5

Elasticity

I. Introduction pages 89-90

A. How Much?
1. Elasticity helps us estimate how much quantity demanded, demand, quantity
supplied and/or supply will change in response to a change in some other
variable.
2. Once we understand the relationship between the change in price and the change
in quantity demanded, we can estimate the change in total expenditure.
B. Measurement is important. All the theory in the universe does no good if we still can’t
answer the question, “How much?”
B. Elasticity is a general concept used to quantify the response in one variable when another
variable changes. The elasticity of A with respect to B is %A/%B.
II. Price Elasticity of Demand pages 90-92
A. Slope and Elasticity
1. Slope is not a good measure of responsiveness. One important reason is that
slope changes when the units of either axis change.
2. Price elasticity of demand is the ratio of the percentage of change in quantity
demanded to the percentage of change in price. It measures the responsiveness of
quantity demanded to changes in price.
% change in quantity demanded
price elasticity of demand=
% change in price
3. Price elasticity of demand is naturally negative. Since we know that, we often
omit the minus sign.
B. Types of Elasticity
1. Perfectly inelastic demand is demand in which quantity demanded does not
respond at all to a change in price. (The demand curve is vertical.) Example:
insulin.

93
 2. Inelastic demand is demand that respondsomewhat, but not a great deal, to
changes in price. Inelastic demand always has a numerical value between zero
and -1. Example: basic telephone service.
3. Unitary elasticity is 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 -1.0). Example: beef.
4. Elastic demand is 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 1.0). Example: bananas
(elasticity = -3).
5. Perfectly elastic demand is demand in which quantity drops to zero at the
slightest increase in price. (The demand curve is horizontal.)
6. The following descriptive text may help your students remember the difference.
(This is from page 92 of the text.)

III. Calculating Elasticities pages 92-99

A. Calculating Percentage Changes
1. The percentage change in quantity demanded is equal to the change in quantity
demanded divided by the first value of quantity. There is a similar definition for
price.
2. Defined this way, the value calculated for the percentage change depends on
which of the two values is used in the denominator.
B. Elasticity Is a Ratio of Percentages
% change in quantity demanded
price elasticity of demand =
% change in price
 C. The Midpoint Formula
1. Instead of having to select one or the other price - quantity pair for the
denominators of the percentage change calculation, why not just use the average?
2. The midpoint formula is 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.
3. The midpoint formula is calculated as:

( Q2 −Q 1 )
( Q 2 +Q 1 )
price elasticity of demand =
[ 2 ]
( P2 −P1 )
( P2 + P1 )
[ 2 ]
( Q 2 −Q 1 )
( Q 2 +Q 1 )
price elasticity of demand =
( P 2 − P1 )
( P 2 + P1 )
º

D. Elasticity Changes along a Straight-Line Demand Curve

1. The slope of a straight line is constant.
2. Elasticity is not the same thing as slope.
E. Elasticity and Total Revenue
1. Total revenue is the total amount sellers receive for their product. This is also the
amount consumers spend on the product (total expenditure).
2. TR = PQ
3. Any increase in P will cause Q to decrease. TR may rise, fall, or remain the same
depending on the comparative magnitudes of the changes in P and Q.
4. Price elasticity of demand tells us everything we need to know:
Elasticity Demand is Price and Total Revenue
between 0 and -1 inelastic change in the same direction
less than -1 elastic change in opposite directions
small changes in price have no
equals -1 unit elastic
effect on total revenue

IV. The Determinants of Demand Elasticity pages 99-102

A. Availability of Substitutes
1. Examples: demand for bananas is elastic but demand for insulin is inelastic.
2. How many substitutes are available?
3. How close are they to the product in question?
B. The Importance of Being Unimportant
1. Products that don’t consume a very large part of our income also don’t command
much of our attention.
2. Since we don’t pay much attention to their price demand for these products tends
to be inelastic.
3. Examples: the demand for salt is inelastic. It’s cheap and we don’t buy it very
often. When was the last time anyone saw an advertised sale on salt?
C. The Time Dimension
1. The longer the time period the more elastic demand becomes.
2. People can find substitutes and change their behavior more over longer time
periods.
3. Example: the long-run elasticity of demand for oil is about 0.7 while the short-
run elasticity is about 0.2.

Unique Economics in Practice

The text discusses the role of taxes on cigarettes as a deterrent to smoking (page 100 or previous
box). The article discusses a proposal in the state of Washington to raise taxes on cigarettes by
$1.00 per pack. In 1999, in response to a proposal advanced by actor – director Rob Reiner,
California voters passed a measure increasing cigarette taxes by $0.50 per pack. The revenue was
stipulated to be used for anti-smoking measures. California also banned smoking in restaurants
and bars in 1998.

Proponents of this tax were amazed to discover their tax did not raise the expected revenue. One
reason is revenue loss from tax evasion. There are three main sources of evasion:
1. smuggling from neighbor states that impose lower taxes (Nevada),
2. purchases from Native American casinos located in California, and
3. outright fraud by retailers who purchase cigarettes without the state tax stamp.

Joe Fitz, the Chief Economists for the California State Board of Equalization, has studied this
issue. He concludes that evasion accounts for about 14.7% of revenue lost and that the amount of
lost tax revenue is between $139 and $210 million dollars.
Source:
http://www.taxadmin.org/FTA/Meet/07rev_est/papers/fitz.pdf
http://www.msnbc.msn.com/id/17170991/

Question: In light of California’s experience with increasing taxes on cigarettes why was a
similar law proposed in Washington?

