Module 1

The Economic Problem

Individuals and firms in an economy face many decisions in everyday life. For example, should I
buy the latest iPhone? How many donuts should I eat? How many people do I need for
production in my company? How many units of output should my company produce?

There are certain restrictions on these decisions, more specially, fixed amounts of resources.
For example, we do not have an infinite amount of money to spend on goods and services.
Firms have time and budget constraints for production.

Society must decide how to employ a fixed supply of resources.

The insights of economics will help us understand how individuals and societies can make the
best possible decisions given constraints.

The Economic Problem and Rational Behaviour

Economists tend to focus on the logic behind human behaviour. They assume that human
beings behave rationally or have rational behaviour. This means that people make choices by
logically weighing the benefits and costs of every available action and then select the most
attractive option based on the wants of the individual. By assuming that people act rationally,
human behaviour can be analyzed and predicted.

The Economic Problem refers to the many choices that people face and the virtually unlimited
wants but having limited resources with which to satisfy those wants.

Scarcity refers to the limited nature of resources. For most individuals, time and money are the
most scarce.

For an economy as a whole, it is the basic requirements for production that are the most scarce.
For example, human resources (labour), natural resources (materials) or capital (money or
investment). These are referred to as Economic Resources.

Natural Resources are nature’s contribution towards production. These could include the land
used for production (i.e., land the building is built on, farms, roads, etc.), raw materials (i.e.,
forests/wood, minerals, etc.), and natural resources (i.e., sunlight, water power, etc.).

Capital Resources refers to the real assets of an economy. These are the processed materials,
equipment, and buildings used in production. For example, Google considers its buildings and
computers as capital resources because it uses them to make products for its users.
Furthermore, personal data that Google collects is also considered as capital resources as it
also uses this data to create products for its users.

The term “capital” has a specific meaning in economics. Capital resources do not include
financial capital such as stocks and bonds. These are considered as financial capital and not
real capital by economists.

There are two types of human resources used in production: Labour and Entrepreneurship.
Labour represents the work force that is employed in production. For example, computer
programmer, bank teller, waiter, etc. Entrepreneurship is the initiative, risk-taking, and innovation
necessary for production. Entrepreneurship brings together natural resources, capital resources,
and labour to produce a good or service. This includes the effort of the inventor who brings a
new smartphone app to the market, the head of a multi-million dollar mining company, the owner
of a convenience store, and a student who starts a summer grass cutting or house painting
business.

When resources are used in production, they produce a certain amount of income. This is
referred to as Resource Income which reflects the resources’ contributions to production. When
a natural resource is employed, the owner of the resources generates rent (payment for
supplying the resource). When human labour is employed, they receive a wage. Providers of
capital resources receive an income in the form of interest. Entrepreneurs generate profit.

The Definition of Economics

Economics is the study of how to distribute scarce resources to make choices. We can divide
economics into two branches: Microeconomics and Macroeconomics, which are studied
separately.

Microeconomics focuses on individual behaviours in various markets. How many units should I
buy at certain prices? How many units of output should my firm produce? How are prices
determined for a certain good or service? How is income distributed in the economy?

Macroeconomics has a wider perspective of the economy. It is concerned with activities of entire
economic sectors. The main sectors are households, businesses, government, and foreign
markets. How these sectors interact determine unemployment rates, interest rates, exchange
rates, general price levels, and economic output in economies.
Economic Models
To understand economic behaviour, economists use economic models. There are various
names for economic models such as laws, principles, or theories. They are a generalization
about or simplifications of economic reality. Economists build abstractions of reality that allow
them to see the basic workings of the economy.

“A good economic model allows economists to see the forest instead of the trees.” – Mark
Lovewell
Economic models can help explain economic trends and behaviours by finding a relationship
between two or more variables. A variable is a factor that has a measurable value. For example,
consider the price of an item and the quantity of an item. In a model, two variables are
connected by a causal relationship. This means that one variable is assumed to affect the other
variable. Suppose, the model states that if the price of the item increases, the quantity
consumed will decrease. The variable that is causing the change in the other is the independent
variable (i.e., price). The variable that is affected is the dependent variable (i.e., quantity).

If the value of a variable increases and the value of the other variable decreases, we say the
variables have an inverse relationship. If the value of a variable increases and the value of the
other also increases, we say the variables have a direct relationship. In the previous example,
price and quantity have an inverse relationship.

In economic models, typically many assumptions are made to simplify the real world. A common
assumption that is made is to hold all other factors affecting the causal relationship constant.
This assumption is known as ceteris paribus, which is the Latin expression for “all other things
remaining the same”. Consider the previous example with the inverse relationship between
price and quantity. We are assuming all other factors that can impact the purchase of the item
(quantity) to remain constant (i.e., consumer income, consumer preferences, etc.).

When using economic models, there is a distinction between two types of economics: positive
and normative. Positive economics is the study of economic reality and why the economy
operates as it does. It is based on economic facts rather than an opinion. This type of
economics is made up of positive statements which can be proven or disproven by using the
scientific method. Examples of positive statements can be “Canadians bought 102,000 cars last
year.” or “If a service charge is imposed, less consumers will use the service.” The second
statement is a positive statement with a condition (i.e., if an event happens, this other event will
occur). Both statements can be proven or disproven with economic data. Normative economics
deals with how the economy should be. In this form of economics, opinions or normative
statements are common. An example of a normative statement is “We should reduce taxes.” or
“A 1% increase in unemployment is worse than a 1% increase in inflation.” People can agree to
the facts but can have different opinions regarding the normative statement.
Utility Maximization
People make economic choices by making effective use of scarce resources. The centre of the
decision making process involves two main concepts: utility and cost.

Utility can be defined as the satisfaction or happiness you derive from an action. Economists
assume that when a person is making an economic choice, they are trying to maximize their
own utility. This is the self interest motive; an individual is primarily interested with their own
welfare. Suppose you are considering whether to buy product A or product B and they both cost
the same amount of money. You will pick the one that gives the most utility.

Opportunity Cost

When a choice is made, the alternative choice cannot be pursued. Instead of measuring costs in
terms of money, economists use a concept that accounts for the trade offs resulting from an
economic choice: opportunity cost. The opportunity cost of any choice is the utility that could
have been gained by choosing the best possible alternative. Consider the previous example
with products A and B. Suppose product A gives you the most utility and you choose to buy
product A. The opportunity cost of buying product A is the utility you could have received if you
purchased product B.

