ECO100Y1Y
<<Chapter7>>
* Factors of production: land, labour, capital
* Production function: the technological relationship between the inputs that a firm uses and the
output that it produces.
Q=f(L,K)
Q: output, K: capital services, L: labour services
*Accounting profits= Revenues – Explicit costs
Economic profits = Revenues – (Explicit costs + Implicit costs)
= Accounting profits – Implicit costs

Implicit costs:
the opportunity cost of the owner’s capital (including a possible risk
premium)
*Profit- Maximizing Output
Profit = TR –TC
TR: total revenue each firm derives from the sale of its output
TC: the total cost of producing that output
The Short Run: the length of time over which some of the firm’s factors of production are fixed
The Long Run: the length of time over which all of the firm’s factors of production can be
varied, but its technology is fixed.
The Very Long Run: the length of time over which all the firm’s factors of production and its
technology can be varied.
*Average product:
AP = TP / L
Total Product: the total amount that is produced during some time period
+ the total product steadily rising, first at an increasing rate, then at a decreasing rate.
>> This causes both the average and the marginal product curves to rise at first and then decline.
A= AP, B=MP
Where AP reaches its maximum, MP=AP.
>> The level of labour input at which average product reaches a maximum is called the point of
diminishing average productivity.
*Marginal product: the change in TP resulting from the use of one additional unit labour.
MP= △TP / △L
*Law of diminishing returns: if increasing amounts of a variable factor are applied to a given
quantity of a fixed factor, eventually a situation will be reached in which the
marginal product of the variable factor declines.
- When the fixed factor is capital and the variable factor is labour, each unit of labour gets a
declining amount of capital to assist it in producing more output. Therefore, equal increases in
labour eventually begin to add less and less to total output.
*The average product curve slopes upward as long as the marginal product curve is above it.
In order for the average product to rise, the marginal product must exceed the average product.
*Total cost: the sum of all costs that the firm incurs to produce a given level of output.
TC = TFC + TVC
ATC = TC / Q = (TFC / Q) + (TVC / Q) = AFC + AVC
*Marginal cost: the increase in total cost resulting from 1 unit increase in the level of output
MC =△ TC /△ Q
*Short-Run Cost Curves
*AFC: steadily declining as output rises / AVC: it declines as output rises, reaching a minimum
at output. As output increases above this level that it, AVC rises
*“U- shaped” ATC curve: it declines initially as output increases, reaches a minimum, and then
rises as output increases further.
*The MC curve declines steadily as output initially increases, reaches a minimum somewhere
and then rises as output increases further. (Fixed factor = capital, variable factor = labour)
- Diminishing AP of the variable factor implies increasing AVC. Diminishing MP of the variable
factor implies increasing MC.
* Changes in Factor Prices
1. An increase in the price of the variable factor will cause an upward shift in the firm’s ATC and
MC curves. 2. The firm’s total fixed costs will rise, but its variable costs will be unaffected. Thus,
the ATC curve will shift up but the MC curve will not move.
<<Chapter 9>>
*Perfect competition: a market structure in which all firms in an industry are price takers and in
which there is freedom of entry into and exit from the industry.
- All the firms in the industry sell an identical product. Consumers know the nature of the
product being sold and the prices charged by each firm. Each firm is small relative to the size of
the industry. The industry is characterized by freedom of entry and exit.
*The Demand Curve for a Competitive industry and for one firm in the industry
- Even though the demand curve for the entire industry is negatively sloped, each firm in a
perfectly competitive market faces a horizontal demand curve because variations in the firm’s
output have no significant effect on price.
*Total revenue: TR = p X Q
Average revenue: AR = TR / Q = (p X Q) / Q = p
Marginal revenue: MR = △TR /△ Q
-
Because price does not change as a result of the firm changing its output, neither MR or
AR varies with output.
-
For a price- taking firm, AR=MR= price. Any quantity the firm chooses to sell will be
associated with this same market price. If the market price is unaffected by variations in
the firm’s output, the firm’s demand curve, its average revenue curve, and its marginal
revenue curve all coincide in the same horizontal line.
*Short – Run Decisions
- Rule 1: A firm should not produce at all if, for all levels of output, the total variable cost of
producing that output exceeds the total revenue from selling it. The firm should not produce
at all if, for all levels of output, the average variable cost of producing the output exceeds the
market price. >> A competitive firm may maximize its profits by shutting down and
producing zero output.

