REVIEW OF ECONOMIC PRINCIPLES
Ranjit Dighe
Last revised 16-Feb.-2006

[These are about a week's worth of lectures on economic principles, mostly micro.  Be aware that unlike my classroom lectures on the same, these notes contain no graphs, so consult your own notes or a textbook for the graphs.]

In these notes:

I.  Demand

II.  Supply
III.  Industry demand and supply curves
IV.  Equilibrium
V.  Perfect competition and the "law of one price"
VI.  Monopoly pricing

VII.  Why monopolies are bad for consumers and society

VIII.  The multiplier


I.  DEMAND

Think about the canned tuna fish that you buy at the supermarket. Some of it is marked "dolphin-safe," whereas some of it is not. Most of us naturally recoil at the thought of cute, intelligent dolphins being routinely slaughtered in tuna nets just because they happen to swim with tuna. Virtually nobody is completely indifferent to the plight of those poor dolphins. Yet tuna that is "dolphin-unsafe" continues to be sold.
-> Q: So why doesn't everyone just buy the dolphin-safe tuna?
---- A: "Dolphin-unsafe" tuna is cheaper.  (Altering tuna-netting practices so as not to catch dolphins is costly, and the type of tuna that don't swim with dolphins -- albacore tuna -- are likewise more expensive than regular tuna.)  While everybody likes dolphins, a great many people are not willing to pay a bit more for their tuna in order to prevent dolphins from being killed. This brings us to the "Law" of Demand.

DEMAND CURVE: a graph showing how much of a given product people will be willing to buy at different prices
-- "Law" of Demand: As the price of a good goes up, the quantity demanded of that good goes down
----> demand curves slope downward
-- [I drew a demand curve in class.  Reproducing graphs on the web is time-consuming and difficult, but I'll try to do it at some point.]

Why demand curves slope downward:

(1) INCOME EFFECT: As the price of a good falls, your real income (in terms of that good) rises; you can now afford to buy more of it, and so you do.

(2) SUBSTITUTION EFFECT: As the price of a good falls, its relative price (i.e., its price relative to other goods' prices) falls, causing you to buy less of other goods (especially close substitutes) and more of that good.

-- These two effects reinforce each other.

To repeat: A change in a good's price causes a movement along the demand curve for that good. What causes the demand curve to shift?

Things that cause demand to increase (demand curve shifts out):

(1) Higher incomes (for normal goods, as people get richer, they buy more of the good)

(2) Increased population

(3) Increased popularity of a good (from changes in people's tastes)

(4) Increases in the price of other, substitute goods
-- Ex.: If CD's become more expensive, the demand for tapes will go up.

(5) Decreases in the price of complementary goods (goods that are used together with the first good)
-- Ex.: If tape decks become cheaper, the demand for tapes will go up.

Note well:

CHANGES IN DEMAND (shifts of the demand curve)
are different from
CHANGES IN QUANTITY DEMANDED (occur in response to price; movements along the demand curve).

The same goes for supply curves.

Exs.
 
Enrollment at SUNY-Oswego is up, so there is more demand for economics textbooks. 
--> demand curve shifts up; 
      demand increases.
The College Store cut the price of new textbooks, so more economics textbooks are being sold. 
--> movement along the demand curve; 
      quantity demanded increases.


II. SUPPLY

SUPPLY CURVE: a graph showing how much of a product will be produced and supplied at different prices
-- "Law" of Supply: As the price of a good goes up, the quantity supplied of that good goes up, too
----> supply curves slope upward
-- Note: A (competitive) firm's supply curve is the upward-sloping portion of its marginal cost (MC) curve. This will be explained in detail later.

Why supply curves slope upward: PROFIT MAXIMIZATION, and diminishing returns.
-- Higher prices mean higher profits (other things equal), so higher prices induce firms to produce more.
-- One of the most basic rules of economics is that if the marginal benefit of doing something (i.e., the benefit you derive from one more unit) exceeds the marginal cost, then keep on doing it.  For a profit-maximizing firm, as long as the extra or marginal revenue (MR) from producing one more unit of the good exceeds the marginal cost (MC) of one more unit, then profits will be greater if the firm keeps on producing.  A profit-maximizing firm will keep on producing up to the point where MR=MC.

Three key assumptions behind the supply curve:

(1) The industry is competitive. (In a monopolistic or otherwise non-competitive industry, there is no supply curve.) A competitive industry is one with a very large number of firms producing an identical product, and free entry and exit from the industry. Firms in such an industry are "price takers," in that they must sell their output at the market price.