The concept of opportunity cost also relates to how individuals spend time. Time spent doing a
certain activity takes away time that could be spent doing other activities. Suppose a student
can spend the next hour studying for a midterm or playing video games. If they choose to study,
the opportunity cost is the utility that could have been received from playing video games for
one hour.

Utility differs for every individual. The amount of utility received from consuming an apple is
different for every individual. This makes utility hard to quantify which makes opportunity costs
hard to quantify.

The Production Possibilities Curve

The production possibilities model illustrates the tradeoffs that society faces with scarce
resources. Like most economic models, it is an abstraction of the real world with assumptions
for simplification. In this model, we assume that only two products are produced, resources and
technology are fixed, and all economic resources are employed to their full potential.
Consider an economy that only produces bread and beer (only two products are produced).
There is a fixed amount of economic resources and technology that can go into producing bread
or beer (i.e., a fixed number of workers, fixed number of machinery/equipment, fixed amount of
wheat, etc.). However, resources can be moved from the production of one product to the other.
Workers that are used to make bread can be moved to make beer. All the economic resources
are employed and used to their full potential means there is no excess. All workers,
machinery/equipment, and wheat are either producing bread or beer (i.e., no unemployment, no
idle machinery/equipment, no storage of wheat, etc.).
To optimize the welfare of its citizens, an economy must make choices regarding how much of
each product they wish to produce in a certain time frame (i.e., week, month, year, etc.). How
much bread and beer should be produced given the available resources of the economy? A
decision is required because making more bread takes resources away from producing beer
and vice versa.

Figure 1.1. Production possibility curve.

Source: Lovewell, 2002.
Long Description
The graph plots Beer on the horizontal axis in thousands of liters. Quantities of 4, 8, and 10,
thousand are indicated on the horizontal axis. Bread is plotted on the vertical axis in thousands
of loaves. Quantities of 500, 900, and 1,000 thousand loaves are indicated on the vertical axis.
Point A is on the vertical axis at 1,000 thousand loaves of bread. Point B is at the coordinates
(4,900). Point C is at the coordinates (8,500). Point D is on the horizontal axis at 10 thousand
liters of beer.

The production possibility curve is a concave line that runs through points A to D. Point E is
drawn in the space inside of the curve, in the direction of the origin (0,0). Point F is a point
drawn on the outside, on the top and right of the curve.

Bread Beer Point in Graph

100 0 A
900 4 B
500 8 C
0 10 D
Source: Lovewell, 2002.
Figure 1.1 and Table 1.1 illustrate those choices. Consider four possible production levels of
bread and beer given by points A, B, C, and D. The table is the economy’s production
possibilities schedule which outlines the possible combinations of bread and beer that can be
produced. Expressing the table in a graph provides the production possibilities curve for the
economy. There is an inverse relationship between the production levels of bread and beer
because if the economy produces more bread, they have to produce less beer due to limited
resources. To produce more beer, the economy will need to shift resources from producing
bread to producing beer. This means production in bread falls and production in beer rises.
There is an inverse relationship between production levels of bread and beer. Therefore, the
curve is downward sloping from left to right. The end points of the curve represents the scenario
in which the economy dedicates all its resources to producing a single product. Point A
represents the economy producing all bread and no beer and vice versa for point D.

The Role of Scarcity

The curve in Figure 1.1 (repeated on this page for reference) represents all the combinations of
bread and beer production that are possible in this economy with the limited available
resources.
Figure 1.1. Production possibility curve.

Source: Lovewell, 2002.

Long Description

The graph plots Beer on the horizontal axis in thousands of liters. Quantities of 4, 8, and 10,
thousand are indicated on the horizontal axis. Bread is plotted on the vertical axis in thousands
of loaves. Quantities of 500, 900, and 1,000 thousand loaves are indicated on the vertical axis.
Point A is on the vertical axis at 1,000 thousand loaves of bread. Point B is at the coordinates
(4,900). Point C is at the coordinates (8,500). Point D is on the horizontal axis at 10 thousand
liters of beer.

The production possibility curve is a concave line that runs through points A to D. Point E is
drawn in the space inside of the curve, in the direction of the origin (0,0). Point F is a point
drawn on the outside, on the top and right of the curve.
Any point on the inside of the curve, point E, is obtainable by this economy. However, point E
represents a production level where all the available resources are not fully used in production.
The economy can produce more bread and beer by moving towards the production possibilities
curve. Compared to point E, any points on the curve uses more of the available resources and
produces more overall output.

Point F represents a point that is unobtainable. As long as the available resources remain fixed
at a certain level, there are not enough resources to produce point F levels of bread and beer.
The curve represents the maximum combinations of bread and beer that can be produced given
the available resources. Any point above and to the right of the curve will require more
resources than the economy currently has.

Increasing Opportunity Costs

The shape of the production possibility curve is referred to as concave. The concave shape
reflects the law of increasing opportunity costs. The law states that as more of one product is
produced, the opportunity cost in terms of the other product increases. The basis of this law
arises from the fact that resources are not perfectly transferable from one output to another. For
example, consider that the economy has some workers with training and experience in baking
bread and some in brewing beer. A worker can produce both but they are better suited at
producing the output they were trained to produce. Consider point A in Figure 1.1, the economy
is only producing bread. If the economy moves to point B, the economy is producing 100,000
less loaves of bread and 4,000 more litres of beer. The opportunity cost of 4,000 litres of beer is
100,000 loaves of bread (or 25 loaves of bread for 1 litre of beer). At the beginning, there
probably exist some workers with beer expertise making bread and those workers can be
shifted from producing bread to their specialty of producing beer. There is a small decrease in
the amount of bread production from the loss of workers to beer production. Moving from point
B to C, the economy gives up 400,000 loaves of bread for 4,000 litres of beer (or 100 loaves of
bread for 1 litre of beer). The opportunity cost of 4,000 litres of beer is now 400,000 loaves of
bread compared to 100,000 from A to B. As the economy produces more beer, more workers
need to be shifted to beer production. Eventually, the economy needs to start moving bakers of
bread to beer making to meet beer production levels. Losing bakers that specialize in making
bread in bread production will decrease production more compared to when the economy had
enough beer specialists working as bakers (i.e., point A to B).