Answer: Politicians are elected by the public at large, not by economists.

V. Other Important Elasticities pages 102-103
A. Income Elasticity of Demand
1. Income elasticity of demand is a measure of the responsiveness of demand to
changes in income:

% change in demand
income elasticity of demand=
% change in income
2. If the income elasticity of demand for housing is 0.8 then a 10 percent increase in
income will cause housing demand to increase by 8 percent.
3. Income elasticity is positive for normal goods but negative for inferior goods.

B. Cross-Price Elasticity of Demand

1. Cross-price elasticity of demand is a measure of the response of the quantity of
one good demanded to a change in the price of another good. It’s helpful to call
these goods Y (percent change in quantity of Y) and X (percent change in price
of X):

% change in demand for Y

cross− price elasticity of demand=
% change in price of X
2. If cross-price elasticity is positive then X and Y are substitutes.
3. If cross-price elasticity is negative then X and Y are complements.
C. Elasticity of Supply
1. Elasticity of supply is a measure of the response of quantity of a good supplied to
a change in price of that good:

% change in quantity supplied

elasticity of sup ply=
% change in price
2. Elasticity of supply is positive in most output markets.
3. The elasticity of labor supply is a measure of the response of labor supplied to a
change in the price of labor. If the labor supply curve bends backward the
elasticity of supply will be negative along that part of the supply curve.
VI. Looking Ahead page 103
Price Quantity Elasticity Total Revenue
increase decrease perfectly elastic falling to zero
increase decrease elastic falling
increase decrease unitarily elastic constant
increase decrease inelastic rising
increase no change perfectly inelastic rising
   Practice  
1. Intuitively, which purchasers of which good will be least responsive to an increase in its price?
(a) Gasoline
(b) Exxon gasoline
(c) Shell gasoline
(d) BP gasoline
ANSWER: (a) For each of the other options, close substitutes are present. For most drivers,
there are few close substitutes for gasoline in general. When price increases,
quantity demanded will decrease only slightly.

2. The formula for “the elasticity of A with respect to B” is

(a) change in A divided by change in B.
(b) change in B divided by change in A.
(c) percentage change in A divided by percentage change in B.
(d) percentage change in B divided by percentage change in A.
ANSWER: (c) Elasticity is a relative concept. It measures the relative change in one variable
with respect to the relative change in the other variable.

3. A 10% fall in the price of shampoo results in a 5% increase in the quantity of shampoo
demanded. Demand is
(a) inelastic.
(b) elastic.
(c) unitarily elastic.
(d) perfectly elastic.
ANSWER: (a) Refer to Table 5.1 on p. 91 for the interpretation of numerical values.

4. The price elasticity of demand can be calculated by

(a) multiplying the percentage change in quantity demanded by the percentage change in
price.
(b) dividing the percentage change in quantity demanded by the percentage change in price.
(c) dividing the percentage change in price by the percentage change in quantity demanded.
(d) multiplying the percentage change in price by the percentage change in quantity
demanded.
ANSWER: (b) Refer to p. 91 for the price elasticity of demand formula.

5. The supply of flapdoodles increases. There is no effect on the equilibrium quantity. Demand is
(a) perfectly inelastic.
(b) elastic.
(c) inelastic.
(d) perfectly elastic.
ANSWER: (a) If demand is completely unresponsive to a price change, it is perfectly inelastic—
a vertical demand curve.

6. The demand for potato chips has a downward-sloping straight-line demand curve. As the price of
chips increases, the price elasticity of demand
 (a) becomes more elastic.
(b) becomes less elastic.
(c) remains constant—the slope of a straight line is constant.
(d) remains constant—each price increase causes an equal decrease in quantity demanded.
ANSWER: (a) Slope does not give a good guide to elasticity. A general rule, though, for a
straight-line demand curve is that, as price rises, demand becomes more elastic.

7. A 10% increase in the price of video games results in a 5% decrease in the quantity of video
games demanded. The price elasticity of demand is            and demand is            .
(a) –0.5; elastic
(b) –2.0; elastic
(c) –0.5; inelastic
(d) –2.0; inelastic
ANSWER: (c) Options (a) and (d) must be wrong—an “elastic” value must have an absolute
value of more than 1 whereas an “inelastic” value must have an absolute value of
less than 1. The relatively large price change prompts a relatively small quantity
change—that’s inelastic.¾
15. The cross-price elasticity of demand between Exxon gas and Havoline motor oil is –0.7. Exxon
gas and Havoline motor oil are            . The cross-price elasticity of demand between Exxon gas
and Chevron gas will be           .
(a) substitutes; positive
(b) substitutes; negative
(c) complements; positive
(d) complements; negative
ANSWER: (c) A negative cross-price elasticity indicates that goods are complements. Because
Exxon and Chevron are substitutes, the cross-price elasticity will be positive.