(2) Profit-maximization (see above)

(3) Diminishing returns
-- Beyond a certain level of production, producing an extra unit of the good gets more and more expensive.  In other words, the marginal cost (MC) of producing an extra unit of the good is increasing.
-- To be precise: Diminishing returns: beyond a certain minimum efficient scale of production, as you produce more and more of a good, the cost of producing that good increases. That is, producing an extra unit of output requires more inputs than it did before.
-- Why: Production generally exhibits diminishing returns in the short run because some factors (capital, land) tend to be fixed in the short run.  Labor is not fixed -- you can hire more workers, but with capital and land fixed, adding more workers means that the average worker will have less capital and land to work with, making them less productive.  At that point, an extra unit of output requires more labor (is more costly) than the previous unit.
---- Diminishing returns might sound like something to be avoided, but in fact it's normal.  A firm tries to maximize its profits rather than minimize its marginal cost.  Producing at the output level that minimizes your MC makes sense only if the price is that low.  As long as the price is higher than that and you can sell the last unit of the good for more than the MC of producing it, it's worth producing in the diminishing-returns range of output.

Putting those assumptions together, we get the following explanation of where the supply curve comes from:
The supply curve is the upward-sloping portion of the marginal cost (MC) curve.
-- [In class I drew a firm's MC curve, which was U-shaped (first falling, then bottoming out, then rising as diminishing returns set in. The upward-sloping part of that curve was colored in and labeled "S" for supply curve. A firm would not want to produce on the earlier, downward-sloping part of the MC curve, because when your marginal costs are falling and the market price is constant, you can always make a higher profit by producing more.]
-- Why: A profit-maximizing firm equates marginal revenue (MR) and marginal cost (MC). In a competitive industry, the firm takes the market price P* as a given and can sell all it wants to at that price; as a result, the marginal revenue (MR) from selling an extra unit of the good is always P*.  Since P*=MR at all times, then the profit-maximizing rule MR=MC becomes

P* = MC
for a competitive firm.  The firm will produce up to the point where its MC equals P*.  So the supply curve just shows what the profit-maximizing outputs for the firm will be at different market prices.
-- (By the way, a monopolist does not have a supply curve.  Only in competitive industries does a supply curve exist.)

Q: What causes the supply curve to shift outward (what causes supply to increase)?

A: For an individual firm, lower (marginal) costs of production cause the supply curve to shift out;
for an entire industry, lower marginal costs of production OR more firms in the industry
cause the supply curve to shift out.
-- Because the
supply curve is the upward-sloping part of the marginal cost (MC) curve, anything that affects MC will affect the supply curve in the same way.

The following things will cause both the firm's supply curve and the industry or market supply curve to shift out:

(1) Lower input prices -- e.g., if labor or physical capital (or raw materials used in production, like mozzarella cheese at Cam's) becomes more expensive, then the cost of production goes up and the supply curve shifts up (or in).

(2) Better technology, i.e. shifts of the production function
-- Better technology makes production cheaper --> the marginal cost curve shifts down, so the supply curve shifts down (or out), too

(3) Other factors: decreased prices of substitutes in production (beef, milk); increased prices of complements in production (beef, leather); increased capacity of firms; decreased inventories of firms

The industry or market supply curve will also shift out in response to the

entry of new firms into the industry.  More firms means a larger quantity will be supplied at each price.  This last point should become clearer in the next section.

III. INDUSTRY DEMAND AND SUPPLY CURVES

First, a little notation. In supply-and-demand diagrams, the letter Q of course stands for quantity, but for individual firms or consumers we use a lower-case q and for entire markets or industries we use an upper-case Q.

A competitive market is made up of thousands of firms and thousands of consumers. The industry output Q, then, is obtained by adding the quantities sold by every firm, or the quantities purchased by every consumer.

-- If there are, say, 10,000 firms in the industry, and the first firm produces an output q1, the second produces an output q2, etc., then we can write:

Q = q1 + q2 + ... + q10,000

-- The same equation could describe the total market sales, if there are 10,000 consumers in the market, and the first consumer buys q1 units, the second buys q2 units, etc.

An INDUSTRY DEMAND CURVE is obtained by "horizontally summing" the individual demand curves of all the consumers in the market.  That means that for every possible price, we sum up the quantities demanded by each consumer and plot that combination of price and quantity as a point on the industry demand curve.  The industry demand curve will necessarily be a lot flatter than any individual consumer's demand curve.

An INDUSTRY SUPPLY CURVE is obtained by "horizontally summing" the individual supply curves of all the firms in the market.

Ex. The demand for ketchup in a 1,000-household economy
Ex. The supply of ketchup in a 200-firm economy.
-- [Something vaguely like this was done in class.]
 

IV. EQUILIBRIUM

The point where the industry supply and demand curves intersect is the market's EQUILIBRIUM.

EQUILIBRIUM: occurs when there is no force acting to change prices, i.e. when quantity supplied equals quantity demanded.