Economic Growth

An economy can experience economic growth, an increase in an economy’s total output of

goods and services. This can be due to an increase in available resources (i.e., found more
fertile land to grow wheat, etc.) or improvements in technology (i.e., more efficient processes to
bake bread and brew beer, faster workers, etc.). Both trends will cause outward shift in the
production possibilities curve as shown by the figure below. An outward shift expands the area
under the curve which means there are more output combinations the economy can obtain. The
economy can choose output levels beyond there previous possibilities.

The opposite is an economic contraction where the economy’s total output of goods and
services decreases. This can be illustrated by an inward shift of the production possibilities
curve. This would be mainly caused by a decrease in available resources (i.e., loss of land to
grow wheat, loss of workers, etc.).

Figure 1.2. Production possibility curve and economic growth.Long Description

The graph has beer on the horizontal axis and bread on the vertical axis. The axes represent
quantities of beer and bread but there are no quantities indicated on the axis. A representation
of a production possibility curve is drawn with a parallel curve drawn above it. There are arrows
indicating a shift of the smaller curve outward to the bigger curve.
When an economy experiences economic growth, the production possibilities curve expands
outward. In an economic contraction, the curve will shrink inwards.

Basic Economic Questions

Due to the problem of scarcity, all economies must answer three basic economic questions:
What to produce? How to produce? For whom to produce?

What to produce? An economy must decide what to produce and how much to produce as
illustrated by the production possibilities curve. For example, if the economy decides to make
bread and beer, they need to decide where on the production possibilities curve they wish to
produce. The characteristics of the economy will influence these decisions (i.e., traditions,
resources, citizens, government, etc.).

How to produce? Once the decision of what to produce has been made, the economy must
decide on how to achieve those production levels. The economy will decide on which resources
will be used and in what quantities. For example, to produce wheat, farmers can purchase
advanced machinery that requires less labour or use basic equipment that requires more labour.
Again, these decisions will be influenced by the characteristics of the economy.

For whom to produce? The economy must determine how to distribute its output. This can be
influenced by many factors such as who owns the inputs, what government is in power, what
are the traditions of the citizens in the economy, etc.

To answer these three questions, the economy organizes its economic system. It represents the
economy’s distinct set of social customs, political institutions, and economic practices. There are
three main types of economic systems; traditional, market, and command. Each type is a
theoretical system and no real world economy is a perfect match. Most economies in the
present are a mixture of the types, combining features from some or all of the types.

A traditional economy makes economic decisions based on customs such as a traditional

division of work between men and women. The mix of outputs, the organization of production,
and the way to distribute outputs are passed on relatively unchanged from generation to
generation. Religion and culture tend to be considered at least as important as material welfare.
Since they are based on tight social constraints, traditional economies are resistant to change.
Consider very remote farming regions whose economies are run along traditional lines.

In a market economy, individuals are free to pursue their own self-interests. This type of
economy is based on the private ownership of economic resources and the use of markets in
making economic decisions. This type of system is typically referred to as capitalism. In this
system, households use incomes earned (i.e., wages, profits, etc.) from their economic
resources by saving some and spending the rest on consumer products. Businesses buy
resources from households (i.e., pay wages for labour, buy crops from farmers, etc.) and employ
these resources to provide consumer products demanded by households. Government
performs only the political functions of upholding the legal system and maintaining public
security. The following figure illustrates the transactions between households and business in a
market economy.

Figure 1.3. The circular flow diagram.

Source: Lovewell, 2020.

Long Description

This flow diagram illustrates how households and businesses participate in two main markets,
one involving consumer products and the other economic resources.

The diagram moves in a circular path with one on the inside of the other. Arrows point from each
step to the next. There are two different paths that are connected by blue and red arrows,
respectively. The blue path is on the outside and runs counterclockwise; it represents physical
flows between households and businesses. The red path is on the inside and runs clockwise; it
represents money flows between households and businesses.

Starting from the top of the blue path circle, the following are written at each quarter interval and
connected by a blue arrow: Economic Resources, Businesses, Consumer Products, and
Households. Similarly for the red path, starting at the top and at each quarter interval is the
following: Household Incomes, Households, Consumer Spending, and Businesses.

In between the red and blue paths, between Economic Resources and Household Incomes is
Resource Markets. In between the paths at the bottom, between Consumer Spending and
Consumer Products is Product Markets.

There is a key to the right of the diagram and is as follows: Resource Markets: Exchange of
natural, capital, and human resources, Product Markets: Exchange of goods and services, Red
Arrow: Money flows between households and businesses, and Blue Arrow: Physical flows
between households and businesses.

A market is a set of arrangements between buyers and sellers that allow them to trade items for
set prices. Product markets are those in which consumer products are traded. Resource
markets are those in which economic resources are traded. Households and businesses
interact with each other in each of these markets. In the product market, for example, a
household buys consumer products from the businesses. In the resource market, for example,
businesses pay individuals for their labour.

A command economy is the opposite of a market economy. It is an economic system based on

public ownership and central planning. All productive property (natural resources and capital) is
owned by the government. All markets are replaced with central planning. Central planners
decide what should be produced, how production should be carried out, and how output should
be distributed. In a market economy, decisions made by households about how much to
consume and how much to save determine the split between consumer and capital products. In
a central economy, central planners determine the split on the basis of their judgement of the
future needs of the entire economy.

Table 1.2. Benefits and drawbacks of market and command economy.

Market Economy Command Economy

Benefits Consumer Sovereignty: the Income Distribution: central
decision of what to produce is planners can decide to
guided by the needs and distribute incomes more
wants of households in their evenly.
role as consumers. Economic Growth: can focus
Innovation: the incentive for on economic growth by
profit encourages innovation devoting more resources to
and entrepreneurship which capital products (i.e.,
helps foster technological machinery, factories, etc.).
advancements.
Drawbacks Income Distribution: without Planning Difficulties: planning
government intervention, the for an entire economy is a
distribution of income can difficult task requiring
create significant inequities. tremendous amounts of
Market Problems: sometimes information that the planner
private markets do not always most likely does not have.
operate in a way that benefits Inefficiencies: since
society as a whole (i.e., government owns productive
pollution, monopoly power). properties, there is no profit
Instability: can display incentives to promote efficient
considerable instability in total use of resources.
output from year to year which Lack of Freedom: putting so
impacts prices and much power in the hands of
employment. government lowers individual
freedoms.

Mixed Economies
Most countries fall between the extreme ends of the traditional, market, and command
economies. A mixed economy is one that combines the use of markets and has a significant
government presence in economic decision making. The mix depends on the relative
importance given to private markets and the economic functions of the government. Canada
and the United States have markets play the dominant economic role. Sweden’s government
has a larger economic role. North Korea’s government plays a very large role and leans heavily
towards command economy type. India and China fall closer towards traditional economies.