When the market price is less than the minimum average variable cost, the competitive
firm will shut down.
-
Rule 2: If it is worthwhile for the firm to produce at all, the firm should produce the
output at which marginal revenue equals marginal cost.

A profit-maximizing firm that is operating in a perfectly competitive market will
produce the output that equates its marginal cost of production with the market price
of its product as long as price exceeds average variable cost. The perfectly competitive
firm adjusts its level of output in response to changes in the market-determined price.
*Short-Run Supply Curves
- A competitive firm’s supply curve is given by the portion of its MC curve that is above its
AVC curve
.
“MC and AVC curves”
“Firm’s supply curve”
-In perfect competition, the industry supply curve is the horizontal sum of the MC above
the level of AVC of all firms in the industry.
*Short-Run equilibrium in a competitive market
- When an industry is in short-run equilibrium, quantity demanded equals quantity supplied,
and each firm is maximizing its profits given the market price.
Profits = TR – TC = (p X Q) – (ATC X Q) = ( p – ATC) X Q
*Long-Run Decisions
- Profits in a competitive industry are a signal for the entry of new firms; the industry will expand,
pushing price down until economic profits fall to zero.
- If firms’ fixed costs are mostly sunk costs, the process of exit in loss-making industries will be
slow. If firms’ fixed costs are mostly non-sunk costs, the process of exit will be faster.
-
Positive profits lead to the entry of new firms; this entry reduces the equilibrium market
price and reduces the profits of all firms.
-
Negative profits lead to the eventual exit of some firms as their capital becomes obsolete
or becomes too costly to operate; this exit increases the equilibrium price and increases
profits for those firms remaining in the market.
*For a competitive firm to be maximizing its long-run profits, it must be producing at the
minimum point on its LRAC curve. In the long-run competitive equilibrium, each firm is operating
at the minimum point on its LRAC.
(1) Maximizing short-run profits, MC=p, (2) Earning profits of zero on its existing plant, SRATC =p,
(3) Unable to increase its profits by altering the scale of its operations.
*In industries with continuous technological improvement, low-cost firms will exist side by side
with older high-cost firms. The older firms will continue operating as long as their revenues cover
their variable costs.
-
The long-run response of a declining industry will be to continue to satisfy demand by
employing its existing plants as long as price exceeds short-run AVC.
<<Chapter 10>>
*A monopolist faces a negatively sloped demand curve. For a monopolist, sales can be
increased only if price is reduced, and price can be increased only if sales are reduced.
The Demand curve = the Price of the product = the monopolist’s AR curve.
-
Because its demand curve is negatively sloped, the monopolist must reduce the price that
it charges on all units in order to sell an extra unit.
-
The monopolist’s marginal revenue is less than the price at which it sells its output. Thus
the monopolist’s MR curve is below its demand curve.
*The perfectly competitive firm is a price taker; it can sell all it wants at the given market
price. In contrast, the monopolist faces a negatively sloped demand curve; it must reduce the
market price to increase its sales.
D is elastic when MR +, D is inelastic when MR –
*Short-Run profit maximization for a Monopolist
Where MR = MC, the profit-maximizing output;
The price charged to consumers is determined by the Demand curve (Demand curve =AR )
*A monopolist does not have a supply curve because it is not a price taker; it chooses its
profit-maximizing price-quantity combination from among the possible combinations on the
market demand curve.
-
The level of output in a monopolized industry is less than the level of output that would
be produced if the industry were perfectly competitive. A monopolist restricts output
below the competitive level and thus reduces the amount of economic surplus generated
in the market. The monopolist therefore creates an inefficient market outcome.
*Cartel: an organization of producers who agree to act as a single seller in order to maximize
joint profits.
- Cartelization of a competitive industry can always increase that industry’s profits. The profitmaximizing cartelization of a competitive industry will reduce output and raise price from the
perfectly competitive levels.
-Cartels tend to be unstable because of the incentives for individual firms to violate the
output restrictions needed to sustain the joint-profit-maximizing price.
