PPM Session

Dr.
Arun Kumar
Course Handout
Course Objectives:
CO1: To understand the fundamental management
principles and concepts and the processes that
influences the firms.
CO2: To understand the role of managers within the
organization
CO3: To recognize the importance of different facets of
management in the competitive world
CO4: Market and its forces
2
Books
Text Book:
Niharika Vohra/Robbinson/Fundamental Book.
Reference Material:
Company websites; newspapers and business
magazines
3
Learning Outcomes
On successful completion of this course, it is hoped that

the participants will be able to critically analyze and
intelligently draw inferences as managers about the
strategies and tactics of organizations.
4
Evaluation Scheme
S. No. Components Weightage

1 Quiz-1 & 2 30%
2 Case Studies 10%
3 Project Report and 20%
Presentation
4 Class participation and 10%
attendance
5 End-term exam 30%
5
Experiential Learning
Project based approach:

• A group of 4/5 students will select a fictional
product or service that they would like to bring to
market. The student/ group then become the class
experts on the product, the company, and the
industry in which it operates. Students are
encouraged to look up articles about that industry in
Business Magazines, Business Journals, Business
News articles in newspapers, company press
releases, Media and Advertisement and
communication websites.
6
Project
 Use of concepts learnt in the course to analyze the
company and its products.
 Degree to which information was sought and attained.
 Quality of critique of company’s situation
 Quality of suggestions for future growth
 Quality of writing
7
Instructor Details
Dr. Arun Kumar
Contact Details
arunkumar@iiitm.ac.in
+91-9664205137
8
Questions for You
 What is your perspective on management?

 Major domains of management
 Main functions of Managers
9
Firm and Household Decisions
10
MARKET
DYNAMICS
11
Firms and Households: The Basic Decision-Making Units
firm An organization that transforms resources

(inputs) into products (outputs). Firms are the
primary producing units in a market economy.
entrepreneur A person who organizes, manages,

and assumes the risks of a firm, taking a new idea
or a new product and turning it into a successful
business.
households The consuming units in an economy.
12 of 69
Input Markets and Output Markets: The Circular Flow
product or output markets The markets in which

goods and services are exchanged.
input or factor markets The markets in which the

resources used to produce products are
exchanged.
13 of 69
In the input, or factor markets, which side of the market do firms
and households occupy?
a. Firms are on the supply side and households on the demand
side.
b. Firms are on the demand side and households on the supply
side.
c. Both firms and households are on the demand side.
d. Both firms and households are on the supply side.
e. Neither firms nor households are part of the demand side or
the supply side.
14
In the input, or factor markets, which side of the market do firms
and households occupy?
a. Firms are on the supply side and households on the demand
side.
b. Firms are on the demand side and households on the supply
side.
c. Both firms and households are on the demand side.
d. Both firms and households are on the supply side.
e. Neither firms nor households are part of the demand side or
the supply side.
15
Input Markets and Output
Markets: The Circular Flow
16
labor market The input/factor market in which

households supply work for wages to firms that
demand labor.
capital market The input/factor market in which

households supply their savings, for interest or for
claims to future profits, to firms that demand funds
to buy capital goods.
17
land market The input/factor market in which

households supply land or other real property in
exchange for rent.
factors of production The inputs into the

production process. Land, labor, and capital are
the three key factors of production.
Input and output markets are connected through the behavior of

both firms and households. Firms determine the quantities and
character of outputs produced and the types and quantities of
inputs demanded. Households determine the types and quantities
of products demanded and the quantities and types of inputs
supplied.
18
Which of the following is supplied by households in factor markets?
a. Labor.
b. Savings.
c. Land.
d. All of the above.
e. None of the above.
19
Which of the following is supplied by households in factor markets?
a. Labor.
b. Savings.
c. Land.
20
Demand in Product/Output Markets
A household’s decision about what quantity of a

particular output, or product, to demand depends
on a number of factors, including:
 The price of the product in question.

 The income available to the household.
 The household’s amount of accumulated
wealth.
 The prices of other products available to the
household.
 The household’s tastes and preferences.
 The household’s expectations about future
income, wealth, and prices.
21
quantity demanded The amount (number of units)

of a product that a household would buy in a given
period if it could buy all it wanted at the current
market price.
22
Changes in Quantity Demanded versus Changes in Demand
The most important relationship in individual

markets is that between market price and quantity
demanded.
Changes in the price of a product affect the quantity demanded

per period. Changes in any other factor, such as income or
preferences, affect demand. Thus, we say that an increase in the
price of Coca-Cola is likely to cause a decrease in the quantity of
Coca-Cola demanded. However, we say that an increase in
income is likely to cause an increase in the demand for most
goods.
23
Price and Quantity Demanded: The Law of Demand
demand schedule A table showing how much of a

given product a household would be willing to buy
at different prices.
demand curve A graph illustrating how much of a

given product a household would be willing to buy
at different prices.
24
TABLE Anna’s Demand Schedule

for Telephone Calls
Price Quantity Demanded
(Per Call) (Calls Per Month)
$ 0 30
.50 25
3.50 7
7.00 3
10.00 1
15.00 0
25
Demand Curves Slope Downward
law of demand The negative relationship between

price and quantity demanded: As price rises,
quantity demanded decreases; as price falls,
quantity demanded increases.
It is reasonable to expect quantity demanded to fall when price

rises, ceteris paribus, and to expect quantity demanded to rise
when price falls, ceteris paribus. Demand curves have a negative
slope.
26
Fill in the blanks. It is reasonable to expect that quantity
demanded will __________ when price rises, ceteris paribus,
and that demand curves have a __________ slope.
a. rise; positive
b. rise; negative
c. fall; positive
d. fall; negative
27
Fill in the blanks. It is reasonable to expect that quantity
demanded will __________ when price rises, ceteris paribus,
and that demand curves have a __________ slope.
a. rise; positive
b. rise; negative
c. fall; positive
d. fall; negative
28
Other Properties of Demand Curves
Two additional things are notable about Anna’s

demand curve.
As long as households have limited incomes and
wealth, all demand curves will intersect the price
axis. For any commodity, there is always a price
above which a household will not or cannot pay.
Even if the good or service is very important, all
households are ultimately constrained, or limited,
by income and wealth.
That demand curves intersect the quantity axis is a
matter of common sense. Demand in a given
period of time is limited, if only by time, even at a
zero price.
29
Other Properties of Demand Curves
To summarize what we know about the shape of

demand curves:
1. They have a negative slope. An increase in
price is likely to lead to a decrease in quantity
demanded, and a decrease in price is likely to
lead to an increase in quantity demanded.
2. They intersect the quantity (X-) axis, a result of
time limitations and diminishing marginal utility.
3. They intersect the price (Y-) axis, a result of
limited incomes and wealth.
30
That demand curves intersect both the price and the quantity axes
is a matter of common sense. Which of the following
explains that they intersect the price axis?
a. Time limitations and diminishing marginal utility.
b. Limited incomes and wealth.
c. The law of demand.
31
That demand curves intersect both the price and the quantity axes
is a matter of common sense. Which of the following
explains that they intersect the price axis?
a. Time limitations and diminishing marginal utility.
b. Limited incomes and wealth.
c. The law of demand.
32
Other Determinants of Household Demand
Income And Wealth
income The sum of all a household’s wages,

salaries, profits, interest payments, rents, and
other forms of earnings in a given period of time.
It is a flow measure.
wealth or net worth The total value of what a

household owns minus what it owes. It is a stock
measure.
33
Income And Wealth
normal goods Goods for which demand goes up

when income is higher and for which demand goes
down when income is lower.
inferior goods Goods for which demand tends to

fall when income rises.
34
Prices of Other Goods and Services
substitutes Goods that can serve as replacements

for one another; when the price of one increases,
demand for the other increases.
perfect substitutes Identical products.
complements, complementary goods Goods that