16. The income elasticity of demand for Havoline oil is +0.6. We can conclude that Havoline oil
(a) is an inferior good.
(b) is a normal good.
(c) is a substitute.
(d) has a demand that is not very sensitive to changes in its price.
ANSWER: (b) An increase in income will raise demand for Havoline. The elasticity is positive.
Options C and D do not refer to income elasticity.¾
 7
The Production Process:
The Behavior of
Profit Maximizing Firms
I. Introduction, pages 135-136
A. The Behavior of Firms
1. Firms purchase inputs to produce and sell outputs.
2. Although the analysis refers to the behavior of perfectly competitive firms, much
of what is said also refers to firms that are not competitive.
B. Production Is Central: Production is the process by which inputs are combined,
transformed, and turned into outputs.
C. Production Is Not Limited to Firms
1. Households also engage in transforming factors of production into useful things.
2. Some government agencies also produce goods and/or services. For example, the
Department of Motor Vehicles produces drivers’ licenses and vehicle license
plates.
3. A firm is an organization that comes into being when a person or group of people
decide to produce a good or service to meet a perceived demand. Most firms
exist to make a profit.
II. The Behavior of Profit-Maximizing Firms, pages 136-140
A. Three Decisions Every Firm Must Make
1. How much output to produce (output quantity supplied).
2. How to produce that output (which technology to use).
a. Changing production technology changes the relationship between input
and output quantities.
b. A technological improvement allows a firm to produce more output with
the same quantities of inputs.
3. How much of each input to purchase (input quantities demanded).
B. Profits and Economic Costs
1. Profit (economic profit) is the difference between total revenue and total cost.
a. Total revenue is the amount received from the sale of the product
(q x p).
b. Total cost (total economic cost) is the total of (1) out-of-pocket costs plus
(2) opportunity cost of all factors of production.
c. The most important opportunity cost not included in accounting cost is
the opportunity cost of capital. The normal rate of return is 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.
With this distinction in mind, define “accounting profit” as total revenue minus only explicit costs and
“economic profit” as total revenue minus all costs, explicit or implicit. Putting the two definitions side by
side can help make this clear:
Accounting Profit = Total Revenue – Explicit Costs
Economic Profit = Total Revenue – Explicit Costs – Implicit Costs
Economic Profit = Accounting Profit - Unrecorded Opportunity Costs
Stress that the difference between the two can be crucial. If you open a restaurant with your own money and
your own labor, your “accounting profit” would ignore the opportunity cost of your time and money. To
figure your “economic profit,” however, you would subtract both of these implicit costs (as well as all
explicit costs).

2. Normal Rate of Return

a. Whenever resources are used for business investment there is an
opportunity cost, namely the value of what those resources could have
earned in their next-best alternative use.
b. The rate of return is the annual flow of net income generated by an
investment expressed as a percentage of the total investment.
c. A normal rate of return is the rate of return on capital that is just
sufficient to keep owners satisfied.
d. A normal rate of return on invested capital is part of the full economic
costs of a business.
e. If a firm earns a zero economic profit it is earning enough accounting
profit to yield a normal rate of return on its invested capital.
f. If the level of economic profit is positive, the firm is earning an above-
normal rate of return.
C. Short-Run versus Long-Run Decisions
1. The short run is the period of time for which two conditions hold:
a. The firm is operating under a fixed scale (fixed factor) of production.
b. Firms can neither enter nor exit an industry.
2. The long run is that period of time for which there are no fixed factors of
production:
a. Firms can increase or decrease the scale of operation.
 b. New firms can enter and existing firms can exit the industry.
3. The difference between the short and long run is the difference between day-to-
day operations and longer-term strategic planning.
D. The Bases of Decisions: Market Price of Outputs, Available Technology, and Input
Prices
1. Firms will choose the optimal method of production, the production method that
minimizes cost.
2. With cost determined and the market price of output known a firm will make a
final judgment about the quantity of product to produce and the quantity of each
input to purchase.
Unique Economics in Practice
There have been many articles written questioning the assumption of profit maximization.
Perhaps the most persuasive response relies on the capital market constraint. Most large firms
are publicly owned corporations. The owners of these firms are the stockholders. Stockholders
mainly focus on the growth in earnings per share – in other words, profit. Businesses that do not
focus on the bottom line will see their stock price fall and will not be able to expand as rapidly as
those firms motivated by profits.
Question: Are there firms not subject to the capital market constraint? (Hint: what types of
organizations are not owned by stockholders?)
Answer: Privately held firms (Bechtel, Hallmark) and not-for-profit organizations (Salvation
Army, Goodwill Industries, Red Cross) are two broad classes of organizations that are not subject
to capital market discipline.
III. The Production Process, pages 140-145
A. Production Technology
1. Production technology is the quantitative relationship between inputs and
outputs.
2. Labor-intensive technology relies heavily on human labor instead of capital.
3. Capital-intensive technology relies heavily on capital instead of human labor.
4. Firms will choose the technology that minimizes costs.
B. Production Functions: Total Product, Marginal Product, and Average Product
1. The production function or total product function is 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.
2. Marginal Product and the Law of Diminishing Returns
a. Marginal product is the additional output that can be produced by adding
one more unit of a specific input, ceteris paribus.
b. The law of diminishing returns states that after a certain point, when
additional units of a variable input are added to fixed inputs, after a
certain point, the marginal product of the variable input declines. This is
also called or the law of diminishing marginal product.
 c. Marginal product is a relationship between the quantity of output and the
quantity of a variable input.
3. Marginal Product versus Average Product
a. Average product is the average amount produced by each unit of a
variable factor of production.
b. Average product follows marginal product but does not change as fast.
c. The average product of labor is also called labor productivity.
»»» Draw a marginal product graph showing its three distinct phases, with increasing, decreasing/positive, and
decreasing/negative marginal product. (See the diagram following.) Call these Phases 1, 2, and 3,
respectively. Ask where increasing returns are occurring. (Phase 1.) Ask why. (The specialization effect is
stronger than the congestion effect.) Ask what is happening to total and to average product in Phase 1. (Both
rising.) Where are there diminishing returns? (Over the remainder of the diagram.)
marginal product
Average and