When P is not equal to P*, then the market is in DISEQUILIBRIUM -- there will either be a shortage (too little) or a surplus (too much) of the good, because quantity supplied is not equal to quantity demanded.
-- Such shortages and surpluses are often caused by the government imposition of price controls (e.g., NYC rent controls cause a shortage of rental housing in NYC )

Economists like the market equilibrium allocation because it maximizes the "social surplus" -- the sum of CONSUMER SURPLUS (CS; the sum total of what consumers are willing to pay for each unit of the good, minus what they actually pay [P*] for every unit) plus PRODUCER SURPLUS (PS; the sum total of what firms receive for each unit they produce [P*], minus the MC of producing each unit; similar to profit).  In this sense, society is better off under the competitive market equilibrium than under any other allocation.

In the absence of price controls, changes in a good's (equilibrium) price and quantity are caused by changes in supply or demand.

Ex. 1 The technology for making ketchup takes a great leap forward
          --> supply of ketchup increases
                                                 Result:
                                                 P decreases
                                                 Q increases (quantity demanded increases)

Ex. 2 A bad tomato harvest raises the (marginal) cost of production
         --> supply of ketchup decreases
                                                 Result:
                                                 P increases
                                                 Q decreases (quantity demanded decreases)

Ex. 3 An increase in the population
         --> demand for ketchup increases
                                                 Result:
                                  P increases
                                  Q increases (quantity supplied increases)

Ex. 4 Health-conscious consumers start shunning ketchup as too salty
         --> demand for ketchup falls
                                                 Result:
                                                 P decreases
                                                 Q decreases (quantity supplied decreases)
 

V. PERFECT COMPETITION AND THE "LAW OF ONE PRICE"

The intersection of the industry supply and demand curves determines the equilibrium price and quantity for the whole industry. The total quantity produced will be divided up among the many firms in the industry, with each one producing up to the point where marginal cost equals price. The firms will all have to charge the same price, the industry equilibrium price P*.
-- Since the good they're producing is identical, and since there are many firms for consumers to choose from, if a firm tried to sell at a price higher than P*, nobody would buy any of its output.
-- A firm could sell its output for less than P* if it wanted to, but what's the point? It can already sell all of its output at P*.

Each firm in the industry, therefore, faces a flat demand curve -- the firm's demand curve is flat at the industry (or market) equilibrium price.  The firm will produce up to the point on its supply curve where MC = P*.

(Each consumer faces a flat supply curve - you can buy all you want at the market price (without causing anyone to raise his price in our to take advantage of you), but you can't buy any units for less than the market prices (no volume discounts, no haggling).

VI. MONOPOLY PRICING

Supply-and-demand is a powerful apparatus for analyzing markets, but that framework applies only to competitive markets -- those with many buyers and sellers, a product that is identical from one firm to the next (e.g., wheat), free entry and exit (from the industry), etc.  When those conditions do not apply, the supply-and-demand model might still have some use, but might also lead one down the wrong track.  And if we're looking at a market that's a MONOPOLY, then supply-and-demand goes out the window.

Defn.
MONOPOLY:  a firm that is the only firm in its industry, or an industry with just one firm in it

In Parker Brothers' famous board game Monopoly, if one player has a monopoly of two or three streets (e.g., Boardwalk and Park Place), then the rent on each street automatically doubles. Parker Brothers got it about half right -- prices are indeed higher under monopoly than under perfect competition. The other big effect of monopoly is to reduce output -- if owning Boardwalk and Park Place meant that you doubled the rent on one of them and closed the other one, then you'd be acting like a true monopolist.

A monopolist raises P and reduces Q, relative to the competitive allocation (P*, Q*).

Q: Why does a monopolist do that?
A: To maximize profit. The monopolist follows the same rule as any profit-maximizing firm, namely:
-- To maximize profit*, produce at the output at which Marginal Revenue = Marginal Cost (MR=MC).
                                  (*Remember that Profit = Total Revenue - Total Cost = TR-TC.)

Competitive firms follow the same profit-maximizing rule, MR=MC.  The difference is that for a competitive firm, the market price (P*) and the firm's marginal revenue (MR) are the same.  That's because a competitive firm takes the market price, P*, as a given; it is too small, relative to the market, to exert any influence over the market price.  It can sell as much as it wants to at P* without changing that market price.

Q: To review, why is the demand curve flat (at P*) for a perfectly competitive firm?
A: Because there are identical substitutes everywhere.
-- There are no identical substitutes for the monopolist's product, however, because there are no other firms in the industry. The monopolist is still subject to the Law of Demand, in that if it charges a higher price it will lose some of its customers. It won't lose all of them, however, unlike a perfectly competitive firm that tried to raise its price above P*.