―go together‖; a decrease in the price of one
results in an increase in demand for the other and
vice versa.
35
Tastes and Preferences
Income, wealth, and prices of goods available are

the three factors that determine the combinations
of goods and services that a household is able to
buy.
Changes in preferences can and do manifest

themselves in market behavior.
Within the constraints of prices and incomes,

preference shapes the demand curve, but it is
difficult to generalize about tastes and
preferences. First, they are volatile. Second,
tastes are idiosyncratic.
36
Expectations
What you decide to buy today certainly depends

on today’s prices and your current income and
wealth.
There are many examples of the ways
expectations affect demand.
Increasingly, economic theory has come to
recognize the importance of expectations.
It is important to understand that demand depends
on more than just current incomes, prices, and
tastes.
37
Shift of Demand versus Movement Along a Demand Curve
TABLE Shift of Anna’s Demand Schedule Due to

increase in Income
Schedule D0 Schedule D1
Quantity Demanded Quantity Demanded
Price (Calls Per Month at an (Calls Per Month at
(Per Call) Income of $300 Per an Income of $600
Month) Per Month)
$ 0.00 30 35
0.50 25 33
3.50 7 18
7.00 3 12
10.00 1 7
15.00 0 2
20.00 0 0
38
shift of a demand curve The change that takes

place in a demand curve corresponding to a new
relationship between quantity demanded of a good
and price of that good. The shift is brought about
by a change in the original conditions.
movement along a demand curve The change in

quantity demanded brought about by a change in
price.
Change in price of a good or service leads to
Change in quantity demanded (movement
along the demand curve).
Change in income, preferences, or prices of other
goods or services leads to
Change in demand (shift of the demand
curve).
39
Refer to the figure below. Which move illustrates the impact of a
decrease in market price on market demand, all else the same?
a. The move from A to B.
b. The move from A to C.
c. Both moves show the same result on demand.
d. None of the above.
40
Refer to the figure below. Which move illustrates the impact of a
decrease in market price on market demand, all else the same?
c. Both moves show the same result on demand.
41
42
43
From Household Demand To Market Demand
market demand The sum of all the quantities of a

good or service demanded per period by all the
households buying in the market for that good or
service.
44
Refer to the figure below. Assume that TVs and VCRs are two
complements and that the diagram below represents the
demand for VCRs. Which move would best describe the
impact of a decrease in the price of TVs on this diagram?
c. Both a and b above.
45
Refer to the figure below. Assume that TVs and VCRs are two
complements and that the diagram below represents the
demand for VCRs. Which move would best describe the
impact of a decrease in the price of TVs on this diagram?
c. Both a and b above.
46
Supply in Product/Output Markets
Successful firms make profits because they are

able to sell their products for more than it costs to
produce them.
profit The difference between revenues and costs.
47
Price and Quantity Supplied: The Law of Supply
quantity supplied The amount of a particular

product that a firm would be willing and able to
offer for sale at a particular price during a given
time period.
supply schedule A table showing how much of a

product firms will sell at different prices.
48
law of supply The positive relationship between

price and quantity of a good supplied: An increase
in market price will lead to an increase in quantity
supplied, and a decrease in market price will lead
to a decrease in quantity supplied.
supply curve A graph illustrating how much of a

product a firm will sell at different prices.
49
TABLE Clarence Brown’s Supply

Schedule for Soybeans
Quantity Supplied
Price (Per Bushel) (Bushels Per Year)
$1.50 0
1.75 10,000
2.25 20,000
3.00 30,000
4.00 45,000
5.00 45,000
50
Other Determinants Of Supply
The Cost Of Production
In order for a firm to make a profit, its revenue

must exceed its costs.
Cost of production depends on a number of

factors, including the available technologies and
the prices and quantities of the inputs needed by
the firm (labor, land, capital, energy, and so on).
51
Other Determinants Of Supply
The Prices of Related Products
Assuming that its objective is to maximize profits, a firm’s decision

about what quantity of output, or product, to supply depends on:
1. The price of the good or service.
2. The cost of producing the product, which in turn depends on:
■ The price of required inputs (labor, capital, and land).
■ The technologies that can be used to produce the
product.
3. The prices of related products.
52
The decision of a profit-maximizing firm about what quantity of
output to supply depends on:
a. The price of the good or service.
b. The cost of producing the product.
c. The technologies that can be used to produce the product.
53
The decision of a profit-maximizing firm about what quantity of
output to supply depends on:
a. The price of the good or service.
b. The cost of producing the product.
c. The technologies that can be used to produce the product.
54
Shift of Supply versus Movement Along a Supply Curve
movement along a supply curve The change in

quantity supplied brought about by a change in
price.
shift of a supply curve The change that takes place

in a supply curve corresponding to a new
relationship between quantity supplied of a good
and the price of that good. The shift is brought
about by a change in the original conditions.
55
TABLE Shift of Supply Schedule for Soybeans

Following Development of a New
Disease-Resistant Seed Strain
SCHEDULE D0 SCHEDULE D1
Quantity Supplied Quantity Supplied
Price (Bushels per Year (Bushels per Year
(per Bushel) Using Old Seed) Using New Seed)
$1.50 0 5,000
1.75 10,000 23,000
2.25 20,000 33,000
3.00 30,000 40,000
4.00 45,000 54,000
5.00 45,000 54,000
56
As with demand, it is very important to distinguish

between movements along supply curves
(changes in quantity supplied) and shifts in supply
curves (changes in supply):
Change in price of a good or service leads to

Change in quantity supplied (movement
along a supply curve).
Change in income, preferences, or prices of other
goods or services leads to
Change in supply (shift of a supply curve).
57
From Individual Supply to Market Supply
market supply The sum of all that is supplied each

period by all producers of a single product.
58
Refer to the figure below. Which of the following moves best describes what
happens when a change in the price of soybeans affects market supply?
a. A move from A to B.
b. A move from A to C.
c. Either move from A to B or A to C.
d. A move from B to C.
59
Refer to the figure below. Which of the following moves best describes what
happens when a change in the price of soybeans affects market supply?
a. A move from A to B.
b. A move from A to C.
c. Either move from A to B or A to C.
d. A move from B to C.
60
Market Equilibrium
equilibrium The condition that exists when quantity

supplied and quantity demanded are equal. At
equilibrium, there is no tendency for price to
change.
Excess Demand
excess demand or shortage The condition that

exists when quantity demanded exceeds quantity
supplied at the current price.
61
Market Equilibrium
Excess Demand
62
Market Equilibrium
Excess Supply
excess supply or surplus The condition that exists

when quantity supplied exceeds quantity
demanded at the current price.
63
Market Equilibrium
Excess Supply
64
Refer to the figure below. When market price is $1.75, which of the following
is correct?
a. There is excess supply.
b. There is a surplus.
c. Quantity demanded is greater than quantity supplied.
65
Refer to the figure below. When market price is $1.75, which of the following
is correct?
a. There is excess supply.
b. There is a surplus.
c. Quantity demanded is greater than quantity supplied.
66
Market Equilibrium
Changes In Equilibrium
When supply and demand curves shift, the equilibrium

price and quantity change.
67
Market Equilibrium
68
Which of the following situations leads to a lower equilibrium price?
a. An increase in demand, without a change in supply.
b. A decrease in supply accompanied by an increase in demand.
c. A decrease in supply, without a change in demand.
d. A decrease in demand accompanied by an increase in supply.
e. An increase in demand accompanied by an increase in supply.
69
Which of the following situations leads to a lower equilibrium price?
a. An increase in demand, without a change in supply.
b. A decrease in supply accompanied by an increase in demand.
c. A decrease in supply, without a change in demand.
d. A decrease in demand accompanied by an increase in supply.
e. An increase in demand accompanied by an increase in supply.
70
Market Equilibrium
Bad News for Orange