Figure 1.4. The range of economic systems.

Source: Lovewell, 2020.

Long Description

A large upside down triangle with Market Economy on the top left vertex. Command Economy
on the top right vertex. Traditional Economy on the bottom vertex of the triangle. The first set of
triangles is labeled Modern Mixed Economies.

Starting from Market Economy and moving to Command Economy, the smaller triangles are
labeled the following: United States, Canada, Sweden, and North Korea. The next set of small
triangles is labeled Traditional Mixed Economies. They are in the center of the triangle
approximately level horizontally. The left triangle is labeled India and the right one labeled
China.

Real world economies can be positioned on or within a triangle whose points indicate the three
basic types of economic systems: traditional, market, or command. Countries with surviving
traditional sectors combine with emerging private and public sectors.
Economic Goals

Determining economic goals is a normative economic issue and depends on political and
societal constraints. Due to these constraints, the degree in which countries pursue economic
goals will differ but the goals themselves are similar. Most countries focus on seven goals:
income equity, price stability, full employment, viable balance of payments, economic growth,
economic efficiency, and environmental stability.

Income equity is achieved when a country’s total output is distributed fairly. However, this
prompts the question, “What is fair?” For example, is it fair that a top executive of a very large
corporation makes 100 times more than a waiter at a small diner? Value judgements will come
into play when determining what is considered fair.

Price stability is government or policy makers trying to minimize the country’s rate of inflation,
which is a country’s rise in the general level of prices. As the price levels rise, households need
to pay more for the same items, which means their purchasing power has fallen. If household
incomes do not rise with inflation, they will be hurt by inflation.

Full employment is the country trying to minimize involuntary unemployment in the labour force.
The labour force is defined as those people who are working plus those who are both
involuntarily unemployed and actively seeking employment. The unemployment rate is the
percentage of the country’s labour force that is involuntarily unemployed. A high unemployment
rate signals a lower total output level than could be possible. The country is producing at a level
that is inside their production possibilities curve where resources are not used to their full
potential.

The balance of payments account summarizes all transactions between two countries that
involve the exchange of currencies. This includes exporting, importing, borrowing, and lending.
These are important activities for any open economy. A viable balance of payments suggests
financial flows in and out of the country are more or less evenly matched.

Economic growth is the outward shift of the production possibilities curve which is achieved
through increase in available resources or technological advancements in production. Economic
growth is an important goal because it increases the standard of living of individuals in the
economy. As an economy expands, the individuals within the economy become better off, for
example, China.

Economic efficiency means getting the highest benefit from an economy’s scarce resources.
Efficiency requires that the scarce economic resources be employed in a way that maximizes
utility.

Environmental sustainability is when economic activities are carried out so that the quality of the
physical environment can be sustained without significant harm. With industrialization, comes
significant increases in pollution. In recent centuries, the world’s air, water, and land resources
have significantly deteriorated with irreversible damage caused. To eliminate, or at least
minimize, the damage, adjustments to the way economic activities are performed must be
taken. For example, concerns over climate change has been increasing over the last couple
decades.

Some of these goals can be complimentary. In some instances, economic growth and
environmental sustainability can be compliments rather than conflicts. With the increasing
demand for environmentally friendly sources of energy such as wind and solar, countries can
invest in creating and developing these industries to meet demand. The industries create and
increase output, provide jobs, and help minimize the damage to the environment.

However, some goals will be in conflict. For example, if a country implements policies to lower
the inflation rate, those policies typically have an inverse impact by decreasing output levels,
increasing unemployment, and increasing the unemployment rate.

Module 2

Introduction

The concepts of demand and supply answers many questions we face in our daily lives relating
to transactions. What determines the price of a product? Why does a company produce that
specific product? How many units of product are for sale? This chapter will study the impact of
these two forces on individual markets. We will gain a better understanding of how the “invisible
hand” of competition with the interaction of demand and supply guides the actions of buyers and
sellers.

Demand and Supply

Every second, there are consumers buying goods and services around the world. Demand and
supply are the concepts in economics that answer many of the questions we ask relating to
these transactions. For example, why are smartphones a certain price? Why do car
manufacturers offer those types of vehicles? Why does the grocery store have those selections
of candy bars? The concepts of demand and supply can answer these questions. These
concepts are equivalent to the concepts of gravity in physics: important, invisible, and very
influential. A product market exists whenever there is a transaction involving consumer products
(i.e., smartphones, oranges, sweatshirts, etc.) between businesses (i.e., Apple, Uniqlo, farmers,
etc.) and households (i.e., everyday consumers). This can occur through a variety of methods
such as online, face-to-face, by mail, and more. Some markets are global, such as crude oil.
Some markets are local, such as chocolate bars at your local convenience store.
What Is Demand?

The household’s behaviour can be illustrated by the concept of demand. It is the relationship
between the various possible prices of a product and the quantities the consumer will purchase
at each price. Quantity demanded is the amount of the product a consumer is willing to
purchase at each price. Quantity demanded is a dependent variable. Price is the independent
variable. Demand is the concept. To focus on the relationship between price and quantity
demanded, we assume ceteris paribus (from Latin, meaning all other things remaining constant).

The Law of Demand

There is an inverse relationship between price and quantity demanded. Consider an individual
that consumes a certain amount of cherries in a month. The following figure illustrates the
potential relationship between price of cherries per kilogram and quantity demanded of cherries
in pounds. Suppose the price of cherries is $10 per kilogram and the individual decides to
consume 2 kilograms per month. If the price of cherries rises to $15 per kilogram, they will most
likely purchase fewer cherries. Suppose at this higher price they only purchase 1 kilogram per
month. If the price falls to $5 per kilogram, the individual will probably consume more cherries
per month. At the lower price, cherries are a better deal in terms of providing satisfaction or
happiness per dollar spent on cherries. Suppose the individual consumes 3 kilograms per
month at the lower price. This inverse relationship between price and quantity demanded, when
all other factors are held constant, is referred to as the Law of Demand.
Figure 2.1. Individual demand curve and schedule.

Source: E. Lun, 2022.

Long Description

Along the horizontal axis, there are indicators of quantity demanded in kilograms per month of
cherries ranging from 1 to 5 (4 hash marks in total). Along the vertical axis are indicators of price
per kilogram of cherries ranging from 5 to 20 increments of 5 (i.e., 5, 10, 15, 20). There are
three points in the graph at coordinates (1,15), (2,10), and (3,5) labeled A, B, and C,
respectively. A downward sloping line connects the three points.

