Chapter 1: What is Economics

Economics: Social science that studies the choices that individuals, businesses, governments, and entire
societies make as they cope with scarcity and the incentives that influence and reconcile those choices. (Parkin
& Robin, 2022)
1) Scarcity - Inability to satisfy all our wants
2) Choices - Due to scarcity, choices must occur
3) Incentives - Reward that encourages an actions or penalty that discourages and action

Microeconomics: Study of choices that individuals and businesses make and how they interact/influence in
markets and government.

Macroeconomics: Study of the performance of the national and global economies.

Two Big Economic Questions:

1) How do choices end up determining what, how, and for whom goods and services are produced?
2) When do choices made in the pursuit of self- interest also promote social interest?

Goods and services - objects that people value and produce to satisfy human wants and needs (Parkin & Robin,
2022)
WHAT? Goods and services (objects that people value and produce to satisfy human wants)
- They can vary depending on the country and time period
Ex. Canada 2% in agriculture vs. China 8% respectively, 28% in manufactured and 41% manufactured goods

HOW? Produced by using resources known as factors of production.

Factor of Production:
1) Land - Gift of nature (Earns rent)
2) Labour - Time and work effort that people devote to producing goods and services (Earns
wages)
Quality of labour depends on human capital - based on knowledge and skills from education,
training and experience.
3) Capital - Tools, instruments, machines, buildings, and other objects used to produce goods and
services (Earns interest)
4) Entrepreneurship - Human resources to organize land, labour and capital (Earns profit)
Ex. HP - originally came from students who pitched it to the professor who told them it would
never work.

WHOM? - Depends on the incomes that people earn for goods and services

Self Interest may lead to Social Interest based on choices

Based on the quantity, factors of production, and benefits of goods & services

Self Interest: Choices that are in your self - interest based on choices that you think are best for you
Social Interest: Choices that are best for society as a whole, based on efficiency and equity
Ex. Which one is best for social interest and self-interest if the PROF lives by the school?
1) Walk 30 mins to work <- Social interest, better for the environment, and society
2) Bike 15 mins to work
 3) Car (Drive) 5 mins to work <- Self-interest, faster, convenient

Economic Way of Thinking:

1) A choice is a tradeoff: giving up one thing to get
something else
2) People make rational choices by comparing benefits
and costs
3) Benefit is what you gain from something
4) Cost is what you must give up to get something
5) Most choices are “ how-much” choices made at the
margin
6) Choices respond to incentives

Choice is a tradeoff: places scarcity and implications, choice, at central stage (Parkin & Robin 2022)
● Ex. Either spending allowance money on a new jacket or a new pair of shoes
Rational Choice: compares cost and benefits and achieves the greatest benefit over cost for person making
choice
● The wants of a person drive the rationality of a choice
● Answers the question of what goods and services will be produced (answer: whatever people rationally
choose to buy)
Benefit: gain or pleasure that it brings and is determined by preferences
● Preferences: what a person likes and dislikes and intensity of those feelings
Cost: something that you have to give up on
Opportunity cost: the highest valued alternative that must be given up to get something
Example:
1) The things you can’t afford to buy if you purchase the AC/DC tickets
2) The things you can’t do with your time if you go to the concert

Marginal Benefit: To make a choice at the margin - evaluate the consequences of making incremental changes,
benefit from pursuing an incremental increase in an activity
● Measured by the amount that a person is willing to pay for an additional unit of good or service
(additional benefit of buying one more unit of the good or service)

Marginal Cost: The opportunity cost of pursuing an incremental increase in an activity

Marginal benefit > Marginal cost

Your rational choice is to do more of that activity
● △ in marginal cost or change in marginal benefit △ the incentives that we face and leads us to
change our choice
● Central idea of economics is that we can predict how choices will change by looking at △ by
looking at changes in incentives (Parkin & Robin 2022)

Positive Statements (what is) Normative Statements (what ought to be)

 ● Can be tested by checking it against the facts, ● Depends on values and cannot be tested, can
might be right or wrong agree or disagree with it
● Ex. One Minute Maid apple juice box contains ● Ex. Apple juice is better than orange juice.
21g of sugar.

Economic Models
● Description of some aspect of the economic world that includes only those features that are needed for
the purpose at hand
● Tested by comparing its predictions with the facts (Parkin & Robin 2022)
● Economists test economic models using natural experiments, statistical investigations and economic
experiments
 Chapter 1: Appendix
Graphs:
● Reveals a relations, by representing a quantity as a distance
● Zero point is origin
○ Vertical line is y-axis
○ Horizontal line is x-axis
Scatter Diagram:
● Plots the value of one variable against the value of another variable for a number of different values of
each variable
● Relationship between two variables

Variables that Move in Variable that Move in Variable that have a Variable that are
the SAME Direction OPPOSITE Direction MAXIMUM or a UNRELATED
MINIMUM

● Positive ● Negative ● Relationships are ● Emphasize

relationship/ relationship/inver positive over part that two
Direct relationship se relationship of their range and variables are
● Line slopes ● Line slopes negative over the unrelated
upwards downwards other part

Slope:
● Relationship is the change in the value of the variable measured on the y-axis divided by the change in
the value of the variable measured on the x-axis
● ∆ Capital DELTA – represent change in OR Rise or Run (△y / △x)
● Calculate the slope of a curved line either at the point or across an arc
● Slope Across an Arc: The average slope of a curved line across an arc is equal to the slope of a straight
line that joins the endpoints of the arc.

Multiple Variables:
● When two or more variables are involved, plot relationship between two variables while holding other
variables constant
● Ceteris Paribus: if all other relevant things remain the same

Linear Equations:
● y = ax + b
● a and b are fixed numbers called constants
● y and x are variables
● When a is zero, y=b, therefore, b is the y intercept
● a is the slope of the line (△y / △x)
● There is a positive relationship when the slope is positive and negative relationship when slope is
negative
 Chapter 1 Practice Questions

1. The inability to spend the night studying and hanging out with friends at the same time is an example of
a. Choices
b. Scarcity
c. Preference
d. Incentive

2. Fines for littering are not considered incentives

a. True
b. False

3. The following are examples of microeconomic questions except

a. Why is Company X producing more of product A this year?
b. Why are consumers purchasing more reusable masks and less disposable masks?
c. What caused the increase in unemployment rate in Canada this year?
d. Which product should Company Y produce more of to gain competitive advantage?

4. Hiring 50 additional employees allowed a company to increase its production by 100 units per day. This
is an example of the _____ part of economic question 1.
a. How
b. Whom
c. What
d. How and what

5. Manufacturing buildings are examples of which of the following factors of production?

a. Capital
b. Entrepreneurship
c. Energy
d. Land
e. Labour

6. Driving 5 minutes to get to the mall instead of walking for 30 minutes is driven by
a. Social interest
b. Scarcity
c. Self interest
d. None of the above

7. Which of the following is a false statement

a. Rational choices help answer the question of what goods and services should be produced
b. Scarcity exists only in a business environment
c. Opportunity cost of something is giving up the second most valued alternative
d. a & c
e. b & c
8. Which of the following is a positive statement
a. Licorice does not taste good
b. Autumn is better than summer
c. The temperature is colder in the winter than in the summer
d. Pretzels are better than popcorn

9. If the increase of one variable results in the increase of another variable, they have a
a. Positive relationship
b. Negative slope
c. No relationship
d. Negative relationship

10. Which of the following earns profit.

a. Land
b. Capital
c. Labour
d. Entrepreneurship

11. Which of the following is true for the equation y=7-5x

a. The slope is 7 and the y-intercept is -5
b. The slope is 7 and the y-intercept is 5/7
c. The slope is 5 and the y-intercept is 7
d. The slope is -5 and the y-intercept is 7

12. Which of the following explains why Mila would purchase her 6th pencil
a. Scarcity
b. Opportunity cost
c. Marginal benefit
d. Marginal cost

1. DeJuan, Joseph.(2022, September 13).Ch01-Q&A [Lecture notes, PDF document]. UW Learn

https://learn.uwaterloo.ca/d2l/le/content/849358/viewContent/4586918/View

2. Parkin, Michael and Robin Bade.(2021).Microeconomics: Canada in the Global Environment, 10th Edition. Pearson Education Canada.

3. Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment, 11th Edition. Pearson Education Canada.
 Chapter 2: The Economic Problem
Production Possibilities and Opportunity Cost:
Production Possibilities Frontier (PPF): is the boundary between goods
that can be produced and goods that can’t be produced. Represented by
the blue curve.
● Focus on two goods at a time, and hold the quantities of all other
goods constant
● Ceteris Paribus: latin for all other things constant
● Shows the maximum combination of outputs (g/s) that can be
produced with given resources and technology
● On PPF – every choice along the PPF involves a tradeoff

Points on the Graph:

1) On the curve: represents a point of production efficiency
2) Inside the curve: represents points that are not efficient
3) Outside the curve: unattainable in the present

Opportunity Cost: next best alternative forgone to pursue action/good – not

price/$$$ with time value
● Ratio between the possible options
● As opportunity cost increases, the PPF starts to bow outward
○ As quantity produced increases, the opportunity cost
increases
○ Some PPFs do not follow this rule → have a linear (straight)
line meaning opportunity cost remains constant

Allocative Efficiency: when we cannot produce more of one good without

giving up some other good that is preferred more
● Always involves producing at a point along the PPF, so all allocatively efficient points are also production
efficient
● Means the marginal benefit of producing one additional unit of a good exceeds the marginal cost in
forgoing additional unit(s) of another different good

Production Efficiency: any point along the PPF where all resources are being used efficiently
Comparative Advantage: if one can perform the activity at a lower
opportunity cost than another
Absolute Advantage: if that person is more productive than another,
both in terms of quantity produced and the opportunity cost from
producing

Economic Growth: expansion of production possibilities - an increase in

the standard of living. Two types:
1) Technological change - development of new goods and of
better ways of producing g/s
 2) Capital Accumulation - growth of capital resources which includes human capital
Costs:
1) Decrease production of consumption g/s to use resources in Research and Development
2) Economic growth is not free
3) OC of economic growth is less current consumption

Economic Coordination:
Firm: economic unit that hires factor of production and organizes those factors to produce and sell goods and
services
Market: any arrangement that enables buyers and sellers to get information and do business with each other
Property rights: social arrangements that govern the ownership, use, and disposal of resources, goods, or
services
Money: is any commodity or token that is generally acceptable as a means of payment
 Chapter 2 Practice Questions

1. What does the PPF graph illustrate?

a. The resources used to produce the goods or services
b. The prices (in dollars)
c. The cost to produce the goods (in dollars)
d. The production alternatives for an economy

2. A point outside the PPF is

a. Efficient
b. Inefficient
c. Unattainable in the present
d. Attainable and efficient
e. non-existent

3. Which of the following causes an inward shift of the PPF?

a. The discovery of a needed vaccine
b. The improvement of technological knowledge
c. Skilled workers leaving the country
d. Increase in funding for training workers

4. The growth of capital resources is

a. Capital accumulation.
b. Technological change.
c. Depreciation.
d. Opportunity cost.

5. When making economic decisions, economists will try to ensure that they are
a. Efficient
b. Effective
c. Quick and effective
d. Efficient and effective

6. Movement along the PPF demonstrates reallocation of resources and_____

a. Opportunity cost
b. Economic growth
c. New access to natural resources
d. None of the above

7. A tradeoff exists when

a. We move from a point within a PPF to a point on the PPF
b. We move from a point on the PPF to a point within the PPF
c. The PPF shifts towards the origin
 d. We move along the PPF

8. Allocative efficiency occurs when

a. Opportunity costs are equal
b. Goods and services produced at the lowest possible cost and are in the quantities that provide
the greatest possible benefit.
c. Opportunity cost is zero
d. b) and c)

9. With allocative efficiency, marginal cost

a. Equals marginal benefit.
b. Is at its maximum.
c. Equals Opportunity Cost.
d. Is at its minimum.

10. What does a concave PPF demonstrate about opportunity cost?

a. They are steadily decreasing as you give up one good for another
b. They are steadily increasing as you give up one good for another
c. They are staying the same as you give up one good for another
d. Not measurable

11. What is the opportunity cost of moving away from home and going to university?
a. Tuition and book costs only
b. Cost of living (residence fees, food, etc.)
c. Forgone salary of working full-time
d. Tuition, book costs, cost of living, and forgone salary

12. If a pizza costs $12 and a hamburger cost $3, the opportunity cost of 8 hamburgers is
a. 1 pizza
b. 2 pizzas
c. 6 hamburgers
d. $24

Use the following information to answer questions 13 & 14.

In a day, Mark can produce either 32 loaves of bread or 4 kilograms of butter. In a day, Sarah can produce either
8 loaves of bread or 8 kilograms of butter.

13. The opportunity cost of producing 1 loaf of bread is

a. 4 kilograms of butter for Mark and 8 kilograms of butter for Sarah.
b. 1/8 kilogram of butter for Mark and 1 kilogram of butter for Sarah.
 c. 20 mins for Mark and 1 hour for Sarah.
d. Not calculable with given information.

14. Which of the following statements is true?

a. Sarah has an absolute advantage in butter production.
b. They gain from trade if Mark specializes in butter production and Sarah specializes in bread
production.
c. After specialization, total consumption will be 32 loaves of bread and 8 kilograms of butter.
d. Mark has the lower opportunity cost of producing bread, while Sarah has the lower opportunity
cost of producing butter.

15. Individuals A and B can both produce goods X and Y. Individual A has a comparative advantage in the
production of X if
a. The amount by which A must reduce production of Y is less than the amount by which B must
reduce production of Y to produce an additional unit of X.
b. The amount by which A must reduce production of Y is more than the amount by which B must
reduce production of Y to produce an additional unit of X.
c. B has superior knowledge about how to produce X.
d. A is faster than B at producing X.

16. Canada has an absolute advantage in producing a good when we

a. Have a comparative advantage in producing that good over the U.S.
b. Can produce the good at a lower opportunity cost than anyone else.
c. Can produce more of that good than anyone else, using the same quantity of inputs.
d. Have better technology than anyone else.

17. Marginal cost is

a. The opportunity cost of producing one more unit of a good or service.
b. Unrelated to the PPF.
c. Always equals marginal benefit.
d. Always greater than marginal benefit.