Juice Fanatics
Orange Juice Prices Could
Skyrocket After Freeze Destroys
Most of California Output
City News
71
Demand and Supply in Product Markets: A Review
Here are some important points to remember about

the mechanics of supply and demand in product
markets:
1. A demand curve shows how much of a product

a household would buy if it could buy all it
wanted at the given price. A supply curve
shows how much of a product a firm would
supply if it could sell all it wanted at the given
price.
2. Quantity demanded and quantity supplied are
always per time period—that is, per day, per
month, or per year.
3. The demand for a good is determined by price,
household income and wealth, prices of other
goods and services, tastes and preferences,
and expectations.
72
Demand and Supply in Product Markets: A Review
Here are some important points to remember about

the mechanics of supply and demand in product
markets:
4. The supply of a good is determined by price, costs

of production, and prices of related products.
Costs of production are determined by available
technologies of production and input prices.
5. Be careful to distinguish between movements along
supply and demand curves and shifts of these
curves. When the price of a good changes, the
quantity of that good demanded or supplied
changes—that is, a movement occurs along the
curve. When any other factor changes, the curve
shifts, or changes position.
6. Market equilibrium exists only when quantity
supplied equals quantity demanded at the current
price.
73
The Price System: Rationing and Allocating Resources
Price Rationing
price rationing The process by which the market

system allocates goods and services to consumers
when quantity demanded exceeds quantity supplied.
75
Refer to the graph below. At what price level is price rationing
especially necessary?
a. At $2.25.
b. At $2.50.
c. At $1.75.
d. None of the above. Price rationing is never desirable.
76
Refer to the graph below. At what price level is price rationing
especially necessary?
a. At $2.25.
b. At $2.50.
c. At $1.75.
d. None of the above. Price rationing is never desirable.
77
Refer to the figure. Start at point C. What is the impact of the shift in supply
on the demand side of the market?
a. After the shift in supply, there is a decrease in quantity demanded.
b. After the shift in supply, there is a decrease in demand.
c. After the shift in supply, there is an increase in demand.
d. After the shift in supply, there is an increase in quantity demanded.
78
Refer to the figure. Start at point C. What is the impact of the shift in supply
on the demand side of the market?
a. After the shift in supply, there is a decrease in quantity demanded.
b. After the shift in supply, there is a decrease in demand.
c. After the shift in supply, there is an increase in demand.
d. After the shift in supply, there is an increase in quantity demanded.
79
Price Rationing
The adjustment of price is the rationing mechanism in free markets.

Price rationing means that whenever there is a need to ration a
good—that is, when a shortage exists—in a free market, the price of
the good will rise until quantity supplied equals quantity demanded—
that is, until the market clears.
80
Refer to the figure below. The price of the good in question in this graph is
primarily determined by:
a. Demand.
b. Supply.
c. Consumer surplus.
d. None of the above. The price is indeterminate.
81
Refer to the figure below. The price of the good in question in this graph is
primarily determined by:
a. Demand.
b. Supply.
c. Consumer surplus.
d. None of the above. The price is indeterminate.
82
Constraints on the Market and Alternative Rationing Mechanisms
On occasion, both governments and private firms decide to

use some mechanism other than the market system to
ration an item for which there is excess demand at the
current price.
Regardless of the rationale, two things are clear:
1. Attempts to bypass price rationing in the market and to
use alternative rationing devices are much more
difficult and costly than they would seem at first glance.
2. Very often, such attempts distribute costs and benefits
among households in unintended ways.
83
Oil, Gasoline, and OPEC

price ceiling A maximum price that
sellers may charge for a good,
usually set by government.
84
queuing Waiting in line as a means of

distributing goods and services: a
nonprice rationing mechanism.
favored customers Those who receive

special treatment from dealers during
situations of excess demand.
ration coupons Tickets or coupons that

entitle individuals to purchase a certain
amount of a given product per month.
black market A market in which illegal

trading takes place at market-determined
prices.
85
Refer to the figure. Assume that the price
of $1.75 is a government imposed
price. Only one of the statements
below is entirely correct. Which one?
a. At a price of $1.75, there is a surplus
of soybeans, which is the result of an
imposed price floor.
b. At a price of $1.75, there is a
shortage of soybeans, which is the
result of an imposed price floor of
$1.75.
c. This graph shows a surplus of
soybeans, which is the result of an
imposed price ceiling of $1.75.
d. This graph shows a shortage of
86
Refer to the figure. Assume that the price
of $1.75 is a government imposed
price. Only one of the statements
below is entirely correct. Which one?
a. At a price of $1.75, there is a surplus
of soybeans, which is the result of an
imposed price floor.
b. At a price of $1.75, there is a
shortage of soybeans, which is the
result of an imposed price floor of
$1.75.
c. This graph shows a surplus of
d. This graph shows a shortage of
87
No matter how good the intentions of private

organizations and governments, it is very difficult to
prevent the price system from operating and to stop
willingness to pay from asserting itself. Every time
an alternative is tried, the price system seems to
sneak in the back door. With favored customers
and black markets, the final distribution may be
even more unfair than that which would result from
simple price rationing.
88
Prices and the Allocation of Resources
Price changes resulting from shifts of demand in

output markets cause profits to rise or fall. Profits
attract capital; losses lead to disinvestment. Higher
wages attract labor and encourage workers to
acquire skills. At the core of the system, supply,
demand, and prices in input and output markets
determine the allocation of resources and the
ultimate combinations of things produced.
89
Prices and the Allocation of Resources
The Price Mechanism at

Work for Shakespeare
Every summer, New York City
puts on free performances of
Shakespeare in the Park.
The true cost of a ticket is $0 plus the opportunity cost of
the time spent in line.
Students can produce tickets relatively cheaply by waiting
in line. They can then turn around and sell those tickets to
the high-wage Shakespeare lovers.
90
The rationale most often used by governments to intervene in the
market system and try to determine its own rationing mechanism
is:
a. Efficiency and productivity.
b. Fairness.
c. Queuing.
d. Elasticity.
91
The rationale most often used by governments to intervene in the
market system and try to determine its own rationing mechanism
is:
a. Efficiency and productivity.
b. Fairness.
c. Queuing.
d. Elasticity.
92
Price Floors
price floor A minimum price below which

exchange is not permitted.
minimum wage A price floor set for the

price of labor.
93
Supply and Demand Analysis: An Oil Import Fee
94
Refer to the figure below. Imposition of the oil import fee causes the
quantity of imports to:
a. Increase by 10 million barrels.
b. Decrease by 10 million barrels.
c. Decrease by 20 million barrels.
d. Decrease by 30 million barrels.
e. Decrease by 50 million barrels.
95
Refer to the figure below. Imposition of the oil import fee causes the
quantity of imports to:
a. Increase by 10 million barrels.
b. Decrease by 10 million barrels.
c. Decrease by 20 million barrels.
d. Decrease by 30 million barrels.
e. Decrease by 50 million barrels.
96
Supply and Demand and Market Efficiency
Consumer Surplus
consumer surplus The difference between the

maximum amount a person is willing to pay for a
good and its current market price.
97
Consumer Surplus
98
Producer Surplus
producer surplus The difference

between the current market price and the full cost of
production for the firm.
99
Producer Surplus
100
Refer to the figure below. How much are suppliers willing to receive
in order to produce 1 million hamburgers?
a. $5.00 per hamburger.
b. $2.50 per hamburger.
c. $0.75 per hamburger.
d. Anywhere between $2.50 and $5.00 per hamburger.
101
Refer to the figure below. How much are suppliers willing to receive in
order to produce 1 million hamburgers?
a. $5.00 per hamburger.
b. $2.50 per hamburger.
c. $0.75 per hamburger.
d. Anywhere between $2.50 and $5.00 per hamburger.
102
Competitive Markets Maximize the Sum of Producer and Consumer

Surplus
103
Competitive Markets Maximize the Sum of Producer and Consumer

Surplus
deadweight loss The net loss of producer and

consumer surplus from underproduction or
overproduction.
104
105
Refer to the figure. What is the impact of the
shift in supply on consumer surplus?
a. Consumer surplus decreases, from acd
to abe.
b. Consumer surplus decreases, from acf
to abg.
c. Consumer surplus increases, from gbcf
to abg.
d. Consumer surplus increases, from
cbed to acd.
e. Consumer surplus does not change
because supply is shifting, not demand.
106
Refer to the figure. What is the impact of the
shift in supply on consumer surplus?
a. Consumer surplus decreases, from acd
to abe.
b. Consumer surplus decreases, from acf
to abg.
c. Consumer surplus increases, from gbcf
to abg.
d. Consumer surplus increases, from
cbed to acd.
e. Consumer surplus does not change
because supply is shifting, not demand.
107
Potential Causes of Deadweight Loss From Under- and