The demand schedule shows that as the price of cherries rises, the quantity demanded falls.
The demand curve illustrates the schedule in a graph. The downward sloping line illustrates the
inverse relationship between the two variables.
 Quantity Demand in kg (per
Price per kg
month)
$5 3
$10 2
$15 1

The Demand Curve

The demand schedule is the table shown in the previous figure. It shows the quantity demanded
at various price points. Illustrating the values in a graph is referred to as a demand curve. The
demand curve is drawn with the price on the vertical axis (y-axis) and the quantity demanded on
the horizontal axis (x-axis). This differs from conventional mathematics where the independent
variable is on the horizontal axis.

The downward slope of the demand curve illustrates the law of demand, the inverse relationship
between price and quantity demanded. From the previous figure, moving from point A to point B
is referred to as a change in quantity demanded. This is a movement along the curve. There is a
change in quantity demanded due to price changes. Only a price change produces a movement
along the curve.

Market Demand

Market demand is the sum of all consumer purchases or quantity demanded at each price. This
can also be illustrated in a schedule or a curve. Consider the previous cherries market and
assume that there are only 2 individuals in this market. Each individual has different demand
curves for cherries, D0 and D1. For example, individual 0 will purchase two kilograms per month
at a price of $10 per kilogram while individual 1 will purchase 3 at the same price. These
quantities are based on what each individual is able and willing to pay for cherries. The total
quantity demanded in this two person market for cherries is 5 kilograms at a price of $10 per
kilogram. Repeat this process for all possible price points of cherries to create the market
demand schedule and curve. The following figure illustrates the market demand schedule and
curve.
Figure 2.2. Individual and market demand curve and schedule.

Source: E. Lun, 2022.

Long Description

There are three graphs in this figure. The first one is titled “Individual 0 Demand Curve for
Cherries”. On the horizontal axis, there are indicators for quantity demanded of cherries ranging
from 1 to 5 in increments of 1. On the vertical axis, there are indicators of price of cherries
ranging from 5 to 20 in increments of 5. There are 3 points on graph at coordinates (1,15),
(2,10), and (3,5). There is a downward sloping line connecting the three points. The line is
labeled D0.
The second graph is titled “Individual 1 Demand Curve for Cherries”. The axis of the graph are
the same as the first. The points on this graph are at coordinates (2,15), (3,10), and (4,5). There
is a line connecting the three points and it is labeled D1.

The final graph is titled “Market Demand Curve for Cherries”. The vertical axis for price is the
same as the previous two graphs. The horizontal axis for quantity demanded ranges from 1 to 7
in increments of 1. It is the same as the previous 2 graphs but the maximum has been extended
to 7. There are three points on the graph at coordinates (3,15), (5,10), and (7,5). There is a
downward sloping line connecting the three points and it is labeled DM.

There are only two consumers in the cherries market. Each has different demand curves for
cherries. The market demand curve is found by adding the number of kilograms purchased by
both individuals at each possible price.

Individual 1
Individual 0 Market
Quantity
Price Quantity Quantity
Demanded in
Demand in kg Demand in kg
kg
5 1 2 3
10 2 3 5
15 3 4 7

Changes in Demand

In previous sections, it was assumed that all other factors affecting the relationship between
price and quantity demanded were constant. The factors that remain constant are known as
demand factors. If these factors are not held constant, they can cause the entire market
demand curve to shift. As a reminder, a change in the price affecting quantity demanded creates
a movement along the demand curve. A change in a demand factor, which we previously held
constant, will cause the demand curve to shift in a certain direction. There are five main demand
factors: number of buyers, income, prices of other products, consumer preferences, and
consumer expectations. With the change in each factor, it must be assumed that all other
factors remain constant.

When the number of buyers for a certain product increases, more purchases are made.
Therefore, the amount of product demanded increases regardless of the price. This is an
increase in demand. For example, if the population of an economy increases, there will be more
consumers of cherries regardless of the price of cherries. An increase in demand is illustrated
by a shift of the entire demand curve to the right. When the number of buyers in the market
decreases, the amount of the product demanded also decreases at every price, thus causing
the entire demand curve to shift to the left. This is called a decrease in demand. The following
figure illustrates both an increase and decrease in demand with D0 to D1 being the increase in
demand and D0 to D2 being the decrease in demand.

Figure 2.3. Change in demand.

Source: E. Lun, 2022.

Long Description

Along the horizontal axis, there are indicators of quantity demanded in millions of kilograms per
year of cherries ranging from 1 to 10. Along the vertical axis are indicators of price per kilogram
of cherries ranging from 5 to 20 increments of 5 (i.e., 5, 10, 15, 20). There are three sets of
points in the graph. The first set is at coordinates (6,15), (7,10), and (8,5). A downward sloping
line connects the three points and it is labeled D0. The second set of coordinates is (8,15),
(9,10), and (10,5). There is a downward sloping line connecting the three points and is labeled
D1. There are arrows indicating the three points from D0 shifted horizontally to D1. The third set
of coordinates is (4,15), (5,10), and (6,5). There is a downward sloping line connecting the three
points and it is labeled D2. There are arrows indicating the three points from D0 shifted
horizontally to D2.
The demand schedule shows that as the price of cherries rises, the quantity demanded falls.
The demand curve illustrates the schedule in a graph. The downward sloping line illustrates the
inverse relationship between the two variables.

When the number of buyers in a market increases, the amount of cherries demanded at all price
levels increases. Each point of the demand curve shifts to the right, from D0 to D1. A decrease
in the number of buyers lowers the amount demanded at every price level, every point on the
demand curve shifts to the left, moving the curve from D0 to D2.

If consumer incomes increase, they purchase more of everything at all price levels. This shifts
the demand curve to the right (similar to an increase in the number of buyers). If the demand of
a good or service increases with an increase in income (direct relationship), the good or service
is referred to as a normal product. Inferior has the opposite effect where an increase in income
decreases the demand of the good or service. Most goods fall into the category of normal
goods. Examples of inferior goods are used cars, “store brand” grocery products, instant
noodles, etc.