<<Chapter 12>>
Market
Industry Characteristics
Structure
Perfect
*Many small firms sell identical products
competition
*All firms are price takers
*Free entry and exit
*Zero profits in long-run equilibrium
*Price =MC
Monopolistic
*Many small firms sell differentiated products
competition
*Each firm has some power to set price
*Free entry and exit
Zero profits in long-run equilibrium*
*Price > MC; less output than in perfect competition; excess capacity
Oligopoly
*Few firms, usually large
*Strategic behavior among firms
*firms often sell differentiated products and are price setters
*Often significant entry barriers
*Usually economies of scale
*Profits depend on the nature of firm rivalry and on entry barriers
*Price usually > MC; output usually less than in perfect competition
Monopoly
*Single firm faces the entire market demand
*firm is a price setter
*Profits persist if sufficient entry barriers
*Price > MC; less output than in perfect competition
*Productive Efficiency
1. Productive efficiency for the firm requires the firm to be producing its output at the lowest
possible cost.
2. Productive efficiency for the industry requires that the marginal cost of production be the
same for each firm.
- If firms and industries are productively efficient, the economy will be on, rather than inside,
the production possibilities boundary.
*Allocative efficiency: a situation in which the market price for each good is equal to that
good’s MC.
- The economy is allocatively efficient when, for each good produced, its MC = p
-Allocative efficiency will be achieved when in each market the marginal cost of producing
the good equals the marginal value of consuming the good.
-Perfectly competitive industries are productively efficient. If an economy could be made up
entirely of perfectly competitive industries, the economy would be allocatively efficient.
-Monopoly is not allocatively efficient because the monopolist’s price always exceeds its
marginal cost.
* Consumer surplus: the difference between the value that consumers place on a product
and the payment that they actually make to buy that product.
>> The area under the demand curve and above the market price line.
* Producer surplus: the price of a good – MC. For each unit sold, producer surplus is the
difference between and marginal cost.
>> The area above the MC curve and below the price line.
-
Allocative efficiency occurs where the sum of consumer and producer surplus is
maximized.
-
The sum of producer and consumer surplus is maximized only at the perfectly
competitive level of output. This is the only level of output that is allocatively efficient.
*When output is below the competitive level, there is always a net loss of total surplus: More
surplus is lost by consumers than is gained by the monopolist. Some surplus is lost because
output between the monopolist and the competitive levels is not produced = deadweight loss of
monopoly.
- Pollution produced by one firm imposes costs on others. This “externality” is an example of what
economists call a market failure because the unregulated market produces more than what is
socially optimal.
*Natural monopoly: An industry characterized by economies of scale sufficiently large that one
firm can most efficiently supply the entire market demand.
* Three types of pricing policies for regulated natural monopolies
1.
3.
-
1.
-The green rectangle below is the loss that occurs using MC pricing.
AC is falling. Thus, setting P = MC will lead to losses, since MC <AC when Ac is falling.
Marginal- cost pricing: set up a tension between the regulator’s desire to achieve the
allocatively efficient level of output and the monopolist’s desire to maximize profits.
2.
Two- Part Tariff: customers pay one price to gain access to the product and a second price
for each unit consumed. The per-unit charge can be based on MC. The flat fee helps cover
fixed costs.
3.
Average- cost pricing: set prices just high enough to cover total costs, thus generating
neither profits nor losses. It will not result in allocative efficiency because P not = MC. It
allows the firm to continue to operate. It leads to inefficient long-run investment decisions.
*The deregulation of oligopolistic industries has been based on the observations that
oligopolistic industries are major engines of growth, and direct control of such industries has
produced disappointing results in the past.
<<Chapter16>>
*The operative choice is not between an unhampered free-market economy and a fully centralized
command economy. It is rather the choice of which mix of markets and government intervention
best suits people’s hopes and needs.
*When the government’s monopoly of violence is secure and functions with effective restrictions
against its arbitrary use, citizens can safely carry on their ordinary economic and social activities.
*The formal defence is based on the concept of allocative efficiency.
*The informal defence of free markets is based on three central arguments
- It applies to market structures other than just perfect competition.
1. Free markets provide automatic coordination of the actions of decentralized decision makers
2. The pursuit of profits in free markets provides a stimulus to innovation and rising material living
standards
3. Free markets permit a decentralization of economic power.
*Market failure: a situation in which the free market, in the absence of government intervention,
fails to achieve allocative efficiency.
1. Market Power: ability to influence market conditions, sell differentiated products and set their
prices, innovate with new things (temporary monopoly)
- Firms that have market power will maximize their profit at a level of output at P > MC. The
result is allocatively inefficient, even though it’s inevitable outcome of the kinds of innovation that
raise living standards over the long term.
