things simple. Hence their total revenue will be equal to their total profits. The market demand is given
in the first two columns of Table 7.2. If there were a monopoly in this market instead of a duopoly, the
monopolist would choose quantity equal to 50 and price also equal to 50, since they maximize total

174
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Introduction to Economics I

revenues. If the two firms form a cartel, they will Using Game Theory to Analyze
also choose this price and quantity since this gives Oligopoly
the highest total revenues in the market. Each firm
Game theory is the study of how people/firms/
can produce 25 units and get 1250TL which is half
countries make decisions in situations in which
of 2500TL. Hence, a cartel produces monopoly
attaining their goals depends on their interactions
quantity at the monopoly price and creates a
with others. In oligopolies, the interactions among
deadweight loss.
firms are crucial in determining profitability
because the firms are large relative to the market.
Now, suppose that one of the firms, say, firm 1,
increases output by 10 units. Then the total quantity In all games---chess, poker, or Monopoly--
is 60TL and the price is equal to 40TL. Firm 1 -the interactions among the players are crucial
produces 35 and firm 2 produces 25 units. The in determining the outcome. Games have three
total revenues of firm 1 is 40*35=1400TL, which characteristics:
is higher than 1250TL. Hence firm 1 can increase 1. Rules that determine which actions are
revenues by increasing quantity. Producing cartel allowable
quantity is not the best response strategy when the 2. Strategies that players employ to attain their
other firm produces cartel quantity. Each firm has objectives in the game
an incentive to increase its quantity and sell more 3. Payoffs that are the results of the interaction
when the price is high. What will firm 2 do? When among the players’ strategies
firm 1 increases its quantity to 35, the price falls to The payoffs in an oligopoly context are the
40TL and firm 2’s revenues fall to 40*25=1000TL. profits earned as a result of a firm’s strategies
Can firm 2 increase its revenues by increasing its interacting with the strategies of other firms.
quantity to 35? If each firm produces 35 units, the
total quantity is 70 units and the price falls to 30TL.
Each firm’s revenues are 30*35=1050TL. Hence
firm 2 will increase its quantity as well. Neither firm
has any incentive to increase its quantity further.
This example shows that at the cartel quantities,
total profits are maximized but each firm has an
incentive to cheat and increase its quantity and Picture 7.3
profits at the expense of the other firm.
A Duopoly Game: Quantity
Table 7.2 Duopoly output and share of revenue Competition Between Two Firms
Quantity Price Total Revenue In this simple example, we use game theory
to analyze the quantity competition in a duopoly.
0 100 0 Suppose there are two firms. Each can choose one
10 90 900 of the two possible quantity strategies: Low quantity
20 80 1600 or High quantity. If they both choose a low quantity
strategy, price and each firm’s profits will be higher
30 70 2100 than the case where they both choose a high quantity
40 60 2400 strategy. In the table below, the first number in each
50 50 2500 box represents firm 1’s profits, the second number
represents firm 2’s profits in TL. Hence if both firms
60 40 2400 choose a low quantity strategy, they each get 100TL. If
70 30 2100 both firms choose a high quantity strategy, they each
80 20 1600 get 70TL. If firm 1 chooses high quantity, while firm
2 chooses low quantity, firm 1 gets 120TL and firm 2
90 10 900 gets 60TL. If the situation is reversed, firm 1 chooses
100 0 0 low quantity, while firm 2 chooses high quantity, firm
1 gets 60TL and firm 2 gets 120TL profits.

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Monopoly and Imperfect Competition

Firm 2 We have seen that firm 1’s best response strategy

is to choose a high quantity when firm 2 chooses
Low High
a low quantity. So, firm 1 is choosing its best
quantity quantity
response strategy. But what about firm 2? Is firm 2’s
Low quantity (100,100) (60,120) choosing a low quantity the best response strategy
Firm 1
High quantity (120, 60) (70,70) when firm 1 chooses a high quantity? Firm 2 gets
60 if it chooses a low quantity and 70 if it chooses
a high quantity in response to firm 1’s strategy of a
Collusion outcome: If the two firms can form a
high quantity. Since 70 is greater than 60, firm 2’s
cartel and decide on their quantities together, they
best response is to choose a high quantity and not a
could go for the outcome that maximizes their
low quantity when firm 1 chooses a high quantity.
total profits. Total profits are maximized at 200TL
when each firm chooses a low quantity level. Is each firm choosing a high quantity a Nash
equilibrium?
Is firm 1’s best response strategy to choose a
high quantity when firm 2 chooses a high quantity?
Collusion is an agreement among the firms
Firm 1 gets 70 when it chooses a high quantity and
of a market about the prices to charge or
60 when it chooses a low quantity. So, yes firm 1’s
output supplied.
best response strategy is to choose a high quantity
when firm 2 chooses a high quantity.
Competitive outcome: Nash equilibrium can be Is firm 2’s best response strategy to choose a
used to find the competitive outcome. We have high quantity when firm 1 chooses a high quantity?
four candidates for a possible Nash equilibrium. Firm 2 gets 70 when it chooses a high quantity and
60 when it chooses a low quantity. So, yes firm 2’s
Let’s start with the collusive outcome. Is each
best response strategy is to choose a high quantity
firm choosing a low quantity a Nash equilibrium?
when firm 1 chooses a high quantity.
To answer this question, we need to check whether
each firm is choosing its best response strategy Since, each firm choosing a high quantity is the
given the strategy of the other firm. best response strategy when the other firm chooses
a high quantity, we conclude that this is a Nash
What is firm 1’s best response when firm 2
equilibrium.
chooses a low quantity? Firm 1 gets 100 if it
chooses a low quantity and 120 if it chooses a high
quantity. Therefore, choosing a high quantity and
not a low quantity is firm 1’s best response when
firm 2 chooses a low quantity. Hence, we conclude
that each firm choosing a low quantity cannot be a
Nash equilibrium.

Nash Equilibrium represents a situation

among the interacting firms, each of
which chooses their best strategy given
the strategies that all the other firms have
already been chosen. Picture 7.4

Dominant Strategy: A dominant strategy is

Next, let’s examine one of the asymmetric
the best response strategy for a firm, no matter
outcomes. For example, is firm 1 choosing a high
what strategies other firms use.
quantity and firm 2 choosing a low quantity a
Nash equilibrium?

176

Introduction to Economics I
It is interesting to note that choosing a high
quantity is a dominant strategy for each firm in this
example. When each firm has a dominant strategy,
the only Nash equilibrium occurs when each firm
chooses its dominant strategy.
It is also interesting to note that, when firms
do not cooperate with each other and selfishly
pursue their own interests, they end up at an
outcome worse for them than the cartel/collusion
outcome. Hence, when firms act independently
and compete, they lose; but consumers and society
as a whole gain, since price is lower, total quantity
is higher and deadweight loss is lower.
3
What are the goals of the Turkish
Competition Authority? Examine
their website to answer this
question. Can you link these goals
to your knowledge of monopoly
and oligopoly?
MONOPOLISTIC COMPETITION
Monopolistic competition is a market
structure in which there are many firms selling
products that are similar but not identical. For
example in the market for blue jeans, there are
many producers such as Mavi Jeans, Levi’s, Guess,
GAP, LC Waikiki. These are all brand names.
Jeans sold by these producers are differentiated
according to style, quality, design, etc. Hence
consumers do not perceive these brand name
jeans as identical. When this is the case, price is
not the only factor that determines consumers’
decisions. When consumers perceive a product
as a unique product without perfect substitutes,
demand facing its producer is no longer perfectly
elastic (horizontal). In other words, demand is
downward sloping similar to the demand curve
facing a monopolist. Hence a firm with a brand
name can choose to charge a high price and sell
a small quantity or a low price and sell a high
quantity just like a monopolist. In other words,
there is no single market price as is the case in
perfect competition. In perfect competition,
7
quantity demanded drops to zero when a perfectly
competitive firm charges a price slightly above
the market price since products are identical
and consumers can buy from another firm at the
market price. In contrast, if Mavi Jeans increases
its price, say, by 20%, its quantity demanded
decreases some but does not drop to zero. There
will still be some consumers willing to pay a
higher price for this brand’s products.
Hence product differentiation makes the profit
maximization problem of a monopolistically
competitive firm similar to that of a monopoly.
A downward sloping demand curve results in a
downward sloping marginal revenue curve that
is less than price. The firm maximizes its profits
by choosing a quantity where marginal revenue
of the last unit produced is exactly equal to its
marginal cost.
Different from a monopoly and similar
to perfect competition, monopolistically
competitive market typically has many sellers
because there are low barriers to entry in this
market. Hence new firms will enter easily when
they observe that existing firms are enjoying
positive profits. For example Levi’s entered the
Turkish market in 1986. As a popular brand
name, this firm enjoyed a high level of profits.
This attracted new entrants into the market, and
Mavi Jeans entered in 1991.
The Monopolistic Competitors in
the Short Run
Each firm in a monopolistically competitive
market is, in many ways, like a monopoly. Since
its product is different from those offered by
other firms, it faces a downward-sloping demand
curve. Figure 7.5 shows the demand, marginal
revenue, marginal cost and average cost curves
for a monopolistically competitive firm. This
firm maximizes its profits by choosing a quantity
at which the marginal revenue of the last unit
produced is exactly equal to its marginal cost. This
is where the marginal revenue and the marginal
cost curves intersect. The firm charges the highest
price that consumers are willing to pay for the last
unit produced. This is given by the demand curve
(PMC).
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Monopoly and Imperfect Competition

Price
11

10

P MC 7 Average Total Cost

6
Profit
5

2
Marginal Marginal Demand
1 Cost Revenue
0
0 1 2 3 4 5 6 7 8 9 10 11
Quantity
Figure 7.5 Monopolistically Competitive Firm in the Short-Run

The Monopolistic Competitors in the Long Run (LR)

When monopolistically competitive Price
firms enjoy positive profits as shown
in Figure 7.5, new firms enter into this ATC
tangent
profitable market. Then, the number of
MC
differentiated products in the market
increases. Some consumers may find these
new products more to their taste and start minimum
consuming them instead of old products.
This consumer behavior in turn decreases
MR D
demand for old products. Hence demand
curve facing an existing monopolistic firm
decreases and shifts to the left as new firms
enter into the market. Figure 7.6 Monopolistically Competitive Firm in the Long-Run

Figure 7.6 shows a monopolistically

competitive firm in the long-run. This
firm’s profits are equal to zero at the profit
maximizing quantity where marginal
revenue (MR) of the last unit is exactly
equal its marginal cost. We observe that the
price is equal to the maximum willingness
to pay price of consumers, shown on the
demand curve, also is equal to average
total cost (ATC) at the profit maximizing
quantity. When price is equal to ATC,
profits are zero (profits=(P-ATC)*quantity.
4
For each of the following products, describe what type of
market structure you think that the good is sold in and
explain your answer: (for example: perfect competition,
oligopoly, monopolistic competition, monopoly)
a. Starbucks Coffee
b. tomatos
c. fuel oil (at the wholesale level)
d. home phone service
e. cement (using in construction)

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Introduction to Economics I

Learning what a monopoly is and

LO 1 why it exists.