Overproduction
When supply and demand interact freely, competitive markets

produce what people want at least cost, that is, they are efficient.
There are a number of naturally occurring sources of market

failure. Monopoly power gives firms the incentive to
underproduce and overprice, taxes and subsidies may distort
consumer choices, external costs such as pollution and
congestion may lead to over- or underproduction of some goods,
and artificial price floors and price ceilings may have the same
effects.
108
Refer to the figure below. The market on the left produces 7 million units,
while the market on the right produces 10 million units. In which
market is the total surplus generated from production and
consumption the highest?
a. In the market on the left.
b. In the market on the right.
c. In neither market. Both markets generate the same amount of
surplus.
d. In neither market. These markets don’t generate any surpluses.
109
Refer to the figure below. The market on the left produces 7 million units,
while the market on the right produces 10 million units. In which
market is the total surplus generated from production and
consumption the highest?
a. In the market on the left.
b. In the market on the right.
c. In neither market. Both markets generate the same amount of
surplus.
d. In neither market. These markets don’t generate any surpluses.
110
111
Elasticity
elasticity A general concept used to quantify the

response in one variable when another variable
changes.
%A
elasticity of A with respect to B 
%B
112
Price Elasticity of Demand
Slope and Elasticity
113
Slope and Elasticity
price elasticity of demand The ratio of the

percentage of change in quantity demanded to
the percentage of change in price; measures
the responsiveness of quantity demanded to
changes in price.
% change in quantity demanded

price elasticity of demand 
% change in price
114
Types of Elasticity
TABLE Hypothetical Demand Elasticities for Four Products

% Change
% Change In In Quantity
Price Demanded Elasticity
Product (% P) (% QD) (% QD ÷ %P)
Insulin +10% 0% .0 Perfectly inelastic
Basic telephone service +10% -1% -.1 Inelastic
Beef +10% -10% -1.0 Unitarily elastic

Bananas +10% -30% -3.0 Elastic
perfectly inelastic demand Demand in which

quantity demanded does not respond at all to a
change in price.
115
Types of Elasticity
116
Types of Elasticity
inelastic demand Demand that responds

somewhat, but not a great deal, to changes in
price. Inelastic demand always has a numerical
value between zero and -1.
A warning: You must be very careful about signs.

Because it is generally understood that demand
elasticities are negative (demand curves have a
negative slope), they are often reported and
discussed without the negative sign.
117
Types of Elasticity
unitary elasticity A demand relationship in which the

percentage change in quantity of a product
demanded is the same as the percentage change in
price in absolute value (a demand elasticity of -1).
elastic demand A demand relationship in which the

percentage change in quantity demanded is larger
than the percentage change in price in absolute
value (a demand elasticity with an absolute value
greater than 1).
perfectly elastic demand Demand in which quantity

drops to zero at the slightest increase in price.
118
When the percentage change in quantity demanded is greater
than the percentage change in price:
a. The value of demand elasticity is greater than one.
b. The demand curve is relatively steep.
c. There are few substitutes for the good in question.
d. There is little responsiveness in quantity demanded to
changes in price.
e. All of the above.
119
When the percentage change in quantity demanded is greater
than the percentage change in price:
a. The value of demand elasticity is greater than one.
b. The demand curve is relatively steep.
c. There are few substitutes for the good in question.
d. There is little responsiveness in quantity demanded to
changes in price.
e. All of the above.
120
Types of Elasticity
A good way to remember the difference between

the two ―perfect‖ elasticities is:
121
Calculating Elasticities
Calculating Percentage Changes
To calculate percentage change in quantity

demanded using the initial value as the base, the
following formula is used:
change in quantity demanded

% change in quantity demanded  x 100%
Q1
Q -Q
 2
x 100%
1
Q 1
122
Calculating Percentage Changes
We can calculate the percentage change in price

in a similar way. Once again, let us use the initial
value of P—that is, P1—as the base for calculating
the percentage. By using P1 as the base, the
formula for calculating the percentage of change in
P is
change in price
% change in price  x 100%
P 1
P -P
 2
x 100%
1
P 1
123
Elasticity Is a Ratio of Percentages
Once all the changes in quantity demanded and

price have been converted to percentages,
calculating elasticity is a matter of simple division.
Recall the formal definition of elasticity:

price elasticity of demand 
% change in price
124
The Midpoint Formula
midpoint formula A more precise way of

calculating percentages using the value halfway
between P1 and P2 for the base in calculating the
percentage change in price, and the value halfway
between Q1 and Q2 as the base for calculating the
percentage change in quantity demanded.
change in quantity demanded

% change in quantity demanded  x 100%
(Q  Q ) / 2
1 2
Q -Q
 2
x 100%
1
(Q  Q ) / 2
1 2
125
Using the point halfway between P1 and P2 as the

base for calculating the percentage change in
price, we get
change in price
% change in price  x 100%
(P  P ) / 2
1 2
P -P
 2
x 100%
1
(P  P ) / 2
1 2
126
Refer to the figure below. Using the arc elasticity formula, the
value of price elasticity of demand equals:
a. 2.5.
b. 6.0
c. 3.7.
d. 0.27.
127
Refer to the figure below. Using the arc elasticity formula, the
value of price elasticity of demand equals:
a. 2.5.
b. 6.0
c. 3.7.
d. 0.27.
128
129
Elasticity Changes Along a Straight-Line Demand Curve
TABLE Demand Schedule for

Office Dining Room
Lunches
Price Quantity
(per Demanded
Lunch) (Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22
130
Refer to the figure. Using the midpoint
formula, calculate the values of
elasticity between points A and B,
and then between points C and D.
Those values are, respectively:
a. –6.4 and –0.294
b. –0.1 and –4.54
c. –0.15 and –3.40
d. –0.5 and –0.5. Elasticity is the same
for both sets of points because the
demand curve is linear; thus, the
slope of the line remains constant.
131
Refer to the figure. Using the midpoint
formula, calculate the values of
elasticity between points A and B,
and then between points C and D.
Those values are, respectively:
a. –6.4 and –0.294
b. –0.1 and –4.54
c. –0.15 and –3.40
d. –0.5 and –0.5. Elasticity is the same
for both sets of points because the
demand curve is linear; thus, the
slope of the line remains constant.
132
Elasticity and Total Revenue
In any market, P x Q is total revenue (TR) received

by producers:
TR = P x Q
total revenue = price x quantity
When price (P) declines, quantity demanded (QD)

increases. The two factors, P and QD move in
opposite directions:
Effects of price changes P  QD 

on quantity demanded: and
P  QD 
133
Because total revenue is the product of P and Q,

whether TR rises or falls in response to a price
increase depends on which is bigger: the
percentage increase in price or the percentage
decrease in quantity demanded.
Effects of price increase on

a product with inelastic demand:  P x QD   TR 
If the percentage decline in quantity demanded

following a price increase is larger than the
percentage increase in price, total revenue will fall.
Effects of price increase on

a product with elastic demand:  P x QD   TR 
134
The opposite is true for a price cut. When demand

is elastic, a cut in price increases total revenues:
effect of price cut on a product

with elastic demand:  P x QD   TR 
When demand is inelastic, a cut in price reduces

total revenues:
effect of price cut on a product

with inelastic demand:  P x QD   TR 
135
When demand is elastic, a decrease in price leads to:
a. A decrease in total revenue.
b. An increase in total revenue.
c. An increase in quantity demanded, but no change in revenue.
d. A change in revenue, without a change in quantity demanded.
136
When demand is elastic, a decrease in price leads to:
a. A decrease in total revenue.
b. An increase in total revenue.
c. An increase in quantity demanded, but no change in revenue.
d. A change in revenue, without a change in quantity demanded.
137
The Determinants of Demand Elasticity
Availability of Substitutes
Perhaps the most obvious factor affecting demand

elasticity is the availability of substitutes.
The Importance of Being Unimportant
When an item represents a relatively small part of

our total budget, we tend to pay little attention to
its price.
The Time Dimension
The elasticity of demand in the short run may be

very different from the elasticity of demand in the
long run. In the longer run, demand is likely to
become more elastic, or responsive, simply
because households make adjustments over time
and producers develop substitute goods.
138
The Determinants of Demand Elasticity
Who Are the Elastic

Smokers?
Bill aims to raise tax on
cigarettes
Seattle Times
139
Other Important Elasticities
Income Elasticity of Demand
income elasticity of demand A measure of the

responsiveness of demand to changes in income.