18. The marginal benefit curve for a good

a. Is upward-sloping.
b. Is bowed outward.
c. Demonstrates the benefit a firm receives from producing one more unit of that good
d. Demonstrates the most a consumer is willing to pay for one more unit of that good.

19. What are the 4 complementary social institutions?

a. Firms, markets, money, entrepreneurship
b. Firms, money, land, capital
c. Firms, property rights, markets, natural resources
d. Firms, markets, property rights, money
e. Land, Labour, Capital, Entrepreneurship

20. The flows in the market economy that go from firms to households are _______.
 a. The income flows of wages, rent, interest, and profits and the flow of expenditure on goods and
services.
b. The real flows of goods and services and the income flows of wages, rent, interest and profits.
c. The real flows of goods and services and the real flows of labour, land, capital and
entrepreneurship.
d. All flowing through goods markets.
e. All flowing through factor markets.

Parkin, Michael and Robin Bade.(2021).Microeconomics: Canada in the Global Environment, 10th Edition. Pearson Education Canada.
 Chapter 3: Demand and Supply
Competitive Market: A market that has many buyers and many sellers so no single buyer or seller can influence
the price
Relative Price: The ratio of its price to the price of the next best alternative good. Contrast money price, which
represents the actual monetary price of a good.

Law of Demand: Ceteris Paribus, the higher the price of a good, the smaller the quantity demanded
● Demand is when a person wants a good, can afford a good, and has made a plan to purchase or acquire
it
● Changes in price affect the demand because
○ Substitution Effect: When the relative price of a good/service rises, people seek substitutes, so
the quantity demanded of the good/service decreases
○ Income Effect: When the price of a good rises relative to income, people cannot afford as much,
so the quantity demanded of the good/service decreases
● Demand curve is a willingness-to-pay curve

Demand vs. Quantity Demanded

● Demand refers to the entire relationship between price and quantity.
Change in demand: Shifts the curve.
● Quantity demanded refers to the amount customers plan to buy at a
certain price at a certain time. Change in quantity demanded involves
moving along the demand curve.

Changes in Demand
Price of Related Substitute: A good that can be used in place of another good (Price of Substitute ↑
Goods then Demand of Good ↑)
Complement: A good that can be used with another good (Price of Complement ↑
then Demand of Good ↓)

Expected Future (Future Price Expected to ↑ then Demand of Good ↑)

Prices (Future Price Expected to ↓ then Demand of Good ↓)

Income Normal Good: Good that increases in demand as income increases (Income ↑ then
Demand of Good ↑)
Inferior Good: Good that decreases in demand as income increases (Income ↑ then
Demand of Good ↓)

Expected Future (Income Expected to ↑ then Demand ↑)

Income and Credit (Income Expected to ↓ then Demand ↓)

Population (Population ↑ then Demand ↑)

(Population ↓ then Demand ↓)

Preferences (Good becomes more Preferred then Demand ↑)

(Good becomes more Preferred then Demand ↓)
Law of Supply: Other things remaining the same, the higher the price of the good, the greater the quantity
supplied
● Supply is when a firm
○ Has the resources and technology to produce it
○ Can profit from producing it
○ Has made a definitive plan to produce and sell it
● Changes in price affect supply because
○ Marginal cost to produce good increases as quantity increases
● Supply curve shows the lowest price someone is willing to sell which is the marginal cost

Supply vs. Quantity Supplied

● Supply refers to the entire relationship between price and quantity. Change in supply shifts the curve.
● Quantity supplied refers to the amount producers plan to sell at a given price. Change in Q supplied
involves movement along the curve.

Changes in Supply
Prices of Factors (Price of Factor of Production ↑ then Supply ↓)
of Production (Price of Factor of Production ↓ then Supply ↑)

Prices of Related Substitute: A good that can be produced with the same resources (Price of
Goods Produced Substitute ↑ then Supply ↓)
Complementary: A good that can be produced together with the other good (Price
of Complement ↑ then Supply ↑)

Expected Future (Future Price Expected to ↑ then Supply ↓)

Prices (Future Price Expected to ↓ then Supply ↑)

# of Suppliers (# of Suppliers ↑ then Supply ↑)

(# of Suppliers ↓ then Supply ↓)

Technology (Technology Advances then Supply ↑)

State of Nature (Natural Disaster then Supply ↓)

Equilibrium Price: Price at which quantity demanded equals quantity
supplied
Equilibrium Quantity: Quantity at which quantity demanded equals
quantity supplied
Surplus: Quantity supplied is greater than quantity demanded
● At a price of $2.00, there is a surplus of 6 million bars
● Price goes down to bring the price to equilibrium

Shortage: Quantity demanded is greater than the quantity supplied

● At a price of $1.00, there is a shortage of 9 million bars
● Price goes up to bring the price to equilibrium

Effects of Change of Demand and Supply

P = Equilibrium Price, Q = Equilibrium Quantity, D = Demand, S = Supply
Increase in Demand Decrease in Demand Increase in Supply Decrease in Supply

P ↑ Q ↑ D ↑ S -- P ↓ Q ↓ D ↓ S -- P ↓ Q ↑ D -- S ↑ P ↑ Q ↓ D -- S ↓

Effects of Change of Demand and Supply at the SAME TIME

Both Demand and Supply Both Demand and Supply Demand Increases and Demand Decreases and
Increase Decrease Supply Decreases Supply Increases

P?Q↑D↑S↑ P?Q↓D↓S↓ P↑ Q ? D ↑ S ↓ P↓Q?D↓S↑

Price Uncertain because Price Uncertain because
Demand Increases Price Demand Decreases Price
/ Supply Decreases Price / Supply Increases
Supply
Quantity Uncertain Quantity Uncertain
because Demand because
Increase Quantity / Demand Decrease
Supply Decreases Quantity / Supply
Quantity Increase Quantity
 Chapter 3 Practice Questions

1. Good X and Good Y are substitutes. An increase in the price of Good X will result in
a. A decrease in demand of Good Y
b. A decrease in the quantity demanded of Good Y
c. An increase in demand of Good Y
d. An increase in the quantity demanded of Good Y

2. A decrease in the quantity supplied is represented by a

a. Rightward shift in the supply curve
b. Leftward shift in the supply curve
c. Movement up the supply curve
d. Movement down the supply curve

Use the figure above to answer questions 3-5

3. In the figure above, which movement represents an increase in quantity demanded but not an increase in
demand.
a. Point a to point d
b. Point a to point e
c. Point b to point c
d. Point a to point b

4. In the figure above, if the good is an inferior good, which movement reflects an increase in income?
a. Point b to point a
b. Point a to point d
c. Point a to point c
d. Point a to point b

5. In the figure above, which movement reflects a decrease in the price of a complement product to the
good.
a. Point a to point c
b. Point a to point b
c. Point a to point d
 d. Point a to point e

Use the figure above to answer questions 6-9

6. The figure above represents the market for kale. Scientists have recently said that eating kale is good for
you. As a result,
a. Demand curve stays the same, and the supply curve shifts from S1 to S2
b. Demand curve shifts from D1 to D2, and the supply curve shifts from S1 to S2
c. Demand curve shifts from D2 to D1, and the supply curve shifts from S2 to S1
d. Demand curve shifts from D1 to D2, and the supply curve stays the same.

7. The figure above represents the market for cigarettes. If the cost of tobacco leaves increases and,
simultaneously, people become more concerned that cigarettes cause lung cancer, what happens to the
equilibrium price and quantity?
a. Price goes up, quantity goes down.
b. Price is unknown, quantity goes down
c. Price goes down, quantity is unknown
d. Price goes down, quantity goes down.

8. The figure above represents the market for oil. Producers expect the price of oil to rise in the future. As a
result,
a. Demand curve shifts from D1 to D2, supply curve stays the same
b. Demand curve shifts from D2 to D1, supply curve stays the same
c. Supply curve shifts from S1 to S2, demand curve stays the same.
d. Supply curve shifts from S2 to S1, demand curve stays the same.

9. The figure above represents the market for bubble tea. People become concerned that drinking too
much bubble tea is bad for you. What happens to the equilibrium price and quantity?
a. Price goes down, quantity is unknown.
b. Price is unknown, quantity remains the same,
c. Price goes down, quantity goes down.
d. Price goes up, quantity goes down.
 Use the figure above to answer questions 10-13
10. The equilibrium price in the above figure is
a. $25
b. $20
c. $15
d. $10

11. At a price of $5, there is

a. A surplus of 400 units
b. A shortage of 400 units
c. A quantity supplied of 100 units
d. An equilibrium quantity of 500 units

12. If the figure above represents an inferior good and income rises, then the equilibrium quantity will be
a. Equal to 300 units
b. More than 300 units
c. Less than 300 units
d. Inconclusive

13. If the cost of the resources used to produce the good above increases, then the equilibrium price will be
a. Equal to $15
b. More than $15
c. Less than $15
d. Inconclusive
 Chapter 4: Elasticity

Definition of Elasticity: how responsive one factor is to other factors

Independent of units of measurement and is based on ratios

Price Elasticity of Demand

Slope Formula: (ΔQ/Qaverage)/( ΔP/Paverage) or (% change in quantity demanded)/(% change in price)
● All price elasticity of demand measures will be negative because of the law of demand – price and
quantity are negatively related. However, it’s the magnitude that reveals how responsive the quantity
change has been to a price change

What does the price elasticity mean and what does it look like?
Name Description

Perfectly Inelastic Demand |Ed| = 0

Quantity demanded does not react to price (ex.

Insulin)

Unit Elastic Demand |Ed| = 1

Quantity demanded changes at the same rate as

price

Perfectly Elastic Demand |Ed| = ∞

Quantity demanded reacts radically to price (ex. Soft

drink from 2 campus machines located side by side)

Inelastic Demand 0 < |Ed| < 1

Quantity demanded changes slower than price (ex.

Food, shelter)

Elastic Demand 1 < |Ed| < ∞

Quantity demanded changes faster than price (ex.

Automobiles)

What makes a good’s demand elastic or inelastic?

Closeness of substitutes The more substitutes a good has and the closer these substitutes
are, the more elastic a good is
 Proportion of income The larger of a share an income’s price takes up, the more elastic a
good is (for example, vacations take up a large % of a person’s
income, meaning vacations are elastic)

Importance of goods The less essential a good is, the more elastic it is (for example,
jewelry is non-essential, so it’s elastic)

Time elapsed since price The more time customers have to react to a price change, the more
change elastic the good is

Revenue and elasticity

● Price changes affect revenue in different ways depending on elasticity
● If the good is elastic, revenue increases as you decrease price
● If the good is inelastic, revenue increases as you increase price
● You can observe the revenue change to determine elasticity

Your demand and elasticity

● If your demand is elastic, your purchase amount will increase by more than 1% with a 1% price cut
● If your demand is inelastic, your purchase amount will increase by less than 1% with a 1% price cut

Income Elasticity of Demand: Measure of how quantity of good responds to change in income
Formula: (ΔQ/Qaverage)/( ΔI/Iaverage) or (% change in quantity demanded)/(% change in income)

Classification of Goods
● Normal Good: If your income elasticity is greater than 0 .: the good is income elastic (greater than 1) OR
income inelastic (less than 1) → increasing income also increases quantity purchased
● Inferior Good: If your income elasticity is less than 0 .: the good is inferior meaning that decreasing
income increases quantity (i.e: fast food), and vice versa

Cross elasticity of demand: Measure of how quantity of good demanded changes based on the price of another
good
Formula: (ΔQ/Qaverage)/( ΔP/Paverage) or (% change in quantity demanded)/(% change in other good’s price)
● If cross elasticity is greater than 0 .: the two goods are substitutes; increase in the price of other good
increases demand
● If cross elasticity is less than 0 .: the two goods are complements; increase in the price of other good
decreases demand

Elasticity of supply: Measures how quantity supplied responds to price change:

Formula: (ΔQ/Qaverage)/( ΔP/Paverage) or (% change in quantity supplied)/(% change in good’s price)
● Vertical line is non-elastic; supply is not affected by price change
● Any slanted line is unit-elastic; supply is affected by price change
● Horizontal line is infinitely elastic; decrease in price could cause cessation of supply

Factors in supply elasticity

● Resource substitution → the easier it is to use the resources for the product in other products, the more
supply elastic
● Time frame → the more time passes after a change in price, the more elastic the quantity supplied of a
good is.
○ Momentary supply is perfectly inelastic.
○ Short-run supply is somewhat elastic.
○ Long-run supply is most elastic.
 Chapter 4 Practice Questions

1. If a good’s demand curve is a horizontal line, then the good has

a. Infinite price elasticity of demand
b. Price elasticity of demand equal to zero
c. Zero income elasticity
d. Price elasticity likely to fall in short run

2. Which one of the following has the most inelastic demand?

a. Apples
b. Peanut butter
c. Gasoline
d. Insulin for a diabetic

3. The price of beef increases by 20%. Beef producers are able to increase productivity of their herds by
15%. What’s the elasticity coefficient for beef?
a. 1.95
b. 0.8
c. 0.75
d. 1.44

4. Which of the following factors influences the elasticity of demand?

a. Income
b. Preferences
c. The closeness of substitutes
d. The closeness of complements

5. If a rise in price leads to a decrease in total revenue, the price elasticity of demand is
a. Negative
b. Zero
c. Greater than zero but less than 1
d. Equal to 1
e. Greater than 1

6. When the price of good X goes up, the quantity demanded for Y goes down. Which of the following is
true?
a. The two goods are complementary
b. The two goods are normal goods
c. The cross-price elasticity coefficient is positive
d. The cross-price elasticity coefficient is zero

7. An increase in demand with a highly inelastic supply will result in:

a. Price falling by a lot and quantity rising by a small degree
b. Price rising by a small degree and quantity rising by a lot
c. Price falling by a small degree and quantity falling by a lot
 d. Price rising by a lot and quantity rising by a small degree

8. A shift in demand would not affect price when supply is

a. Perfectly inelastic
b. Unit elastic
c. Perfectly elastic
d. Of zero elasticity

9. When the price elasticity of demand is _____, demand for the good is perfectly inelastic.
a. Equal to infinity
b. Greater than 1
c. Equal to 1
d. Between 1 and zero
e. Equal to zero

10. When the price elasticity of demand is _____, demand for the good is elastic.
a. Equal to infinity
b. Greater than 1
c. Equal to 1
d. Between zero and 1
e. Equal to zero