A monopoly is a firm that is the only producer in its market. A monopoly arises when a single firm
owns a key resource, when the government gives a firm the exclusive right to produce a good, when
a single firm can supply the entire market at a cost smaller than many firms could or when there
are network externalities such that benefit of a good to a consumer increases with the number of
consumers using the good.

Summary
LO 2 Learning how monopolies make
pricing and output decisions.

Since a monopoly is the only producer in its market, it faces a downward-sloping demand curve for
its product. When a monopoly increases production by one unit, it causes the price of its good to fall
lover than the previously produced units. Hence the marginal revenue of a monopolist is less than the
price of the additional unit.
A monopolist maximizes profits by producing the quantity at which the marginal revenue of the last
unit is equal to its marginal cost. The monopoly then chooses the maximum price that consumers are
willing to pay for the last unit produced, and this price is on the demand curve and greater than the
marginal cost.

Understanding the welfare costs

LO 3 of monopolies.

A monopolist’s profit maximizing level of output is less than the output that maximizes economic
surplus (consumer surplus + producer surplus). When the monopoly charges a price above the
marginal cost, some consumers who value the good more than its cost of production do not buy it and
this creates a deadweight loss.

LO 4 Learning what an oligopoly is and

why oligopolies exist.

Oligopolists would like to form cartels and act like monopolies, self interests and the difficulty to
enforce cartel agreements drive them toward competition.

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Monopoly and Imperfect Competition

LO 5 Learning possible pricing strategies

and output outcomes in an oligopoly.

The Nash equilibrium concept describes why oligopolists end up at an outcome worse than the cartel
outcome when each firm chooses its best response strategy taking other firms’ strategies as given.
Summary

LO 6 Understand the meaning of the

Nash equilibrium

The Nash equilibrium concept describes why oligopolists end up at an outcome worse than the cartel
outcome when each firm chooses its best response strategy taking other firms’ strategies as given.

LO 7 Define the monopolistic

competition.

Monopolistic competition is a market with many firms producing similar but differentiated products.
Each monopolistic firm faces a downward sloping demand curve similar to a monopoly and faces the
possibility that its demand may decrease due to entry by other firms.

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Introduction to Economics I

Answer questions 1-4 based on the following table

displaying a monopolist’s market demand and total
cost.
6
Jeans are produced in a monopolistically
competitive industry. Each jean producer’s product
Price Quantity Total Cost is different from other producers’ products. Below
$19 1 $50 are given the Demand, Marginal Revenue (MR)
18 2 55 and Marginal Cost curve (MC) for ABC jeans is

Test Yourself
17 3 57.50 given.
16 4 65.00
Price
15 5 73.50 8
14 6 83.00 7
ATC
tangent
13 7 93.50 6
MC
12 8 106.00 5

4
minimum
3

1 The marginal revenue of the 4th unit is: 2

MR D
1

A. 9 B. 11 C. 13 Quantity (In Thousands)

1 2 3 4 5 6 7 8
D. 15 E. 17

2 The marginal cost of the 6th unit is:

What are the firm’s profit maximizing price and
quantity of jeans?
A. 7.5 B. 8.5 C. 9.5
A. p=7, q=1 B. p=5, q=3
D. 10.5 E. 11.5
C. p=4, q=4 D. p=2, q=3
E. p=3, q=4
3 The profit maximizing quantity is:
A. 3 B. 4 C. 5 Refer to the following information for questions 7-9
D. 6 E. 7
There are two coffee shops in a small city. Each coffee
shop can charge either a high price or a low price for a
4 If the monopolist could perfectly price disri- cup of coffe. The first number represents firm 1’s profits
minate, how many units will it sell? and the second number represents firm 2’s profits.
A. 4 B. 5 C. 6 Firm 2
D. 7 E. 8 High price Low price
High price (80,80) (50,100)
5 Ayşe runs a Burger King franchise. She sells Firm 1
Low price (100,50) (60,60)
250 Whoppers per week at a price of 10.25TL. If
she lowers the price to 10.20TL, she will sell 251
Whoppers. What is the marginal revenue of the 7
If the two firms form a cartel to make pricing
251st Whopper? decisions together, which strategies will be chosen?
A. -3.20 B. -2.30 C. 2.30 A. Both firms choose a high price.
D. 2.80 E. 3.20 B. Both firms choose a low price.
C. Firm 1 chooses a high price and Firm 2 chooses
a low price.
D. Firm 1 chooses a low price and Firm 2 chooses
a high price.
E. None of the above

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Monopoly and Imperfect Competition

8 Which one will be firm 1’s best response 10 Which of the following statements correctly
strategy when firm 2 chooses a high price? identifies the demand curve that a monopolist
A. A low price faces?
B. A high price A. It is perfectly elastic.
C. A low output
Test Yourself

B. It is vertical
D. A high output C. It is a negatively sloped market demand curve
E. None D. It is positively sloped
E. A monopolist does not face a demand curve
9 What is the Nash equilibrium of this price
setting game?
A. Firm 1 chooses a high price and firm 2 chooses
a low price
B. Both firms choose a high price
C. Both firms choose a low price
D. Firm 1 chooses a low price and firm 2 chooses
a high price
E. None of the above.

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Introduction to Economics I

1. C If your answer is not correct, review the topic 6. B If your answer is not correct, review the topic
of “Monopoly”. of “Oligopoly”.

If your answer is not correct, review the

2. E If your answer is not correct, review the topic 7. A

Answer Key for “Test Yourself”

topics of ” Oligopoly” and “Monopolistic
of “Monopoly”.
Competition”.

If your answer is not correct, review the

3. D If your answer is not correct, review the topic 8. A
topics of“Oligopoly” and “Monopolistic
of “Monopoly”.
Competition”.

If your answer is not correct, review the

4. B If your answer is not correct, review the topic 9. C
topics of ” Oligopoly” and “Monopolistic
of “Monopoly”.
Competition”.

5. D If your answer is not correct, review the topic 10. C If your answer is not correct, review the topic
of “Oligopoly”. of “Monopoly”.

Consider the market for natural gas where natural gas is transmitted
via gas pipelines. What are the sources for economies of scale in

Suggested answers for “Your turn”

this market? Is this market a natural monopoly? Explain.

Costs of gas pipelines used in the supply of natural gas are large fixed costs.
Maginal costs in this industry are much smaller compared to these fixed
costs. Average fixed costs decrease as more natural gas is transmitted via these
your turn 1 pipeines. This gives rise to economies of scale and average total costs (which is
the sum of average fixed cost and average variable cost) decrease as more and
more gas is transmitted via these pipelines. One firm can supply the entire
market more cheaply than two firms if each of the two firms has to incur the
fixed cost of pipelines.

A perfectly competitive firm has a supply curve. Does a

monopolist have a supply curve?

A monopoly chooses the profit maximizing price and quantity on the market
your turn 2 demand curve, and therefore does not have a supply curve. A supply curve
exists for price taking firms in competitive markets.

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Monopoly and Imperfect Competition

What are the goals of the Turkish Competition Authority? Examine

their website to answer this question. Can you link these goals to
your knowledge of monopoly and oligopoly?

One of the primary goals of the Turkish Competition Authority is to prevent

anti-competitive, such as cartel formation, between firms. In oligopoly theory,
we have seen that cartels are like monopolies, charge too high of a price,
decrease consumer surplus and create deadweight loss. When oligopolists
Suggested answers for “Your turn”

your turn 3
compete, firms’ profits decline but consumer surplus and total economic
surplus increase. Visit the website of the Turkish Competition Authority for
a complete list of goals.
http://www.rekabet.gov.tr/en-US/Pages/Our-Vision-Mission

For each of the following products, describe what type of

market structure you think that the good is sold in and explain
your answer: (for example: perfect competition, oligopoly,
monopolistic competition, monopoly)
a. Starbucks Coffee
b. tomatos
c. fuel oil (at the wholesale level)
d. home phone service
e. cement (using in construction)

a. Starbucks Coffee: Monopolistic Competition

b. tomatos: Perfect Competition
your turn 4 c. fuel oil (at the wholesale level): Oligopoly
d. home phone service: Monopoly
e. cement (used in construction): Oligopoly

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Robert S. Pindyck and Daniel L. Rubinfeld (2008),
Microeconomics, 6th international edition,
Pearson Education International.
Parkin, M. (2012), Economics, 10th Edition, Pearson,
NY, USA

184
 Factors of Production
Chapter 8 and Factor Markets
After completing this chapter, you will be able to:

1 2
Learning Outcomes

Explain how labor market equilibrium takes

Identify the three factors of production place
Define capital, explain how to determine the
net present value of an investment project, and
explain how the net present value calculation

3 Analyze the causes and effects of shifts in

labor demand and supply
4 aids the decision maker in determining
whether or not to pursue an investment project

5 6
Explain and illustrate the loanable funds market
Explain the demand curve for capital and the and explain how changes in the demand for
factors that can cause it to shift capital affect that market and vice versa

7 Explain what determines economic rent 8 Explain what determines rent differentials

9 Explain how rent functions as a cost to the

individual firm

Chapter Outline Key Terms

Introduction Labor
The Labor Market Capital
Equilibrium in Labor Market Land
The Capital Market Labor Market
The Market for Loanable Funds Capital Market
The Land Market Loanable Funds Market
Wage
Interest
Rents
Production Function
Technology
Net Present Value

186
Introduction to Economics I
INTRODUCTION
A firm needs to bring inputs together to produce
goods or services. These inputs are called Factors of
Production. Classical economists identified three
widely defined groups of the factors of production:
Labor, capital and land. The Labor includes
human resources that contribute to production.
Firms pay wage to the labor they use in production.
The Capital stands for machinery, equipment,
buildings and other tools which are used in the
production of goods and services. In economics,
as a factor of production, the capital refers to
the physical capital, not to the financial capital.
Although money is not a factor of production,
firms often use credits to buy or hire the capital
they use for production, and pay interest in return.
Even if they use their own funds, the opportunity
cost of using them is the interest foregone. So, the
compensation for the use of capital is interest.
The Land includes not only the physical area
that the production facilities are built upon, but
also other natural resources, such as water, wind,
oil, natural gas, etc., that are used in production.
The price of using land is called rent.
Factors of production are the inputs used
to produce goods and services.
An individual firm’s demand for different factors
of production is, among other things, very much
dependent on the number of goods or services it
produces. If the firm wants to produce more, it
needs to use more inputs. This, in turn, increases
its demand for different factors of production. For
this reason, the demand for a factor of production
is called “derived demand”, in the sense that it is
derived from the demand and supply interaction
in the market for the good or service it is used for.
The rest of this chapter covers how competitive
markets for labor, capital and land work.
THE LABOR MARKET
The market for labor is where firms hire
employees to perform different tasks in their
organizations. We assume in our analysis that this
market is a competitive market. In this market,
households supply the labor and firms demand
it. As it is the case in other competitive markets,
interaction of supply and demand determines the
equilibrium price (wage) and equilibrium quantity
(employment) in the market. It is also assumed
that the firms operate in the perfectly competitive
markets, in which they are profit-maximizers, and
the workers are rational and utility-maximizers.
In modern economies, most firms need
employees with different skill sets to operate
efficiently. For example, the skills you need to be
a good factory worker are not the same as the ones
needed to be a good accountant or a good manager.
Research and development (R&D) departments
need employees with different skills from quality
control departments. Thus, the demand for and
supply of each different skill set is separate, and
not necessarily the same. For example, increased
availability of personal computers during the
1980s increased the demand for workers who had
the skills to work with a computer. On the other
hand, the demand for unskilled workers decreased.
As a result, college education has become more and
more important, radically increasing the number
of college graduates all over the world.
Although it is possible to analyze the markets
for workers with different skill sets separately, this
would be mostly repetitive. In our analysis we will
assume that all workers have the same skill set; in
other words, they have homogenous skills. You can
assume that we are analyzing the labor market for
employees with a certain skill set.
Demand for Labor
Firms often use factors of production in
different ways. Similar goods or services can be
produced using different techniques. For example,
producers of shirts use generally the same factors
of production: workers (labor), machines (capital),
production area (land) to name a few. However
some producers prefer to use more capital per
worker, while others prefer less capital and more
labor. As you will recall from Chapter 5, the
relationship between the factors of production that
a firm uses and the output it produces is called a
firm’s production function. A typical production
function can be expressed as:
Q = TP = f (K, L, N)
187