The prices of other products can also influence the demand of goods and services. Substitute
products are products that can be consumed in place of one another. For example, butter and
margarine, Coke and Pepsi, fibre internet and cable internet. When the price of a product rises,
consumers choose to purchase more of the available substitute. This shifts the demand curve of
the substitute product to the right. For example, consider the market for Coke and Pepsi. If the
price of Coke rises, by the Law of Demand, quantity demanded falls for Coke. Consumers will
replace their consumption of Coke with Pepsi and move into the Pepsi market. This is
increasing the number of buyers for Pepsi which shifts the Pepsi demand curve to the right.
Complementary products are products that are consumed together. For example, coffee and
sugar, cars and gasoline, video games and video game consoles. If the price of a product rises,
the demand of the complementary goods will decrease and shift the complementary goods
demand curve to the left. For example, if the price of coffee rises, consumers will buy less
coffee. With consumers drinking less coffee, less sugar is consumed. This is a decrease in the
number of buyers of sugar shifting the demand curve of sugar to the left.

Consumer preferences affect buying patterns of consumers. For example, nutritional concerns
of foods will impact the demand for certain foods. Influence from advertising or social media can
impact the demand of goods. Suppose a new scientific study was released and showed a
significant decrease in the likelihood of cancer if people consumed more chocolate. We will see
an increase in the number of buyers for chocolate because they do not wish to get cancer. This
will create a shift to the right for the demand curve of chocolate.

Consumers have expectations about future changes in price of products and of their own
income. This will impact their current purchases of goods. For example, suppose consumers
expect a future price drop for cherries (i.e., received word of a future sale). There will be a
current decrease in the demand for cherries. Consumers will decrease their consumption now,
and consume them later at the lower price. Alternatively, if consumers expect their incomes to
grow in the future and prices to remain constant, their demand for normal goods will rise.
Changes in Quantity Demanded versus Changes in Demand
It is important to remember the difference between change in quantity demanded and change in
demand. A change in quantity demanded involves the change in price holding all other factors
constant. The change in price affects the change in quantity demanded. This is a movement
along the curve. Changes in demand involves a change in a demand factor holding all other
factors constant. The result is a shift of the entire demand curve.

Figure 2.4. Change in quantity demanded and change in demand.

Source: E. Lun, 2022.
Long Description
There are two graphs in this figure. The first is titled “Change in Quantity Demanded”. The
horizontal axis is labeled “Quantity Demanded” and the vertical axis is labeled “Price”. There is a
downward sloping line drawn in the graph. The line has two points on it. There is a double sided
arrow pointing at both points. The second graph is titled “Change in Demand”. The second
graph has the same axes as the first. There are two parallel downward sloping lines drawn in
the graph. The left one is labeled as D0 and the right one is labeled as D1. There are arrows
indicating a horizontal movement of D0 to D1.
A change in quantity demanded involves the change in price holding all other factors constant.
This is a movement along the curve as illustrated by the graph on the left. A change in demand
involves a change in a demand factor holding all other factors constant. This shifts the entire
demand curve as illustrated by the graph on the right.

What Is Supply?
In the product market, supply is related to the selling activities of businesses. In any competitive
market, supply is the relationship between the various possible prices of a product and the
quantities of the product that the businesses are willing to put on the market. The independent
variable is price and the dependent variable is quantity supplied. Quantity supplied is the
amount of product businesses are willing to supply at each price. Market supply is the sum of all
producers’ quantities supplied at each price. All other factors that affect supply are assumed to
be constant. This is all similar to the concept of demand, but with supply.

The Law of Supply

Price and quantity supplied have a direct relationship. When the price of a product increases,
the quantity supplied of the product increases. For example, if the price of cherries per kilogram
rises, farmers will find it attractive to increase the quantity supplied of cherries because the
higher price provides the incentive of increased earnings for every kilogram produced. The
direct relationship between price and quantity supplied is referred to as the Law of Supply.
The Supply Curve

The law of supply can be illustrated in a supply schedule and the supply schedule can be
illustrated by a graph. The figure below shows both the supply curve and supply schedule.
Similar to the demand curve, a change in the price of the product causes a change in quantity
supplied. This is represented by a movement along the supply curve. For example, moving from
point E to point F in the figure below.

Figure 2.5. The market supply curve and schedule.

Source: E. Lun, 2022.

Long Description
The horizontal axis represents the quantity supplied in millions of kilograms per month of
cherries. There are indicators ranging from 2 to 14 in increments of 2. The vertical axis
represent the price per kilogram of cherries. There are indicators ranging from 5 to 20 in
increments of 5. There are three points on the graph and the coordinates are (6,5), (10,10), and
(14,15). There is an upward sloping line connecting the three points.

The supply curve shows that as the price per kg of cherries rises, the quantity supplied also
rises. For example, if the price per kg rises from 5 to 10, the quantity supplied of cherries rises
from 6 to 10 million kg. The supply curve is positively sloped and this illustrates the Law of
Supply, the direct relationship between price and quantity supplied.

Table 2.3. Market supply schedule for cherries.

Quantity Supplied in millions of kg (per

Price per kg
month)
5 6
10 10
15 14

Changes in Supply

Similar to demand, there are other factors that were previously held constant that can change to
impact supply. These factors cause the entire supply curve to shift to the right or left and they
are known as supply factors. The six main supply factors are the number of producers, resource
prices, state of technology, changes in nature, prices of related products, and producer
expectations.
Figure 2.6. Changes in supply.

Source: E. Lun, 2022.

Long Description

Along the horizontal axis, there are indicators of quantity supplied in millions of kilograms per
month ranging from 2 to 18 in increments of 2. Along the vertical axis are indicators of price per
kilogram ranging from 5 to 20 in increments of 5 (i.e., 5, 10, 15, 20). There are three sets of
points in the graph. The first set is at coordinates (6,5), (10,10), and (14,15). An upward sloping
line connects the three points and it is labeled S0. The second set of coordinates is (8,5),
(12,10), and (16,15). There is an upward sloping line connecting the three points and is labeled
S1. There are arrows indicating the three points from S0 shifted horizontally to S1. The third set
of coordinates is (4,5), (8,10), and (12,15). There is am upward sloping line connecting the three
points and it is labeled S2. There are arrows indicating the three points from S0 shifted
horizontally to S2.
When the number of producers increases in the market, the quantity supplied of cherries
increases at all possible prices. This shifts the supply curve to the right from S0 to S1. A
decrease in the number of producers will decrease the quantity supplied at all possible prices
shifting the supply curve to the left from S0 to S2.