11. _________ indicates when the demands for two or more goods are related.
a. The cross elasticity of demand
b. The income elasticity of demand
c. The price elasticity of demand
d. The normal elasticity of demand

12. The price of product A falls from $22 to $15. During this time, product B’s quantity demanded rises from
42 to 65. Product C’s quantity demanded rises from 68 to 95. Which good is a greater compliment to
product A?
a. Product B
b. Product C

13. Luxury goods tend to have income elasticities of demand that are
a. Greater than 1
b. Greater than zero but less than 1
c. Negative
d. Less than the income elasticity of demand for normal goods

14. If good X is a complement of good Y, then the cross elasticity of demand is

a. Infinity
b. Positive
c. Zero
d. Negative
15. If good X is a substitute to good Y, then the cross elasticity of demand is
a. Infinity
b. Positive
c. Zero
d. Negative

16. Short-run supply is

a. More elastic than monetary supply
b. Less elastic than long-run supply
c. More elastic than both monetary and long-run supply
d. a) and b)

17. Long-run supply is

a. Less elastic than monetary supply
b. More elastic than short-run supply
c. More elastic than both monetary and short-run supply
d. a) and b)

18. If the supply curve passes through the origin, then the price elasticity of supply is
a. Zero
b. -1
c. 1
d. Greater than 0 but less than 1
e. Greater than 1

19. The price of a surfboard In Hawaii used to be $400, but recently, due to the increase of tourists, the price
has increased to $450. Waterskis, which are also popular in Hawaii, their total amount sold last year was
$10,000. This year stores are expecting to sell 12,000 waterskis. What is the cross Elasticity of demand
for waterskis and surfboards?
a. 1.54
b. 2.71
c. -2.71
d. 0.36
 Chapter 5: Efficiency and Equity
Resource Allocation Methods
● Allocation through market price (decentralized market planning approach): people are willing and able
to buy the resource and get the resource. Consider how strongly a person wants a G/S through
willingness to pay.
● Allocation via a Command System (centralized market planning approach / planned market approach):
allocated by the command of someone in authority.
○ Works well in organizations when very clear lines of authority exist.
■ Difficult to execute in entire economy, when # of transactions and activities involved is
large
● Allocation by Majority Rule: allocated by majority vote.
○ Works well when large # of individuals are impacted by a decision or when self-interest leads to a
bad decision
● Allocation by contest: allocated to winner.
○ Works well when the efforts of “players” are hard to monitor and reward directly
● First-come, first-served allocation: allocated to those who come first in a line.
○ Works best when scarce resources can serve just 1 person at a time in sequence
● Lottery allocation: allocated to those with winning numbers, draw lucky cards, or come lucky.
○ Works well when there’s no effective way to distinguish among potential users of a scarce
resource.
● Allocation according to personal characteristics: allocated to those with the “right” characteristics (e.g.
kidney transplant to best suited patient).
● Allocation by force: allocated through force, like war and theft.
○ Provides an effective way of allocating resources (ex. State transfers wealth from rich to poor
through forced taxes).

Demand, Willingness to Pay, and Value

● Marginal Benefit: Value of one more unit of a good or service
● Value: Measured as the maximum price that a person is willing to pay
○ Willingness to pay determines demand
○ A demand curve is a marginal benefit curve

Individual Demand and Market Demand

● Individual Demand: Relationship between the price of a good and the quantity demanded by one person
● Market Demand: Relationship between the price of a good and the quantity demanded by all buyers in
the market
 ● Market Demand Curve: Horizontal sum of individual demand curves

Consumer Surplus
● Consumer Surplus: The excess of the benefit received from a good over the amount paid for it
● Calculated as the marginal benefit (or value) of a good minus its price, summed over the quantity bought
○ Measured by the area under the demand curve and above the price paid, up to the quantity
bought
● E.g. When the market price is $1

● To use consumer surplus in a practical manner, firms identify the benefit obtained by consumers, and
leverage this information in defining a pricing strategy for their goods/services. It helps firms understand
net benefit/change when the price of goods/services changes.

Supply, Cost, and Minimum Supply-Price

● Cost: What the producer gives up
● Price: What the producer receives
● Marginal Cost
○ Cost of one more unit of a good or service
○ Minimum price a firm is willing to accept
○ Minimum supply-price determines supply
■ A supply curve is a marginal cost curve

Individual Supply and Market Supply

 ● Individual Supply: Relationship between the price of a good and the quantity supplied by one producer
● Market Supply: Relationship between the price of a good and the quantity supplied by all producers
● Market Supply Curve: Horizontal sum of the individual supply curves
Ex. Maria and Max are the only producers of pizza.

Producer
Surplus
● Producer Surplus: The excess of the amount received from the sale of a good over the cost of producing
it
● Calculated as the price received for a good minus the minimum-supply price (marginal cost), summed
over the quantity sold
○ Measured by the area below the market price and above the supply curve, summed over the
quantity sold
○ E.g. The market price of a pizza is $15

○
○ Red areas show the cost of producing the pizzas sold
■ Producer surplus is the value of the pizza sold in excess of the cost of producing it
○ To use producer surplus in a practical manner, firms and governments identify the benefit
obtained by engaging in market transactions to define a pricing strategy and help them
understand net benefit and change when price of G/S changes.
Efficiency of Competitive Equilibrium
● A competitive market creates an efficient allocation of resources at equilibrium
○ Equilibrium: quantity demanded = quantity supplied
● Resources are used efficiently when marginal social benefit (MSB) = marginal social cost (MSC)
○ Marginal Social Benefit: Society’s marginal benefit
○ Marginal Social Cost: Society’s marginal cost
● When the efficient quantity is produced, total surplus (consumer surplus + producer surplus) is
maximized
○ Goods and services are produced at the lowest cost in quantities that produce the greatest value

● When Productions is
○ Less than the equilibrium quantity, MSB > MSC
○ Greater than the equilibrium quantity, MSB < MSC
○ Equal to the equilibrium quantity, MSC=MSB

Market Failure
● Market Failure: When a market delivers an inefficient outcome
● Can occur because
○ Too little of an item is produced (underproduction)
○ Too much of an item is produced (overproduction)
● Results in a deadweight loss to society (decrease in total surplus)
Underproduction and Overproduction
Underproduction Overproduction

● If production is restricted to an amount less ● If production is expanded to an amount

than the equilibrium quantity, there is greater than the equilibrium quantity, a
underproduction and the quantity is deadweight loss arises from
inefficient overproduction

● A deadweight loss equals the decrease in ● This loss is a social loss

total surplus; the grey triangle

● This loss is a social loss

Sources of Market Failure

● In competitive markets, underproduction or overproduction arises when there are
○ Prices and quantity regulations
○ Taxes and subsidies
○ Externalities (third parties that affect the market)
○ Public goods (consumed by everyone without charge, but financed by the consumer) and
common resources
○ Monopoly
○ High transactions costs

Is the Competitive Market Fair?

Ideas about fairness can be divided into two groups:
1. It’s Not Fair if the Results Aren’t fair
○ Utilitarianism: The idea that only equality brings efficiency
■ Should strive to achieve “the greatest happiness for the greatest number”
○ If everyone gets the same marginal utility from a given amount of income and if the marginal
benefit of income decreases as income increases, then taking a dollar from a richer person and
giving it to a poorer person increases the total benefit
○ Only when income equally distributed has the greatest happiness been achieved
2. It’s Not Fair if the Rules Aren’t Fair
○ Based on the symmetry principle
○ Symmetry Principle: Requirement that people in similar situations be treated similarly
○ Equality of opportunity, not equality
■ Robert Nozick suggested that fairness is based on two rules:
 1. The state must create and enforce laws that establish and protect private property
2. Private property may be transferred from one person to another only by voluntary
exchange
■ This means that if resources are allocated efficiently, they may also be allocated fairly
 Chapter 5 Practice Questions

1. Which method of resource allocation should be used when there is no effective way to distribute scarce
resources?
a. Allocation via a Command System
b. Allocation by force
c. Allocation by Lottery
d. First-come, first-served allocation

2. Which method of resource allocation is difficult to execute when there's a large number of transactions
and activities involved, and doesn’t have a clear line of authority?
a. Allocation via a Command System
b. Allocation by market price
c. Allocation by personal characteristics
d. Allocation by contest

3. What is market demand?

a. The average of quantity demanded of a good by all buyers in the market
b. The relationship between price of a good and the quantity demanded by all buyers in the market
c. The relationship between price of a good and the quantity demanded by all suppliers in the
market
d. The relationship between the quantity demanded by all buyers and quantity demanded by all
suppliers in the market

4. Which aspect is NOT true for marginal cost?

a. Cost of one more unit of good or service
b. Minimum price a firm is willing to accept
c. The marginal cost curve is the supply curve
d. Maximum supply-price

5. What happens at market equilibrium?

a. There’s deadweight loss
b. The quantity demanded equals quantity supplied
c. There’s more social benefit than social cost
d. There’s inefficient allocation of resources

6. The restaurant sells the first hamburgers at $8, but customers are willing to pay $10. The hamburger’s
marginal cost for producing the first burger is $4. What is the producer surplus on that hamburger?
a. $2
b. $4
c. $10
d. $6

7. An idea of fairness that emphasizes income equality is

a. Utilitarianism
b. Fair opportunity
 c. Symmetry principle
d. Fair rules

8. When does overproduction occur?

a. MSB > MSC
b. MSB < MSC
c. MSB = MSC

9. What is the consumer surplus?

a. AKMN
b. RPL
c. BRL
d. BPL

10. A market that has low transaction costs results in

a. Overproduction
b. Underproduction
c. Increase of tax
d. Zero deadweight loss

11. Which is NOT a source of market failure?

a. Price and quantity regulation
b. Tax and subsidies
c. No public goods
d. High transaction costs

12. What is deadweight loss?

a. The decrease in total surplus
b. The decrease in consumer surplus
c. The decrease in producer surplus
d. The increase in total surplus
13. A country taxes their wealthy class, resulting in their wealth going towards impoverished individuals in
their country. This would be an example of:
a. Allocation by majority rule
b. Allocation by contest
c. First-come, first-served allocation
d. None of the above
 Chapter 6: Social Welfare
Price Control: free market in allocative efficiency, it does not necessary mean all producers = consumers or
society benefits b/c the government will institute some form of price control

Price Ceiling: regulation that makes it illegal to charge a price

higher than a specified level
● Rent Ceiling set below equilibrium creates:
1) A housing shortage
2) Increased search activity
3) A black market/parallel market

● Leads to higher prices, profitable with carte act like

monopoly
● Used if good is necessity or merit good
Problems: discrimination – shortages create parallel markets,
increased search activity, queues, rationing

Increased Search Activity: time spent looking for someone w/

whom to do business
● Costly and opportunity cost of housing equals its rent ( regulated) plus the opportunity cost of the
search activity (unregulated)

Black Market: illegal market that operates alongside a legal market in which a price ceiling or other restriction
has been imposed

Illegal arrangements are made between renters and landlords

at rents above the rent ceiling – and generally above what the
rent would have been in an unregulated market

Who Gains: consumers who obtain the good at the new lower prices
Who loses: consumers who cannot obtain the good (shortages), producers who cannot receive equilibrium
price – quality of goods may be reduced
1) Inefficiency: underproduction of housing services, marginal social benefit from housing services
exceeds its marginal social cost and a deadweight loss arises

- Rent ceiling above the equilibrium does not have any effect on market
Fairness:
Fair Rules: rent ceiling is unfair b/c it blocks voluntary exchange
Fair Results: rent ceiling is unfair b/c it does not generally benefit the poor
● Scare housing allocated by the following ways – no fair outcome
○ Lottery: scarce housing to the lucky
○ First come, first serve – scarce housing to those who have the greatest foresight and get
their names on the list first
○ Discrimination – scare housing based on self interest of the owner

Price Floor: regulation that makes it illegal to trade at a price lower than
a specific level
● minimum price (set above market equilibrium by central
authority)

Minimum Wage:
● Brings Unemployment, quantity of labour supplied by workers
exceeds the quantity demanded by employer = surplus of
labour

● Assist producers + guarantee production in agriculture

● Creates opportunity cost benefit producers – not consumed
by market

Problem: surplus creates parallel market

● Increase unemployment of low-skilled younger workers

Inefficiency of Minimum wage:

● Leads to inefficient outcome
● Quantity of labour employed is less than the efficient
quantity
● Supply of labour measures to marginal social cost of
labour measures the marginal social cost of labour to
workers ( leisure forgone)

Solution: buffer stocks, subsidize jobs/ producers

Incidence of Indirect Taxes + Subsidies

Tax Incidence: division of the burden of tax btw buyers

and sellers
● Item is taxed, price may rise by full amount,
lesser or not at all
Indirect tax: tax on expenditure/sale tax
Specific tax: a fixed amount of tax imposed upon a
product
Ad valorem tax: tax is a percentage of the selling price

Tax as a Wedge:
● Tax is like a wedge driven btw the price the
buyer pays and the price the seller receives
 ● W/ tax the equilibrium quantity is no longer at the intersection of the demand and supply curves
● Equilibrium quantity is the quantity where the vertical gap between the curves equal the size of the
tax

Taxes and Efficiency: except in extreme cases of perfectly inelastic demand or perfectly inelastic supply when
the quantity remains the same, imposing a tax creates inefficiency

● Marginal social benefit > Marginal social cost = tax is inefficient

● Tax revenue takes part of the total surplus
● Decrease quantity creates a deadweight loss

Tax on Seller: Tax on Buyer:

Tax Incidence of Elasticity of Demand: division of the tax between buyers and sellers depends on the
elasticities of demand and supply
1) Perfectly inelastic demand: the buyer pays the entire tax
● The more inelastic the demand, the larger the buyer’s share of the tax
2) Perfectly elastic demand: the seller pays the entire tax

Perfectly Inelastic Demand: Perfectly Elastic Demand:

● Demand curve is vertical, tax imposed on ● Demand curve is horizontal, tax imposed
good = buyer pays the entire tax on good = seller pays the entire tax
Tax Incidence of Elasticity of Supply: effect of the elasticity of supply on the division of the tax payment
1) Perfectly inelastic supply: the seller pays the entire tax
2) Perfectly elastic supply: the buyer pays the entire tax
● The more elastic the supply, the larger the buyer’s share of the tax

Perfectly Inelastic Supply: Perfectly Elastic Supply:

● Supply curve is vertical, tax imposed on ● Supply curve is horizontal =, tax imposed
good = seller pays the entire tax on good = buyer pays the entire tax

Taxes in Practice:
● Levied on g/s with an inelastic demand or inelastic supply
○ Alcohol, tobacco, and gasoline have inelastic demand, so the buyers of these items pay most
of the tax on them
○ Labour has a low elasticity of supply, the seller (worker) pays the most income tax and Social
Security tax
Taxes and Fairness:
1) Benefits principle: proposition that people should pay taxes equal to the benefits they receive from
the services provided by government
o Those who benefit the most pay the most taxes
2) Ability to pay principle: proposition that people should pay taxes according to how easily they can
bear the burden of the tax
o Rich people can more easily bear the burden than a poor person can
o Reinforces the benefits principle to justify high rates of income tax on high incomes

Production Quotas and Subsidies:

● Production Quotas: upper limit to the quantity of a good that may be produced during a specified
period
● Subsidy: payment made by the government to a producer

Production Quota: set by a government or an Subsidies: amount of money given directly to firms
organization, to encourage production or used to by the government to encourage production and
restriction production to support a certain price level consumption.

