g. describe the shapes of the short-run marginal cost, average variable cost, average fixed
cost, and average total cost curves;
1. Once a firm reaches a level of output at which diminishing returns occur, larger and larger
additions of the variable factor are necessary to increase output by one more unit.
2. The result is that the MC of the additional output increases. So long as MC is below ATC,
producing additional units of output will bring down the ATC curve.
3. At some point, however, MC will rise by enough to exceed ATC. After the point where MC =
ATC, additional units of output will raise ATC causing the ATC curve to be U-shaped. Thus
the MC curve will cut the ATC curve at its minimum point.
Cost Curve Relationships
MC =
∆
TC ÷
∆
q
AVC = TVC ÷ q
ATC = AFC + AVC
Quantity, q
Costs
AFC = TFC ÷ q
MC always cuts ATC and AVC
at their minimum points!
h. define economies and diseconomies of scale, explain how they each is possible, and relate
each to the shape of a firm’s long-run average total cost curve;
Economies of Scale: Reductions in firm’s per unit costs as all factors of production are
increased in an optimal way.
• Possible reasons: 1) Mass production, 2) specialization of factors of production, and 3)
“learning by doing” scale economies.
Diseconomies of Scale: Increases in firm’s per unit costs as all factors of production are
increased in an optimal way.
• Possible reasons: 1) coordination inefficiencies, 2) increasing difficulties in conveying
information, and 3) increased principal-agent problems.
Constant Returns to Scale: No change in firm’s per unit costs as all factors of production
are increased in an optimal way.
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Economies and Diseconomies of Scale
Diseconomies of Scale
Quantity, q
Costs
Economies of Scale
Constant Returns to Scale
i. describe the factors that cause cost curves to shift.
Factors that Cause Cost Curves to Shift
i) Prices of Resources : Increase in price of resources used (inputs to production)
will cause a firm’s cost curves to shift upwards.
ii) Taxes : Increased taxes shift up a firm’s cost curves. Tax on variable input shifts
MC, AVC, & ATC. Fixed tax shifts AFC & ATC.
iii) Technology : Cost-reducing technological improvements will lower a firm’s cost
curves. Which curves depend on whether technology affects fixed or variable costs.
1. C. “Price Takers and the Competitive Process”
The candidate should be able to:
a. distinguish between price takers and price searchers;
Price-Takers:
• Firms that take market price as given when selling their product. Each is small relative
to market, cannot affect price.
Price-Searchers:
• Firms that face a downward-sloping demand curve for their product. Price charged by
firm affects amount it sells.
b. discuss the conditions that characterize a purely competitive (price taker) market;
Purely Competitive Markets
• Markets characterized by large number of small firms producing identical products in
industry with complete freedom or entry/exit.
• Also termed price-taker markets.
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c. explain how and why price takers maximize profits at the quantity for which marginal cost,
price, and revenue are equal;
Marginal Revenue of each unit of output sold = Market Price.
• Price-taking firm sets output so Marginal Cost of last unit of output produced
equals market price = marginal revenue.
• If MR > MC then selling an additional unit adds to profit, should produce more.
• If MR < MC then selling additional unit lowers profit, should produce less.
Maximum profit when MR = P = MC of last unit produced and sold.
d. calculate and interpret the total revenue and the marginal revenue for a price taker;
For a price taker, total revenue is simply equal to the price in the market times the number of units of
output sold.
Marginal revenue, the change in total revenue/change in output, is constant for a price taker and equal
to the market price of the product.
e. explain the decision by price takers with economic losses to either continue to
operate, shut down, or go out of business;
A firm that is making losses, i.e. AC > P, will choose to continue to operate in the short-run
so long as:
1. it can cover all its variable costs, and
2. it expects price to be high enough to cover its average cost in the future.
In the short run, the firm must pay its fixed costs even if it shuts down. So long as price
exceeds average cost, the firm will be able to pay part of its fixed costs. This strategy makes
sense so long as the firm expects that at some point price will rise sufficiently to cover both
its variable and fixed costs.
If either of the conditions above do not hold, i.e. price is too low for the firm to cover its
variable costs OR the firm does not expect price to be sufficient to cover average total cost
in the future, then the firm should go out of business.
f. describe the short-run supply curve for a firm and for a competitive market;
SR Supply for Individual Firm
• = Marginal Cost curve above AVC.