AP
I II III
Units of MP
output

Go to Phase 3, where MP is negative. What does this mean? (Additional units of input cause total output to
decrease.) What must be happening to TP? (Falling.) AP? (Falling.) Ask when TP started to fall. (When MP
became negative, when it crossed the horizontal axis.) When did AP start to fall? (When MP dips below AP.)
What is happening in Phase 2? (MP is falling because the congestion effect has prevailed; TP is rising; AP is
rising and then falling.) Ask why AP shows this behavior. (Once again, the average-marginal rule.)º

C. Production Functions with Two Variable Factors of Production

1. Increasing the quantity of one input (say capital) will usually increase the average
product of the other input (say labor). This happens if the two inputs are
complementary.
2. Diminishing returns will not set in as quickly.
IV. Choice of Technology, pages 145-147
A. Inputs can substitute for each other in addition to being complementary.
1. As the relative prices of inputs change, the cost-minimizing input combinations
change.
2. Demand for inputs that have become relatively more costly will usually fall.
Demand for inputs that have become relatively less costly will usually rise.
(Some inputs must be used in fixed proportions so substitution will not always be
possible.)
 B. Two things determine the cost of production
1. Input prices
2. Available technologies.
3. Firms will choose the technology that minimizes costs given current input prices.

 Extended Application
Application 1: MP and AP Curves for a Photocopy Service
Suppose you decide to open a photocopy service near campus. Your fixed inputs (in the short
run) are office space and a single photocopying machine. Your only variable input is labor. (It is
true that you also need paper to make copies, but we are viewing your “output” as a service
—“turning blank pages into printed copies”—rather than a good—“paper copies.” In providing
this service, labor is the only variable input.)
The following table illustrates output (thousands of copies per day) for each number of workers:

Labor TPL MPL APL

0 0 — —
1 2,000 2,000 2,000
2 8,000 6,000 4,000
3 12,000 4,000 4,000
4 15,000 3,000 3,750
5 17,000 2,000 3,400
6 18,000 1,000 3,000
7 17,000 –1,000 2,430

Note that one worker can produce 2,000 copies in one day. Add a second worker, however, and
the number of copies rises dramatically to 8,000. This is an example of the gains from
specialization. A single worker must divide his or her time between photocopying and taking
orders; the constant back and forth gets in the way of making copies. Add a second worker,
however, and both can specialize: One limits work time to copying, the other just takes orders.
Add a third worker and there is someone to monitor the machines to be sure paper and toner are
always in proper supply, reducing down time. The third worker can also occasionally take orders
or run the copy machine, enabling the other two workers to take breaks, thus reducing worker
fatigue and time-consuming mistakes.
Note, however, that the gains from the third worker (4,000) are smaller than the gains from the
second (8,000). Diminishing returns to labor have set in: We are adding a variable input (labor) to
fixed inputs (photocopying machines and office).
Diminishing returns continue as workers four through six are added, and after this negative
returns set in: Adding the seventh worker actually makes output decrease, presumably because
there is crowding around the single photocopying machine, and workers get in each other's way.
 Perhaps also—with so many workers—supervision becomes more difficult, and workers can
slack off more easily.
In the following diagram, we plot all of the information about marginal product found in the
table. Note that as we change from one to two workers, we have increasing returns to labor and
the marginal product curve slopes upward. From two through six workers, we have diminishing
returns to labor, and the marginal product curve slopes downward. From six to seven workers, we
have negative returns to labor, and marginal product has dropped below the horizontal axis.

6,000
5,000
marginal product
Average and

4,000
3,000
2,000 AP

1,000

0
1 2 3 4 5 6 7
Number of workers MP

What about the average product of labor? In the table, students can see that when going from one
to two workers, marginal product is larger than average product, and so average product rises. A
newly hired worker who adds more to output than the average output of all previous workers
pulls the average up. In the graph, we can see that the MP curve rises above the AP curve when
the second worker is hired, so the AP curve is rising.
The third worker, however, adds 4,000 to output, which is exactly equal to the preexisting
average of all workers. Thus, adding the third worker should leave average product unchanged. In
the graph, we see that at three workers, the average and marginal product curves intersect.
Finally, workers four through six add to total product, but each adds less than the preexisting
average of all workers. Thus, as each of these workers is hired, the average is pulled down. In the
graph, we see that the MP curve lies below the AP curve, and that AP is falling as the fourth,
fifth, and sixth worker are hired.
The point to remember is this: The shapes of the marginal and average product curves are not
arbitrary. These shapes are determined by how much production we can expect from different
numbers of workers, based on technology and expected worker behavior. Remember too that in
deriving average and marginal product curves, we always assume that other nonlabor inputs are
fixed. In our example, office space and the number of photocopying machines are the fixed
inputs.

  Practice  
Use the following information for the next three questions. Jason has a plot of land that has three
alternative uses: R, S, and T. The revenue from each use is $5, $6, and $8, respectively. The accounting
cost of each use is zero.
1. The opportunity cost of using the land for Use S is
(a) $5, the value in Use R.
(b) $8, the value in Use T.
(c) $1, the difference in value between Use R and Use S.
(d) $2, the difference in value between Use T and Use S.
ANSWER: (b) Opportunity cost is the value of the next-best alternative, Use T.

2. The economic profit of using the land for Use S is

(a) –$8, the value in Use T.
(b) $8, the value in Use T.
(c) –$2, the difference in value between Use T and Use S.
(d) $2, the difference in value between Use T and Use S.
ANSWER: (c) Economic profit is total revenue (which for Use S is $6) minus total costs.
Accounting costs are zero, but economic (opportunity) costs are $8 (the revenue
from Use T).