income elasticity of demand 
% change in income
140
Which of the following is a true statement?
a. The fewer substitutes available for a product, the greater the
price elasticity of demand.
b. The more time that passes, the more inelastic the demand for a
product becomes.
c. When an item represents a small portion of our total budget,
demand for that item is likely to be inelastic.
141
Which of the following is a true statement?
a. The fewer substitutes available for a product, the greater the
price elasticity of demand.
b. The more time that passes, the more inelastic the demand for a
product becomes.
c. When an item represents a small portion of our total budget,
demand for that item is likely to be inelastic.
142
Cross-Price Elasticity Of Demand
cross-price elasticity of demand A measure of the

response of the quantity of one good demanded to
a change in the price of another good.
% change in quantity of Y demanded

cross - price elasticity of demand 
% change in price of X
143
Elasticity Of Supply
elasticity of supply A measure of the response of

quantity of a good supplied to a change in price of
that good. Likely to be positive in output markets.
% change in quantity supplied

elasticity of supply 
% change in price
144
Elasticity Of Supply
elasticity of labor supply A measure of the

response of labor supplied to a change in the price
of labor.
% change in quantity of labor supplied

elasticity of labor supply 
% change in the wage rate
145
POINT ELASTICITY (OPTIONAL)
146
147
The analysis of the interaction between firms and households
assumes that:
a. Labor and capital are supplied by households.
b. Labor and capital are supplied by firms.
c. The demand curve for labor illustrates the households’
participation in the labor market.
148
The analysis of the interaction between firms and households
assumes that:
a. Labor and capital are supplied by households.
b. Labor and capital are supplied by firms.
c. The demand curve for labor illustrates the households’
participation in the labor market.
149
Household Choice in Output Markets
Every household must make three basic decisions:
1. How much of each product, or output, to demand
2. How much labor to supply
3. How much to spend today and how much to save

for the future
150
Every household must make three basic decisions. Which of
these decisions is more closely associated with the capital
market?
a. How much of each product to demand.
b. How much labor to supply.
c. How much to spend today and how much to save for the
future.
d. How much to invest.
151
Every household must make three basic decisions. Which of
these decisions is more closely associated with the capital
market?
a. How much of each product to demand.
b. How much labor to supply.
c. How much to spend today and how much to save for the
future.
d. How much to invest.
152
The Determinants of Household Demand
Several factors influence the quantity of a given good or service

demanded by a single household:
 The price of the product
 The income available to the household
 The household’s amount of accumulated wealth
 The prices of other products available to the household
 The household’s tastes and preferences
 The household’s expectations about future income,
wealth, and prices
153
The Budget Constraint
budget constraint The limits imposed on

household choices by income, wealth,
and product prices.
TABLE Possible Budget Choices of a Person Earning

$1,000 Per Month After Taxes
Monthly Other
Option Rent Food Expenses Total Available
?
A $ 400 $250 $350 $1,000 Yes
B 600 200 200 1,000 Yes
C 700 150 150 1,000 Yes
D 1,000 100 100 1,200 No
choice set or opportunity set The set of options

that is defined and limited by a budget
constraint.
154
Preferences, Tastes, Trade-Offs, and Opportunity Cost
155
HOUSEHOLD CHOICE IN OUTPUT MARKETS
The Equation Of The Budget Constraint
In general, the budget constraint can be written:
PXX + PYY = I,
where PX = the price of X, X = the quantity of X

consumed, PY = the price of Y, Y = the quantity
of Y consumed, and I = household income.
156
HOUSEHOLD CHOICE IN OUTPUT MARKETS
Budget Constraints Change When Prices Rise or Fall
157
Refer to the figure below. What explains the moves in the budget lines in
graphs A and B?
a. Both the rotation in A and the shift in B are caused by increases in
income.
b. The rotation in graph A is caused by a decrease in the price of X, while
the shift in B is caused by an increase in income.
c. Both the rotation in A and the shift in B are caused by decreases in the
prices of goods X and Y.
d. The rotation in graph A is caused by a change in income, while the
rotation in graph B is the result of a decrease in the price of one of the
goods.
158
Refer to the figure below. What explains the moves in the budget lines in
graphs A and B?
a. Both the rotation in A and the shift in B are caused by increases in
income.
b. The rotation in graph A is caused by a decrease in the price of X, while
the shift in B is caused by an increase in income.
c. Both the rotation in A and the shift in B are caused by decreases in the
prices of goods X and Y.
d. The rotation in graph A is caused by a change in income, while the
rotation in graph B is the result of a decrease in the price of one of the
goods.
159
The Basis of Choice: Utility
utility The satisfaction, or reward, a product yields

relative to its alternatives. The basis of choice.
Diminishing Marginal Utility
marginal utility (MU) The additional satisfaction

gained by the consumption or use of one more unit
of something.
total utility The total amount of satisfaction obtained

from consumption of a good or service.
law of diminishing marginal utility The more of any

one good consumed in a given period, the less
satisfaction (utility) generated by consuming each
additional (marginal) unit of the same good.
160
TABLE Total Utility and Marginal

Utility of Trips to the
Club Per Week
Trips Total Marginal
to Club Utility Utility
1 12 12
2 22 10
3 28 6
4 32 4
5 34 2
6 34 0
161
Allocating Income To Maximize Utility
TABLE Allocation of Fixed Expenditure per Week Between Two Alternatives
(5) Marginal
(1) Trips to Club (3) Marginal Utility per Dollar
per Week (2) Total Utility Utility (MU) (4) Price (P) (MU/P)
1 12 12 $3.00 4.0
2 22 10 3.00 3.3
3 28 6 3.00 2.0
4 32 4 3.00 1.3
5 34 2 3.00 0.7
6 34 0 3.00 0
(5) Marginal Utility
(1) Basketball (3) Marginal per Dollar
Games per Week (2) Total Utility Utility (MU) (4) Price (P) (MU/P)
1 21 21 $6.00 3.5
2 33 12 6.00 2.0
3 42 9 6.00 1.5
4 48 6 6.00 1.0
5 51 3 6.00 .5
6 51 0 6.00 0
162
The Utility-Maximizing Rule
In general, utility-maximizing consumers spread out their

expenditures until the following condition holds:
MU X MU Y
utility-maximizing rule:  for all goods
PX PY
utility-maximizing rule Equating the ratio of the marginal

utility of a good to its price for all goods.
diamond/water paradox A paradox stating that (1) the things

with the greatest value in use frequently have little or no
value in exchange and (2) the things with the greatest value
in exchange frequently have little or no value in use.
163
In the formula below, the marginal utility per dollar spent on good X
is less than the marginal utility per dollar spent on good Y. To
increase total utility, the consumer should:
marginal utility of good X marginal utility of good Y


price of X price of Y
a. Increase the consumption of good X.
b. Increase the consumption of good Y.
c. Increase the consumption of both goods.
d. Decrease the consumption of both goods.
e. Maintain consumption constant
164
In the formula below, the marginal utility per dollar spent on good X
is less than the marginal utility per dollar spent on good Y. To
increase total utility, the consumer should:
marginal utility of good X marginal utility of good Y


price of X price of Y
a. Increase the consumption of good X.
b. Increase the consumption of good Y.
c. Increase the consumption of both goods.
d. Decrease the consumption of both goods.
e. Maintain consumption constant
165
Income and Substitution Effects
Google: Is It Work
or Is It Leisure?
By providing many services
at the workplace, Google
has potentially affected the
trade-off people make
between work and leisure.
In the end, without increasing wages, Google may have
reduced the marginal utility of leisure and made people
more willing to work longer hours.
166
The Production Process: The Behavior of Profit-maximizing Firms
production The process by which inputs are

combined, transformed, and turned into outputs.
Production Is Not Limited to Firms
firm An organization that comes into being when a

person or a group of people decides to produce a
good or service to meet a perceived demand. Most
firms exist to make a profit.
167
The Behavior of Profit-Maximizing Firms
All firms must make several basic decisions to

achieve what we assume to be their primary
objective—maximum profits.
168
Profits and Economic Costs
profit (economic profit) The difference between

total revenue and total cost.
profit = total revenue - total cost
total revenue The amount received from the sale

of the product (q x P).
169
total cost (total economic cost) The total of (1)

out-of-pocket costs, (2) normal rate of return on
capital, and (3) opportunity cost of each factor of
production.
The term profit will from here on refer to economic

profit. So whenever we say profit = total revenue -
total cost, what we really mean is
economic profit = total revenue - total economic cost
170
Normal Rate of Return
normal rate of return A rate of return on capital

that is just sufficient to keep owners and investors
satisfied. For relatively risk-free firms, it should be
nearly the same as the interest rate on risk-free
government bonds.
TABLE Calculating Total Revenue, Total Cost, and Profit