Here, Q stands for Quantity Output and
TP stands for Total Product. When talking
about production, these two terms can be used
interchangeably. K means physical capital, L means
labor and N means land (or natural resources). Some
economists believe technology and entrepreneurship
(the skill to use land, labor and capital to produce
and sell goods and services for a profit) should also
be in the production function.
Production Function shows the relations-
hip between the quantity of inputs (Capi-
tal, labor, atc.) used and the quantity of
output (product) produced.
When a firm needs to increase or decrease its
production, it will have to adjust the amount of
inputs it uses. In the short-run, a firm cannot
change the amounts of all factors of production,
since it is more expensive, and it typically takes
longer to change the amount of capital or land
than it does to change labor. It might take months
for a manufacturing plant to order and install
new machinery. Land cannot be transported, so
sometimes even if the firm wants more land, it
would not be possible to grow the plant. Similarly,
other natural resources take time to transport and it
is costly to change their amounts. However, being
very mobile and much cheaper to hire and fire as
needed, labor is the easiest factor of production
to change. For this reason, in times of economic
trouble, firms tend to fire workers as the first
measure. Similarly, when the economy starts to
recover, increasing employment is among the first
signs to look for.
When a firm employs an extra unit of labor in
the short run, when other factors are constant, the
resulting increase in production is called “marginal
product of labor” (MPL). In other words, the
“marginal product of labor” (MPL) is computed
as the change in the total product divided by the
change in labor input. That is:
ΔTP
= MPL
ΔL
188
Factors of Production and Factor Markets
Marginal product of labor is the increase
in total output produced from additional
unit of labor is employed.
How much did this worker just add to the
revenues of the firm? Since we assume the firm
works in a competitive market, it can sell its
production at a constant price, P. Multiplying this
by the marginal product of the worker gives us the
Marginal Revenue Product of Labor (MRPL). That
is:
P*MPL = MRPL
The Marginal Revenue Product of Labor
(MRPL) shows us the value of the production made
by the last worker hired by the firm. In other words,
it demonstrates the contribution made by the last
hired worker to the revenues of the firm. Table 8.1
demonstrates the example of a pizza restaurant
in the short run. The owner has already invested
100 units into other factors of production, so they
are constant. There is no production without any
worker. The first worker hired manages to produce
and sell 20 pizzas all by himself/herself, so the
change in Total Product (TP) is 20, which is the
Marginal Product of Labor (MPL). When the firm
hires a second worker, production increases by 30,
probably due to the possibility of division of labor
(one focusing on cooking and other on customers,
cleaning etc.) However, eventually there will be a
point where new workers start adding less and less
to production than the previous ones. Workers 3 to
5 keep increasing production but each contribute
less than before. Hiring Worker 6 does not increase
production, Worker 7 actually causes a decrease in
production.
Introduction to Economics I

Table 8.1 Short Run Marginal Product and Marginal Revenue Product of a Firm

Total Product Marginal Product Price of Pizzas Marginal Revenue Product

Labor (L) Other Factors
(TP) of Labor (MPL) (P) of Labor (MRPL)
0 100 0 - 10 -
1 100 20 20 10 200
2 100 50 30 10 300
3 100 70 20 10 200
4 100 80 10 10 100
5 100 85 5 10 50
6 100 85 0 10 0
7 100 80 -5 10 -50

It is noticed that MPL keeps falling after Worker 2. Worker 3 adds 20 to total production (less than 30),
Worker 4 adds 10, and so on. Every firm eventually faces a point in production after which employing
extra units of labor yields smaller and smaller increases. This fact is called “The Law of Diminishing
Marginal Product of Labor”. Figure 8.1 shows a symbolic MPL curve.

MPL increase, at first the firm enjoys the benefits of

extra labor to take advantage of unused capital and
natural resources. However, eventually these benefits
diminish and marginal productivity starts dropping.
If you are wondering how adding the Worker 7 to
labor force could actually drop the total product,
imagine putting all these people in a very small
restaurant with a couple of tables. The last guy just
stands in the way of others, damaging production.
There is simply no way for him to contribute with
the current setup. He would be useful only if you
Amount of Labor (L) could somehow enlarge the restaurant or bring in
Figure 8.1 Marginal Product of Labor might increase for new capital (e.g. delivery equipment). However, you
the first few workers, but it will eventually start decreasing cannot do it instantly. It takes time.
with every new worker, and might even go negative if the We return to Table 8.1. Assume the pizza market
firm keeps hiring. is competitive and the price of a pizza is set at 10.
Worker 1 produces 20 pizzas which are sold for
What is the reason for these changes in MPL? $10 each, bringing a total revenue of 200. Worker 2
Worker 2 seems to be the one with the best marginal increases production by 30, helping the restaurant earn
productivity. Is it because s/he is smarter or more an extra $300 in the process. Worker 6 does not increase
hardworking than the others? Not necessarily. Even if production and brings in no extra revenue. Worker 7
all the workers were clones, The Law of Diminishing actually causes the firm to lose $50. You should notice
Marginal Product of Labor would still be at work that MP and MRP go parallel to each other. As the
in the short run. To understand why, we need to amount of L L
labor increases, they both drop.
remember that other factors of production cannot be
changed in the short run. In other words, the owner of A very important question here is this: If the going
this restaurant does not have enough time to order and market wage were $200, how many workers would
set up a new oven, or move the restaurant somewhere the restaurant in Table 8.1 hire? 1st
, 2nd
and 3rd workers
else with more space, etc. As the number of workers each contribute enough to justify that wage. The 4
th

contributes only $100. He would not be hired for $200.

189
 Factors of Production and Factor Markets

Wage

w*

MRPL

L2 L* L1 Amount of Labor (L)

Figure 8.2 A competitive firm is a price-taker in labor market. When the going wage is w*, it hires L* units of labor.

What if the wage were $50? The restaurant
could afford 5 workers, since each one, including
Worker 5 brings in extra production worth at
least that much. Not the 6th, because he does not
contribute at least 50. So, the MRPL function
shows how much labor the firm would hire for
different levels of wage. In that sense, MRPL
function serves as the Labor Demand Curve for
a firm. If the labor market is competitive, the firm
is a price-taker and can hire as many workers as it
likes at the current wage. Figure 8.2 demonstrates
the relationship between a firm’s labor demand and
market wage. If the equilibrium market wage is
equal to w*, the firm will hire L* units of labor. It
would not hire more than that (for example L1),
since wage would be higher than MRPL, meaning
that the firm pays more than the value of the extra
labor to the firm. The firm would not hire less, for
example L2, since by hiring less than L*, the firm
would be sacrificing the gains to be made from the
extra workers between L2 and L*, each of whom
brings more revenue than the wage to the firm.
You may have noticed that even though the
MPL has a hook at low levels of labor, we do not
have it on the MRPL curve. Actually we could draw
that part too. However, a rational firm will never
stop its hiring while new labor brings more extra
production than the previous one. For example,
even though Worker 1 and Worker 3 have the same
MRPL, the pizza restaurant in our example would
hire 3 workers, not just one. It would not want
to miss the second worker. So, we just ignore the
crooked part since the amount of labor the firm
decides to hire will never be on that part. The same
goes for the part where MPL is negative.
1
How is a competitive firm’s
labor demand related to labor
productivity?
Market Demand for Labor
So far we have seen the mechanics of a single
firm’s labor demand. At a given wage level, each
firm has a certain level of demand for labor. Adding
up the labor demand by all individual firms, we
find the market demand for labor for each wage
level. The process is very similar to acquiring
the market demand for a good, which we saw in
Chapter 2. The market demand curve for labor
is downward sloping, indicating that more labor
will be demanded at lower wages, since the curve
is a horizontal sum of MRPL curves of individual
firms. For example, if there are only firms A and B
in the market and each demands 10 units of labor
at a wage of $15, the market demand for labor at
that wage is equal to 20, i.e. the total demand of
the two firms.
The Determinants of Labor Demand
There is obviously an inverse relationship between
the wage and the quantity of labor demanded. We
know this because that is the information we have

190
Introduction to Economics I

from individual MRPL curves of the firms. However,
the amount of labor demand at a given wage is
affected by some other factors as well:
Market Price: As you recall, marginal revenue
product of labor is shown with the equation of:
P*MPL = MRPL. In the equation, P stands for
the market price of the good or service the firm
produces. When that price increases, MRPL for
a given wage and MPL will increase, shifting the
curve to right. This happens because the value of
the contribution of every extra worker increases
with price, letting firms hire extra more workers.
Returning to Table 8.1., let’s assume that the market
equilibrium wage is 100. The firm would hire
only four workers. However, if the price of pizzas
doubles to $20, the restaurant would be willing to
hire Worker 5 as well, since his contribution would
be worth $100 now.
On the other hand, if the market price for the
good that it produces drops, labor demand of the
firm decreases as well. This means less employment
at a given wage.
At the beginning of this chapter, we used the
term “derived demand”. Demand for labor is
an example. If consumers demand more of the
good or service that the labor is used for, this will
increase the market price and, eventually, the labor
demand.
Technology: So far in our analysis, we have
assumed the availability of a certain level of
technology. When there is a technological change,
it typically affects the productivity of workers. For
example, the availability of personal computers
since 1980s has increased labor productivity in
almost all industries. Technological change usually
means higher productivity for labor, meaning an
increase in MPL. This also shifts the MRPL curve
to right, increasing labor demand. However, not
all technological change favors labor. Sometimes
technological change means that workers are
replaced by machines (capital) and as a result of
this, labor is demanded less. So, even though higher
technology is generally considered to have a positive
effect on labor productivity and labor demand, it is
possible to see just the opposite as well.