SR Supply for Market
• = horizontal sum of all the marginal cost curves of firms in the industry.
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g. contrast the role of constant cost, increasing-cost, and decreasing-cost industries in
determining the shape of a long-run market supply curve.
Long Run Supply Curve:
• shows minimum price that firms will supply any level of market output, given
sufficient time to adjust all factors of production & allow for any entry/exit from
the industry.
Economies of Scale determine Shape of LR Supply
• Constant Returns to Scale (i.e. Constant cost) industry will have horizontal LR
Supply Curve.
• Increasing Returns to Scale (i.e. Declining cost) industry will have downward-
sloping LR Supply Curve.
• Decreasing Returns to Scale (i.e. Increasing cost) industry will have upward-
sloping LR Supply Curve.
h. explain the impact of time on the elasticity of supply.
Elasticity of supply usually increases in long run as more time is allowed to firms to adjust
production in response to changes in prices. Over time, firms can adjust the levels of all
factors of production in optimal ways to meet changes in price.
1. D. “Price-Searcher Markets with Low Entry Barriers”
The candidate should be able to:
a. describe the conditions that characterize competitive price-searcher markets;
Competitive Price-Searcher Markets
• Each firm faces a downward-sloping demand curve for their output.
• Firms produce differentiated products. Output of other firms close substitutes, so
individual firm’s demand curve is highly elastic.
• Low entry barriers allow entry or exit of firms if existing firms earn non-zero
economic profits. Each firm faces competition from existing firms in industry &
potential new entrants.
b. explain how price searchers choose price and output combinations;
Profit-maximizing Behavior for a Price Searcher
• Sets output level so that Marginal Cost equal to Marginal Revenue.
• For Price Searcher, Marginal Revenue is related to shape of the Demand Curve.
• Intuition for two factors at work to sell additional unit of output.
o Lower price, sell extra unit and receive additional revenue but
o Receive lower price on all existing units also so lose some revenue
o Marginal revenue no longer equals price.
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c. summarize the debate about the efficiency of price-searcher markets with low barriers to
entry, including the concepts of contestable markets, entrepreneurship, allocative efficiency,
and price discrimination;
(PRO) In the long run, competition along with free entry and exit will drive prices down to
level of average costs.
• Contestable markets: market where costs of entry or exit are low, so firms risk
little by entry.
• Efficient production and zero economic profits should prevail.
• Market can be contestable even if capital requirements for entry are high.
(CON) LR equilibrium is not allocatively efficient, however, because firms produce less
than the minimum ATC level of output.
• Advertising in differentiated product markets may be wasteful & self-defeating.
• Benefits of dynamic competition improves customer choices of quality and
convenience versus trade-off of higher prices.
d. explain how price discrimination increases output and reduces allocative inefficiency;
Price discrimination occurs when a producer charges different consumers different prices for
the same product.
• Requires supplier able to identify and separate at least two groups with different
price elasticities, and
• Prevent those buying at low price from reselling to higher priced customers.
• Segmentation of groups with different price elasticities allows suppliers to charge
different prices to each, possibly resulting in higher profits than with single price.
On balance, output in industry higher with price discrimination than without. Moves
industry output closer to competitive output level associated with allocative efficiency.
1. E. “Price-Searcher Markets with High Entry Barriers”
The candidate should be able to:
a. discuss entry barriers that protect some firms against competition from potential market
entrants;
• Economies of Scale : Large fixed costs mean decreasing per unit costs.
• Government Licensing : Legal barriers to entry established by gov’t.
• Patents : Property rights given to newly invented products or processes.
• Control over an Essential Resource : Single firm has control over an essential resource
or technology.
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b. differentiate between a monopoly and an oligopoly;
Monopoly is a market characterized by:
• Single seller of a well-defined product with no good substitutes.
• High barriers to entry of any other firms into market for the product.
Oligopoly is a market characterized by:
• Small number of rival firms in industry.
• Interdependence among sellers as each is large relative to market.
• Substantial economies of scale in production of the good.
• High barriers to entry firms into market.
c. describe how a profit-maximizing monopolist sets prices and determines output;
Profit-maximizing Behavior for a Monopolist
• Sets output level so that Marginal Cost equal to Marginal Revenue.
• Marginal Revenue is related to shape of the Demand Curve. Intuition for two
factors at work to sell additional unit of output.