3. To maximize profits, Jason should utilize the land for            . If Jason is a typical producer in this
industry, we would expect firms to            this industry.
(a) Use S; enter
(b) Use S; leave
(c) Use T; enter
(d) Use T; leave
ANSWER: (c) Use T offers the highest profit ($2). In the long run, firms will be attracted to the
industry by the positive economic profits.

Use the following information for the next two questions. Amos can sell as many cantaloupes as he
wishes at the market price of $2.00 each. Total cost to Amos of carrying each cantaloupe to market is
50¢. He chooses to sell 10 cantaloupes.

4. His total revenue is

(a) $1.50.
(b) $2.00.
(c) $15.00.
(d) $20.00.
ANSWER: (d) Total revenue is price ´ quantity.

5. Amos is making
(a) a total economic profit of $15.00.
(b) a total economic profit of $20.00.
(c) a normal rate of return of 10%.
(d) a total economic profit of $1.50.
ANSWER: (a) Total economic profit is total revenue less total cost. For Amos, total revenue is
$20.00 and total cost is $5.00.

6. Jocelyn Willetts starts a VCR repair service. She invests $60,000 in the business. The normal rate
of return in the VCR repair trade is 12%. At the end of the first year, Jocelyn’s economic profit is
$5,000. She should
(a) leave this industry. A normal profit is $60,000 ´ 0.12, i.e., $7,200, and she is earning less
than this.
 (b) probably leave this industry. She has ignored other costs of production.
(c) stay in the industry. She is earning more than the normal rate of return.
(d) probably stay in the industry. 8.33% rate of return is below average, but it might take
more time to establish customer loyalty.
ANSWER: (c) If Jocelyn has an economic profit, she must be earning more than the normal rate
of return, i.e., she is earning more than enough to keep her interested.¾

  Practice  
Use the following table to answer the next five questions.

Labor (Workers) Total Product Marginal Product Average Product

0 0 — —
1 15
2 32
3 48
4 60
5 10
6 13

11. Total product, if six workers are employed, is

(a) 70 units of output.
(b) 73 units of output.
(c) 78 units of output.
(d) 86 units of output.
ANSWER: (c) Total product is average product times the number of workers (13 ´ 6).

12. Average product, if five workers are employed, is

(a) 10 units of output.
(b) 12 units of output.
(c) 14 units of output.
(d) 15 units of output.
ANSWER: (c) With four workers, total product is 60 units. The fifth worker adds 10 more units
to make a total of 70. Average product is total product divided by the number of
workers (70/5).

13. Diminishing returns set in with the            worker.

(a) first
(b) second
(c) third
(d) fourth
 ANSWER: (c) The marginal products of the first, second, and third workers, respectively, are
15, 17, and 16. The decline begins with the third worker.

14. Average product begins to decrease with the            worker.

(a) first
(b) second
(c) third
(d) fourth
ANSWER: (d) The average products of the first, second, third, and fourth workers, respectively,
are 15, 16, 16, and 15. The decline begins with the fourth worker.

15. The marginal product of the sixth worker is

(a) 8 units of output.
(b) 13 units of output.
(c) 14 units of output.
(d) 78 units of output.
ANSWER: (a) Total product of five workers is 70. Total product of six workers is 78. The sixth
worker adds 8 units of output.

16. When marginal product is decreasing, average product is

(a) decreasing.
(b) increasing.
(c) negative.
(d) None of the above
ANSWER: (d) Average product may be increasing or decreasing but, without additional
information, we can’t say for certain.¾
 8
Short-Run Costs
and Output Decisions
DETAILED CHAPTER OUTLINE
I. Introduction, page 155
A. This chapter focuses on production costs.
1. To calculate costs a firm must know the quantities and prices of inputs it needs to
produce its output.
2. For simplicity some of this analysis assumes input prices are constant. This
means input markets are assumed to be perfectly competitive. Figure 8.1 from
the text (page 155, shown below) summarizes the distinction between revenue
and cost.

II. Costs in the Short Run, pages 156-166

A. Short-Run Cost
1. Total cost equals total fixed costs plus total variable costs:
TC = TFC + TVC
2. A fixed cost is any cost that does not depend on the firm’s level of output.
a. These costs are incurred even if the firm is producing nothing.
b. There are no fixed costs in the long run.
3. A variable cost is a cost that depends on the level of production. Variable costs
change when the rate of output changes.
B. Fixed Costs
1. Total Fixed Costs (TFC) or overhead is the total of all costs that do not change
with output even if output is zero
2. Average Fixed Cost (AFC) is total fixed cost divided by the number of units of
output; a per-unit measure of fixed costs. As output rises AFC falls. Spreading
overhead is the process of dividing total fixed costs by more units of output.
Average fixed cost declines as quantity rises.
3. Firms have no control over fixed costs in the short run. Therefore fixed costs are
also sunk costs in the short run.
4. A sunk cost is any cost that does not change when a decision is made.
C. Variable Costs
1. A variable cost is a cost that depends on the level of output.
2. Total Variable Cost (TVC) is the total of all costs that vary with output in the
short run.
a. Variable costs change as output changes because the cost of additional
output depends directly on the additional input quantities that are
required, the price of each input, and how the input price changes as the
quantity demanded changes (the input supply function).
b. The total variable cost curve is a graph that shows the relationship
between total variable cost and the level of a firm’s output. This graph is
usually not linear, implying average variable cost changes as output
changes.
3. Marginal Cost (MC) is the increase in total cost that results from producing 1
more unit of output. Marginal costs reflect changes in variable costs.
a. Marginal cost is the increase in total cost when output is increased by
one unit.
b. Since fixed costs are fixed, marginal cost is also the increase in total
variable cost when output is increased by one unit.
4. The Shape of the Marginal Cost Curve in the Short Run
a. The MC curve’s shape is caused by diminishing returns.
b. Marginal costs will eventually increase with the level of output produced
in the short run.
»»» Because marginal cost (MC) is used throughout this chapter, it is important to stress the importance of
marginal analysis. Show students that MC = TC/Q = TVC/Q. Point out that the above equality must
logically be true at all times because fixed costs do not vary with changes in Q. In other words TFC/Q =
0.º

5. Graphing Total Variable Costs and Marginal Costs

a. MC is the slope of TVC.
b. MC will be minimized at the point of inflection of the TVC curve.