Initial Investment: Market Interest Rate Available: $20,000 0.10 or 10%
Total revenue (3,000 belts x $10 each) $30,000
Costs
Belts from Supplier $15,000
Labor cost 14,000
Normal return/Opportunity Cost of Capital ($20,000 x 0.10) 2,000
Total Cost $31,000
Profit = total revenue - total cost -$1,000
171
Among the components of total cost is:
a. Total revenue.
b. A normal rate of return.
c. Economic profit.
d. Productivity.
172
Among the components of total cost is:
a. Total revenue.
b. A normal rate of return.
c. Economic profit.
d. Productivity.
173
Short-Run Versus Long-Run Decisions
short run The period of time for which two

conditions hold: The firm is operating under a
fixed scale (fixed factor) of production, and firms
can neither enter nor exit an industry.
long run That period of time for which there are no

fixed factors of production: Firms can increase or
decrease the scale of operation, and new firms
can enter and existing firms can exit the industry.
174
The Bases of Decisions: Market Price of Outputs, Available

Technology, and Input Prices
In the language of economics, I need to know

three things:
1. The market price of output

2. The techniques of production that are available
3. The prices of inputs
Output price determines potential revenues. The

techniques available tell me how much of each
input I need, and input prices tell me how much
they will cost. Together, the available production
techniques and the prices of inputs determine
costs.
175
The Bases of Decisions: Market Price of Outputs, Available

Technology, and Input Prices
optimal method of production The production

method that minimizes cost.
176
The Production Process
production technology The quantitative

relationship between inputs and outputs.
labor-intensive technology Technology that relies

heavily on human labor instead of capital.
capital-intensive technology Technology that relies

heavily on capital instead of human labor.
177
Firms in an economy with high labor costs have an incentive to use:
a. Labor-intensive technologies.
b. Capital-intensive technologies.
c. Less than optimal production technologies.
d. The production method than maximizes cost.
178
Firms in an economy with high labor costs have an incentive to use:
a. Labor-intensive technologies.
b. Capital-intensive technologies.
c. Less than optimal production technologies.
d. The production method than maximizes cost.
179
Production Functions: Total Product, Marginal Product, And Average

Product
production function or total product function A

numerical or mathematical expression of a
relationship between inputs and outputs. It shows
units of total product as a function of units of
inputs.
TABLE Production Function

(1) Labor Units (2) Total Product (3) Marginal Product (4) Average Product of Labor
(Employees) (Sandwiches per Hour) of Labor (Total Product + Labor Units)
0 0 - -
1 10 10 10.0
2 25 15 12.5
3 35 10 11.7
4 40 5 10.0
5 42 2 8.4
6 42 0 7.0
180

Product
181
The shape of the short-run production function is fundamentally attributed
to:
a. A labor constraint.
b. A capital constraint.
c. The assumption that not all workers are equally capable.
182
The shape of the short-run production function is fundamentally attributed
to:
a. A labor constraint.
b. A capital constraint.
c. The assumption that not all workers are equally capable.
183

Product
Marginal Product and the Law of Diminishing Returns
marginal product The additional output that can

be produced by adding one more unit of a specific
input, ceteris paribus.
law of diminishing returns When additional units of

a variable input are added to fixed inputs after a
certain point, the marginal product of the variable
input declines.
Diminishing returns always apply in the short run,

and in the short run every firm will face diminishing
returns. This means that every firm finds it
progressively more difficult to increase its output as
it approaches capacity production.
184

Product
Marginal Product Versus Average Product
average product The average amount produced

by each unit of a variable factor of production.
total product
average product of labor 
total units of labor
185
Production Functions: Total

Product, Marginal Product, And
Average Product
186
The relationship between the average product of labor (APL) and the
marginal product of labor (MPL) is as follows:
a. When MPL is below APL, APL rises.
b. When MPL is above APL, APL rises.
c. APL increases as long as MPL increases.
d. MPL > APL when APL is declining.
e. When MPL is equal to APL, APL is minimum.
187
The relationship between the average product of labor (APL) and the
marginal product of labor (MPL) is as follows:
a. When MPL is below APL, APL rises.
b. When MPL is above APL, APL rises.
c. APL increases as long as MPL increases.
d. MPL > APL when APL is declining.
e. When MPL is equal to APL, APL is minimum.
188
Production Functions with Two Variable Factors of Production
How Fast Should a Truck

Driver Go?
Modern technology, in the form of
on-board computers, allows a
modern trucking firm to monitor
driving speed and instructs
drivers.
189
Choice of Technology
Inputs Required to Produce 100 Diapers Using Alternative Technologies

Technology Units of Capital (K) Units of Labor (L)
A 2 10
B 3 6
C 4 4
D 6 3
E 10 2
Cost-Minimizing Choice Among Alternative Technologies (100 Diapers)

(4) (5)
(2) (3) Cost = (L X PL) + (K X PK)
(1) Units of Units of PL= $1 PL = $5
Technology Capital (K) Labor (L) PK = $1 PK = $1
A 2 10 $12 $52
B 3 6 9 33
C 4 4 8 24
D 6 3 9 21
E 10 2 12 20
190
Choice of Technology
Two things determine the cost of production: (1)

technologies that are available and (2) input prices.
Profit-maximizing firms will choose the technology
that minimizes the cost of production given current
market input prices.
UPS Technology Speeds

Global Shipping
New UPS Technologies Aim to
Speed Worldwide Package
Delivery
Information Week
191
Short-Run Costs and Output Decisions
192
Costs in the Short Run
fixed cost Any cost that does not depend on the

firms level of output. These costs are incurred even
if the firm is producing nothing. There are no fixed
costs in the long run.
variable cost A cost that depends on the level of

production chosen.
total cost (TC) Fixed costs plus variable costs.
TC = TFC + TVC
193
Fixed Costs
Total Fixed Cost (TFC)
total fixed costs (TFC) or overhead The total of

all costs that do not change with output even if
output is zero.
TABLE Short-Run Fixed Cost (Total and Average)

of a Hypothetical Firm
(1) Q (2) TFC (3) AFC (TFC/Q)
0 $1,000 $ -
1 1,000 1,000
2 1,000 500
3 1,000 333
4 1,000 250
5 1,000 200
194
If fixed cost at Q = 100 is $170, then:
a. fixed cost at Q = 0 is zero.
b. fixed cost at Q = 0 is less than $170.
c. fixed cost at Q = 200 is $340.
d. fixed cost at Q = 200 is $170.
e. There is insufficient information given to calculate any
amount of cost.
195
If fixed cost at Q = 100 is $170, then:
a. fixed cost at Q = 0 is zero.
b. fixed cost at Q = 0 is less than $170.
c. fixed cost at Q = 200 is $340.
d. fixed cost at Q = 200 is $170.
e. There is insufficient information given to calculate any
amount of cost.
196
Fixed Costs
Total Fixed Cost (TFC)
197
Average fixed cost:
a. Increases as output increases.
b. Decreases as output increases.
c. Remains constant as output increases.
d. First decreases then, beyond some point, it begins to increase.
198
Average fixed cost:
a. Increases as output increases.
b. Decreases as output increases.
c. Remains constant as output increases.
d. First decreases then, beyond some point, it begins to increase.
199
Fixed Costs
Average Fixed Cost (AFC)
average fixed cost (AFC) Total fixed cost divided

by the number of units of output; a per-unit
measure of fixed costs.
TFC
AFC 
q
spreading overhead The process of dividing

total fixed costs by more units of output. Average
fixed cost declines as quantity rises.
200
Variable Costs
Total Variable Cost (TVC)
total variable cost (TVC) The total of all costs

that vary with output in the short run.
total variable cost curve A graph that shows the

relationship between total variable cost and the
level of a firm’s output.
201
Variable Costs
TABLE Derivation of Total Variable Cost Schedule from Technology and Factor Prices
Units of Input Required Total Variable Cost Assuming
Using (Production Function) PK = $2, PL = $1
Produce Technique K L TVC = (K x PK) + (L x PL)
1 unit of A 4 4 (4 x $2) + (4 x $1) = $12

output
B 2 6 (2 x $2) + (6 x $1) = $10
2 units of A 7 6 (7 x $2) + (6 x $1) = $20

output
B 4 10 (4 x $2) + (10 x $1) = $18
3 units of A 9 6 (9 x $2) + (6 x $1) = $24

output
B 6 14 (6 x $2) + (14 x $1) = $26
202
Which of the following curves embodies information about both input prices
and technology?
a. The total fixed cost curve.
b. The average fixed cost curve.
c. The total variable cost curve.
203
Which of the following curves embodies information about both input prices
and technology?
a. The total fixed cost curve.
b. The average fixed cost curve.
c. The total variable cost curve.
204
Variable Costs
205
Variable Costs
Marginal Cost (MC)
marginal cost (MC) The increase in total cost that

results from producing 1+ more unit of output.
Marginal costs reflect changes in variable costs.
TABLE Derivation of Marginal Cost from Total Variable Cost
Units of Output Total Variable Costs ($) Marginal Costs ($)