Similar to demand, an increase in the number of producers in an industry causes an increase in

supply. The quantity supplied will increase at all prices and this shifts the supply curve to the
right. If there is a decrease in the number of producers, this will decrease the quantity supplied
at each price and shift the supply curve to the left. The figure above illustrates the increase and
decrease in the number of producers in an industry and the effect on the supply curve. If there is
an increase in the number of producers, the curve shifts from S0 to S1. If there is a decrease in
the number of suppliers, the curve shifts from S0 to S2.

Businesses buy natural and capital resources to produce goods. If there is a price increase in
resource prices for an industry, the costs of businesses operating in that industry will increase.
For a business to maintain the same budget or expenditure, the businesses will have to
decrease output. The decrease in output is a decrease in quantity supplied at all price levels
and shifts the supply curve to the left. For example, lumber prices increase for the furniture
industry. To maintain the same expenditures, manufacturers buy less wood and produce less
furniture.

Improvements in technology can help businesses become more efficient in their production
process. With a more efficient production process, more units of output can be produced at
every price and quantity supplied will increase. This shifts the supply curve to the right. For
example, suppose workers at a manufacturing plant become more efficient because they have
worked there for a long time and accumulated experience. Their output per hour increases due
to their experience and the output of the business increases.

Some businesses’ output is dependent on the randomness of nature. For example, farmers’
crops are heavily dependent on favourable weather. If the weather is favourable for their crop,
they will have good yield and quantity supplied will increase for all prices. If the weather is not
favourable, there will be poor yield.

A product’s supply can be influenced by changes in the prices of other products. Consider a
farmer that can grow corn or wheat on their field. The farmer will grow the crop that has the
highest price. If corn has the higher price, the supply of corn will increase and the supply curve
for corn will shift to the right. However, if wheat has the higher price, the supply curve for wheat
will shift. The cheaper crop supply curve will remain the same or decrease if other farmers
decide to move from the cheap crop to the expensive crop.

The expectation of prices can influence the supply of products. Suppose a farmer expects
barley prices to soon fall. In this case, the farmer will provide as much barley to sell now to take
advantage of the higher price before it falls. This increases the supply curve for barley. If prices
are expected to rise in the future, farmers can hold onto their products and wait until prices rise
before they sell to take advantage of higher prices. This will decrease the supply and shift the
supply curve to the left.

Changes in Quantity Supplied versus Changes in Supply

It is important to remember the difference between change in quantity supplied and change in
supply. A change in quantity supplied involves the change in price holding all other factors
constant. The change in price affects the change in quantity supplied. This is a movement along
the curve. Changes in supply involves a change in a supply factor holding all other factors
constant. The result is a shift of the entire supply curve. Similar to the discussion of changes in
quantity demanded and changes in demand.

Market Equilibrium

In a competitive market, demand and supply are critical in matching the decisions of consumers
and producers. Changes in price drive quantity demanded and supplied to a point of stability.
This is referred to as market equilibrium. It is where the demand and supply curves intersect. If
the market is not in equilibrium, the market will try to correct itself to achieve equilibrium. This
section will talk about how equilibrium is reached.
Figure 2.7. Movement of price towards equilibrium.

Source: E. Lun, 2022.

Long Description

Along the horizontal axis, there are indicators of quantity in millions of kilograms per month
ranging from 5 to 15 in increments of 1. Along the vertical axis are indicators of price per
kilogram ranging from 5 to 20 in increments of 5 (i.e., 5, 10, 15, 20). There are two sets of points
in the graph. The first set is at coordinates (6,15), (10,10), and (14,5) labeled A, E, B,
respectively. A downward sloping line connects the three points and it is labeled D (for demand).
The second set of coordinates is (6,5), (10,10), and (14,15) labeled B, E, and A, respectively.
There is an upward sloping line connecting the three points and is labeled S (for supply). There
is a horizontal dotted line to indicate the price level of 15, 10, and 5. There is a vertical dotted
line to indicate the quantity of 10. The distance between points A and A at the price level of 15 is
labeled as “Surplus”. The distance between points B and B at the price level of 5 is labeled as
“Shortage”.

Table 2.4. Market demand and supply schedule for cherries.

 Quantity Demanded Quantity Supplied in
Surplus (+) or
Price per kg in millions of kg per millions of kg per
Shortage (-)
year year
5 14 6 -8
10 10 10 0
15 6 14 8

Source: E. Lun, 2022.

If a market is not in equilibrium, it is either in a surplus or shortage. Consider the market for
cherries illustrated in the figure above. If the price of cherries is $15 per kilogram, quantity
demanded is 6 million kilograms and quantity supplied is 14 million kilograms. The quantity
supplied exceeds the quantity demanded by consumers creating a surplus of 8 mill kilograms of
cherries. As a result, producers of cherries are holding onto 8 million kilograms of cherries that
no one wants to buy at $15 per kg. This is unwanted inventory for the producers. The pressures
created by the surplus will drive the price of cherries down. Producers will respond to their
surplus inventory by lowering the price. As the price falls, two adjustments are taking place.
First, consumers buy more at the lower price and the quantity demanded rises. This is reflected
by a movement downward along the demand curve from point A. Second, producers offer less
for sale so the quantity supplied decreases. This is illustrated by a downward movement along
the supply curve from point A. Both of these responses will continue until the price reaches
where quantity demanded equals quantity supplied (Point E), at the intersection of the two
curves. Once this occurs, the market has reached a stable equilibrium point. The quantity is
referred to as equilibrium quantity.

The opposite situation is a shortage. If the price of cherries is $5 per kg, the quantity demanded
is 14 million kilograms and the quantity supplied is 6 million kilograms. The quantity demanded
exceeds the quantity supplied creating a shortage in cherries. Due to the shortage, some
consumers are unable to purchase cherries. The shortage creates pressures for the price to
rise. To meet the demand of the consumers, the producers will need to raise prices to produce
more cherries. This is a movement upward along the supply curve from point B towards point E.
As the price rises, less consumers purchase cherries. This is a movement upward along the
demand curve from point B towards point E. The shortage will shrink until quantity demanded is
equal to quantity supplied at the equilibrium point, E.