»»» The MC curve is not the slope of AVC. º

 6. Average Variable Cost (AVC)
a. Average variable cost (AVC) is total variable cost divided by the number
of units of output.
b. Marginal cost is the cost of one additional unit, but average variable cost
is the average cost per unit of all the units being produced.
7. Graphing Average Variable Costs and Marginal Costs
a. AVC follows MC.
b. As diminishing returns take hold and MC rises, AVC will also increase.
c. This is the familiar relationship between marginal and average. When
MC is above AVC, AVC is rising. When MC is below AVC, AVC is
falling.
D. Total Costs
1. Total cost (TC) is total fixed costs plus total variable costs.
TC = TFC + TVC
2. Average total cost (ATC) is total cost divided by the number of units of output.
a. ATC is total cost per unit. ATC = TC/q.
b. ATC is also AFC + AVC. ATC = AFC + AVC.
3. The Relationship Between Average Total Cost and Marginal Cost
a. ATC also follows MC but lags behind it.
b. The reason is that AFC declines continuously as Q increases. This makes
the minimum point on the ATC curve occur at a higher Q than the
minimum AVC.
E. Short-Run Costs: A Review
Economics in Practice: Average and Marginal Costs at a College, page 166

Pomona College in California has an annual operating budget of $120 million. With this budget,
the college educates and houses 1,500 students. So the average total cost of educating a Pomona
student is $80,000 per year. Suppose college administrators are considering a small increase in
the number of students it accepts and believe they could do so without sacrificing quality of
teaching and research. Given that the level of tuition and room and board is considerably less than
$80,000, can the administrators make a financial case to support such a move?

The key issue here is to recognize that for a college like Pomona—and indeed for most colleges
—the average total cost of educating a student is higher than the marginal cost. For a very small
increase in the number of students, the course-related expenses probably would not go up at all.
These students could likely be absorbed into existing courses with no added expense for faculty,
buildings, or administrators. Housing might be more of a constraint, but even in that regard
administrators might find some flexibility. Thus, from a financial perspective, the key question
about expansion is not how the average total cost of education compares to the tuition, but how
tuition compares to the marginal cost. For this reason, many colleges would, in fact, find it
financially advantageous to expand student populations if they could do so without changing the
quality and environment of the school.
 The cost curves also help us understand the downward spiral that can affect colleges as their
populations fall. In 2005, Antioch College in Ohio announced that it would be phasing out its
undergraduate program. The culprit? Declining attendance caused the average total cost of
educating the remaining few students to skyrocket, despite attempts to control costs. Given the
inevitability of some fixed costs of education (to educate even a modest student body requires
facilities and a college president, for example), as the number of students falls, the average total
cost rises.

TOPIC FOR CLASS DISCUSSION:

Unique Economics in Practice

Microsoft Corp. spent over $120 million programming and debugging their Windows Vista
operating system. This is the amount of fixed cost. The marginal cost of producing one more
copy of Windows Vista is very low, about equal to the cost of the disk.

Source: Microsoft Corporation Final 10K report for 2007, page 45. Available at
http://www.microsoft.com/msft/SEC/default.mspx .
Question: Do you think the computer software industry is likely to have a large number of firms
or only a few firms? Explain your answer.
Answer: The software industry is likely to be a decreasing cost industry with only a few large
firms.
III. Output Decisions: Revenues, Costs, and Profit Maximization, pages 167-171
To calculate potential profits firms must combine cost analyses with information on potential
revenues from sales.
A. Perfect Competition
1. Perfect competition is an industry structure in which there are many firms, each
small relative to the industry, producing 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.
2. Perfect competition requires firms to produce homogeneous products that are
undifferentiated products; products that are identical to, or indistinguishable
from, one another. The output produced by one firm is identical to the output
produced by every other firm.
3. Firms in perfectly competitive markets are often called price takers because they
take the market price as given.
4. The demand curve faced by a firm in a perfectly competitive market will be
horizontal.
5. Perfectly competitive markets allow firms to enter or leave the industry at very
low cost.

B. Total Revenue and Marginal Revenue

1. Total revenue is 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 × q).
 2. Marginal revenue is the additional revenue that a firm takes in when it increases
output by one additional unit. In perfect competition, P = MR.
3. The marginal revenue curve and the demand curve facing a competitive firm are
identical. P* = d = MR.
»»» It takes little time and is very useful to use some numerical examples to illustrate that MR = Price = TR/Q.
Be sure to mention that MR = Price only in perfectly competitive markets. Once again this is consistent with
the assumptions made in the introduction to Part II.º

Unique Economics in Practice

In reality there are no markets that are perfectly competitive. But some markets are highly
competitive. One example is small print shops. There are many small print shops in any city.
They all produce the same output and charge roughly the same price. While some will try to
differentiate themselves by offering design services or free delivery, most are content to earn a
normal rate of return on their investment.
Question: Using a local business directory such as the Yellow Pages, count the number of small
print shops in your area.
Answer: My local telephone book has ads for 57 print shops. You might note the mix of
technologies – photocopying and offset printing – as a point of differentiation.