Inefficiency: producers have an incentive to cheat Inefficiency: overproduction

● Marginal social benefit = market price, ● Marginal Social benefit = market price,
which has increases which has fallen
● Marginal social cost has decreased ● Marginal social cost ( on supply curve)
has risen
● Marginal social cost > Marginal social
benefit

Market for Illegal Goods:

Penalties on Sellers – Based on the diagram
● If the penalty on the seller is the amount
HK, then the quantity supplied at the
market price of Pc is Qp
● Supply of the drug decrease to S + CBL
● The new equilibrium is at point F
Penalties on Buyers – Based on the diagram
● If the penalty on the buyer is the amount
JH, the quantity demanded at a market
price of Pc is Qp
● Demand for the drug decreases to D-CBL
● The new equilibrium is at point G
 ● Price rises and quantity decrease ● Price rises and the quantity decreases
● The opportunity cost of buying illegal
goods rise above Pc b/c buyer pays the
market price + cost of breaking the law

Penalties of both sellers and buyers: both the demand for

the drug and the supply of the drug decreases

Legalizing and taxing drugs:

● Illegal good can be legalized and taxed

● High enough tax rate would decrease
consumption to the level that occurs when trade
is illegal

Tax and Fairness

Economists propose 2 conflicting principles of fairness to apply to a tax system:

1) The benefit principle: proposition that people should pay taxes equal to the benefits they receive from
the services provided by government
2) The ability-to-pay principle: proposition that people should pay taxes according to how easily they can
bear the burden of tax
 Chapter 6 Practice Questions
1. What happens in a market (ex. Rent) if there is a ceiling: above the equilibrium point? Below the equilibrium
point?

a. In both situations there is no effect, market works as if there was no ceiling

b. Above equilibrium point: housing shortage, increased search activity, a black market; below equilibrium
point: no effect
c. Above equilibrium point: no effect; below equilibrium point: housing shortage, increased in search
activity, a black market
d. Regardless in both situations there is a housing shortage, increased search activity, a black market

2. Given the image below, identify the: equilibrium rent and quantity, amount of shortage in the market, and the
maximum black market rent

a. Equilibrium rent and quantity: $1600, 80,000 units; shortage amount: 80, maximum black market rent:
$2000 at the 100,000th unit
b. Equilibrium rent and quantity: $1600, 80,000 units; shortage amount: 40; maximum black market rent:
$2000 at the 60,000th unit
c. Equilibrium rent and quantity: $1600, 80,000 units; shortage amount: 80; maximum black market rent:
$1200 at the 60,000th unit

3. Rent ceilings are _______ because:

 a. Unfair, as it: does not generally benefit the poor BUT allows for voluntary exchange
b. Always fair: benefiting the poor AND allows for voluntary exchange
c. Unfair, as it: does not allow for voluntary exchange BUT benefits the poor
d. Unfair: does not allow for voluntary exchange and does not benefit the poor

4. ______ is one of the resource allocation methods used in the presence of a rent ceiling in a rental market, in
which individuals give scarce housing to: friends, family members, or those of the selected race/sex/ethnicity
a. Lottery
b. Barter
c. First come first serve
d. Discrimination

5. A price floor (ex. Minimum wage) is only effective if it’s set ____ the equilibrium quantity and rate. This is due
to the labor demanded being ____ than the labor supplied. This causes a labor ___
a. Above; less than; surplus
b. Above; greater than; shortage
c. Above; less than ; shortage
d. Below; greater than; surplus

6. A production quota is:

a. The lower limit to the quantity of a good that may be produced during a specific period
b. An upper limit to the quantity of a good that may be produced, in general
c. An upper limit to the quantity of a good that may be produced during a specific period
d. An upper limit to three price of a good that may be produced t during a specific period

7. In an effective quota:
a. Price decreases, costs rises, and quantity of good decrease
b. Price rises, costs rises, and quantity of good increases
c. Price decreases, cost fall, and quantity of good decrease
d. Price rises, costs fall, and quantity of good decreases

8. When a good is subsidized what happens to its: supply curve, costs, price, and quantity of goods?
a. Supply shifts to the right and upwards, all the others increase
b. Supply shifts to the right and downwards, price falls, costs rise, and quantity of goods increase
c. Supply shifts leftward and upwards, price rises, costs fall, quantity of goods decrease
d. Supply shifts leftward and downwards, price falls, costs rise, and quantity of goods increase

9. When an item is taxed, what happens if: price rises by the full amount, price rises by a lesser amount, price
doesn’t rise at all
a. Buyers pay the tax, sellers pay the tax, buyers and sellers share the burden of the tax
b. Sellers pay the tax, buyers pay the, buyers and sellers pay the burden of the tax
c. Buyers pay the tax, buyers and sellers share the burden of the tax, sellers pay the tax
d. In all the situations, both the buyers and sellers pay some of the tax

10. For a perfectly inelastic demand in a market, buyers pay the entire tax. This is:
a. True, buyers DO pay the entire tax
 b. False, SELLERS pay the entire tax
c. False, BOTH BUYERS AND SELLERS pay the tax

11. For a perfectly elastic demand in a market. The demand is a ___ line, the supply line shifts ____ due to tax,
and the ___ pays the entire tax
a. Vertical, upwards and right, seller
b. Vertical, upwards and left, buyer
c. Horizontal, upwards and left, seller
d. Horizontal, upwards and left, buyer

12. In regards to fairness for taxes, which principle(s) of fairness can be applied to a tax system?
a. Benefits principle
b. Ability-to-pay principle and fair-rules
c. Fair-results and benefits principle
d. Ability to pay principle and benefits principle
 Chapter 8: Utility and Demand
Consumption Possibilities: all the things that you can afford to buy (Parkin & Robin 2022)

Budget Line: shows the limit of one’s consumption possibilities

● Any possibilities on the budget line, or inside it, however, outside line is not possible

Preferences: likes and dislikes

Utility: benefit or satisfaction from consuming a good or service (Parkin & Robin 2022)

Total Utility: total benefit a person gets from the

consumption of goods - ↑consumption = ↑utility
(Parkin & Robin 2022)

● Ex. no consumption = no utility

Marginal Utility: change in total utility that results from a

unit-increase in the quantity of the good
consumed from a good (Parkin & Robin 2022)

● Principle of Diminishing Marginal Utility: As the

quantity consumed of a good increases, the change in utility (marginal utility) decreases
Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment, .
11th Edition. Pearson Education Canada.
There are 2 approaches in determining consumer equilibrium: Spreadsheet Solution and Choosing at margin

Spreadsheet Solution: direct way to find the utility maximizing choice

1. Find combinations of goods/services that can be bought with the given income
2. Find the total utility for each just affordable combination
3. The combination that results in the highest total utility is the consumer’s choice

Consumer Equilibrium: a situation in which one is able to allocate all their income so that it maximizes the total
utility (Parkin & Robin 2022)

Marginal Utility: increase in total utility that results from consuming one more unit of the good (Parkin & Robin
2022)

Marginal Utility per dollar: marginal utility from a good that results from spending one more dollar on it (Parkin
& Robin 2022)
● Marginal utility/price

Utility-Maximizing Rule: consumer’s total utility is maximized by

following the rule:

1. Spending all the available income (Parkin & Robin 2022)

2. Equalize the marginal utility per dollar of all goods
● When marginal utility/dollar of good A = marginal
utility/dollar of good B
 Parkin Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment,
11th Edition. Pearson Education Canada.
Predictions of Marginal Utility Theory:

1. Fall in the price of a Movie (good A)

○ Price of a good falls the quantity demanded of that good increases – demand slopes downwards
(Parkin & Robin, 2022)
○ MUA/PA > MUB/PB caused by decrease in price of A (smaller denominator) → restore equilibrium
by ↑ consumption of A to lower MUA and ↓ consumption of B to increase MUB (↓ numerator of
good A and ↑ numerator of good B)
○ As price of A falls and quantity demanded increases, there is movement along demand curve and
as consumption of good B decreases, there is decrease in demand

2. Rise in the price of Cola (good B)

○ Price of a good rises the quantity demanded of that good decreases
○ MUB/PB < MUA/PA caused by increase in price of B (greater denominator) → restore equilibrium
by ↓ consumption of B to lower MUB and ↑ consumption of A to increase MUA (↓ numerator of
good A and ↑ numerator of good B)

3. Rise in Income
○ Rise in income = demand for normal good increases
○ Causes increase in demand, since more is demanded, but price remains the same

4. Paradox of value : water is essential to life, but cheaper than diamonds, which is not essential (Parkin &
Robin, 2022)
○ Paradox resolved by distinguishing between total utility and marginal utility (Parkin & Robin,
2022)
○ Water: price low, total utility is large, and marginal utility is small
Diamond: price high, total utility is small, and marginal utility is high

Behavioural Economics: studies the ways in which limits on the human brain’s ability to compute and
implement rational decisions influences economic behaviour (i.e. decisions and its consequences)

1. Bounded Rationality: rationality that is bounded by computed power of the human brain (Parkin & Robin,
2022)
a. Consumers cannot rationally make choices – rely on other decision making methods (gut, rule of
thumb, views)
2. Bounded Willpower: Less than perfect willpower that prevents us from making a decision that will regret
(Parkinm & Robin, 2022)
3. Bounded Self-Interest: Limited self- interest that sometimes results in suppressing our own interests to
help others – finance, future, and saving are key factors (Parkin & Robin, 2022)

Endowment Effect: tendency for people to value something more highly simply because they own it (Parkin &
Robin, 2022)

Neuroeconomics: study of the activity of the human brain when a person makes an economic decision (Parkin
& Robin, 2022)
 Chapter 8 Practice Questions
1. What does a budget line tell you
a. The marginal utility of consuming an additional good
b. Limits of consumption possibilities
c. All the possible combinations you cannot afford
d. None of the above

2. When a combination possibility is outside the budget line

a. It is affordable
b. It provides the most utility
c. It is unaffordable
d. A and B

3. Marginal utility is best defined as

a. Benefit or satisfaction from consuming a good or service
b. The change in total utility resulting from one unit increase in goods consumed
c. The factors of production used to produce a good or service
d. A and B

4. When consuming an additional unit of good, total utility decreases

a. True
b. False

5. Marginal utility is
a. Positive, but increases less for every unit consumed
b. Positive and increases for every unit consumed
c. Negative but increases for every unit consumed
d. None of the above

6. All of the following are ways to find the utility maximizing choice except
a. Spreadsheet solution
b. Choosing by the margin
c. Using a budget line
d. A and C
e. None of the above

7. Someone reached consumer equilibrium

a. When half of their income is spent to maximize total utility
b. When all of their income is spent to maximize total utility
c. When they choose a possible combination on the budget line
d. When all their income is spent

8. If the marginal utility received from consuming an additional cup of slushies is 60 units and each cup
costs $2.50, what is the marginal utility per dollar
 a. 150.00
b. 62.50
c. 57.50
d. 24.00

9. Which of the following is a that ensure utility is maximized

a. Marginal utility per dollar is equal for both goods
b. Total utility per dollar is equal for both goods
c. Spend all available income
d. Spending over budget curve
e. A and C

10. When the marginal utility per dollar of good A is larger than the marginal utility per dollar of good B, what
are actions that can be taken to restore equilibrium
a. Increase the consumption of good A and decrease the consumption of good B
b. Increase the consumption of good B
c. Allocate more income
d. No actions required because It is already at equilibrium

11. What is the effect of consuming more of good A to restore equilibrium when the price of good A
decreases
a. Movement along the supply curve
b. Movement along demand curve
c. Shift in demand curve
d. None of the above

12. What is the effect of an increase in income

a. Movement along the supply curve
b. Movement along the demand curve
c. Shift in supply curve
d. Shift in demand curve

13. What happens to a normal good when income increases

a. Demand increases
b. Demand decreases
c. Quantity demanded increases
d. Quantity demanded decreases

14. What are factors that resolve the “Paradox of Value”

a. Demand
b. Marginal utility per dollar
c. Marginal utility
d. Total utility
e. C and D

15. Which of the following is an explanation that resolves the “Paradox of Value”
 a. Water: total and marginal utility are large, Diamonds: total and marginal utility are small
b. Water: total and marginal utility are small, Diamonds: total and marginal utility are large
c. Water: total utility is large while marginal utility is small, Diamonds: total utility is small while
marginal utility is large
d. Water: total utility is small while marginal utility is large, Diamonds: total utility is large while
marginal utility is small

1. DeJuan, Joseph.(2022, November 7).Ch08-ParkinBade-CaFall2022 [Lecture notes, PDF document]. UW

Learn https://learn.uwaterloo.ca/d2l/le/content/849358/viewContent/4635097/View

2. Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment, 11th
Edition. Pearson Education Canada.
 Chapter 9: Possibilities, Preferences, and Choices
Budget Line: describes the limit to the household’s consumption choices
Budget Equation:
Expenditure = Income Income=Y
Income = Price of Good A x Quantity of Good A + Price of Good B x Quantity of Good B OR
Budget Equation for good X= Qx=Y/Px-(Py/Px)Qy

Real income: income expressed as a quantity of goods the household can afford to buy
● Real income in terms of cola is the point on her budget line where
it meets y-axis