For a monopolist, the demand curve is not flat but is downward-sloping (like a typical industry demand curve; remember, the monopolist is the industry.)  Instead of being able to sell any amount at the market price P*, in the monopolist's case there is a specific sales amount (the quantity demanded) associated with each possible price.
-->
For a monopolist, MR < P.
Why:  In order to sell an extra unit, the monpolist must lower the price of every single unit sold. (Selling different units at different prices is called price discrimination, and is illegal, not to mention very difficult.)

Comparing a monopolist with a perfectly competitive firm, we find these crucial differences:
 
Characteristic Perfectly Competitive Firm Monopolist
TOTAL REVENUE (TR) = (P*) * q

This amount will always increase as output is increased, because the price (P*) is a constant.

[P(Q)]* Q
   |
P(Q) means "P is a function of Q." P is a function of Q in that the price the monopolist receives depends on the quantity the monopolist wants to produce.

For QD to go up, P must fall. In that sense, P is a function of Q.

MR =  P* P + [ Q * DP/DQ ]

P is the price received for the last unit sold.
(DP/DQ is the slope of the demand curve; it is the price reduction associated with selling one more unit; it is a NEGATIVE NUMBER.
--> MR = P + {a negative number}
  --> MR < P

Because MR < P for a monopolist, the monopolist's MR curve lies UNDER the monopolist's demand curve. (If the demand curve is a straight line, the MR curve will also be a straight line and will be twice as steep. This can be proved mathematically, though we won't bother proving it here.  For a competitive firm, the MR curve and the [flat] demand curve are one and the same.  By the way, in both cases the demand curve is the same as the average revenue curve, AR.)

--> The profit-maximizing point where MR = MC is not the same point where the demand curve crosses the (upward-sloping part of) the MC curve, as it would be in perfect competition. In perfect competition, the profit-maximization rules P=MC and MR=MC are the same thing, because P=MR in perfect competition.
---- Instead, the profit-maximizing point for a monopolist is at a smaller quantity (Qm) than the quantity (Q*) where the demand curve crosses the MC curve. And at that quantity, the price the monopolist charges, Pm, is greater than the competitive equilibrium price P*. Also note:
                                                                                    Pm > MC
(the price has to be greater than the MC here, because P > MR always holds for a monopolist, and MR = MC at the profit-maximizing point).
 

VII.  WHY MONOPOLIES ARE BAD FOR CONSUMERS AND SOCIETY

[First we reviewed a graph of what equilibrium looks like and how the "social surplus" (CS+PS; i.e., consumer surplus + producer surplus) is maximized under perfect competition.  Then I drew the corresponding graph for a monopolist.  The upshot:]

Because the monopolist raises the price and restricts the quantity, relative to the competitive equilibrium, consumer surplus (CS) is much smaller and producer surplus (PS) is much larger  -- a lot of the surplus gets transferred from the consumer to the monopolist.  Also, there is a "dead-weight loss" of the CS+PS associated with the reduction in quantity.  Altogether the social surplus is smaller under the monopoly allocation than under the competitive allocation.
 

VIII.  THE MULTIPLIER

(This is a macro concept, one that will come into play in this course when we look at such topics as the impact of a new sports stadium or a professional sports franchise on a local economy.)

MULTIPLIER = the total increase in GDP (or in aggregate spending) associated with a $1 initial increase in spending.  An initial increase in consumer, investment, or government spending can have a ripple effect on the economy, because every new expenditure generates income for somebody, and that person will spend part of his new income, and whoever receives the money for that next purchase will spend part of it on another purchase, and so on.  An initial increase in spending could ultimately raise GDP by a large multiple of the original amount spent.

In introductory macro, with a number of restrictive assumptions, the simple multiplier = 1 / (1 - MPC), where MPC is the Marginal Propensity to Consume, defined as the fraction of an extra dollar of income that people will spend on their consumption.  Plugging in plausible values like .90 or .95 for the MPC, the simple multiplier would be 10 or 20, which is huge. In the real world, the multiplier is much smaller than that, because of such "leakages from the spending stream" as taxes, import consumption, price inflation, crowding out of investment, etc.
-->
Taking all of those things into account, in the U.S., the "real-world multiplier" is about 1.4.
-- At the city or state level (where a new stadium is supposed to affect the economy), the multiplier is probably much smaller because much of the increase in people's income gets re-spent elsewhere (not only on imports but also on goods produced in other cities and states, which are like imports in this case, because they are not part of the local economy).
-- It is possible in real life to have a multiplier of less than 1; if so, then a $1 increase in government spending increases GDP by less than $1.  (Likewise, the multiplier may be larger on some government projects than on others.)  While the spending increase still raises GDP, taxpayers may find that the spending provides too little "bang for the buck," since that money could have been spent elsewhere or returned to them in the form of lower taxes.