Wage

w*

MRPL1

MRPL
L* L1 Amount of Labor (L)
Figure 8.3 An increase in labor demand due to a change in one of the determinants of it. As the MRPL shifts right to
MRPL1, the firm hires more labor at a given wage (from L* to L1)

Prices of other Factors of Production: In the short run, we assume the other factors of production
cannot be changed. However, if capital or land becomes cheaper relative to labor, in the long run firms
may decide to employ more of them and less of labor, and vice versa. It is also possible to compare the
methods of production in a developed country where the physical capital is relatively cheaper and a those
in a developing country where the labor is relatively cheaper. When the former produces textiles, it usually
uses a capital-intensive production method (i.e. it relies more on capital than on labor) with automated
machines doing the job. When the latter produces textiles, the production function is more labor-intensive
(i.e. more labor and less capital) since it is cheaper.

191
 Factors of Production and Factor Markets

Number of Firms in the Market: If some
firms are making positive economic profits in a
competitive market, there will be new entrants. Each
one of these new competitors will need its own set
of employees, implying a higher demand for labor
at any given wage level. Similarly, when firms in a
market are having losses, some of them will leave.
This implies less demand for labor at any wage.
much money. On the other hand, if she decides to spend
her day working, she will not have any time left to spend
in leisure activities. She will have more money to spend,
but not as much time to spend the money. In that sense,
wage is the opportunity cost of leisure for a worker.

What are the main factors

determining labor demand
aside from the wage?

Supply of Labor Picture 8.1

We have seen that firms want to employ more
workers as long as the workers bring them in at least
as much as the wages they pay. The workers, on the
other hand, have a different decision to make. If a
worker chooses to work, s/he earns wages. However,
work is (usually) not much fun and s/he gets tired,
feels stress and pressure at work. The other choice
s/he has for spending his/her day is with leisure
activities such as hobbies, games, watching TV or
just hanging out with friends, which are just the
opposite of working.
Each worker faces a tradeoff between work and
leisure. If he/she decides not to work at all, she forgoes
the benefits of working, i.e. wages. In other words, she
will have a lot of time to spend as she wishes, but not
The lower the wage, the lower the opportunity
cost of leisure. Then, the individual might not
want to work much, since she would not be
making much money working anyway. However,
as the wage increases, spending her time in leisure
becomes more expensive. So, she decides to work
more to take advantage of higher wages, giving up
leisure. There is an obvious positive relationship
between wages and the willingness to work. We can
easily conclude that an individual worker’s labor
supply curve is upward sloping. Since the labor
market’s supply curve is the sum of all individual
labor supply curves, it is also upward sloping.

LS

w2

w1

L2 L1 Amount of Labor (L)

Figure 8.4 Backward-bending labor supply curve. When the wage is higher than w1, the quantity of labor supplied
decreases.

192
Introduction to Economics I
When the wage is high enough, some of the
workers may decide that they have can afford to
work less and spend more leisure time, since they
can make enough money to pay for their bills even
if they work less. So, after a high level of wages,
people may start to work less if wage increases. This
may create what is called a backward-bending
supply curve for labor. Figure 8.4 shows an example
of this curve. Let us assume that there is a high
level of wage in the market. The market supply of
labor is L1. If the wages increase even further, t (let
us say, w2), some workers decide that they do not
need to work more, since they already earned as
much as they needed when the wage was w1. With
a higher wage level, they can actually work less and
still get the same income. So, they offer less labor,
and quantity of labor supplied drops to L2.
Even though a backward-bending labor supply
curve is a possibility, it is an issue only if wages are
really high. For our analysis from this point on, we
will assume that wages are lower than that level,
so there will be no backward-bending part in our
labor supply curve.
The Determinants of Labor Supply
A market supply curve for labor shows the
total amount of labor that the workers are ready
to supply at a given wage. This amount is affected
by some other factors which are assumed to be
constant when the supply curve is drawn: changes
in population, changes in tastes and changes in
opportunities in other labor markets.
Wage
LS3
w number of players in the market
L3 L1 L2
Figure 8.5 An increase in labor supply due to the factors other than wage different labor markets in the
means a rightward shift from Ls1 to Ls2, while a decrease in labor supply can
be shown by a leftward shift to Ls3.
If one of these factors affects labor supply positively,
labor supply curve shifts right, meaning higher supply
of labor for any given wage. If there is a negative
effect on labor supply, the curve shifts left. Figure 8.5
demonstrates these movements. Starting from Ls1, an
increase in labor supply means a rightward shift to
Ls2. For the same wage, the labor demand now is L2,
which is greater than L1. Similarly, a decrease in labor
supply from Ls1 takes us to Ls3, and for the same wage,
to a lower amount of labor supplied (L3).
Changes in Population: Population in a
country or an area can change for many reasons.
During peacetime, almost all countries see increases
in their population. As the newborn babies grow
and reach working age, they enter the market,
increasing labor supply.
Immigration is another reason for population
change. When people immigrate into a country,
some of them enter the labor force and increase
the number of workers willing to supply their labor
at a given wage rage. Similarly, migrations from a
country or an area (due to war, famine, crime etc.)
causes a drop in the number of available workers
and shifts the labor supply curve left.
Changes in Tastes of Workers: For a long time
in world history, women were not encouraged to
work for a wage. Especially after the Second World
War, fast growing economies in many countries
and social changes meant more labor force
participation from women. Nowadays women are
considered as much a crucial part of the labor force
as men in all but a few countries in the world. This
change in preferences caused extra
shifts in labor supply to the right.
LS1 LS2 Another example is that of
professional football. About a
hundred years ago it was not
considered a real job. So, the
was not large. However, it is a big
business with some unbelievable
payment opportunities today,
and almost every child dreams of
becoming a professional football
player. The labor supply curve has
shifted right a long way.
Opportunities in Other
L Labor Markets: There are many
193
 Factors of Production and Factor Markets

world. Some are separated by sets of skills Wage

(tomato farmers have different skills from LS
computer programmers) and some are
by national or geographical barriers. If w1
the wage level increases in a labor market
while it does not change in others, some
w’
of the workers with compatible skills
from lower-wage markets will move to
2
the higher-wage ones. Workers from poor w
countries try to enter the labor markets
of rich countries because of the wage LD
level differences. Similarly, a new factory
in an area shifts some of the local work
L’ L
force there, decreasing labor supply for
labor markets of other industries such Figure 8.6 Labor Market equilibrium
as agriculture. If workers leave the labor
market for opportunities in other places, labor Changes in Equilibrium
supply shifts left. If workers join the local labor Suppose there is a new and widely popular TV
market because it is better than the one they were show set in a pizza restaurant. It makes eating pizza
working, labor supply shifts right. popular, increasing the demand for pizzas. We saw in
Chapter 2 that this shifts the pizza demand curve right
and, ceteris paribus, increases pizza prices. Higher
pizza prices mean higher MRPL for pizza restaurants
3 since the value of each new worker’s marginal product
is higher now. Each firm is ready to hire more labor
What are the main factors at each wage. So, the labor market demand shifts
determining labor supply other right. Figure 8.7 shows how wages and the amount
than wage? of labor hired in the market adjust to this. At the
beginning, the market is at equilibrium with w* wage
and L* amount of labor hired. The rightward shift in
EQUILIBRIUM IN LABOR MARKET labor demand creates an excess demand for labor in
Figure 8.6 shows the equilibrium in the Labor the market (L*2 -L*), causing wages to rise all the way
Market. If wage is w1, there is excess supply in up to the new market-clearing wage, w1. As the wage
the labor market. This means some workers who level increases, excess demand disappears.
want to work at this wage level will be Wage
unable to find a job (unemployment). As LS
a result, the wage will be driven down.
On the other hand, if wages are as low
as w2, workers do not want to work that 1
w
much but firms demand more workers.
So, there will be excess demand and the w’
wage will increase. w* is the equilibrium
or market-clearing wage where labor w2
demand is equal to labor supply. At this LD1
wage level, L is the amount of labor to
*

be employed. In other words, if there is LD

an imbalance in the labor market, wage
adjusts and brings the market to an L’ L’1 L’2 L
equilibrium. Figure 8.7 An increase in labor demand increases the equilibrium
wage and employment.

194
Introduction to Economics I
On the other hand, a decrease in labor demand,
let us say due to some firms going out of business
because of lack of profits, creates just the opposite
effect, shifting the demand curve left, creating an
excess supply of labor and ending up with lower
equilibrium wage and lower employment.
Changes in labor supply are caused by several
factors. For example, a sudden influx of workers
from other areas due to famine, war, unemployment
etc. could increase the number of people willing
to work at all wages. Figure 8.8 demonstrates how
the labor market adjusts. Labor supply curve shifts
right, and the resulting excess supply of labor (L2-
L*) causes the market wage level to drop from
w* all the way down to w1. As a result, the new
equilibrium means lower wages (w1<w*) for more
workers (L1>L*).
Wage
LS
w’
w1
LD
L’ L’1 L’2
Figure 8.8 An increase in labor supply decreases the equilibrium
wage and increases employment.
These examples all show us the same thing: labor
markets are multi-layered mechanisms. An employer’s
decision to hire or fire workers is often caused by
events in other markets or the economy in general.
Prior to the widespread availability of personal
computers and word-processing programs, all firms
employed people specialized in using typewriters
(hand-operated mechanical writing machines) since
they required a certain amount of skill to use and had
little room for error. Today’s average office worker can
easily type and print a document on his/her computer
using an auto-correction software (or just speak to
her computer which can understand and print it),
so there is almost no need for special employees for
that kind of skill any more. It is always a good idea to
follow technological changes and new developments
in related markets and try to acquire skills that are
likely to be demanded in the future. Today we cannot
imagine an office employee without average computer
skills, but those who realized the importance of it and
acquired them during the 80s had a huge advantage
in the job market.
4
On September 25, 2016, a truck operated by
a computer in the United States delivered its
goods to its destination nearly 200 km away for
the first time in history. A human driver was
also present for safety, but he did not need to
intervene. How would this development affect
the future of truck drivers?
LS1
THE CAPITAL MARKET
In the preceding sections, it has been
shown that those hiring decisions also
determine how much labor to use during
the production process and how much
a worker is paid. While businesses are
deciding on the optimum quantity of
labor in the production of their goods and
services, they should also decide on the
quantities of other inputs to production
L simultaneously. For example, a pizza
restaurant might have to determine the
size of its pizza oven, pizza preparation
fridge, and dough mixer in order to make
them available to its pizza makers. Thus,
a significant role has traditionally been assigned to
capital as a factor of production, because capital
makes labor more productive. We can think of
capital as the machinery, tools and buildings
humans produced in the past by not consuming
some portion of an economy’s commodities then.
Rather, these past products were invested to be used
for production in the future. Giving up present
consumption for the future one is the main theme of
all capital accumulation. Some common examples
of capital include hammers, forklifts, conveyer belts,
computers, and trucks. Capital differs based on
the worker and the type of work being done. For
example, a dentist may use a sickle probe, a dental
195