Economics in Practice: Case Study in Marginal Analysis:

An Ice Cream Parlor, pages 170-171

The following is a description of the decisions made in 2000 by the owner of a small ice cream
parlor in Ohio. After being in business for 1 year, this entrepreneur had to ask herself whether she
should stay in business. The cost figures on which she based her decisions are presented next.
These numbers are real, but they do not include one important item: the managerial labor
provided by the owner. In her calculations, the entrepreneur did not include a wage for herself;
but we will assume an opportunity cost of $30,000 per year ($2,500 per month).

The store sells ice cream cones, sundaes, and floats. The average price of a purchase at the store
is $1.45. The store is open 8 hours per day, 26 days a month, and serves an average of 240
customers per day. From the preceding information, it is possible to calculate the store’s average
monthly profit. Total revenue is equal to 240 customers × $1.45 per customer × 26 days open in
an average month: TR = $9,048 per month.

Adding fixed costs of $3,435.00 to variable costs of $4,317.04, we get a total cost of operation of
$7,752.04 per month. Thus, the firm is averaging a profit of $1,295.96 per month ($9,048.00 –
$7,752.04). This is not an “economic profit” because we have not accounted for the opportunity
cost of the owner’s time and efforts. In fact, when we factor in an implicit wage of $2,500 per
month for the owner, we see that the store is suffering losses of $1,204.04 per month ($1,295.96
– $2,500.00).

By adding the 2 hours, the store turns an economic loss of $1,204.04 per month into a small
($11.98) profit after accounting for the owner’s implicit wage of $2,500 per month.
 B. Comparing Costs and Revenues to Maximize Profits: We assume that the industry is
perfectly competitive and that firms seek to maximize total profit.
1. The Profit-Maximizing Level of Output is where marginal cost equals marginal
revenue.
a. Firms will continue to increase output as long as marginal revenue
exceeds marginal cost because marginal profit (= MR – MC) is positive.
b. Since MR = P in perfectly competitive markets, a firm in such a market
will produce the quantity of output that makes MC = P.
2. A Numerical Example
C. The Short-Run Supply Curve: For a competitive firm, the short-run supply curve is
identical to the marginal cost curve.
1. Because the demand curve is horizontal, shifts in the demand curve will simply
trace the MC curve.
2. There is one important exception to this rule covered in a later chapter. If
P<AVC, the firm will temporarily shut down. That implies the short-run supply
curve is made up of two pieces. The first is the MC curve above the AVC curve.
The second part is the part of the vertical axis for P<AVC (since the firm will
produce Q = 0 when P<AVC).

  Practice  

Begin by completing the following table. Confirm that there are two output levels where marginal
cost and marginal revenue are equal. Are these output levels equally desirable, in terms of profitability?
q TC TR MC MR Total Profit
0 $30 0

1 $50

2 $65

3 $75

4 $83

5 $90

6 $98

7 $107

8 $117

9 $132

10 $152
 In fact, at one of these two production levels, it would be more advantageous to shut down
production entirely and, if fixed costs were higher, perhaps neither would be worthwhile. Clearly the
“MR = MC” rule requires modification.
Can you explain why the earlier of the two intersection points can never be the profit-maximizing
choice?
1. Which of the following statements about fixed costs is true?
(a) Fixed costs increase as time goes by.
(b) Average fixed cost graphs as a U-shaped curve.
(c) Fixed costs are zero in the long run.
(d) Fixed costs are zero when the firm decides to produce no output.
ANSWER: (c) All resources (and all costs) are variable in the long run.

2. As output increases, total fixed costs

(a) increase.
(b) remain constant.
(c) decrease.
(d) decrease and then increase.
ANSWER: (b) Because fixed resources are a given quantity, the costs of those resources are a
given quantity too.

3. The            curve decreases continuously as output increases.

(a) average fixed cost
(b) average variable cost
(c) total fixed cost
(d) total variable cost
ANSWER: (a) Total fixed cost remains constant as output increases. AFC = TFC/q is reduced as
quantity increases.

4. Of the following,            is the most likely to be a variable cost.

(a) the wage of a security guard
(b) the firm’s rent on its factory building
(c) the firm’s electricity bill
(d) the firm’s interest payment on a bank loan
ANSWER: (c) In the other three cases, as output level changes, the cost is unlikely to change.

5. As output level increases, the difference between average total cost and average variable cost
(a) increases, because total cost includes fixed costs.
(b) decreases, because additional units of output spread fixed cost over a larger number of
units and reduce its importance.
(c) remains constant, because total fixed cost (which is included in total cost) is a constant.
(d) decreases and then increases, because they are U-shaped curves.
ANSWER: (b) Refer to the reason given. ATC = AVC + AFC. AFC decreases as output level
increases.