0 0
1 10 10
2 18 8
3 24 6
206
Variable Costs
The Shape of the Marginal Cost Curve in the Short Run
207
Variable Costs
The Shape of the Marginal Cost Curve in the Short Run
In the short run, every firm is constrained by some

fixed input that (1) leads to diminishing returns to
variable inputs and (2) limits its capacity to
produce. As a firm approaches that capacity, it
becomes increasingly costly to produce
successively higher levels of output. Marginal
costs ultimately increase with output in the short
run.
208
Variable Costs
Graphing Total Variable Costs

and Marginal Costs
TVC TVC
slope of TVC    TVC  MC
Δq 1
209
Which of the following is marginal cost?
a. The slope of the total variable cost curve.
b. Total variable cost divided by the number of units of output.
c. The wage rate times the units of labor employed.
210
Which of the following is marginal cost?
a. The slope of the total variable cost curve.
b. Total variable cost divided by the number of units of output.
c. The wage rate times the units of labor employed.
211
Variable Costs
Average Variable Cost (AVC)
average variable cost (AVC) Total variable cost

divided by the number of units of output.
TVC
AVC 
q
212
Variable Costs
Average Variable Cost (AVC)
TABLE Short-Run Costs of a Hypothetical Firm

(3) (4) (6) (7) (8)
(1) (2) MC AVC (5) TC AFC ATC (TC/q or
q TVC ( TVC) (TVC/q) TFC (TVC + TFC) (TFC/q) AFC + AVC)
0 $ 0 $ - $ - $1,000 $ 1,000 $ - $ -
1 10 10 10 1,000 1,010 1,000 1,010
2 18 8 9 1,000 1,018 500 509
3 24 6 8 1,000 1,024 333 341
4 32 8 8 1,000 1,032 250 258
5 42 10 8.4 1,000 1,042 200 208.4
- - - - - - - -
- - - - - - - -
- - - - - - - -
500 8,000 20 16 1,000 9,000 2 18
213
Variable Costs
Graphing Average Variable Costs and Marginal Costs
214
Total Costs
215
Total Costs
Average Total Cost (ATC)
average total cost (ATC) Total cost divided by

the number of units of output.
TC
ATC 
q
ATC  AFC  AVC
216
Total Costs
Average Total Cost (ATC)
217
Refer to the figure below. Which distance from point D is equal to total
fixed cost?
a. The distance from D to B.
b. The distance from D to C.
c. The distance from D to A.
d. None of the above. Fixed cost cannot be measured from point D.
218
Refer to the figure below. Which distance from point D is equal to total
fixed cost?
a. The distance from D to B.
b. The distance from D to C.
c. The distance from D to A.
d. None of the above. Fixed cost cannot be measured from point D.
219
Total Costs
The Relationship Between Average Total Cost and Marginal Cost
The relationship between average total cost and

marginal cost is exactly the same as the
relationship between average variable cost and
marginal cost.
If marginal cost is below average total cost,

average total cost will decline toward marginal
cost. If marginal cost is above average total cost,
average total cost will increase. As a result,
marginal cost intersects average total cost at
ATC’s minimum point, for the same reason that it
intersects the average variable cost curve at its
minimum point.
220
Short-Run Costs: A Review
TABLE A Summary of Cost Concepts

Term Definition Equation
Accounting costs Out-of-pocket costs or costs as an accountant would -
define them. Sometimes referred to as explicit costs.
Economic costs Costs that include the full opportunity costs of all -
inputs. These include what are often called implicit
costs.
Total fixed costs Costs that do not depend on the quantity of output TFC
produced. These must be paid even if output is zero.
Total variable costs Costs that vary with the level of output. TVC
Total cost The total economic cost of all the inputs TC = TFC + TVC
used by a firm in production.
Average fixed costs Fixed costs per unit of output. AFC = TFC/q
Average variable costs Variable costs per unit of output. AVC = TVC/q
Average total costs Total costs per unit of output. ATC = TC/q ATC = AFC + AVC
Marginal costs The increase in total cost that results from MC = TC/q
producing 1 additional unit of output.
221
Refer to the figure below. What is the value of total variable cost when 300
units of output are produced?
a. $1,800
b. $10,200
c. $20,000
d. $7,200
e. $17,400
222
Refer to the figure below. What is the value of total variable cost when 300
units of output are produced?
a. $1,800
b. $10,200
c. $20,000
d. $7,200
e. $17,400
223
Output Decisions: Revenues, Costs, and Profit Maximization
Perfect Competition
perfect competition An industry structure in

which there are many firms, each small relative to
the industry, producing virtually identical products
and in which no firm is large enough to have any
control over prices. In perfectly competitive
industries, new competitors can freely enter and
exit the market.
homogeneous products Undifferentiated

products; products that are identical to, or
indistinguishable from, one another.
224
Perfect Competition
225
Total Revenue (TR) and Marginal Revenue (MR)
total revenue (TR) The total amount that a firm

takes in from the sale of its product: the price per
unit times the quantity of output the firm decides to
produce (P x q).
total revenue  price x quantity

TR  P x q
marginal revenue (MR) The additional revenue

that a firm takes in when it increases output by one
additional unit. In perfect competition, P = MR.
226
Marginal revenue equals the change in total revenue associated with:
a. Marginal cost.
b. Hiring an additional worker.
c. Increasing the price per unit of output sold.
d. Selling an additional unit of output.
e. Decreasing sales revenue from laying off an additional worker.
227
Marginal revenue equals the change in total revenue associated with:
a. Marginal cost.
b. Hiring an additional worker.
c. Increasing the price per unit of output sold.
d. Selling an additional unit of output.
e. Decreasing sales revenue from laying off an additional worker.
228
Comparing Costs and Revenues to Maximize Profit
The Profit-Maximizing Level of Output
229
The Profit-Maximizing Level of Output
As long as marginal revenue is greater than

marginal cost, even though the difference between
the two is getting smaller, added output means
added profit. Whenever marginal revenue
exceeds marginal cost, the revenue gained by
increasing output by 1 unit per period exceeds the
cost incurred by doing so.
The profit-maximizing perfectly competitive firm

will produce up to the point where the price of its
output is just equal to short-run marginal cost—the
level of output at which P* = MC.
The profit-maximizing output level for all firms is

the output level where MR = MC.
230
Refer to the figure below. Which level of output maximizes profit?
a. 100 units.
b. 200 units.
c. 300 units.
d. 340 units.
231
Refer to the figure below. Which level of output maximizes profit?
a. 100 units.
b. 200 units.
c. 300 units.
d. 340 units.
232
A Numerical Example
TABLE Profit Analysis for a Simple Firm

(1) (2) (3) (4) (5) (6) (7) (8)
TR TC PROFIT
q TFC TVC MC P = MR (P x q) (TFC + TVC) (TR - TC)
0 $ 10 $ 0 $ - $ 15 $ 0 $ 10 $ -10
1 10 10 10 15 15 20 -5
2 10 15 5 15 30 25 5
3 10 20 5 15 45 30 15
4 10 30 10 15 60 40 20
5 10 50 20 15 75 60 15
6 10 80 30 15 90 90 0
233
A Numerical Example
Case Study in Marginal