- The challenge of economic policy is then to accept monopolistic and oligopolistic “imperfect”
competition for the range of choices and scale advantages they provide, while keeping firms in
active competition with one another so as to gain the economic growth that result from their
innovative practices.
2. Externalities: effects on parties not directly involved in the production or use of a commodity.
= Third-party effects.
- Whenever actions taken by firms or consumers directly impose costs or confer benefits on
others.
- Private cost: the cost faced by the private decision maker, including production costs, advertising
costs, and so on.
-Social cost: the private cost but also include any other costs imposed on third parties
-Discrepancies between private cost and social cost occur when there are externalities. The
presence of externalities, even when all markets are perfectly competitive, leads to allocatively
inefficient outcomes.
- Negative externalities, positive externalities:
-With a positive externality, a competitive free market will produce too little of the good. With a
negative externality, a competitive free market will produce too much of the good.
4.
Non-rivalrous and Non-exlcudable Goods
-
Rivalrous: a good or service is rivalrous if, when one person consumes one unit of it, there
is one less unit available for others to consume
-
Excludable: a good or service is excludable if its owner can prevent others from
consuming it.
a) Private goods: goods or services that are both rivalrous and excludable (chocolate bar)
b) Common-property resource: a product that is rivalrous but not excludable, they tend to
be overused by private firms and consumers.(fisheries)
c)
Excludable but Non-rivalrous Goods: to avoid inefficient exclusion, the government often
provides for free non-rivalrous but excludable goods and services.(libraries)
d) Public goods: goods or services that can simultaneously provide benefits of a large group
of people. = collective consumption goods. (national defence)
-
Because of the free-rider problem, private markets will not always provide public goods.
In such situations, public goods must be provided by government. The optimal quantity
of a public good is such that MC = the sum of all user’s marginal benefits of the good.
Excludable
Non-Excludable
Rivalrous
Private goods
Common-property resources
Non-rivalrous
Art galleries, roads,
Public goods
bridges, cable,
*Asymmetric information: a situation in which one part to a transaction has more or better
relevant information about the transaction than the other party.
a) Moral hazard: when one party to a transaction has both the incentive and the ability to shift
costs onto the other party.
- Individuals and firms who are insured against loss will often take less care to prevent that loss
than they would in the absence of insurances.
-The market failure arises because the action by the insured individual or firm raises total costs for
society.
b) Adverse selection: Self- selection, within a single risk category, of persons of above-average risk.
- The tendency for people who are more at risk than the average to purchase insurance and for
those who are less at risk than the average to reject insurances.
*Market failures
1. Firms with market power will charge a price greater than MC. The level of output in these cases
is less than the allocatively efficient level.
2. When there are externalities, social and private marginal costs are not equal. If there is a
negative externality, output will be greater than the allocatively efficient level. If there is a positive
externality, output will be less than the allocatively efficient level.
3. Common- property resources will be overused by private firms and consumers. Public goods
will be underprovided by private markets.
4. Situations in which there is asymmetric information-both moral and hazard and adverse
selection-can lead to allocative inefficiency.
*Broader social goals
-Income distribution, preferences for public provision, protecting individuals from others,
paternalism, social responsibility, economic growth, a general principle.
- Changing the distribution of income is one of the roles for government intervention that
members of a society may desire. Others include values that are placed on public provision for its
own sake, on protection of individuals from themselves or from others, on recognition of social
responsibilities, and on the promotion of economic growth.
*cost-benefit analysis: an approach for evaluating the desirability of a given policy, based on
comparing total costs with total benefits.
*The tools of Government intervention
-public provision, redistribution programs, regulation
*The costs of government intervention
1. Direct Costs: all forms of government intervention use real resources and hence impose direct
costs.
2. Indirect Costs: most government interventions in the economy impose costs on firms and
households over and above the taxes that must be paid to the government to finance its policies.
- changes in sots of production ,costs of compliance , rent seeking(behavior whereby private
firms and individuals try to use the powers of the government to enhance their own economic
well-being in ways that are not in the social interest)
-In the aggregate, the indirect costs of government intervention are substantial. But they are
difficult to measure and are usually dispersed across a large number of firms and households.