6. If labor is a variable resource and the wage rate increases, then the total variable cost curve will
and the total cost curve will            .
(a) shift upwards at all levels of output; shift upwards at all levels of output
(b) shift upwards at all levels of output; pivot upwards
(c) pivot upwards; shift upwards at all levels of output
(d) pivot upwards; pivot upwards
ANSWER: (d) When output is zero, variable cost is zero. Both curves will pivot upwards from
their point of intersection with the vertical axis.
7. Complete the following table. Total fixed cost is $10.

q TC TFC TVC ATC AFC AVC

0 $10 — — —
1 $18
2 $24
3 $30
4 $36
5 $40
6 $54
7 $70

ANSWER: Refer to the following table.

q TC TFC TVC ATC AFC AVC

0 $10 $10 $0 — — —
1 $18 $10 $8 $18.00 $10.00 $8.00
2 $24 $10 $14 $12.00 $5.00 $7.00
3 $30 $10 $20 $10.00 $3.33 $6.67
4 $36 $10 $26 $9.00 $2.50 $6.50
5 $40 $10 $30 $8.00 $2.00 $6.00
6 $54 $10 $44 $9.00 $1.67 $7.33
7 $70 $10 $60 $10.00 $1.43 $8.57

8. Eva and ZsaZsa own small factories producing decorative boxes. Eva uses a production process
that has high fixed costs and low variable costs, and ZsaZsa uses a process that has low fixed
costs and high variable costs. Each factory is producing 100 boxes per week, and the total costs
are equal. If each firm increases output by 10 boxes per week
(a) Eva’s total cost will increase more than ZsaZsa’s.
(b) Eva’s total cost will increase less than ZsaZsa’s.
(c) Eva’s total fixed cost will increase more than ZsaZsa’s.
(d) Eva’s total fixed cost will increase less than ZsaZsa’s.
ANSWER: (b) An increase in output will increase variable costs, and ZsaZsa’s variable costs,
which are higher, will increase more. Total fixed costs do not change as output
changes.¾
  Practice  
19. Complete the following table based on the information given. The price of this product is $10 per
unit.
q TC TR MC MR
0 $10

1 $18

2 $24

3 $30
 4 $36

5 $40

6 $54

7 $70

ANSWER: Refer to the following table.

q TC TR MC MR
0 $10 $0

1 $18 $10 $8 $10

2 $24 $20 $6 $10

3 $30 $30 $6 $10

4 $36 $40 $6 $10

5 $40 $50 $4 $10

6 $54 $60 $14 $10

7 $70 $70 $16 $10

20. Referring to the table above, what is the profit-maximizing output level?
(a) 3 units
(b) 5 units
(c) 6 units
(d) 7 units
ANSWER: (b) Five units is the last output level at which marginal revenue exceeds marginal
cost.

21. Referring to the preceding table, the maximum total profit is

(a) zero.
(b) $6.
(c) $10.
(d) $50.
ANSWER: (c) At 5 units, total revenue is $50 and total cost is $40.

22. Jill and John Pantera produce earthenware mugs. They can sell their mugs at $2 each. They find
that the marginal cost of production for the first, second, third, fourth, and fifth mug is 50¢,
$1.00, $1.50, $2.00, and $2.50, respectively. Assuming that Jill and John do produce some mugs,
which of the following statements is true?
(a) The profit-maximizing output level is three mugs.
(b) Jill and John can make a positive profit from selling their mugs.
(c) Jill and John should produce the fourth mug.
 (d) Because marginal cost is increasing by 50 cents per mug, there is a constant rate of
increase in total cost.
ANSWER: (c) The fourth mug allows the Panteras to maximize profits (assuming that profits
are made). Option (b) is wrong because we have no information about total cost,
only how it’s changing. Option (d) is incorrect—refer to the information in the
next question.

Use the following information about the Panteras’ enterprise, Mugs-R-Us, for the next four questions.
Total fixed cost is $4.00. Mugs sell for $2.50 each.

q TC TR MC MR
0 $4.00

1 $.50

2 $1.00

3 $1.50

4 $2.00

5 $2.50

6 $3.00

23. Total revenue for 4 mugs is            and total cost is            .
(a) $2.50; $4.00
(b) $10; $9.00
(c) $2.50; $9.00
(d) $10; $4.00
ANSWER: (b) TR = $2.50 ´ 4 = $10.00. TC = $4.00 + $0.50 + $1.00 + $1.50 + $2.00 = $9.00.
Refer to the following table.

q TC TR MC MR
0 $4.00 $0.00

1 $4.50 $2.50 $0.50 $2.50

2 $5.50 $5.00 $1.00 $2.50

3 $7.00 $7.50 $1.50 $2.50

4 $9.00 $10.00 $2.00 $2.50

5 $11.50 $12.50 $2.50 $2.50

6 $14.50 $15.00 $3.00 $2.50

24. At three units of output, marginal revenue            marginal cost. To maximize profits, Mugs-R-Us
should            production.
(a) exceeds; increase
(b) exceeds; decrease
(c) is less than; increase
(d) is less than; decrease
ANSWER: (a) MR = P = $2.50. MC = $1.50. They should increase production. Refer to
Question 23 for the completed table.

25. To maximize profits, Mugs-R-Us should produce            mugs. Jill and John Pantera will make a
total economic profit of            .
(a) four; $1.00
(b) four; –$1.00
(c) five; $1.00
(d) five; –$1.00
ANSWER: (c) MR = MC at five units of output. TR = $12.50 and TC = $11.50. Refer to
Question 23 for the completed table.

26. If the total fixed cost of production increased to $6.00, Mugs-R-Us should produce            mugs.
Jill and John Pantera will make a total economic profit of            .
(a) four; $1.00
(b) four; –$1.00
(c) five; $1.00
(d) five; –$1.00
ANSWER: (d) MC will not be affected by the change in fixed cost, so the profit-maximizing
output level will remain at five units. TR will still be $12.50, but TC will now be
$13.50. Refer to Question 23 for the completed table.¾