mirror and an examination room to provide medical
services. Your teacher may use textbooks, desks, and
a whiteboard to produce education services.
Capital is the equipment, machines and
structures used by firms to produce goods.
Picture 8.2
An interesting feature of capital is that assets
mentioned above are themselves products—capital
goods—and they are exchanged in markets, just
as a cup of coffee, a suit or a cellphone. There are
markets for capital goods in which their prices and
quantities are determined — just as the markets for
the products that you studied in Chapter 2.
Financial capital consists of the funds that firms
use to buy and operate capital. A financial market
is where businesses get the funds that they use to
buy capital. In a financial market, while firms are
the demanders of the funds, people are the savers
and ready to lend their sacrificed consumption, in
other words, their savings. Financial markets are
the channels through which firms borrow financial
resources to buy capital.
The Demand for Capital
Since a firm demands physical capital to produce
goods and services, its demand for capital arises. As
it is stated in the beginning of the chapter, a firm’s
decision to employ an additional unit of a factor
depends on the last unit’s marginal revenue product
and marginal revenue cost. The firm continues to
hire a factor until they are equal to each other. In
this matter, capital is same as the other production
196
Factors of Production and Factor Markets
factors. However, the revenues and cost that are
created using capital are distributed over time. As a
result of this fact, the determination of the present
value of marginal revenue products and marginal
factor costs is a significant issue while measuring a
firm’s demand for capital.
Capital and Net Present Value
In order to understand the relationship between
net present value and investment decision, we can
apply the following example. Suppose our pizza shop
owner is thinking about buying a new pizza oven for
his/her shop. Assume that the purchasing price of
the oven is $25,000. The shop owner expects to use
the oven for five years and then sell it for $3,000.
The shop owner has the $25.000 on hand now. At
this point, s/he has to make a decision as to whether
to buy this oven or to purchase a bond which bears
5% annual interest rate. In addition, s/he expects
that the new oven will have the operation costs of
$3,000 each year, but the new oven will bring an
additional revenue of $10,000 per year.
Here is the main question: Should the owner
purchase the pizza oven? This question can be
answered by calculating the net present value
(NPV) of the oven. The NPV is calculated by the
difference between all the expected revenues from
an asset’s present value and the present value of
all the costs related to it. By calculating NPV in
fact we are measuring the difference between the
present value of the marginal revenue products
and that of the marginal factor costs. If the NPV is
higher than zero, the profit of the firm will go up
as a result of purchasing the machine. On the other
hand, the implication of the negative NPV is that
buying an interest-generating asset would yield a
higher revenue.
The net present value of an asset expected to
last for t years can be calculated by the following
formula:
NR1 NR 2 NRt + Ps
NPV = −Pp + + 2 + ...+ t
(1+ i ) (1+ i ) (1+ i )
Here, Pp stands for the purchasing price of an
asset, NR is the difference between the revenue
received from an asset and the operating costs per
period, Ps is the selling price of an asset and i is the
annual interest rate.
Introduction to Economics I
If we put the amounts in the formula for our pizza shop, then the net present value of the pizza oven willbe:
NPV = −25000 +
10000 − 3000
+
7000
+
2 3
(1+ i ) (1+ i )
Since the calculated NPV is greater than zero, the
shop owner will increase profits by buying the oven
instead of purchasing a bond yielding 5%. Thus,
owner will decide to go on and buy the oven and
that is called investment. Investment is defined as
an addition to capital stock, therefore, any purchase
of new capital goods qualifies as investment.
Finally, an investor sometimes has to make a
decision about which investment project to choose
from different projects. In this case, to undertake
a project, the investor will calculate the NPV of
these projects. Then, s/he will pick the project that
yields the highest NPV. For instance, there are
there projects and each has the NPV of $1,000,
$1,200 and $500, respectively. Of these three
projects, the second one has the highest NPV, thus
an entrepreneur will chose that project.
5
An entrepreneur has $50,000 at hand now.
That amount is the price of a machine he needs
to buy for his firm. There are two different
machines and he needs to make a decision about
which one to buy. Both machines are expected
to have the annual operating costs of $5,000. It
is expected that the new machine will bring an
additional revenue of $107,500 in sum over the
next 5 years. However, each machine’s expected
additional revenues is different for each year.
While the first machine’s expected earnings
for the next five years respectively are $15,000,
$20,000, $22,500, $25,000 and $25,000, the
expected additional revenues of the second
machine are $25,000, $25,000, $22,500,
$20,000 and $15,000 for each year. Finally, the
first machine can be sold for $10,000, but the
second one for$5,000. With a 10% interest rate
on bond which projects should be chosen?
7000
+
7000
+
(10000 + 3000) = $7, 657
4 5
(1+ i ) (1+ i ) (1+ i )
The Demand Curve for Capital
The analysis we have just made about the decision
of shop owner regarding whether to purchase pizza
oven or not, actually tells us about the factors that
are important in determining the capital’s demand
for an economy. These factors are the price have to
be paid to obtain the oven, the marginal revenue
product received by having it, the operating costs
of it, the price we could receive eventually by selling
the same machine and the interest rate. Among
these factors, only the oven’s purchasing price and
the percentage of the interest rate are known to
the shop owner when considering to buy the pizza
oven. All the other factors are expected values that
are expected to be realized in the future. Thus, the
decision to undertake an investment project mostly
depends on the expected benefits, and the costs
will be generated through the use of the purchased
equipment.
The determinants of the capital demand are
the price have to be paid to obtain the capital
good, the marginal revenue product received
by having it, the operating costs of it, the
price we could receive eventually by selling
the same machine and the interest rate.
One of the factors considered above is of special
importance: the interest rate prevailing at the time
an investor makes his or her choice. Since the
interest rate is considered as a discount factor that
equates the expected future returns of an investment
to its present value, it plays an important role in the
calculation of NPV. Because, a project’s purchasing
and selling prices, its expected revenues and
operating costs over the time will be same, different
prevailing interest rates could result in rejecting an
investment project. For example, our pizza shop
owner would not buy the pizza oven if the interest
rate is 15%, a rate in which the calculated NPV is
equal to -43,40TL. Therefore, it is not profitable
to buy the new pizza oven. Rather, the pizza owner
197

would be better off by putting the funds elsewhere,
such as buying a bond.
At any one time, millions of options like that
of pizza owner related to the acquisition of capital
will be under consideration. Each decision will
depend on the purchasing price of a specific piece
of capital, the expected cost of its use, its expected
marginal revenue product, its selling price, and the
interest rate. Firms, at the same time, have another
decision to make that is whether to keep the capital
they already have. Should they continue to use the
capital, or should they sell them? The NPV of each
unit of capital has to be calculated, then a firm
could decide on whether to keep the capital or not.
The interest rate affects such decisions of firms.
While the NPV of holding capital will go up at
lower rates of interest, it doesn’t make sense to hold
on to some capital at higher rates of interest.
Since the interest rate is the main determinant
of a firm’s decision to purchase a new capital and
to keep its existing capital, the demand curve for
capital in Figure 8.9 shows that at each interest rate
a firm’s intention to keep the amount of capital is
down-sloping.
Interest Rate (%)
8 A
6 B
Demand for
Capital
15 20
Quantity of Capital
Figure 8.9 Demand for Capital
The quantity of capital the firms will want to
hold depends on the interest rate. The higher the
interest rate is, the less amount of capital the firms
will want to hold. At point A, in figure 8.9., we see
that at an interest rate of 8%, $15 billion worth
of capital is demanded in the economy. At point
B, a reduction in the interest rate to 6% increases
the quantity of capital demanded to $20 billion. A
corollary is that a decline in the interest rate raises
the quantity of capital demanded.
198
Factors of Production and Factor Markets
Factors Affecting Demand for Capital
What are the reasons that might cause changes
in the demand for capital? To answer this question,
we should look for reasons other than interest rate
changes, because changes in interest rate is not
going to cause changes in the demand for capital.
In fact, we stay on the same demand curve. Thus,
talking about demand changers means that the
demand curve should shift to the right or left.
Since the demand for capital reflects the marginal
revenue product of capital, anything that influences
the marginal revenue product of capital will affect
the demand for capital. Therefore, if factors affect
the marginal product of capital, the prices of the
goods which capital produces, and the costs of
acquiring and holding capital demand for capital
will also change. What could these factors be?
First of all, in our earlier example, we reached
the conclusion that expectations are very important
while making choices related to capital. The
expected revenues and costs over the expected life of
an asset are used to calculate NPV. An implication
is that if expectations of firms change, their demand
for capital will also change. If for some reason, such
as strong sales in the recent past, sales expectations
are increased, firms would increase the amount
of the product they produce; thus they also raise
their demand for capital. Similarly, if it is predicted
that economy is weakening, a recession will be
likely to occur. In this case, firms will expect lower
sales in the future that decides not to produce new
products and then not to invest on new capital.
As a result, demand for capital declines, and the
demand curve shifts to the left.
Another factor which can increase the marginal
product of capital involves technological changes.
In fact, advances in technology increase the demand
for particular types of physical capital, but decrease
the demand for others. Coal is such an example.
Third of all, demand for all products goes up
as the population and income increase. As we
mentioned in the beginning of the chapter, the
demand for a factor is a “derived” demand. As
population and incomes go up, a greater demand
for products can be expected. Thus, the demand
for capital will also increase.
Relative factor prices constitute the fourth
reason that might change the demand for capital.
The profit-maximizing combination of resources
Introduction to Economics I
for the firm will be where the ratios of marginal
product to factor price are equal for all factors of
production, for a given total cost and in a perfectly
competitive situation. For a firm that uses labor
(L) and capital (K), for example, this requires that
MPL/PL=MPK/PL, where MPL and MPK are the
marginal products of labor and capital, respectively,
and PL and PK are the prices of labor and capital,
respectively. Suppose these equalities hold and
the price of capital goes up. Then, the ratio of the
marginal product of capital to its price declines,
and all other things being constant, it would cause
firms to substitute other factors of production for
capital. Thus, the demand for capital, would go
down.
Finally, tax policies applied by the government
can affect the price of the capital indirectly. For
instance, assume the government decreases the tax
rate on firms’ profit if they increase their expenses
on capital. Such a policy would effectively lower the
price of capital, causing firms to substitute capital
for other factors of production and increasing the
demand for capital. On the other hand, an increase
on the corporate taxes would raise capital’s price,
then substitution of the other factors of production
for capital occurs and the result is falling demand
for capital.
THE MARKET FOR LOANABLE
FUNDS
The interest rate, in macroeconomics, is often
determined in the framework of total money
supply and total money demand for an economy.
However, since we focus on microeconomics, we
should rather consider a micro-based theory of
interest rate. Specifically, the loanable funds theory
of interest explains the interest rate not in terms
of the total supply of and demand for money but,
rather, in terms of the supply of and demand for
funds available for lending and borrowing.
A firm can finance its purchase of capital in
different ways if it decides to increase its capital
stock. First of all, the firm might already have the
funds available to itself. Secondly, funds can also be
raised by selling shares of stock if the firms’ shares
are traded in the stock market. Another option is
that the funds for the capital can be borrowed from
a bank. Finally, issuing and selling its own bonds
could be another choice for the firm.
Picture 8.3
When the firm issues and sells its own bonds,
the firm makes a promise to make interest
payments to the owners of its bonds as they
come due. Borrowing from a bank also involves a
commitment to pay the interest rate on time.
Interest rate is an important factor in the
decision of firm on whether to purchase or to
keep capital regardless of the financing options
preferred. When the company gets a credit from
a bank or issues its own bonds, the interest rate
shows the price to be paid for the use of that
money. It is the price that borrowers need to pay
lenders for transferring purchasing power from the
present to the future. On the other hand, there is
an opportunity cost if a firm uses its own funds
to acquire the capital. Instead, a firm can lend
those funds directly to other firms by purchasing
their bonds or indirectly by lending funds to them
through a financial intermediary. Therefore, the
interest rate raises the opportunity cost of using
funds to purchase capital rather than putting the
funds to the best alternative use available to the
firm.
The interest rate is determined by the forces of
demand and supply in a market called the loanable
funds market in which borrowers (demanders of
funds) and lenders (suppliers of funds) encounter.
To understand the role that the interest rate plays
in the demand for capital, it is proper to assume
that there is no difference in prevailing interest
rates that specific consumers and firms face in the
economy1.
Actually, the interest rate on mortgage is lower than that
1
of on credit cards. A new or start-up company can borrow
funds or issue bonds at higher interest rates than a large or
an established firm. Length of the loan, risk and handling
charges are the main factors that generate variations in the
rate of annual interest.
199