Relative price: magnitude of the slope of the budget line

● Shows how many cases of cola must be forgone for good b
Changes in price: ↑price of good on x-axis decrease the affordable
quantity of that good and increases the slope of the budget line
Changes in Income: ∆ in money income = parallel shift of budget line
● Slope doesn’t change because relative price doesn’t change

Indifference curve: combination of goods among which a consumer is

indifferent
1) All points on curve are preferred to all the points below
indifference curve
2) All points above indifference curve are preferred to all the points on the indifference curve

Preference Map: series of indifference curves

● Higher the curve on a graph, the greater the preference
● Marginal Rate of Substitution (MRS) : measures the rate at which a
person is willing to give up good y to get an additional unit of good x –
which remaining indifferent
● Magnitude of the slope of the indifference curve measures the marginal
rate of substitution

Steep Indifference Curve Flat Indifference Curve

● High MRS ● Low MRS
● Person is willing to give up large ● Person is willing to give up a small
quantity of Y to get but more of X quantity of y to get more x
Marginal Rate of Substitution: measures the rate at which a person is willing to give up good y to get an
additional unit of good x while at the same time remain indifferent
● Diminishing Marginal Rate of Substitution: general tendency for a person to be willing to give up less of
good y to get one more unit of good x, while at the same time remaining indifferent as the quantity of
good x increases.
Degree of Substitutability: shape of the indifference curves reveal the degree of substitutability between two
goods

Predicting Consumer Choices:

Best Affordable Choice:

1) On the budget line
2) On the highest attainable indifference curve
3) Has a marginal rate of substitution between the two goods equal to the relative price of the two goods
Change in Price: Price Effect (See diagram at end)
● Change in the price of a good on the quantity of the good consumed
○ Price of good falls, then the budget line rotates outwards (becomes flatter)
Change in Income: Income Effect
● Change in income on the quantity of the good consumed
○ Decrease in income = budget line shifts left
Substitution Effect (See diagram at end): effect of a change in price on the quantity bought when the consumer
remains on the same indifference curve
● Price cut for Lisa, Lisa is now back on her original indifference curve but with a lower price of movies
and her best affordable point is K
● Movement from C to K is substitution effect
● Relative Price falls, consumer always substitutes more of the good for other goods – first reason why
the demand curve slopes downward

Income Effect (See diagram at end): With more income to spend – income effect is positive
● Isolate the income effect: reverse the hypothetical pay cut and restore Lisa’s income to its original level
● Movement from K to J is Income effect
● Normal good: income effect reinforces the substitution effect and is the second reason why the demand
curve slopes downwards
Inferior Goods: Income increases, the quantity bought decreases
● Income effect is negative, and works against the substitution effect
○ As long as substitution effect dominates, the demand curve still slopes downward
● If negative income effect is stronger than substitution effect
○ Lower price for inferior goods brings a decrease in the Qd – the demand curve slopes upward
Back to the Facts:
● Best affordable choices determine spending patterns
● Changes in price and income change the best affordable point and change consumption patterns
 Chapter 9 Practice Questions
1. The Budget line describes the limit to
a. Household’s consumption choices
b. Consumer’s spending habits
c. Market’s marginal cost
d. Consumer’s lifestyle

2. What is the formula to calculate Income

a. Income = Price of Good B x Quantity of Good A + Price of Good A x Quantity of Good B
b. Income = Price of Good A x Quantity of Good A + Price of Good B x Quantity of Good B
c. Income= Price of Good A x Price of Good B + Quantity of Good A x Quantity of Good B
d. Income= Marginal Benefit x Quantity of Goods

3. Which word(s) best matches the definition of “income expressed as a quantity of goods the household
can afford to buy”
a. Maximum Consumption
b. X-Intercept
c. Real Income
d. Relative Income

4. Relative Price is best described using

a. Slope of graph
b. Y-intercept and X-intercept
c. Point of Allocative efficiency
d. Good A minus Good B

5. The price of one good divided by the Price of another is the:

a. Relative price
b. Marginal price
c. Demand price
d. Monetary price

6. What happens to the Budget line if the price of Good X (X-axis) increases
a. It bows outward
b. It flattens
c. It stays the same
d. It becomes steeper

7. What is true about series of indifference curves on a preference map

a. Higher curves are less preferable
b. Lower curves are most preferable
c. A flat curve means an individual is will to give up large quantity of Y to get but more of X
d. A steep curve means an individual is will to give up large quantity of Y to get but more of X
8. For the figure below: Which definition best matches the graph

a. Perfect substitutes
b. Perfect complements
c. Ordinary Goods
d. Inferior Goods

9. The best affordable price is

a. On the budget line, on the highest attainable indifference curve, has a marginal rate of
substitution equal to the relative price between the two goods
b. Above the budget line, on the highest attainable indifference curve, has a marginal rate of
substitution greater than relative price
c. Where budget line intercepts marginal rate of substitution
d. Maximum point on Budget line

10. You consume two goods, Peaches and Apples. Apples on the Y axis and Peaches on the X. If your
income doubles the price of Apples doubles and the price of peaches cuts in half then the budget line:
a. Become steeper
b. Becomes flatter
c. Shifts rightward then becomes steeper
d. Shifts leftward then become flatter

11. Which effect matches the definition “effect of a change in price on the quantity bought when the
consumer remains on the same indifference curve”
a. Marginal effect
b. Price effect
c. Substitution effect
d. Relative effect
12. For the figure below: What would be classified as the substitution effect

a. A movement from point A to C

b. A movement from point B to A
c. A movement from point A to D
d. A shift from line 1 to 2

13. For the figure below: A fall in price of good (X) using price effect would be

a. A movement from D to A
b. A shift from line 2 to 1
c. A shift from A to B
d. A shift from C to B
14. For the figure below: A rise in income would cause a shift from

a. A shift from D to C
b. A shift from A to C
c. A shift from B to D
d. A shift from A to B

15. A consumer is choosing between two goods, Apples and Oranges. The consumer is at their best
affordable point. Then the price of apples decreased. If both goods are normal goods, which statement
is true about the new best Affordable point?
a. Consumer will consume more apples, we cannot tell if they will consume more or less oranges.
b. Consumer will consume more Apples and More oranges
c. Consumer will consume only oranges
d. Consumer will consume More apples less Oranges

16. Spending patterns are determined by

a. Lowest price
b. Best affordable price
c. Highest price
d. Lowest indifference curve
 Chapter 10: Economic Cost and Profit
Firm: An organization that hires factors of production and organizes them to produce and sell goods/services

The Firm’s Goal: Maximize profit

● If the firm fails to maximize its profit, the firm is either eliminated or taken over by another firm

Accounting Profit
● Measures a firm’s profit to ensure that the firm pays the correct amount of tax and show its investors
how funds are being used
○ Explicit Costs: Costs that are borne directly by the use of the factors of production.
○ Conventional Depreciation: Fall in the value of a firm’s capital over time.
● Profit = Total Revenue - Total Cost (Explicit Costs + Conventional Depreciation)

Economic Accounting
● Measures a firm’s profit to predict the firm’s decisions
● Implicit Costs: Sum of all hidden opportunity costs forgone, but not paid in real money.
○ The goal of these decisions is to maximize economic profit
● Economic Profit = Total Revenue - Total Cost (total cost measured as the opportunity cost of
production)

A Firm’s Opportunity Cost of Production

● The value of the best alternative use of resources used in production
● The sum of the cost of using resources: bought in the market, owned by the firm, and supplied by the
firm’s owner

Resources Bought in the Market: Amount spent on resources in the market is an opportunity cost of
production, the firm could have bought different resources to produce some other good/service

Resources Owned by the Firm: If the firm owns capital and uses it to produce its output
● It could have sold the capital and rented capital from another firm
○ The firm implicitly rents the capital from itself
● The firm’s opportunity cost of using the capital it owns is called the implicit rental rate of capital
○ The implicit rental rate of capital is made up of:
■ Economic Depreciation
● The change in the market value of capital over a given period
■ Interest Forgone
● The return on the funds used to acquire the capital

Resources Supplied by the Firm’s Owner

● The owner might supply both entrepreneurship and labour
● The profit that an entrepreneur can expect to receive an average is called the normal profit
○ Normal Profit: Cost of entrepreneurship (is an opportunity cost of production)
● The owner might supply labour but not take a wage
○ The opportunity cost of the owner’s labour is the wage income forgone by not taking the best
alternative
The Firm’s Profit-Maximizing Decisions
● What to produce and in what quantities?
● How to produce?
● How to organize and compensate its managers and workers?
● How to market and price its products?
● What to produce itself and what to buy from other firms?

The Firm’s Constraints

● The firm’s profits are constrained by:
○ Technology constraints
■ Using the available technology, the firm can only produce more if it hires more. Hiring
more resources increases the costs and limits additional profit
○ Information constraints
■ Firms have limited information about quality and effort of workforce, present and future
customer buying plans, and competitor’s plans
○ Market constraints
■ Firms are constrained by consumer’s willingness to buy and competitor’s prices
■ Amount of resources the firm can buy is constrained by willingness of people to work and
invest into the firm (incurred expenditures limits profit)

Technological Efficiency: When a firm uses less of at least one input and no more of the other inputs to produce
a given quantity of output
● There can be more than one technologically efficient combination
● Impossible to be technologically efficiency by decreasing a given good with all others constant

Economic Efficiency: When the firm produces a given quantity of output at the least cost. Depends on relative
cost of capital and labour
● Technological efficiency deals with quantity of inputs creating quantity of outputs while economic
efficiency deals with costs of inputs used
● Economically efficient production processes are also technologically efficient
● Technologically efficient processes may or may not be economically efficient

Information And Organization

● Command systems
○ Commands goes down the hierarchy while information (feedback) goes upwards (managerial
hierarchy)
○ Used when it is easy to monitor performance or when a small deviation from the ideal
performance is very costly
● Incentive systems
○ Using rewards to induce workers to perform to maximize firm’s profits
○ Used when difficult to monitor performance or too costly to monitor
The Short Run
● A time frame in which the quantity of one or more resources used in production is fixed
● For most firms, the capital, called the firm’s plant, is fixed in the short run
● Other resources used by the firm (such as labour, raw materials, and energy) can be changed in the short
run
● Short-run decisions are easily reversed

The Long Run

● The long run is a time frame in which the quantities of all resources - including the plant size - can be
varied
● Long-run decisions are not easily reversed
● Sunk Cost
○ A cost incurred by the firm and cannot be changed
○ If a firm’s plant has no resale value, the amount paid for it is a sunk cost
○ Irrelevant to a firm’s current decisions

Short-Run Technology Constraint

● To increase output in the short run, a firm must increase the amount of labour employed
● Three concepts describe the relationship between output and the quantity of labour employed:
○ Total Product (TP) - total output produced in a given period
○ Marginal Product (MP) - change in total product that results from a one-unit increase in the
quantity of labour employed
○ Average Product (AP) - total product divided by the quantity of labour employed

Product Schedules
● As the quantity of labour employed increases: total product increases,
marginal product increases initially...but eventually decreases, and
average product decreases

Product Curves: show how the firm’s total product, marginal product, and
average product changes as the firm varies the quantity of labour employed

Total Product Curve

● Shows how total product changes with the quantity of labour employed
● Separates attainable output levels from unattainable output levels in the
short run

Marginal Product Curve

● The height of each bar measures the marginal product of labour
● The marginal product of labour curve passes through the mid-points of
these bars
● Almost all production processes are like the ones shown here and have
○ Increasing marginal returns initially
○ Diminishing marginal returns eventually
Increasing Marginal Returns
● Initially, the marginal product of a worker exceeds the marginal product of the previous worker and the
firm experiences increasing marginal returns
● Increasing marginal returns arise from increased specialization and division of labour

Diminishing Marginal Returns

● Eventually, the marginal product of a worker is less than the marginal product of the previous worker and
the firm experiences
diminishing marginal returns (Parkin & Robin, 2022) Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada
in the Global Environment, 11th Edition. Pearson Education Canada.

● Arises because each additional worker has less access to capital and less space in which to work
● Law of Diminishing Return
○ A firm uses more of a variable input with a given quantity of fixed inputs, the marginal product of
the variable input eventually diminishes (Parkin & Robin, 2022)

Average Product Curve

● When MP > AP , AP increases
● When MP < AP, AP decreases
● When MP = AP, AP is at its maximum

Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the

Global Environment, 11th Edition. Pearson Education Canada.

Short-Run Cost
● To produce more output in the short run, the firm must employ more labour, which means that it must
increase its costs (Parkin & Robin, 2022)
● Three cost concepts and three types of cost curves are: total cost,
marginal cost, and average cost (Parkin & Robin, 2022)

Total Cost
● Total cost (TC): is the cost of all resources used
● Total fixed cost (TFC): is the cost of the firm’s fixed inputs (Parkin
& Robin, 2022)
○ Fixed costs do not change with output
● Total variable cost (TVC): is the cost of the firm’s variable inputs
(Parkin & Robin, 2022)
○ Variable costs do change with output
Parkin, Michael and Robin Bade.(2022).Microeconomics:
Canada in the Global Environment, 11th Edition. Pearson Education Canada.
 ● Total cost equals to the sum of total fixed costs and total variable costs:
○ TC = TFC + TVC
● The TVC curve gets its shape from the TP curve
○ The quantity of labour on the x-axis is replaced with total variable cost and graphed with cost on
the y-axis and output on the x-axis

Marginal Cost
● Marginal cost (MC): the increase in total cost that results from a one-unit increase in total product
(Parkin & Robin, 2022)
● Over the output range with increasing marginal returns, marginal cost falls as output increases (Parkin &
Robin, 2022)
● Over the output range with diminishing marginal returns, marginal cost rises as output increases (Parkin
& Robin, 2022)

Average Cost
● Average cost measure can be derived from each of the total cost measures:
○ Average fixed cost (AFC): is total fixed cost per unit of output (Parkin & Robin, 2022)
○ Average variable cost (AVC): is total variable cost per unit of output (Parkin & Robin, 2022)
○ Average total cost (ATC): is the total cost per unit of output (Parkin & Robin, 2022)
■ ATC = AFC + AVC

Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment, 11th Edition. Pearson Education Canada.