Analysis: An Ice Cream
Parlor
An analysis of fixed costs,
variable costs, revenues, profits,
and opening longer hours were
used by this ice cream parlor to
determine whether to stay in
business.
234
235
236
237
238
239
240
Oligopoly
oligopoly A form of industry (market) structure

characterized by a few dominant firms. Products
may be homogenous or differentiated.
Market Structure in an Oligopoly
Five Forces model A model developed by Michael

Porter that helps us understand the five
competitive forces that determine the level of
competition and profitability in an industry.
TABLE Percentage of Value of Shipments Accounted for by the Largest Firms in

High-Concentration Industries
Four Eight Number
Industry Designation Largest Firms Largest Firms Of Firms
Primary copper 99 100 10
Cigarettes 95 99 15
Household laundry equipment 93 100 13
Cellulosic man-made fiber 93 100 8
Breweries 90 94 344
Electric lamp bulbs 89 94 57
Household refrigerators and freezers 85 95 18
Small arms ammunition 83 89 109
Cereal breakfast foods 82 93 45
Motor vehicles 81 91 308
Source: U.S. Department of Commerce, Bureau of the Census, 2002 Economic Census, Concentration Ratios: 2002 ECO2-315R-1, May 2006.
concentration ratio The share of industry output in

sales or employment accounted for by the top
firms.
contestable markets Markets in which entry and

exit are easy.
Oligopoly Models
The Collusion Model
cartel A group of firms that gets together and

makes joint price and output decisions to
maximize joint profits.
tacit collusion Collusion occurs when price- and

quantity-fixing agreements among producers are
explicit. Tacit collusion occurs when such
agreements are implicit.
Oligopoly Models
The Price-Leadership Model
price leadership A form of oligopoly in which one

dominant firm sets prices and all the smaller firms
in the industry follow its pricing policy.
The Cournot Model
duopoly A two-firm oligopoly.

Oligopoly Models
The Cournot Model
249
When a group of profit-maximizing oligopolists colludes on price and
output, the result is exactly the same as:
a. The perfectly competitive case.
b. The monopolistically competitive case.
c. The monopoly case.
d. None of the above. The collusion model yields results is unlike
any other market structure.
When a group of profit-maximizing oligopolists colludes on price and
output, the result is exactly the same as:
a. The perfectly competitive case.
b. The monopolistically competitive case.
c. The monopoly case.
d. None of the above. The collusion model yields results is unlike
any other market structure.
Game Theory
game theory Analyzes the choices made by rival

firms, people, and even governments when they
are trying to maximize their own well-being while
anticipating and reacting to the actions of others in
their environment.
dominant strategy In game theory, a strategy that

is best no matter what the opposition does.
Game Theory
Game Theory
prisoners’ dilemma A game in which the players

are prevented from cooperating and in which each
has a dominant strategy that leaves them both
worse off than if they could cooperate.
Game Theory
Game Theory
Nash equilibrium In game theory, the result of all

players’ playing their best strategy given what their
competitors are doing.
maximin strategy In game theory, a strategy

chosen to maximize the minimum gain that can be
earned.
The prisoners’ dilemma yields the following outcome:
a. Both criminals would be better off confessing, but they choose not
to confess.
b. Both criminals would be better off not confessing, but they choose
to confess.
c. If both criminals confess, they both get the most lenient sentence
possible.
d. When both criminals confess, they get the maximum sentence.
e. Whether the criminals confess or not, they get the maximum
sentence.
The prisoners’ dilemma yields the following outcome:
a. Both criminals would be better off confessing, but they choose not
to confess.
b. Both criminals would be better off not confessing, but they choose
to confess.
c. If both criminals confess, they both get the most lenient sentence
possible.
d. When both criminals confess, they get the maximum sentence.
e. Whether the criminals confess or not, they get the maximum
sentence.
Game Theory
Game Theory
Repeated Games
tit-for-tat strategy A repeated game strategy in

which a player responds in kind to an opponent’s play.
In contestable markets, large oligopolistic firms tend to behave like:
a. Cartels.
b. Duopolies.
c. Monopolies.
d. Perfectly competitive firms.
e. Monopolistically competitive firms.
In contestable markets, large oligopolistic firms tend to behave like:
a. Cartels.
b. Duopolies.
c. Monopolies.
d. Perfectly competitive firms.
e. Monopolistically competitive firms.
Oligopoly and Economic Performance
With the exception of the contestable-markets

model, all the models of oligopoly we have
examined lead us to conclude that concentration in
a market leads to pricing above marginal cost and
output below the efficient level.
Industrial Concentration and Technological Change
One of the major sources of economic growth and

progress throughout history has been
technological advance.
Several economists, notably Joseph Schumpeter

and John Kenneth Galbraith, argued in works now
considered classics that industrial concentration,
where a relatively small number of firms control
the marketplace, actually increases the rate of
technological advance.
The Role of Government
Regulation of Mergers
Celler-Kefauver Act Extended the government’s

authority to control mergers.
Herfindahl-Hirschman Index (HHI) An index of

market concentration found by summing the
square of percentage shares of firms in the
market.
TABLE Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical

Industries, Each with No More Than Four Firms
Percentage Share Of:

Firm 1 Firm 2 Firm 3 Firm 4 Herfindahl- Hirschman Index
Industry A 50 50 - - 502 + 502 = 5,000

Industry B 80 10 10 - 802 + 102 + 102 = 6,600
Industry C 25 25 25 25 252 + 252 + 252 + 252 = 2,500
Industry D 40 20 20 20 402 + 202 + 202 + 202 = 2,800
What is the Herfindahl-Hirschman Index (HHI) for an industry in which
five firms each control 20% of the market?
a. 20
b. 100
c. 2,000
d. 5,000
What is the Herfindahl-Hirschman Index (HHI) for an industry in which
five firms each control 20% of the market?
a. 20
b. 100
c. 2,000
d. 5,000
TABLE
Industry Definition Some Sample HHIs
Beer 3,525
Ethanol 326
Las Vegas gaming 1,497
Critical care patient monitors 2,661
actions by a group of firms that are profitable for each

of them only as the result of the accommodating
reactions of others. This behavior includes tacit or
express collusion, and may or may not be lawful in
and of itself.
A Proper Role?
Certainly, there is much to guard against in the

behavior of large, concentrated industries.
Barriers to entry, large size, and product
differentiation all lead to market power and to
potential inefficiency. Barriers to entry and
collusive behavior stop the market from working
toward an efficient allocation of resources.

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Dr.

On successful completion of this course, it is hoped that

S. No. Components Weightage

Project based approach:

 What is your perspective on management?

firm An organization that transforms resources

entrepreneur A person who organizes, manages,

households The consuming units in an economy.

product or output markets The markets in which

input or factor markets The markets in which the

labor market The input/factor market in which

capital market The input/factor market in which

land market The input/factor market in which

factors of production The inputs into the

Input and output markets are connected through the behavior of

A household’s decision about what quantity of a

 The price of the product in question.

quantity demanded The amount (number of units)

Changes in Quantity Demanded versus Changes in Demand

The most important relationship in individual

Changes in the price of a product affect the quantity demanded

Price and Quantity Demanded: The Law of Demand

demand schedule A table showing how much of a

demand curve A graph illustrating how much of a

Price and Quantity Demanded: The Law of Demand

TABLE Anna’s Demand Schedule

Price and Quantity Demanded: The Law of Demand

Demand Curves Slope Downward

law of demand The negative relationship between

It is reasonable to expect quantity demanded to fall when price

Price and Quantity Demanded: The Law of Demand

Other Properties of Demand Curves

Two additional things are notable about Anna’s

Price and Quantity Demanded: The Law of Demand

Other Properties of Demand Curves

To summarize what we know about the shape of

Other Determinants of Household Demand

Income And Wealth

income The sum of all a household’s wages,

wealth or net worth The total value of what a

Other Determinants of Household Demand

Income And Wealth

normal goods Goods for which demand goes up

inferior goods Goods for which demand tends to

Other Determinants of Household Demand

Prices of Other Goods and Services

substitutes Goods that can serve as replacements

perfect substitutes Identical products.

complements, complementary goods Goods that

Other Determinants of Household Demand

Tastes and Preferences

Income, wealth, and prices of goods available are

Changes in preferences can and do manifest

Within the constraints of prices and incomes,

Other Determinants of Household Demand

What you decide to buy today certainly depends

TABLE Shift of Anna’s Demand Schedule Due to