Profit-Maximizing Monopolist
Cost, C and
Price, p
Quantity, q
MR Curve
Demand
MC = Supply
q
Monop
p
Monop
q
Comp
p
Comp
d. discuss price and output under oligopoly, with and without collusion;
Collusion:
Under collusion, i.e. acting as a cartel, oligopolists can coordinate supply decisions to
maximize the joint profits of all the firms. The cartel essentially acts like a monopolist in
market, setting higher price and lower output in order to generate positive economic profits.
Without Collusion:
Once the collusion by the cartel has established the monopoly price in the market, each
member of the cartel has an incentive to cheat by increasing their own supply at the high
price to increase its share of profits in the market. Thus without collusion, the oligopolists
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end up competing with one another on prices, driving the market outcome to that associated
with perfect competition, where price is lower, output is higher, and all firms earn zero
economic profits.
e. discuss why oligopolists have a strong incentive to collude and to cheat on collusive
agreements;
By colluding, i.e. acting as a cartel, oligopolists can coordinate supply decisions to
maximize the joint profits of all the firms. Cartel seeks to create a monopoly in market that
results in higher prices and positive economic profits.
Once the collusion by the cartel has established the monopoly price in the market, however,
each member of the cartel has an incentive to cheat by increasing their own supply at the
high price to increase its share of profits in the market.
f. discuss the obstacles to collusion among oligopolistic firms;
Incentive for any firm to cheat on cartel agreement to increase its profits. Obstacles to
success of collusion:
• Increase in number of firms making up oligolpoly.
• If price cuts by individual firms difficult to detect & prevent.
• Low barriers to entry. Successful collusion induces new entrants.
• Unstable demand conditions lower likelihood collusion successful.
• Vigorous antitrust actions increase cost of collusion.
g. describe government policy alternatives that are intended to reduce the problems stemming
from high barriers to entry.
i) Restructure existing firm or firms to stimulate competition.
• May not be possible if economies of scale form barrier. Natural monopoly
occurs if declining per unit costs of large range of output.
ii) Reduce Artificial Barriers to Trade
• If few firms dominate domestic market, may get increased competition by
encouraging foreign firms to supply market.
iii) Regulate the Dominant Producer(s)
• Government may regulate price charged by monopolist or oligopolists in the
market to achieve more efficient outcomes.
o Average Cost Pricing: set output so ATC = Demand Curve
o Marginal Cost Pricing: set output so MC = Demand Curve
iv) Supply Market with Government Production
• Particularly appropriate for public goods. Concerns about efficiency.
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F. “The Supply of and Demand for Productive Resources”
*** All New for 2003
The candidate should be able to
a. explain the relationship between the price of a resource and the quantity demanded of that
resource;
The demand for a resource is a “derived” demand, in that the demand for the resource arises
indirectly from the demand for goods that that resource helps to produce.
As the price of a resource rises, producers using that resource respond in two ways:
i) they substitute towards other resources that are less expensive; and
ii) they pass on the higher price of the resource as higher prices and reduced quantities
of the goods being produced using the resource.
Both of these responses produce an inverse relationship between the price of the resources
and the quantity of the resource demanded, i.e. its demand curve is downward-sloping.
b. identify and describe the influence of three factors that cause shifts in the demand curve
for a resource;
The three factors that cause shifts in the demand curve for a resource are:
i) A change in the demand for a product will cause a similar change in the demand for
the resource used in the production of that product:
ii) Changes in the productivity of the resource will alter the demand for that resource.
An increase in the productivity of a resource will increase its demand because this
makes the resource cheaper per unit of output it produces.
iii) Changes in the price of a related resource will alter the demand for the original
resource. A rise in the price of a related resource that is complementary in production
to the original resource will cause the demand for the original resource to fall. A rise in
the price of a related resource that is a substitute in production to the original resource
will cause the demand for the original resource to rise.
c. define the marginal revenue product of a resource and explain how it influences the
demand for that resource;
Marginal Revenue Product (MRP) of a resource is equal to its marginal product times the
selling price of the product that it helps to produce. The marginal product of a resource is
equal to the additional units of the good produced by using one additional unit of the
resource as an input in production.
A profit-maximizing firm will increase their use of the resource as long as the marginal cost
(MC) of the additional unit of the resource is less than the resource’s marginal revenue
product.