A Loanable funds market is where the
forces of demand and supply meet.
The Demand for Loanable Funds
In the previous section we
analyzed that the net present
value of the capital in question
determines whether a firm decides
Interest rate (percent)
to undertake an investment
project, thereby purchasing capital, .
E
or to keep the existing capital. We
also learned that the net present
value depends on the interest rate.
The lower the interest rate gets, the
greater the amount of capital that
firms will want to purchase and
Quantitiy of Loanable Funds per period (billion of dollars)
hold gets, since lower interest rates
translate into more capital with Figure 8.10 The Demand and Supply of Loanable Funds
positive net present values. The
desire for more capital means, in turn, a desire for
more loanable funds. Similarly, at higher interest
rates, less capital will be demanded, because more
of the capital in question will have negative net
present values. Higher interest rates, therefore,
mean less funding demanded.
Consumers also demand loanable funds
because earlier consumption is preferred to later
consumption. It is a fact that sometimes the present
income of an individual household falls below
the average income level expected over a lifetime.
Individuals may go to credit market to borrow
whenever they realize a temporary decline in their
current income, assuming that they expect their
income to go back to normal later on. In addition,
purchases can be distributed more evenly during
their life time by borrowing. Thus, they are able
to raise their lifetime total utility. Both consumer
and business demand more loans as the interest
rate decreases and demand less as the interest rate
goes up. When we add together the demand of
the households and businesses for loanable funds,
we obtain a demand curve for loanable funds as
given in Figure 8.10 below. As seen, the demand
for loanable funds is negatively-sloped.
200
Factors of Production and Factor Markets
At lower interest rates, firms demand more capital
and therefore more loanable funds. The demand for
loanable funds is downward-sloping. The supply
of loanable funds is generally upward-sloping. The
equilibrium interest rate, iE, will be found where the
two curves intersects. The lower the interest rate is,
the more capital the businesses will demand. Then,
the more capital the companies demand, the greater
the funding (required) to finance it becomes.
Supply of Loanable Funds
Demand for Loanable Funds
The Supply of Loanable Funds
Funds are supplied to the loanable funds market
by lenders (savers) those who are households or
businesses that in order to have more available
funds in the future, they are willing to give up some
current use of them. Generally, lending option is
preferred as the interest rates increase. However,
compared to the firms, the decision of consumers
about saving should be analyzed more deeply.
Economists think that when households make
their consumption choice at any point of their
life, they consider the stream of income over their
lifetimes not the current income they have. This
means that households’ consumption possibilities
are defined by the expected income. Thus,
consumers make the decision of whether to spend
less of their expected income now in the hope that
they will have more available income to spend in
the future or to consume more now by borrowing
against their future income.
If households do not spend all of their income
on consumption in any given time period, they
will have positive saving. So, one can define saving
as the income not spent on consumption. On the
other hand, dissaving (negative saving) is generated
by having less income than consumption during a
Introduction to Economics I
period. Dissaving can be financed by borrowing or
by using past savings. While a consumer’s wealth
increases with saving, dissaving lowers it. In fact, a
person’s wealth is the difference between the sum
of the value of all past saving and all past dissaving.
Saving is the difference between income
and consumption.
Saving can be determined as an option to
postpone consumption. Since households who
defer their use of wealth are paid in the name of
interest rates for their sacrifices, interest rates are
compensations to savers. An important issue at this
point whether or not higher interest rates encourage
the consumers to delay their purchasing decisions.
The answer to this problem is “uncertain”. Just as
the quantity of labor supply might not be increased
by higher wages, the quantity of saving might not
be increased by higher interest rates. The problem,
once again, lies in the fact that the income and
substitution effects of a change in interest rates will
pull (work) in opposite directions.
When the interest rate goes up, the price (the
cost) of the current consumption will also go up.
A higher opportunity cost of current consumption
due to the increase in interest rate generates a
substitution effect that causes a decline in the
activity of a consumer to purchase smaller amounts
of product in the current period. Therefore, saving
will increase as a result of the substitution effect.
However, a consumer will receive more income
on his saving, if the interest rate increases. Because
consumption is a normal good in the current
period, it is expected that a raise in income could
lead to an increase in current consumption. Yet,
an increase in current consumption implies a
reduction in saving. Therefore, we face reduced
saving as a result of income effect of a higher interest
rate. A corollary is that whether a consumer’s
saving will go up or down in response to a higher
interest rate depends on the relative strength of the
substitution and income effects.
The effect of an increase in interest rates
on saving is ambiguous. An increase in
interest rates causes saving to increase due
to substitution effect but to decrease due
to income effect. Since both effects work
in opposite directions, the total effect is
ambiguous.
Since changes in interest rates generate income
and substitution effects that direct saving in
opposite directions, we cannot be sure what will
happen to saving if interest rates change. The
combined effect of all consumers’ and firms’
decisions, however, generally leads to an upward-
sloping supply curve for loanable funds shown in
Figure 8.10. This means that the substitution effect
usually dominates the income effect.
The equilibrium interest rate (iE) is determined
by the intersection of the demand and supply
curves in the market for loanable funds.
6
How is the equilibrium interest rate determined
in the loanable funds theory?
Capital and the Loanable Funds
Market
We can conclude that the demand for capital and
the loanable funds market are related to each other since,
as we have seen, the relationship between the interest
rate and the quantity of capital demanded is negative,
and the equilibrium interest rate is determined in the
loanable funds market. Since the purchase of new
capital is usually financed in the loanable funds market,
a change in the demand for loanable funds follows a
change in the demand for capital, and that influences
the interest rate. A change in the interest rate, in turn,
impacts the quantity of capital demanded on any
demand curve. Therefore, the relationship between
the demand for capital and the loanable funds market
goes both ways. Changes in the demand for capital
impacts the loanable funds market, and changes in the
loanable funds market can alter the quantity of capital
demanded. This two way relationship is illustrated and
explained in Figure 8.11.
201
 Factors of Production and Factor Markets

Panel (a) Panel (b)

S1
Interest rate (percent)

Interest rate (percent)

. .
2 2
. .
1 1

D2

D1 D1 D2
K1 K2
Quantitiy of Loanable Funds per period Quantitiy of Capital per period
Figure 8.11 Loanable Funds and the Demand for Capital

In figure 8.11, in Panel (a) the initial interest rate is i1. Quantity of capital firms will hold can also be
At i1 in Panel (b), K1 units of capital are demanded (on affected by the events occurring in the loanable
curve D1). Now, suppose an improvement in technology funds market. Suppose, for example, that
increases the marginal product of capital, shifting the consumers decide to decline current consumption
demand curve for capital in Panel (b) to the right to D2. and, thus, to supply more funds to the loanable
Firms can be expected to finance the increased acquisition funds market at any interest rate. This change in
of capital by demanding more loanable funds, shifting consumer preferences shifts the supply curve for
the demand curve for loanable funds to D2 in Panel (a). loanable funds in Panel (a) of Figure 8.12 from
The interest rate, thus, rises to i2. Consequently, in the S1 to S2 and lowers the interest rate to i2. If there
market for capital, the demand for capital is greater and is no change in the demand for capital D1, the
the interest rate is higher. The new quantity of capital quantity of capital firms demand increases to K2
demanded is K2 on demand curve D2. in Panel (b).

Panel (a) Panel (b)

Interest rate (percent)

S1
Interest rate (percent)

S2

. .
1 1
. .
2 2

D1 D1
K1 K2
Quantitiy of Loanable Funds per period Quantitiy of Capital per period
Figure 8.12 A Change in Loanable Funds Market and the Demand for Capital

THE LAND MARKET

Another factor of production is land. However, besides land, any natural resource used in the production of
goods and services is also considered as land. In Economics, the word ‘land’ is used in the sense of not only the

202
Introduction to Economics I
soil or surface of the earth as is ordinarily understood
but also all nature, living and lifeless. It includes all
natural resources that we can get free from air, water
and land; such as, oceans, lakes and rivers, mineral
deposits, rainfall, water-power, fisheries, forests and
numerous other things which nature provides and
man uses. Land resources are the raw materials in the
production process. These resources can be renewable
meaning they can be used repeatedly, such as forests,
or nonrenewable, such as oil or natural gas, meaning
they can be used only once without being replaced
once they have been used. The income that resource
owners earn in return for land resources is called rent.
Economic rent is the price paid for the use of land and
other natural resources which are completely fixed in
total supply. This fixed supply actually makes rental
payments different form wage and interest. In this
sense, from the perspective of the economists, the land
rate is the “surplus” payment.
Like all other factors of production, the price of
land which is land rent is determined in the land
market. Thus, we can use supply and demand analysis
to determine the equilibrium price of a specific land.
The following assumptions related to the land market
are made for the purpose of analysis. First of all, there
is no quality differences between any acres of land,
meaning that each acre of land is productive as every
other acre. Secondly, all land is used just for one
purpose, for example, producing carrots. Finally, the
land is rented or leased in a competitive market.
In Figure 8.13 the supply of arable land in the
economy as a whole which is shown by the supply
curve (S), and the demand curve (D) represents the
demand of producers for the use of that land.
S of a particular type and in a particular location
Land rent ($)
R RE
D Land market equilibrium occurs where a
L Acres of Land (L)
Figure 8.13 Equilibrium land rent
Similar to all production factors, demand for
land is also a derived demand meaning that an
acre of land’s demand is directly related to the
final product produced using that land. Because
of diminishing returns and since producers must
decrease prices to sell additional units of output, the
demand curve (D) for land is downward-sloping.
The downward-sloping demand curve indicates
that, the lower the rent, other things remaining the
same, the greater the quantity of land demanded.
Picture 8.4
Perfectly Inelastic Supply
What separates Land market from the other
production markets is its unique feature related to
quantity supplied. First, the quantity is fixed, thus
the household’s choices cannot change the quantity
supplied. That gives us perfectly inelastic supply
curve (S) of land (in both the short run and the
long run), as shown in Figure 8.13 The amount
of land owned by households can be changed, but
when one person sells some land, another person
buys it. The aggregate quantity of land supplied
stays constant. Another unique feature is that the
production cost of land is zero. It is a “free and
non-reproducible gift of nature”. The economy
has so much land, and that is all. Such cultivation
activities as clearing, drainage, and irrigation can
make any parcel of land more useable within limits.
However, these are considered as improvements in
capital not increases in the amount of land itself.
downward-sloping demand curve and a perfectly
inelastic supply curve intersect. That is shown in
Figure 8.13 above. Point E represents that the
equilibrium is established in the land market and
the land rent is RE.
203