● The AFC curve shows that average fixed cost falls as output increases (Parkin & Robin, 2022)
○ The AVC and ATC curve is U-Shaped
○ As output increases, average variable cost falls to a minimum and then increases (Parkin &
Robin, 2022)
The MC Curve The ATC Curve

● MC is below AVC when AVC is falling ● MC is below ATC when ATC is falling
● MC is above AVC when AVC is rising ● MC is above ATC when ATC is rising
● MC equals AVC when AVC is at ● MC equals ATC when ATC is at minimum

The ATC curve is U-Shaped because:

● Initially, MP exceeds AP, resulting in rising AP and falling AVC
○ Eventually, MP falls below AP, resulting in falling AP and rising AVC
● The ATC curve is U-shaped for the same reasons
 ○ ATC falls at low output levels because AFC is falling quickly
● The ATC curve is the vertical sum of the AFC curve and the AVC curve
● Two opposing forces that cause the U-shape of the ATC curve:
○ Spreading total fixed cost over a larger output - AFC curve slopes downward as output increases
(Parkin & Robin, 2022)
○ Eventually diminishing returns - the AVC curve slopes upward and AVC increases more quickly
than AFC is decreasing (Parkin & Robin, 2022)

Total Product and Total Variable Cost

● TVC is flipped (x and y axis) when output is on y-axis and variable cost is on x-axis

Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment

11th Edition. Pearson Education Canada.

Average and Marginal Product and Cost

● The shapes of a firm’s cost curves are determined by the
technology it uses:
○ When MP reaches its maximum, MC is at its minimum
○ When MP is rising, MC is falling
○ AP is at its maximum when AVC reaches its minimum
○ When AP is rising, AVC is falling
● Increasing marginal returns, MP increasing, MC decreasing
● Diminishing marginal return, MP decreasing, MC increases

Parkin, Michael and Robin Bade.(2022).Microeconomics:

Canada in the Global Environment, 11th Edition. Pearson Education Canada.

Shifts in the Cost Curves

● Position of a firm’s cost curves depends on two factors:
● Technology
○ An increase in productivity shifts the product curve upward and the cost curves downward
○ If a technological advance results in the firm using more capital and less labour, fixed costs
increase and variable costs decrease
○ In this case, average total cost increases at low output levels and decreases at high output levels
● Prices of Factors of Production
 ○ An increase in a fixed cost shifts the total cost (TC) and average total cost (ATC) upward but
does not shift the marginal cost (MC) curve
○ An increase in a variable cost shifts the total cost (TC), average total cost (ATC), and marginal
cost (MC) curves upward

Long-Run Cost
The Production Function
● Relationship between the maximum output attainable and quantities of capital and labour
● In the long run, all costs are variable costs
● Behaviour of long-run cost depends upon the firm’s production function
● As the size of the plant increases, the output that a given quantity of labour can produce increases
○ For each plant, as the quantity of labour increases, diminishing returns occur

Diminishing Marginal Product of Capital

● The increase in output resulting from a one-unit increase in the amount of capital employed
● A firm’s production exhibits diminishing marginal returns to labour (for a given plant) as well as
diminishing marginal returns to capital (for a quantity of labour)
● For each plant, diminishing marginal product of labour creates a set of short run, U-shaped cost curves
for MC, AVC, and ATC

Short-Run Cost and Long-Run Cost

● The average cost of producing a given output varies and depends on the firm’s plant
● The larger the plant, the greater is the output at which ATC is at a minimum
● For example, a firm has 4 different plants: 1, 2, 3, or 4 knitting machines
○ Each plant has a short-run ATC curve and the firm can compare the ATC for each output at
different plants

Long-Run Average Cost Curve

● The relationship between the lowest attainable average total cost and output when both the plant and
labour are varied
● Is a planning curve that tells the firm that plant that minimizes the cost of producing a given output
range
● Once the firm has chosen its plant, the firm incurs the cost that corresponds to the ATC curve for the
plant
Economies and Diseconomies of Scale
● Economies of scale are features of a firm’s technology that lead to falling long-run average as output
increases
● Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as
output increases
● Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost
as output increases

Minimum Efficient Scale

● A firm experiences economies of scale up to some output level
● Beyond that output level, it moves into constant return to scale or diseconomies of scale
● Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its
lowest level
● If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale
output level

1. DeJuan, Joseph.(2022, November 7).Ch08-ParkinBade-CaFall2022 [Lecture notes, PDF document]. UW

Learn https://learn.uwaterloo.ca/d2l/le/content/849358/viewContent/4635097/View

Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment, 11th
Edition. Pearson Education Canada.
 Chapter 10 Practice Questions
1. What is the goal of a firm
a. To maximize profit
b. To maximize costs
c. To hire as many employees as possible
d. To open as many stores as possible

2. The following costs are fixed except

a. Rent
b. Salaries
c. Machinery
d. Interest Expenses

3. Accountants measure profit by subtracting total opportunity cost from total revenue
a. True
b. False

4. Total opportunity cost includes all of the following except

a. Resources bought in the market
b. Resources owned by the firm
c. Resources sold in the market
d. Resources provided by the owner of the firm

5. A Firm's Opportunity cost is

a. The cost of using resources bought in the market, owned by the firm and supplied by the firm’s
owner
b. Costs paid in cheques
c. Resources bought in the market only.
d. Resources borrowed from the owner

6. If the economic profit is zero then

a. We have normal profit
b. Negative profit
c. Maximum profit
d. Minimum profit

7. A technological change that will increase productivity will shift the product curve ____ and the cost curve
____
a. Upward, Upward
b. Downward Upward
c. Upward, Downward
d. Downward, Downward

8. A firm is an institution that hires ______ and organizes them to sell and produce goods
a. Labour
 b. Factors of production
c. Entrepreneurship
d. Capital

9. If the AVC is equal to 35 and the AFC is equal to 16 then the ATC is equal to
a. 19
b. 560
c. 15
d. 51

10. If the TC is equal to 50 and the TVC is 30 then the TFC is equal to
a. 20
b. 80
c. 1500
d. 30

11. When MP is rising, MC is _____

a. Falling
b. Rising
c. At a maximum
d. At a minimum

12. Producing at a point above the total product curve is

a. Inefficient
b. Attainable
c. Unattainable
d. Efficient

13. In the short run, all costs are variable costs

a. True
b. False

14. Which of the following is false about sunk costs

a. Has already been incurred
b. Irrelevant to firms current decisions
c. Is the amount paid for a firm if a firm’s plant has no resale value
d. Not easily reversible

15. The position of a firm's cost curve depends on:

a. Technology, and price of the product
b. Price of the product and the prices of factors of production
c. Technology, and the prices of factors of production
d. None of the above

16. Production function of a firm is the relationship between:

a. Minimum output attainable, and quantities of capital
 b. Maximum output attainable, and quantities of labor
c. Minimum output attainable, and quantities of labor
d. Maximum output attainable, and quantities of capital
e. Maximum output attainable, and quantities of both capital and labor

17. Plant size ____ firm’s ATC (average total cost). Therefore the larger the plant, the ____ is the output at which
ATC is at ___
a. Effects, lesser, a minimum
b. Effects, greater, a maximum
c. No effect, greater, all points
d. Effects, greater, minimum

18. True or false: The short run ATC curves are individual, whilst the long run ATC curve is a sum of all individual
ATC curves
a. True
b. False

1. DeJuan, Joseph.(2022, November 7).Ch010-ParkinBade-CaFall2022 [Lecture notes, PDF document]. UW

Learn https://learn.uwaterloo.ca/d2l/le/content/849358/viewContent/4635097/View

2. Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment, 11th
Edition. Pearson Education Canada.
 Chapter 11: Perfect Competition
Perfect Competition:
1) Many firms sell identical products to many buyers
a) Faces maximum amount of competition
2) There are no restrictions to entry into the industry
3) Established firms have no advantages over new ones
4) Sellers and buyers are well informed about prices

Perfect Competition:
1) Firm’s minimum efficient scale is small relative to market demand, so there is room for many firms in the
market
2) Each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t
care which firm’s good they buy

Price Takers: PC each firm is a price taker

- firm that cannot influence the price of a good or service
- no single firm can influence the price “ take the equilibrium market price”
- Each firm’s output is a Perfect Substitute for the output of the other firms, so the demand for each firm’s
output is perfectly elastic

Economic Profit and Revenue: MAXIMIZE economic profit = total revenue – total cost
- Total Cost: opportunity cost of production, which includes normal profit
- Total Revenue: Price X Quantity
- Marginal Revenue: Change in total revenue that results from a one unit increase in the quantity sold
Marginal Revenue Curve (MR) = DEMAND curve for firm’s product
- Demand for firm’s product is Perfectly elastic b/c ones firm’s sweater is a
perfect substitute for the sweater of another firm
- Market demand is not perfectly elastic b/c a sweater is a substitute for
some other good

Firm’s Decisions: A perfectly competitive firm chooses the output that

maximizes its economic profit
1) How to produce at minimum cost
2) What quantity to produce
3) Whether to enter or exit a market

At a low output level, the firm incurs an economic loss – can’t cover its fixed cost
- At intermediate output levels, the firm makes an economic profit
At high output level, the firm incurs an economic loss – firm faces steeply rising costs because of diminishing
returns
- Firm maximizes its economic profit when it produces at MAX

Marginal Analysis and Supply Decision: uses marginal analysis to determine the profit maximizing output
- MR is constant, and MC eventually increases as output increase, profit is maximized by producing the
output at which marginal revenue = marginal cost
MC = MR = REVENUE MAXIMIZING
- Economic profit decreases if output changes in
either direction, so economic profit is maximized
MR >MC = economic profit increases if output increases
MR < MC = economic profit decreases if output increase

Temporary Shutdown Decision:

- if a firm makes an economic loss, it must decide whether to exit the market or to stay in the market
- if a firm decides to stay in the market, it must decide whether to produce something or to shut down
temporarily

Loss Comparisons;
- Firm’s loss equals total fixed cost ( TFC ) + total variable cost ( TVC) minus total revenue (TR)
Economic loss = TFC + TVC – TR
= TFC + ( AVC -P) X Q
- If the firm shuts down: Q = 0, firm still pays its TFC
Shutdown Point: Price and quantity at which it is indifferent between producing the profit maximizing quantity
and shutting down
- SHUTDOWN = MINIMUM AVC
- Point is the same point at which MC curve crosses the AVC curve
- Firm is indifferent btw producing and shutting down temporarily
- Firm incurs a loss equal to total fixed cost (TFC)
Supply Curve:
- Perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing output varies as the
market price varies, other things remaining the same (Parkin & Robin 2022)
- Firm produces the output at which marginal cost = marginal revenue, MR = P, firm’s supply curve is linked
to its marginal cost curve
o Price BELOW shutdown point = firm produces nothing
Market Supply in SHORT RUN:
- Shows the quantity supplied by all firms in the market at each price when each firm’s plant and the number
of firms remain the same (Parkin & Robin 2022)
Output, Price, and Profit in the SHORT RUN:
- AT SHUTDOWN PRICE: some firms will produce the shutdown quantity, and others will produce zero
- Market supply is horizontal

Change in Demand:
- INCREASE in demand brings a rightward shift of the market demand curve: the price rises and the quantity
increases
- DECREASE in demand brings a leftward shift of the market demand curve: price falls and the quantity
decrease (Parkin & Robin 2022)
Profits and Losses in the Short Run:
- Maximum profits is not always a positive economic profit
- To see if the firm is making a profit or incurring a loss compare the firm’s ATC at the profit – maximizing
output w/ market price
- SR: firm might make economic profit, breakeven, or economic loss
- LR: firms break even because firms can enter or exit market

3 outcomes:
a) Price = average total cost and the firm makes zero economic profit ( breaks even)
b) Price > average total cost and the firm makes a positive economic profit
c) Price < average total cost and the firm incurs an economic loss – economic profit is (-)
Note: when $ < ATC, it doesn’t necessarily mean the firm wants to shut down right away. Need to determine
if they feel loss is temporary and whether the price is higher or lower than AVC. (Parkin & Robin 2022)

New firms enter an industry in which existing firms make an economic profit
Firms exit an industry in which – economic loss incur

PROFIT:
- Firms have incentive to enter market
- Market supply increases and market
price fall
LR: market price falls until firms are making
zero economic profit
LOSS
- Firms have incentive to exit market
- Market supply decreases and market
prices rises
LR: market price continues to rise until firms
make zero economic profit

Changes in Demand and Supply as Technology Advances:

An Increase in Demand:
- Shifts the market demand curve rightward: ↑ market price & ↑ quantity. Market price > firm’s minimum
average total cost .: economic profit

Parkin Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment,

11th Edition. Pearson Education Canada.
-
- Induces firms to enter the market (due to economic profit) .: ↑ market supply and price ↓
- As price ↓, the quantity produced by all firms start to ↓, and each firm’s economic profit start to ↓
o Parkin Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment,
11th Edition. Pearson Education Canada.
-
- Eventually, market price returns to its original price, firms are in balance and firms make zero economic profit
(firms no longer enter the market )

o
Parkin Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment, 11th Edition. Pearson Education Canada.