*Government Failure
a) Decision Makers’ Objectives
- Economists needed only to identify places where the market functioned well on its own, and
places where government intervention could improve the market’s functioning.
b) Public Choice Theory
- seeks to explain how public officials make their decisions. They are assumed to act not in the
best interests of their constituents but according to their own agendas, which often conflict with
the public interest.
c) Democracy and inefficient public choices
d) governments as monopolists
- Evaluating the costs and benefits of government intervention requires a comparison of the
private economic system as it actually works (not as it might work ideally) with the pattern of
government intervention as it actually performs (not as it might perform ideally)
*The costs and benefits of government intervention must be considered in deciding whether,
when, and how much intervention is appropriate. Among the costs are the direct costs that are
incurred by the government, the costs that are imposed on the parties who are regulated, directly
and indirectly, and the costs that are imposed on third parties. These costs are seldom negligible
and are often large.
<<Chapter17>>
*When there are negative externalities, social marginal cost exceeds private MC because the act of
production generates costs for society that are not faced by the producer.
-A negative externality implies that a competitive free market will produce more output than the
allocatively efficient level. Reducing output by one unit would increase allocative efficiency and
thus make society as a whole better off.
-Internalizing the externality: a process that results in a producer or consumer taking account of a
previously external effect. The socially optimal level of output is at the quantity for which all MC,
private plus external, equal the marginal benefit to society.
-The optimal amount of pollution abatement occurs where the MC of reducing pollution is just
equal to the marginal benefits from doing so.
<<Chapter18>>
*Taxation and Efficiency
- The direct burden of a tax is the amount paid by taxpayers. The excess burden reflects the
allocative inefficiency of the tax.
-An income tax generates both a direct and an excess burden. An efficient tax system is one that
minimizes the amount of excess burden (deadweight loss) for any given amount of tax revenue
generated.
*Public expenditure in Canada
-A large part of public expenditure is for the provision of goods and services. Other types of
expenditures, including subsidies, transfer payments to individuals, and intergovernmental
transfers, are also important.
<<Chapter33>>
*Without trade, everyone must be self-sufficient; with trade, people can specialize in what they do
well and satisfy other needs by trading.
*Absolute advantage: the situation that exists when one country can produce some commodity
at lower absolute cost than another country
- reflects the differences in absolute costs of producing goods between countries.
*Comparative advantage: the situation that exists when a country can produce a good with less
forgone output of other goods than can another country
-based on opportunity costs
-the gains form specialization and trade depend on the pattern of comparative, not absolute,
advantage.
-world output increases if countries specialize in the production of the goods in which they have
a comparative advantage.
-International trade leads to specialization in production and increased consumption possibilities.
1. Country A has a comparative advantage over Country B in producing a product when the
opportunity cost of production in Country A is lower. This implies, however, that it has a
comparative disadvantage in some other products
2. The opportunity cost of product X is the amount of output of other products that must be
sacrificed in order to increases the output of X by one unit.
3. When opportunity costs for all products are the same in all countries, there is no comparative
advantage and there is no possibility of gains from specialization and trade.
4. When opportunity costs differ in any two countries and both countries are producing both
products, it is always possible to increase production of both products by a suitable reallocation
of resources within each country.
*In industries with significant scale economies, small countries that do not trade will have low
levels of output and therefore high costs. With international trade, however, small countries can
produce for the large global market and thus produce at lower costs. International trade therefore
allows small countries to reap the benefits of scale economies.
*The law of one price states that when a product is traded throughout the entire world, the prices
in various countries will differ by no more than the cost of transporting the product between
countries. Aside from differences caused by these transport costs, there is a single world price.
*Countries export products whose world price exceeds the price that would exist domestically if
there were no foreign trade.
-Countries export the goods for which they are low-cost producers. That is, they export goods for
which they have a comparative advantage.
*Countries import products whose world price is less than the price that would exist domestically
if there were no foreign trade.
-Countries import the goods for which they are high-cost producers. That is, they import goods
for which they have a comparative disadvantage.
*Terms of trade: the ratio of the average price of a country’s exports to the average price of its
imports
-Changes in the terms of trade lead to changes in a country’s consumption possibilities.
-The terms of trade determine the quantity of imports that can be obtained per unit of exports
-A favourable change in the terms of trade- a rise in export prices relative to import prices- is
beneficial for a country because it expands tis consumption possibilities.