Changes in Demand
Because the quantity of land supplied is fixed,
the rent is determined by demand. One should ask
now, “What determines the demand for land?”.
Actually, we have already discussed the factors such
as: the price of the good produced on the land,
the productivity of land which depends in part
on the quantity and quality of the resources with
which land is combined, and the prices of the other
resources that are combined with land.
As shown in Figure 8.14, if the demand for
land goes up, the demand curve shifts to the right
from D1 to D2 and thus the land rent would go up
from R E1 to R E2 . On the other hand, if the demand
for land decreases, the demand curve shifts to
the left from D1 to D3 and the land rent would
fall from R E1 to R E3 . However, in either case, the
amount of land supplied would remain the same
at quantity L. Since the quantity of land supplied
cannot be altered, amount of land could not be
influenced by the changes in economic rent. A
simple corollary is that rent is a unique income
because the resources that receive a rent would
still be available even if the rent were zero.
Land Rent ($)
Supply of Land
R2E E2
R1E E1
D2
R3E E3
D1
D3
L Acres of Land (L)
Figure 8.14 Changes in Equilibrium Land Rent
7 the next best use of the resource, rises from alternative
It is argued that land is a “free” good. How can
you support this argument by using a supply and
demand graph for land?
204
Factors of Production and Factor Markets
Factors Affecting Demand
So far, we have seen that since the supply of
land is fixed, low demand would make the rent low
and high demand would make the rent high. But,
what are the reasons for the rent differences even the
demand is the same? One reason why some acres
of land earn much higher rents than others is that
the differences in productivity of specific piece of the
lands. If we drop our assumption which all units of
land are equally productive, and consider such factors
as fertility of soil and climatic factors as rainfall and
temperature might generate vast differences in
their productivity. For example, agricultural goods
like wheat, corn, rice, tomatoes, etc. can only be
produced in soil best suited to growing any of these
products. Such productivity differences are reflected
in resource demand and prices. Competitive bidding
by producers will establish a high rent for highly
productive land compared to less productive land.
Another significant factor generating variations
in land rent is where the land is located. Other
things equal, renters will pay more for a unit of
land strategically located with respect to materials,
location, transportation, labor and customers than
they will for a unit of land whose location is far
away from these.
8
It has been seen that different land rent is charged
for two plots of 500 acres of land that are used for
growing rice and located in the same county of a
state. State some reasons to explain these differences.
Alternative Uses of Land
A piece of land is not just demanded for production
of agricultural products. First of all, people also demand
it to build houses on. A government might also plan
to build a highway. Finally, businesses may want to
build a factory site or a warehouse. In other words, an
opportunity cost that is the forsaken production from
uses of land. Since the fixed amount of land can be used
in different ways, a firm has to pay rent to cover those
opportunity costs in order to have the right to use the
land for its special aims. Similar to wages and interest,
rent is another cost of production for an individual firm.
Introduction to Economics I

LO 1 Identify the three factors of

production

There are 3 main factors of production. Labor symbolizes the human resources, Capital stands
for tools, machines, buildings and other things that are produced and used in production and
Land which means all of the natural resources used in production. Demand for factors of
production is called “derived demand” since it is directly affected by the demand for goods
and services they are used for.

Summary
LO 2 Explain how labor market
equilibrium takes place

Labor demand is closely related to Marginal Revenue Product of Labor (MRPL) which means the extra
revenue generated by the last hired unit of labor. A rational, profit-maximizing firm in a competitive
industry will keep hiring workers until wage is equal to MRPL. Other factors affecting labor demand are:
prices of goods and services that the labor is used for, technology, prices of other factors of production
and number of firms in the market.
Labor supply is related to the tradeoff between work and leisure, meaning that workers have to choose between
wage earned from work and utility gained from leisure activities. The other factors affecting labor supply are:
changes in population, changes in preferences of workers and opportunities in other labor markets.
Labor demand and supply in the market determine the level of wage and employment, with wage increasing
or decreasing as needed to close any gap between demand and supply.

LO 3 Analyze the causes and effects of

shifts in labor demand and supply

Labor demand is closely related to Marginal Revenue Product of Labor (MRPL) which means the extra
revenue generated by the last hired unit of labor. A rational, profit-maximizing firm in a competitive
industry will keep hiring workers until wage is equal to MRPL. Other factors affecting labor demand are:
prices of goods and services that the labor is used for, technology, prices of other factors of production
and number of firms in the market.
Labor supply is related to the tradeoff between work and leisure, meaning that workers have to choose between
wage earned from work and utility gained from leisure activities. The other factors affecting labor supply are:
changes in population, changes in preferences of workers and opportunities in other labor markets.
Labor demand and supply in the market determine the level of wage and employment, with wage increasing
or decreasing as needed to close any gap between demand and supply.

205
 Factors of Production and Factor Markets

Define capital, explain how to determine the net present

value of an investment project, and explain how the
LO 4 net present value calculation aids the decision maker in
determining whether or not to pursue an investment project

The main theme of all capital accumulation is that people by not consuming today, actually
they are postponing their present consumptions for future ones. If they prefer to consume
more in the future, that means they are consuming less than what they earn, they value future
consumption compared to current one. The difference between their present earnings and
consumption is called savings and people expect to receive additional gains in the future by
Summary

saving today. Thus, the additional gains from savings plus their expected future earnings will
generate more income to spend in the future. A corollary is that, people need an incentive to
postpone current consumption and economists call that incentive interest rate. Interest rate
plays a significant role in a firms’ decision about whether to buy a capital good or not. In order
to purchase a capital good, firms calculate the net present value of an investment project. The
net present value of an investment is the difference between the present value of its expected
earnings and that of its expected cost. Since returns from an investment gathered in the future
all the revenues and costs considered as expected values. However, a discounting factor which
is interest rate needed to calculate the present value of an investment project. An entrepreneur,
with a fund on hand, might have to make a choice between different projects. His or her
decision depends on the net present value of each project. The rule is that only projects with
positive present value is undertaken and the project with the highest net present value are always
preferred.

Explain the demand curve for

LO 5 capital and the factors that can
cause it to shift

The demand curve for capital represents the inverse relationship between interest rate and the
quantity demanded. It is drawn as negatively sloped and represents the lower the interest rate the
higher quantity of capital is demanded. Changes in expectations about the economic conditions,
changes in technology, changes in the demand for products, changes in relative factor prices
and changes in tax policy are the factors that influence the demand for capital goods. Expected
economic growth, improvements in technology, increases in the demand for the products that
specific capital is used during the good’s production process, increases in the other factors of
production, and an appropriate tax policy that causes reduction in the price of the capital good
all increases demand for capital shifting the demand curve to the right, and then with given
interest rate the quantity of a capital good is demanded rises.

206
Introduction to Economics I

Explain and illustrate the loanable funds market

LO 6 and explain how changes in the demand for
capital affect that market and vice versa

The supply of loanable funds is an upward-sloping curve—a larger quantity of funds will be made available
at high interest rates rather than at low interest rates. Most individuals prefer present consumption and
must be paid to defer consumption by saving. The demand for loanable funds is inversely related to the
rate of interest. At higher interest rates fewer investment projects will be profitable since fewer projects
yield a high rate of return needed to compensate for the high interest cost. Therefore, using demand and
supply analysis of loanable funds market, one can find the market clearing price which is the interest rate.
The equilibrium interest rates occur where demand for fund and supply of fund are equal to each other.

Summary
In other words, it is the interest rate where these curves intersect.
There is a simultaneous relationship between capital market and loanable fund market. If, for example,
the demand for loanable funds increases, the equilibrium interest rate will increase. Therefore, fewer
investment projects will be profitable and then causing a reduction in demand for capital goods.
Similarly, if the demand for capital goods increase the demand for loanable funds will also increase.
Assuming that the supply of loanable funds stays the same, the market clearing interest rate will go up.
In turn, the quantity demanded for capital will be lowered by a higher interest rate.
The demand for loanable funds shows the inverse relationship between the interest rate and the quantity
of loanable funds demanded. At lower interest rates, more loanable funds will be demanded than at higher
interest rates. The demand for loanable funds is a function of the demand for loans expressed by different
groups in the economy—consumers, businesses, and governmental institutions. These groups borrow more
when the interest rate is low because it is less expensive to borrow money. The supply of loanable funds
shows a positive relationship between the interest rate and the quantity of loanable funds supplied. The
higher the interest rate is, the more incentive households will have to supply loanable funds to financial
institutions. Consumers are more willing to forego consumption. When graphed, the demand for loanable
funds is a down sloping curve, and the supply of loanable funds is an up sloping curve. The intersection of
the supply curve and the demand curve for loanable funds determines the rate of interest.

LO 7 Explain what determines

economic rent

Economic rent is the price paid for the use of land (or natural resources) whose supply is basically fixed. The
first characteristic, therefore, is that the supply curve for land or natural resources is perfectly inelastic or fixed.
Land and natural resources also have no production costs and are a “free” gift of nature. Therefore, an increase in
economic rents provides no incentive function to bring forth more land. The second characteristic is that demand
is the only active determinant of economic rent. As demand rises and falls, economic rents will rise and fall.

LO 8 Explain what determines rent

differentials

Economic rent is the price paid for the use of land or natural resources whose supply is perfectly inelastic. The
supply of land is perfectly inelastic because it is virtually fixed in the quantity available. Supply has no influence
in determining economic rent. Demand is the active determinant of economic rent. As demand increases or
decreases, economic rent will increase or decrease given the perfectly inelastic supply of land. Economic rent
serves no incentive function given the fixed supply of land. It is not necessary to increase economic rent to bring
forth more quantity, as is the case with other resources. For this reason, economists consider economic rent to
be a surplus payment.

LO 9 Explain how rent functions as a

cost to the individual firm

From society’s perspective, economic rent is a surplus payment. It is a payment above and beyond what is ne-
cessary to get use of the resource. From a firm’s perspective, economic rent is a cost. Firms must pay economic
rent to bid the land it wants to use for its production away from alternative uses.