Decrease in Demand:
- ↓ demand has the opposite effects increase in demand
- Shifts the demand curve leftward
1) Price falls, quantity decreases
2) Firms incur an economic loss
3) Induces exit
4) Short- run market supply curve shifts leftward
5) Market supply decrease, the price stops falling and starts to rise
- Rising price, each firm increases its output as it moves along its marginal cost curve/ supply curve
- New LR equilibrium occurs when the price has risen to equal minimum ATC
o No incentive to exit the market
o Small number of firms produce the equilibrium quantity
Supply:
- From LR: new technology becomes available that lowers production costs, the first firms that use the new
technology make economic profit. ATC and MC curve shift downward w/ new technology

o
- Economic profit causes new-technology firms to enter the market .: market supply ↑ and price ↓

o
- The lower price causes old-technology firms to incur economic loss .: some exit the market, others adopt
the new technology

o
- All firms are using new technology, market supply increased and firms are making 0 economic profit

Competition and Efficiency:

Efficient use of Resources:
- Used efficiently when no one can be made better off w/out making someone else worse off
- Situation arises when marginal social benefit = marginal social cost
- Pressures of competition makes each firm produce at lowest possible ATC and use the least-cost
technology

Choices, Equilibrium and Efficiency:

- Efficient use of resources in terms of the choice of consumers and firms coordinated in market equilibrium
Choices:
- Consumers demand curve shows how the best budget allocation changes as the price of a good changes
o At ALL points along their demand curves, consumers get the most value out of their resources
- People who consume the good are the only ones who benefit the good – demand = marginal social benefit
curve
- Competitive firm’s supply curve shows how the profit-maximizing quantity changes as the price of a good
changes
- Points on the supply: MOST value out of their resources
o If the firm that produces the good bear all the cost of producing it, then the market supply
curve is the marginal social cost curve

Equilibrium and Efficiency:

- Competitive Equilibrium, resources are used efficiently – QD = QS so MSB = MSC
o Gain from trade for consumers is measured by consumer surplus
o Gain from trade for producers is measured by the producer surplus
 o TOTAL GAIN from trade = TOTAL SURPLUS
§ LR equilibrium total surplus is maximized
o Resources are allocated efficiently
o TOTAL Surplus is maximized

Zero Economic Profit:

- Each firm in the market has the plant that enables it to produce at the lowest possible average total cost
- Consumers are as well off as possible b/c the good cannot be produced at a lower cost and the price =
least possible cost
 Chapter 11 Practice Questions

1. Which one of the following is a characteristic of perfect competition?

a. Many firms sell identical products to many buyers
b. There’s no restriction of entry for the industry
c. Established firms have no advantages over new ones
d. Sellers and buyers are well informed about prices
e. All of the above

2. Choose the statement that is incorrect

a. Increase in demand brings a rightward shift of the market demand curve
b. Perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing output varies as
the market price varies
c. A firm in a perfectly competitive market is a price setter
d. All options are correct

3. A perfectly competitive market has a ___________ market demand curve and _________ individual
producer demand curve
a. Horizontal; downward sloping
b. Downward sloping; horizontal
c. Horizontal; upward sloping
d. Vertical; horizontal

4. The shutdown point is the intersection between

a. MC and AVC
b. MC and ATC
c. MC and TFC
d. ATC and AVC

5. When price is below shutdown point,

a. Firms will continue producing
b. Firms will produce nothing
c. Firms are generating economic profit
d. A & C

6. Which of the following is true

a. When price is greater than average total cost, the firm makes an economic loss
b. In the long run, firms might make economic profit, breakeven, or economic loss
c. When existing firms make economic loss, new firms are likely to enter market
d. Increase in demand increase the quantity and price

7. How will the market price and economic profit be affected in the long run as firms adopt technology
a. Increase, profit
b. Decrease, loss
c. Increase, zero
d. Decrease, zero
8. Which of the short run outcomes allows the firm to make positive economic profit?
a. Price = ATC
b. Price > ATC
c. Price < ATC
d. Firm cannot make positive economic profit in short run

9. When firms are given the incentive to enter market

a. Existing firms in the market are making a profit
b. In the long run, market price increases until firms are making zero economic profit
c. In the long run, market price decreases until firms are making zero economic profit
d. A and B
e. A and C

10. When there is zero economic profit,

a. Each firm in the market has a plant that enables it to produce at the lowest possible AFC
b. Each firm in the market has a plant that enables it to produce at the lowest possible ATC
c. Consumers are not well off because the good’s price is at the lowest price
d. None of the above

11. The market demand curve is the MSB curve if:

a. If the people who consume the good are the ones who benefit the most from the good
b. If the people who consume the good are the only ones who benefit from the good
c. If the people who produce the good are the only ones who benefit from the good

1. DeJuan, Joseph.(2022, December 10).Ch011-ParkinBade-CaFall2022 [Lecture notes, PDF document]. UW

Learn https://learn.uwaterloo.ca/d2l/le/content/849358/viewContent/4658631/View

2. Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment, 11th
Edition. Pearson Education Canada.
 Chapter 12: Monopoly
Monopoly: Market that produces a good or service for which no close substitute exists
- One supplier that is protected from competition by a barrier preventing the entry of new firms (Parkin &
Robin 2022)

Two key features:

1) No close substitutes
2) Barriers to entry

No close substitutes:
- If a good has a close substitute, even if it is produced by only one firm, that firm effectively faces
competition from the production of the substitute.
- A monopoly sells good with no close substitutes

Barriers to entry: Constraint that protects a firm from potential competitors

1) Natural: barriers to entry create natural monopoly
Natural Monopoly: market in which economies of scale enable one firm to supply the entire market at the lowest
possible cost
2) Ownership: occurs if one firm owns a significant portion of key resources
3) Legal: barriers to entry create a legal monopoly
Legal Monopoly: market in which competition and entry are restricted by the granting of (Parkin & Robin 2022):
a) Public Franchise – US Postal Service, public franchise to deliver first class mail
b) Government License – practice law or medicine
c) Patent or Copyright

Monopoly Price- Setting Strategies:

- Monopoly firm sell larger quantity at a lower price and there are two pricing strategies include (Parkin &
Robin 2022):
1) Single- price monopoly: is a firm that must sell each unit of its output for the same price to all its customers
(Parkin & Robin 2022)
2) Price Discrimination: practice of selling different units of a good or service for different prices (Parkin &
Robin 2022)
- Although it may look like customer is benefitting from this, firm is charging the highest possible price for
each unit and making largest possible profit (Parkin & Robin 2022)

Price and Marginal Revenue

- Monopoly is a price setter, not a price taker like a firm in perfect competition
- Demand for monopoly output is MARKET DEMAND
o To sell a larger output, a monopoly must set a lower price (Parkin & Robin 2022)
Total Revenue = Price X Quantity Sold
MR: change in total revenue that results from one- unit increase in the
quantity sold (Parkin & Robin 2022)
- Single price monopoly: MR < P
Marginal Revenue & Elasticity:
- Single price monopoly’s marginal revenue is related to the elasticity of
demand for the good (Parkin & Robin 2022)
- DEMAND IS ELASTIC: fall in the price = ↑TR and MR is Positive
- DEMAND IS INELASTIC: fall in the price = ↓TR and MR is Negative
o Rise in revenue from increase in quantity sold is outweighed by
the fall in revenue from the lower price per unit
- DEMAND IS UNIT ELASTIC: fall in price does not change total revenue
o Rise in revenue from the greater quantity sold EQUALS the fall
in revenue from the lower price per unit
o MR = 0 <- revenue maximized

Parkin Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment,

11th Edition. Pearson Education Canada.
Monopoly – DEMAND IS ALWAYS ELASTIC:
- Single price monopoly never produces an output at which demand is inelastic
- If it did: firm could increase price charged and produce a smaller quantity

Price and Output Decision:

- Same technology constraints as competitive market
- Produces at profit maximization -> MR = MC but equilibrium price on
demand curve
- Monopoly can make economic profit even in long run because
barriers to entry protect the firm from market entry by competitor
firms

Parkin Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment,

11th Edition. Pearson Education Canada.
Price and Output Comparison
Perfect competition
- equilibrium, occurs where the supply curve and demand curve intersect
- each firm takes price and maximizes its profit by producing the output at which its own marginal cost
equals the price (Parkin & Robin 2022)
Monopoly
- they produce quantity at which MC=MR
- market supply curve becomes monopoly’s MC curve

Efficiency Comparison:
Efficiency of perfect competition:
Total surplus = Consumer Surplus + Producer Surplus is Maximized
Inefficiency of monopoly:
Smaller output and higher price = deadweight loss arises
- Redistribution of Surplus: some of lost consumer surplus goes to monopoly as producer surplus
Rent Seeking: pursuit of wealth by capturing economic rent ( any surplus, CS/PS or Economic profit) (Parkin &
Robin 2022)
1) Buy a monopoly – searching for a monopoly that is for sale at a lower price than the monopoly’s economic
profit
2) Create a monopoly – uses resources in political activity
- Blue area shows potential producers surplus without rent seeking, resources used in rent seeking can wipe
out the monopoly’s producer surplus
- Shifts ATC curve upward and producer surplus disappears and deadweight loss increases to grey area

Parkin Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment ,

11th Edition. Pearson Education Canada.

Price Discrimination: practice of selling different units of a good or service for different price
Monopoly must:
1) Identify and separate different buyer types
a. Among groups of buyers (airline tickets)
c. Among units of goods (buy one get one promotions)
2) Sell a product that cannot be resold
- Note: not all price difference are price discrimination, as they may be reflecting the difference in production
costs

Increase Profit & Producer Surplus:

- By price discriminating, a monopoly captures consumer surplus and converts it into
producer surplus (Parkin & Robin 2022)
- Producer surplus is total revenue – area under the marginal cost curve (TVC)

1) Economic profit = total revenue – total cost

2) Producer surplus = total revenue – total variable cost
3) Economic profit = producer surplus – total fixed cost
Perfect Price Discrimination: occurs if a firm is able to sell each unit of output for the highest price someone is
willing to pay (Parkin & Robin 2022)
- output increase to the point at which price equals marginal cost
- Marginal Revenue = Price, so demand curve is also marginal revenue curve
Efficiency and Rent Seeking with Price Discrimination:
- The more perfectly a monopoly can price discriminate, the closer its output is to the competitive output ( P=
MC) and more efficient is the outcome
- pushes consumer surplus to zero, which is identical to perfect competition

Difference between perfect competition and perfect price discrimination:

1) Monopoly captures the entire consumer surplus
2) Since monopoly captures total surplus, rent seeking is profitable

Monopoly Regulation
Regulation: rules administered by government agency to influence prices, quantities, entry, and other aspects of
economic activity (Parkin & Robin 2022)
Deregulation: the process of removing regulation of prices, quantities, entry, and other aspects of economic
activity in a firm or industry

Theories about how regulation actually works:

1) Social interest theory: political and regulatory process relentlessly seeks out inefficiency and regulates to
eliminate deadweight loss
2) Capture theory: regulation serves the self interest of the producer, who captures the regulator and
maximizes economic profit

Efficient Regulation of Natural Monopoly:

- Demand and cost conditions create natural monopoly: quantity produced is less than the efficient quantity
- How can government regulate a natural monopoly so that it produces an efficient quantity?

Marginal Cost Pricing Rule: A rule that sets the price of a good or service equal to the marginal cost of
producing it
- the natural monopoly in the social interest sets the quantity where MSB = MSC
● Efficient regulation sets the price = marginal cost
● Average cost > price so firm incurs economic loss (Parkin & Robin 2022)
1) Price discriminate to cover loss
2) Charge a one time fee to cover fixed cost then charge a price = marginal cost

Second-Best Regulations
Average Cost Pricing Rule: Permit the firm to produce the quantity at which price equals average cost and result
in zero economic profit
Government might pay a subsidy = monopoly loss
Problem:
- Not possible for the regulator to be sure what the firm’s costs are
(Parkin & Robin 2022)
1) Rate of return regulation: firm must justify its price by
showing that its return on capital doesn’t exceed a
specified target rate
o Serving the self interest of the firm rather than the social
interest because the firm’s manager have an incentive
to inflate costs and use more capital than the efficient
amount
2) Price cap regulation: highest price the firm is permitted to
set
o Gives the firm an incentive to operate efficiently and
keep costs under control
o Lowers price and increases the quantity as max price is
set
 Chapter 12 Practice Questions

1. What is a monopoly
a. Market producing products with a few close substitutes
b. Market producing products with a lot of close substitutes
c. Market producing products with no substitutes
d. A & C

2. All of the following are barriers of entry expect:

a. Natural barrier
b. Demand barrier
c. Ownership barrier
d. Legal barrier

3. When a monopoly uses a single price strategy, marginal revenue is greater than price.
a. True
b. False

4. If the demand for a single price monopoly is elastic, which of the following is true:
a. increase in the price = ↓TR and MR is Negative
b. MR = 0 <- revenue maximized
c. fall in the price = ↓ TR and MR is Positive
d. increase in the price = ↑TR and MR is Positive

5. What does the relationship between marginal revenue and elasticity of demand tell you
a. Profit maximizing monopoly will always produce in inelastic range
b. Profit maximizing monopoly will never produce in elastic range
c. Profit maximizing monopoly will never produce in inelastic range
d. None of the above

6. Rent seeking is
a. Opportunity cost of time spent looking for a house
b. Pursuit of wealth by capturing any surplus
c. Pursuit of lowering production costs
d. None of the above

7. Rent seeking shifts ATC curve upwards and eliminates deadweight loss
a. True
b. False

8. The following are theories that explain how regulations work except:
a. Economic rent theory
b. Social interest theory
c. Capture theory
d. None of the above
9. What are/is method(s) that enable companies to follow marginal cost pricing rule:
a. Price discriminating to cover loss
b. Relying on government subsidies
c. Charging a one time fee to cover fixed costs
d. A & C

10. What is the problem that arises when implementing average cost pricing:
a. Lack of barriers to entry
b. Decrease in demand
c. Not sure of exact firm’s cost
d. A & C

1. DeJuan, Joseph.(2022, December 10).Ch012-ParkinBade-CaFall2022 [Lecture notes, PDF document]. UW

Learn https://learn.uwaterloo.ca/d2l/le/content/849358/viewContent/4669076/View

2. Parkin, Michael and Robin Bade.(2022).Microeconomics: Canada in the Global Environment, 11th
Edition. Pearson Education Canada.
 Chapter 13: Monopolistic Competition
Monopolistic Competition: market structure in which
1) Large number of firms compete
- Each firm has a small market share so limited market power to influence the price of its product
- Each firm is sensitive to the average market price but pays no attention to the actions of others
o No action directly affects the actions of others
- Collusion or conspiring to fix prices is impossible
2) Each firm produces a differentiated product
- Practices produce differentiation if the firm makes a product that is slightly different from the
products of competing firms
3) Firms compete on product quality, price, and marketing
a) Quality: design, reliability, and service
o Demand for each firm’s product is downward sloping but there is a trade off between price
and quality
o Firm must market its product – advertising and packaging
4) Firms are free to enter and exit the industry
- No barriers to entry in monopolistic competition so firms cannot make an economic profit in LR

Firm’s SR output and Price Decision:

- Firm that has decided the quality of its product and its marketing program produces the profit –
maximizing quantity ( MR = MC)
- Price is determined from the demand for the firm’s product and the highest price that the firm
can charge for the profit – maximizing quantity
- Operates like single priced monopoly
- Economic Profit = P> ATC

Profit Maximizing might be loss minimizing:

- Economic loss in SR
o Profit maximizing quantity P < ATC and firm incurs and economic loss
- Long run: zero economic profit:
o LR: economic profit induces entry
o Entry continues as long as firm in the industry earns an economic profit P> ATC
§ Maximizes profit at MR = MC
- As firms enter the industry, each existing firms loses some of its market share
- Demand for product decreases
o Decreases quantity at which MR = MC and lowers the maximum price that the firm can
charge to sell this quantity
o Firm’s price and quantity fall until P = ATC and each firm earns zero economic profit