Profit is maximized when the level of the resource is such that its marginal cost is equal to its
marginal revenue product. i.e. MRP = MC
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d. explain the necessary conditions to achieve the cost-minimizing employment levels for two
or more variable resources;
A profit-maximizing firm with two or more variable resources will set the level of utilization
of each resource so that the MRP of that resource is just equal to its Marginal Cost.
MRP
j
= MC
j
= Price of Resource j per unit for each resource j = 1, 2, 3, …
For each resource, its MRP is the price of the final good (P) times the Marginal Product of
that resource for the output of the final good (MP
j
).
MRP = P x MP
j
= MC
j
= Price of Resource j per unit or
Price of Resource j
j
MP
P=
This is true for each resource used in producing the final good so the cost-minimizing
condition can be summarized as:
3
1 2
Price of Resource 1 Price of Resource 2 Price of Resource 3
MP
MP MP
P= = = =K
e. discuss the factors that influence the supply and demand of resources in the short run and
long run;
In the short-run:
Supply: Many resources tend to be fixed in amount or relatively immobile across markets.
This leads to a short-run supply curve that is inelastic, i.e. steeply sloping upwards, as
owners of resources demand higher prices in the face of increased short-run demand.
Demand: Adjusting the production process to changes in resource prices is difficult in the
short-run, thus the short-run demand for resources is also likely to be inelastic, i.e.
steeply sloping downwards.
In the long-run:
Supply: Investment, exploration and depreciation allows for greater changes in the amount
of resources available. Thus the long-run supply curve tends to be more elastic, i.e. less
steeply sloped upwards, than the short-run supply curve for the resource.
Demand: Adjusting the production process to changes in resource prices is easier in the
long-run, thus the long-run demand for resources is also likely to be more elastic, i.e.
less steeply sloped downwards than short run demand.
f. explain how prices for resources are determined in a market economy;
In a market economy the equilibrium price of a resource is the level that equilibrates demand
and supply. If there is an excess supply of the resource at a given market price, then the
unemployed resources will place downward pressure on the market price, bringing demand
and supply back into equilibrium.
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g. explain the process through which changing resource prices influence resource utilization
and the performance of the economic system.
Changes in the price of a resource influence the behavior of both its users and its suppliers.
When the price of a resource rises, users will search for ways to economize on the use of the
resource and they may also switch to resources that are substitutes in the production process.
Higher prices will lead suppliers of the resource to look for ways to increase the supply of the
resource through additional investment and exploration. It is likely new supply will take some
period of time to reach the market.
2. “The Financial Environment: Markets, Institutions, and Interest
Rates” *** All New for 2004
The candidate should be able to
a. identify and explain the factors that influence the supply and demand for capital;
Supply of Capital from savers in the economy is influenced by the following factors:
- Time Preferences for consumption : high rate of time preference indicate that current
consumption is highly valued relative to future consumption. This leads to a lower supply of
capital from savers.
- Risk: Higher levels of risk in lending mean less capital will be supplied for any given rate of
return.
- Inflation: Higher expected inflation leads savers to require higher rates of return to offset the
effects of inflation on the purchasing power of money.
Demand for Capital is influenced by the following factors:
- Production Opportunities : The more productive the projects financed by the borrowed savings,
the higher the rate of return borrowers will be willing to pay to secure the financing.
b. describe the role of interest rates in allocating capital;
Firms with the more profitable projects to finance will bid away capital from firms with less profitable
projects. Thus interest rates in capital markets ensure that scarce capital made available by savers
finances the most profitable projects in the economy.
c. explain how the supply of and demand for funds determine interest rates;
Interest rates are the rental price of capital determined by demand and supply in the capital markets.
The interest rate for each type of security is determined by the intersection of demand and supply in
each market. At this point the supply of capital from savers in each market is just equal to the demand
for capital from firms in each market.
d. discuss the factors that cause the supply and demand curves for funds to shift;
Supply and demand curves in a capital market shift if with changes in any of the fundamental factors
in LOS 2.1.a. Thus an increase in time preference will reduce the supply of saving (and capital) to the
market. Similarly, and increase in the profitability of projects in the economy as a whole will increase
the demand for capital, shifting the demand curve outwards.
Capital markets are also interdependent, thus a change in demand or supply in one market is likely to
spill over into affecting demand or supply in related capital markets. A rise in demand in the market
for one type of security raises the interest rate in that market. The higher return will lead some savers
to redirect their savings into this market, increasing the supply of capital in the original market while
simultaneously decreasing the supply of capital to the other types of securities.
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