207

1 Which of the following is not a factor of
production?
A. A worker
B. A Construction Machine
Test Yourself
C. Land
D. Money
E. A robot
2 A firm is selling its product in a competitive
market for $10 each. It has the following MPL
schedule. If the market wage is $150, how many
units of labor does this firm hire?
L MPL MRPL
0 -
1 10
2 15
3 10
4 5
A. 1 Unit B. 2 Units
C. 3 Units D. 4 Units
E. 0 Unit
3 Assume that we are analyzing the labor
market for construction workers. Which of the
following causes a decrease in labor demand?
A. Development of a hand-held device which detects
if the concrete meets the required standards,
reducing the possibility of errors by workers.
B. An increase in house prices.
C. New construction companies in the market.
D. Development of a new construction platform which
automatically builds and places concrete blocks.
E. None of the above
4 Which of the following causes a decrease in
labor supply in the labor market of the banking
sector?
A. Increased wages in insurance sector.
B. Decreased wages in insurance sector.
C. More firms in banking sector.
D. Immigration of foreign workers with compatible
skills.
E. None of the above
208
Factors of Production and Factor Markets
5 In which of the following (ceteris paribus),
definitely increases employment in the labor market?
A. An increase in labor demand and an increase in
labor supply
B. An increase in labor demand and a decrease in
labor supply
C. A decrease in labor demand and an increase in
labor supply
D. A decrease in labor demand and a decrease in
labor supply
E. It is not possible to increase employment
6 In which case, a landowner will not receive
any rent?
A. If the supply curve lies entirely to the left of the
demand curve.
B. If the supply curve lies entirely to the right of
the demand curve.
C. If there is no tax on land.
D. If the supply and demand curves for land
intersect.
E. If the supply curve of land is perfectly inelastic.
7 Which of the following is correct?
A. Land rent is a cost to both society and firms.
B. Land rent is not a cost to either the society or
the firms.
C. Even though land rent is a cost from society’s
viewpoint, it is not a cost to firms.
D. Even though land has no production cost from
society’s viewpoint, rental payments are costs
to firm.
E. Since the supply curve of land is perfectly
inelastic, land rent is not considered as a cost
to firm.
8 The equilibrium interest rate equates:
A. Nominal and real interest rates
B. Taxes and government spending
C. The quantities demanded and supplied of
loanable funds
D. Consumption and saving
E. Money and bond rates
Introduction to Economics I
9 If the government were to pass a law
exempting interest on saving from taxation, what
would happen to the loanable fund market and
equilibrium interest rate?
A. Demand for loanable funds would increase and
the equilibrium interest rate would rise.
B. Demand for loanable funds would decrease and
the equilibrium interest rate would fall.
C. Supply of loanable funds would decrease and
the equilibrium interest rate would rise.
D. Supply of loanable funds would increase and
the equilibrium interest rate would fall.
E. Equilibrium interest rate would be unaffected.
10 Other things equal, which of the following
happens as a result of an increase in the productivity
of capital goods?
A. Increase the demand for loanable funds and
Test Yourself
increase the equilibrium interest rate.
B. Increase the demand for loanable funds and
decrease the equilibrium interest rate.
C. Increase the supply of loanable funds and
decrease the equilibrium interest rate.
D. Increase the supply of loanable funds and
increase the equilibrium interest rate.
E. Increase the demand and supply of loanable
funds and no change in interest rate.
209
 Factors of Production and Factor Markets

If your answer is not correct, please read the

1. D If your answer is wrong, please read the 6. B
part “Land Market”, including “Changes in
“Introduction” of the chapter once again.
Answer Key for “Test Yourself”

Demand” and study “Figure 8.14.”

If your answer is not correct, please read the part

2. B If your answer is not correct, please read the 7. D
“Land Market”, including “Alternative uses of
discussion about “Table 8.1” once again.
Land”.

If your answer is not correct, please read the If your answer is not correct, please read the
3. D 8. C
part “Determinants of Labor Demand” once part “Capital Market”, including “Market for
again. Loanable Funds”.

If your answer is not correct, please read the If your answer is not correct, please read the
4. A 9. D
part “Determinants of Labor Supply” once part “Capital Market”, including “Capital and
again. the Loanable Funds Market”.

If your answer is not correct, please read the If your answer is not correct, please read the
5. A 10. A
part “Equilibrium in Labor Market”, including part “Capital Market”, including “Capital
“Changes in Equilibrium”. and the Loanable Funds Market”.

210
Introduction to Economics I

How is a competitive firm’s labor demand related to

labor productivity?

Suggested answers for “Your turn”

Competitive firms hire labor as long as it brings more income to them than
its cost. In this sense MRPL (the revenue gained from an extra unit of labor)
is crucial. It, in turn, depends on its two components: MPL (extra production
your turn 1 made by the last unit of labor hired) and P (market price of the good that is
produced by the firm). The higher either of them, the higher the MRPL and,
naturally, the demand for labor by the firm.

What are the main factors determining labor

demand aside from the wage?

The Main determinant s of labor demand aside from wage are: the price of the
good or service produced by the labor, prices of other factors of production
your turn 2 that can be substituted for labor, technological changes, and the number of
firms in the market for labor.

What are the main factors determining labor

supply other than the wage?

The main factors determining labor demand aside from the wage are: the
society’s perception concerning work in general and in that particular sec-
your turn 3 tor, changes in equilibrium wage in other labor markets, and changes in
population.

On September 25, 2016, a truck operated by a computer in the

United States delivered its goods to its destination nearly 200
km away for the first time in history. A human driver was also
present for safety, but he did not need to intervene. How would
this development affect the future of truck drivers?

If the technology is implemented as it is expected, at least some of the truck

drivers (especially the ones operating on straightforward routes) will be replaced
by so-called “robot drivers”. This means less demand for labor, and accordingly,
your turn 4 a leftward shift in labor demand curve. Assuming that labor supply is the same,
there would be excess supply of labor at the current wage rate and wages would
need to go down, along with lower employment in the sector.

211
 Factors of Production and Factor Markets

An entrepreneur has $50,000 at hand now. That amount is the price of a machine he needs
to buy for his firm. There are two different machines and he needs to make a decision
about which one to buy. Both machines are expected have the annual operating costs of
Suggested answers for “Your turn”

$5,000. It is expected that the new machine will bring an additional revenue of $107,500
in sum over the next 5 years. However, each machine’s expected additional revenues are
different for each year. While the first machine’s expected earnings for the next five year
respectively are $15,000, $20,000, $22,500, $25,000 and $25,000, expected additional
revenues of second machine are $25,000, $25,000, $22,500, $20,000 and $15,000 for
each year. Finally, the first machine can be sold by $10,000, the second machine’s selling
price is $5,000. With a 10% interest rate on bond which projects should be chosen?

your turn 5

To answer this problem we need to calculate the net present value of these projects. Then our deci-
sion will be the picking the project with higher net present value. The following table shows the net
earnings for each project for the each year.

Project A Project B
(I) (II) (III) (IV) (V) (VI)
Year Revenue Operating Net Revenue Revenue Operating Net Revenue
($) Costs ($) ($) (II-I) ($) Costs ($) ($) (V-IV)
1 15,000 5,000 10,000 25,000 5,000 20,000
2 20,000 5,000 15,000 25,000 5,000 20,000
3 22,500 5,000 17,500 22,500 5,000 17,500
4 25,000 5,000 20,000 20,000 5,000 15,000
5 25,000 5,000 20,000 15,000 5,000 10,000
TOTAL 107,500 25,000 82,500 107,500 25,000 82,500

We assumed each project brings an additional revenue at the end of the first year. Don’t forget that
each machine has selling prices of $10,000 and $5,000 respectively. Since given interest rate is 10%,
we can calculate NPV for each project.

15000 − 5000 20000 − 5000 22500 − 5000 25000 − 5000

NPVA = −50000 + + 2
+ 3
+ 4
(1+ 0.1) (1+ 0.1) (1+ 0.1) (1+ 0.1)
+
(25000 + 10000) − 5000 = $16.923
5
(1+ 0.1)
25000 − 5000 25000 − 5000 22500 − 5000 20000 − 5000
NPVB = −50000 + + 2
+ 3
+ 4
(1+ 0.1) (1+ 0.1) (1+ 0.1) (1+ 0.1)
+
(15000 + 5000) − 5000 = $17.418
5
(1+ 0.1)
When we compare NPV of both projects, we see that both project A and project B have positive
values. That means both project can be undertaken. But an entrepreneur at this point will choose
the project with the higher NPV, which is Project B.

212
Introduction to Economics I

How is the equilibrium interest rate is determined in

the loanable funds theory?

Suggested answers for “Your turn”

The demand for loanable funds shows the inverse relationship between
the interest rate and the quantity of loanable funds demanded. At lower
interest rates, more loanable funds will be demanded than at higher
interest rates. The demand for loanable funds is a function of the demand
for loans expressed by different groups in the economy—consumers,
businesses, and governmental institutions. These groups borrow more
when the interest rate is low because it is less expensive to borrow money.
your turn 6 The supply of loanable funds shows a positive relationship between the
interest rate and the quantity of loanable funds supplied. The higher
the interest rate is, the more incentive households will have to supply
loanable funds to financial institutions. Consumers are more willing to
forego consumption. When graphed, the demand for loanable funds is
a down sloping curve, and the supply of loanable funds is an up sloping
curve. The intersection of the supply curve and the demand curve for
loanable funds determines the rate of interest.

It is argued that land is a “free” good. How can you support

this argument by using a supply and demand graph for land?
Land Rent ($)

0
Acres of Land (L)

your turn 7
D

In the graph drawn above represents demand for and supply of acres of land.
S curve as being perfectly inelastic supply curve represents the specific feature
of the land that is fixed in quantity. On the other hand, D stands for demand
curve for acres of land. It has similar to all other demand curves of factors
of production. The demand curve has been drawn as negatively sloped. The
equilibrium Land rent occurs where demand for and supply of acres of land
equal to each other. However, if the demand curve lies totally left of the
inelastic supply curve, these curves are not going to intersect each other. That
means the demand for specific acres of land is so low that, there is excess
supply of land. The important point here at what rent the excess supply of
land occurs. As seen in the graph this happens where the land rate is zero, thus
we can argue that for this sort of demand, the land is “free good”.

213
 Factors of Production and Factor Markets

It has been seen that a different land rent is charged for each of the two plots
of 500 acres of land that are used for growing rice and located in the same
county of a state. State some reasons to explain these differences.
Suggested answers for “Your turn”

The lands differ in quality and this difference can lead to differences in productivity.
The soil on one plot of land might be better than the one on another plot of land,
thereby increasing the yield per acre on that plot over the other plot of land.
your turn 8 These productivity differences will lead to differences in the demand for the two
plots of land. Since demand is the only determinant of land rent, the differing
demands will lead to different rents. There may also be location considerations
that may make one plot of land more attractive than the other plot of land, and
these preferences get expressed in the demand for each plot of land.

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