Monopolistic VS Perfect Competition:

Monopolistic:
1) Excess capacity: produces less than the quantity at which ATC is minimum
2) Markup: amount by which price exceeds its marginal cost
LR: Produce at less than efficient scale, quantity at which ATC is a minimum
 - Operate w/ excess capacity
- Downward sloping demand curve for their products drive this result

Perfect Competition:
1) No excess capacity and no markup
a. Perfectly elastic demand curve for products drives this result
Efficient:
Price = marginal social benefit
- Firm’s marginal cost = marginal social cost
- Price exceeds marginal cost, marginal social benefit exceeds marginal social cost
- LR: firm in monopolistic competition produces less than efficient quantity

Markup: arises from product differentiation

- People value product variety, but product variety is costly
- Efficient degree of product variety is the one for which MSB from product varies = marginal
social cost
- Loss arises from having greater degree of product variety

Product Development:
- Economic profit, firm in monopolistic competition must be in a state of continuous product
development
- New product development allows for a firm to gain a competitive edge, if only temporarily,
before competitors imitate the innovation
Innovation is costly: increases total revenue
- Firms pursue product development until the marginal revenue from innovation = marginal cost
of innovation
- Amount of production development is efficient if the marginal social benefit from an innovation
( amount consumers willing to pay) = marginal social cost that firms incur to make the innovation
Advertising:
- Firm w/ differentiated product needs to ensure that customers know that its product differs
from its competitors
- Use advertising and packaging to achieve this goal
- Large proportion of its price we pay for a good cover of costing of selling it
- Advertising expenditures affect the firm’s profit
1) Increase cost
2) Change demand
Selling Costs and Total Costs:
- Fixed Cost: selling costs, ex advertising expenditures
o Might lower the average total cost by increasing the quantity produced and spreading their
fixed cost over the larger output
o Shifts ATC upwards but the firm operates at a lower average total cost than it would
without advertising
o Shrink markup, the demand for a firm’s ouput is not elastic and its markup is large
- Average Fixed Costs: decrease as output increases, so selling costs increase average total cost
at any given quantity but do NOT change marginal cost
 - Selling efforts such as advertising are successful if they increase the demand for the firm’s
products
Using Advertising to Signal Quality:
- To signal high quality of their products
- Signal: action taken by an informed person or firm to send a message to uninformed people
Brand Names:
- Provide information about quality and consistency, more likely to use one good vs another
- Incurred the cost of establishing a brand name with expectations

Efficiency of Advertising and Brand Names:

- To the extent that advertising and selling costs provide consumers with information and
services that they value more highly than their cost, efficient activities
 Chapter 13 Practice Questions

1. Which of the following is NOT true in a monopolistic competition:

a. Large number of firms compete
b. Each firm produces a differentiated product
c. Firms compete on product quality, price, and marketing
d. Firms face barriers upon entry and exit of the market

2. In the short-run, a firm in monopolistic competition:

a. Operates opposite to how a single priced monopoly does
b. Economic Profit = 0
c. Price is determined from the demand for the firm’s product and the highest price that the firm
can charge for the profit – maximizing quantity
d. Maximizing quantity: MR > MC

3. In the long-run, a firm in monopolistic competition:

a. Economic profit = 0
b. Economic profit > 0
c. Economic profit induces exit
d. Entry occurs so long as economic profit = 0 (P = ATC)

4. As firms enter the industry, which of the following DOES NOT occur:
a. Increases quantity at which MR = MC and increases the maximum price that the firm can charge
to sell this quantity
b. firms loses some of its market share
c. Demand for products decrease
d. Firm’s price and quantity fall until P = ATC

5. If a firm produces less than the quantity at which ATC is minimum:

a. There is no excess capacity
b. The firm has excess capacity
c. The firm is in perfect competition
d. None of the above

6. Markup: the amount by which price exceeds _______

a. Marginal cost
b. Marginal revenue
c. Total cost
d. Average total cost

7. In perfect competition, which of the following is true:

a. Firms encounter excess capacity
b. Markups are common
c. Perfectly elastic demand curve for products
 d. Price always exceeds marginal cost

8. Firms pursue product development until

a. Firms begin to enter the market
b. Marginal revenue from innovation is double the marginal cost of innovation
c. Total revenue begins to increase
d. Marginal revenue from innovation = marginal cost from innovation
9. How do advertising expenditures affect a firm’s profit?
a. Increase cost; cannot change demand
b. Decreases cost; increases demand
c. Increases cost; changes demand
d. Increases cost; always decreases demand

10. Which of the following is true about brand names?

a. Provides information about the organization’s internal structure
b. Expectations are not a cost establishing a brand name
c. Provide information about quality and consistency, more likely to use one good vs another
d. Incentivizes the company to produce a low quality product/service
 Chapter 14: Oligopoly
Oligopoly is a market structure in which:
- Natural or legal barriers prevent the entry of new firms
- Small number of firms compete
Barriers to entry:
- Natural or legal barriers to entry can create oligopoly
- Duopoly: market with two firms
- Legal oligopoly: arise even where the demand and cost leave room for a larger number of firms

Two natural oligopoly situations:

Natural Duopoly Natural Oligopoly with 3 Firms

Small number of firms: only a few firms, they are interdependent and face a temptation to cooperate
Interdependence: with a small number of firms, each firm’s profit depends on every firm’s action
Temptation to Cooperate: firms in oligopoly face the temptation to form a cartel
Cartel: group of firms acting together to limit output raise prices, and increase profit + ILLEGAL

Oligopoly Games:
Game Theory: tool for studying strategic behavior, which is behavior that takes into account the expected
behavior of others and the mutual recognition of interdependence

All games share four common features:

1) Rules
2) Strategies: all the possible actions of each player
3) Payoffs
4) Outcomes

The Prisoner’s Dilemma: two prisoners have been caught committing a petty crime. Each is held in a separate
cell and cannot communicate with each other.
Strategies: both confess, both deny, one confesses and one denies x2
1) Confess to the larger crime
2) Deny having committed the larger crime
Payoff: each prisoner can workout what happens to him with PAYOFF MATRIX
o Table that shows the payoff for every possible action by each player for every possible action
by the other player

Outcome: if a player makes a rational choice in pursuit of his own best interest, he chooses the action that is
best for him, given any action taken by the other player
- If both players are rational, and choose their actions in this way, the outcome is an equilibrium called a
NASH EQUILIBRIUM

The Dilemma: arises as each prisoner contemplates the consequences of his decision and puts himself in the
place of his accomplice
- Each knows that it would be best if both denied
- But each also knows that if he denies it is in the best interest of others to confess
- Leads to equilibrium of the game

An Oligopoly Price-Fixing Game

- Games like the prisoner's dilemma is played in duopoly
- Duopoly: market in which only two producers that compete
- Captures the essence of oligopoly

Cost and Demand Conditions: two firms meet the market demand at the least cost
- Two firms enter into a collusive agreement
- Collusive agreement: agreement between two or more firms to restrict output, raise the price, and increase
profits
- Illegal in USA and undertaken in secret - CARTEL
Strategies: both comply, both cheat, one complies and one cheats X2
- Comply OR Cheat
o Profit: MC = MR where MC @ATC MIN
o Firms in a cartel act like a monopoly and maximize economic profit
o Cartel’s marginal cost curve is the horizontal sum of MC curve of two firms- monopoly

Cheats on Collusive Agreement: ATC > Price for Complier and Cheat: Price > ATC
Both Cheat: make zero economic profit – perfect competition
Nash Equilibrium in Duopolists’ Dilemma:
- Nash equilibrium is that both firms cheat
- Quantity and price are those of a competitive market, and firms make zero economic profit

Other Oligopoly Games:

- Advertising and research
- Development (R&D) games
o Economic game of chicken can arise when R&D creates a new technology that cannot be
patented
o Both firms benefit from R&D of either firm
 o Equilibrium of R&D of chicken is for one firm to do the R&D and the other firm to not do the
R&D

Repeated Duopoly Game:

- Game played repeatedly, it is possible for duopolies to successfully collude and make monopoly profit
- If players take turns and move sequentially, many outcomes possible

1) Cooperative Equilibrium: firms make and share the monopoly profit – punishment strategies enable the
firms to comply and achieve it

2) Tit for Tat Strategy: one player cooperates this period if the other player cooperated in the previous period
but cheats in the current period if the other player cheated in the previous period

3) Trigger Strategy: one in which a player cooperates if the other player cooperates but plays the NASH
equilibrium strategy forever thereafter if the other player cheats

Games and Price Wars:

- May result from tit for tat strategy where there is an additional complication – uncertainty about change in
demand
- Fall in demand might lower the price and bring forth a round of tit for tat punishment

Sequential Entry Game in a Contestable Market:

- Contestable Market: a market in which firms can enter and leave so easily that firms in the market face
competition from potential entrants – firms plays a sequential entry game
- Limit Pricing: sets the price at the highest level that is consistent with keeping the potential entrant out

Canada’s Anti-Combine Law:

- Anti-Combine Law: law regulating oligopolies and prevents them from becoming or behaving like
monopolies
- Canada’s first anti- combine law was enacted in 1889
- Law today is defined in the competition act of 1986
- The 1986 act established a competition bureau and a competition tribunal
- Act distinguishes between criminal and non-criminal practices
Criminal Practices include:
- Conspiracy to fix prices
- Bid rigging
- False advertising
Noncriminal practices include:
- Mergers
- Abuse of dominant position
- Exclusive

Anti Combine Cases:

NutraSweet: gain a monopoly in aspartame by licensing the use of its swirl only on products for which it had an
exclusive deal
Bell Canada Enterprises: tried to tie the sale of advertising space in YELLOW PAGES to the sale of advertising
services from on of its subsidiaries
 Chapter 14 Practice Questions
1. Which of the following statements is true regarding oligopolies?
a. It is often very easy for new firms to enter the market
b. A market structure in which a limited number of firms compete in the market
c. There are only three natural or legal barriers surrounding market entry
d. None of the above

2. Which of the following are not aspects of games?

a. Rules
b. Fairness Policies
c. Payoffs
d. Outcomes

3. What occurs when someone chooses the best response based on someone else’s decision?
a. Nash equilibrium
b. Dilemma equilibrium
c. Payoff matrix
d. None of the above

4. Canada’s Anti-Combine Law, regulates:

a. All markets
b. Markets in perfect competition
c. Monopolies
d. Oligopolies

5. In a duopoly, what occurs when player 1 cheats while player 2 complies?

a. Both players gain economic profit
b. Both players gain zero economic profit
c. Player 1 gains economic profit while player 2 incurs economic loss
d. Player 2 gains economic profit while player 1 incurs economic loss

6. True or False: The Tit-for-Tat strategy is one where a player will cheat in the next round if their opponent
did not cheat in the previous period
a. True
b. False

7. What is true about the trigger strategy?

a. When a player cheats, the other player plays the Nash equilibrium strategy forever
b. One player cooperates with the other player in the first interaction and then mimics their
subsequent moves
c. When a player cooperates, the other player cooperates as well
d. Both A and C

8. Which of the following statements are true regarding cartels?

a. They are illegal
b. They don’t exist
c. They refer to a ‘massively tiny firm’ where a large number of firms collude
d. None of the above

9. What is true about a duopoly?

a. There is one firm controlling the market
 b. There are two firms with a large market share
c. No natural or legal barriers
d. None of the above

10. If collusion is successful, what occurs?

a. The price is the same as a monopoly
b. Economic profit increases
c. Output decreases
d. All of the above

11. If the efficient scale of production only allows two firms to supply a market, the market is a _____. In the
case of 3 firms, the market is then a ____.
a. Natural duopoly, three-firm monopoly
b. Natural duopoly, natural oligopoly
c. Two-firm monopoly, cost based oligopoly

12. Conspiracy, bid rigging, abuse of dominant position, and false advertising are all criminal practices,
except:
a. Bid rigging
b. Conspiracy
c. Abuse of dominant position
d. False advertising
e. b and c
f. None of the above
 Answer Key

Chapter 1: What is Economics?

1.B 2.B 3.C 4.A 5.A 6.C 7.E 8.C 9.A 10.D 11.D 12.C

Chapter 2: The Economic Problem

1.C 2.C 3.C 4.A 5.D 6.A 7.D 8.B 9.A 10.B 11.D 12.B 13.B 14.D 15.A 16.C 17.A 18.D 19.D 20.B

Chapter 3: Demand and Supply

1.C 2.D 3.D 4.C 5.C 6.D 7.B 8.D 9.C 10.C 11.B 12.C 13.B

Chapter 4: Elasticity
1.A 2.D 3.C 4.C 5.E 6.A 7.D 8.C 9.E 10.B 11.A 12.A 13.A 14.D 15.B 16.D 17.C 18.C 19.A

Chapter 5: Efficiency and Equity

1.C 2.A 3.B 4.D 5.B 6.B 7.A 8.B 9.D 10.A 11.C 12.A 13. D

Chapter 6: Social Welfare

1.C 2.B 3.D 4.D 5.A 6.C 7.D 8.B 9.C 10.A 11.C 12.D

Chapter 8: Utility and Demand

1.B 2.C 3.B 4.B 5.A 6.C 7.B 8.D 9.E 10.A 11.B 12.D 13.A 14.E 15.C

Chapter 9: Possibilities, Preference, and Choices

1.A 2.B 3.C 4.A 5.A 6.D 7.D 8.B 9.A 10.B 11.C 12.A 13.C 14.D 15.A 16.B

Chapter 10: Economic Cost and Profit

1.A 2.B 3.B 4.C 5.A 6.A 7.C 8.B 9.D 10.A 11.A 12.C 13.B 14.D 15.c 16.e 17.d 18.a

Chapter 11: Perfect Competition

1.E 2.C 3.B 4. A 5.B 6.D 7.D 8.B 9.D 10.B 11.B

Chapter 12: Monopoly

1.C 2.B 3.B 4.A 5.C 6.B 7.B 8.A 9.D 10.D
Chapter 13: Monopolistic Competition
1.D 2.C 3.A 4.A 5.B 6.A 7.C 8.D 9.C 10.B

Chapter 14: Oligopoly

1.B 2.B 3.A 4.D 5.C 6.B 7.D 8.A 9.B 10.D 11.B 12.C