The Role of Price

If there is a surplus or a shortage, the price in a competitive market changes until equilibrium is
reached. When equilibrium is reached, the pressures for further adjustments of price is
eliminated. The market will remain at equilibrium until changes in demand or supply factors
cause demand or supply to shift. When this happens, the shortage or surplus resulting from the
changes will force the market into a new equilibrium point.
Changes in Demand
Consider a scenario where a scientific study was released about the health benefits of cherries.
This creates a shift of the demand curve to the right from D0 to D1. Refer to the figure below. If
prices remain at the equilibrium price of $10 per kilogram, this will create a shortage of 1 million
kilograms of cherries. The quantity demanded at a price of $10 per kilogram after the demand
shift is 11 million kilograms but producers are only willing to supply 10 million kilograms. As
discussed in a previous section, the pressures of a shortage will drive price up towards point B.
Quantity demanded will decrease and quantity supplied will increase until they equal at the
equilibrium point. This new equilibrium will have a higher price and a higher quantity compared
to the old equilibrium.

Figure 2.8. Effects of changes in demand on equilibrium.

Source: E. Lun, 2022.

Long Description
Along the horizontal axis, there are indicators of quantity in millions of kilograms per month
ranging from 6 to 15 in increments of 1. Along the vertical axis are indicators of price per
kilogram ranging from 5 to 25 in increments of 5. There are two sets of points in the graph for
demand. The first set is at coordinates (6,15), (10,10), and (14,5) with the middle point labeled
as A. A downward sloping line connects the three points and it is labeled D0. The second set of
coordinates is (7,15), (11,10), and (15,5) with the middle point labeled as A. There is a
downward sloping line connecting these points and it is labeled as D1. The horizontal distance
between the two points labeled A is labeled as “Shortage”. There is a set of points for the supply
curve at (6,5), (10,10), and (14,15). There is an upward sloping line connecting the three points
labeled S0. The intersection of D1 and S0 is labeled as point B.

Changes in Supply

Consider a scenario where there is technological advancement in producing cherries (i.e., faster
harvesters, more automated processes, etc.) and this shifts the supply curve for cherries to the
right from S0 to S1. At the equilibrium price of $10 per kilogram, this will create a surplus of 1
million kilograms of cherries. Producers are willing to supply 11 million kilograms of cherries but
consumers are only willing to consume 10 million kilograms. As discussed previously about
surpluses, the pressures from the surplus will drive prices down. Quantity supplied will fall and
quantity demanded will rise. Price will continue to fall until the equilibrium point B. The new
equilibrium compared to the old equilibrium will have a lower price and higher quantity.
Figure 2.9. Effects of changes in supply on equilibrium.

Source: E. Lun, 2022.

Long Description

Along the horizontal axis, there are indicators of quantity in millions of kilograms per month
ranging from 6 to 15 in increments of 1. Along the vertical axis are indicators of price per
kilogram ranging from 5 to 20 in increments of 5. There are two sets of points in the graph for
supply. The first set is at coordinates (6,5), (10,10), and (14,15) with the middle point labeled as
A. An upward sloping line connects the three points and it is labeled S0. The second set of
coordinates is (7,5), (11,10), and (15,15) with the middle point labeled as A. There is an upward
sloping line connecting these points and it is labeled as S1. The horizontal distance between the
two points labeled A is labeled as “Surplus”. There is a set of points for the demand curve at
(6,15), (10,10), and (14,5). There is a downward sloping line connecting the three points labeled
D0. The intersection of D0 and S1 is labeled as point B.

Changes in Both Demand and Supply

If both demand and supply curves shift at the same time, the prediction of equilibrium price and
quantity becomes more difficult. Suppose both of the previous shifts to demand and supply
occurred simultaneously. Demand and supply both shift to the right. Depending on the
magnitude of the demand shift relative to the supply shift, a number of different equilibriums can
occur. Consider the following figure. If the supply shift was greater than the demand shift, the
new equilibrium has a lower price and greater quantity. If the demand shift is greater than the
supply shift, the new equilibrium will have a higher price and higher quantity compared to the old
equilibrium.

Figure 2.10. Effects of changes in demand and supply on equilibrium.

Source: E. Lun, 2022.

Long Description

There are two graphs in this figure. Both graphs have the horizontal axis representing quantity
and the vertical axis representing price. On the first graph, there are two parallel downward
sloping demand curves. The left one labeled D0 and the other D1. There are arrows indicating a
shift of the demand curve from D0 to D1. On the same graph there are two parallel upward
sloping supply curves. The left one is labeled S0 and the other S1. The distance between the
supply curves is drawn greater than the distance between the demand curves. There is an
arrow indicating the supply curve shifts from S0 to S1. There is a point indicating the
intersection of D0 and S0. There is a point indicating the intersection of D1 and S1. An arrow is
drawn to show the first intersection has moved down and to the right to the second intersection.
On the second graph, there are two parallel downward sloping demand curves. The left one
labeled D0 and the other D1. There are arrows indicating a shift of the demand curve from D0 to
D1. On the same graph there are two parallel upward sloping supply curves. The left one is
labeled S0 and the other S1. The distance between the supply curves is drawn smaller than the
distance between the demand curves. There is an arrow indicating the supply curve shifts from
S0 to S1. There is a point indicating the intersection of D0 and S0. There is a point indicating
the intersection of D1 and S1. An arrow is drawn to show the first intersection has moved up
and to the right to the second intersection.

Demand and supply can also move in opposite directions. Consider a scenario where demand
shifts to the right and supply shifts to the left. We can conclude that price will rise but depending
on the magnitudes of the shift in demand and supply relative to each other, quantity can
increase or decrease compared to the old equilibrium.

Module 3

Introduction

Elasticity refers to the responsiveness of supply or demand in relation to its price. It measures
how difficult it is to change quantity with price. For example, there are goods where consumers
can find many substitutes (i.e., fruits, beverages, clothing, etc.) and a small change in price can
have major changes in quantities for these goods since consumers have many substitutes
available. There are other goods, where substitutes are rare or non-existent (i.e., gasoline,
medication, etc.) and a change in the price of these goods might have small or no effect on
quantity since there are no substitutes to replace them. This module will look at the concept of
elasticity, calculate and compare elasticity, and see how this key concept helps measure, in
numerical terms, the impact of the interplay of demand and supply in competitive markets.

Elastic and Inelastic Demand

The previous module looked at the relationship between the price of a product and the quantity
demanded. According to the Law of Demand, as the price rises, the quantity demanded of the
product falls (for most goods and services). A demand schedule or a demand curve provided
levels of quantity demanded at each possible price level and changes in quantity demanded can
be calculated from a change in price. This module will refine that analysis by studying the
numerical relationship between changes in price and quantity demanded. For example, if the
price of a product is reduced by half, will quantity demanded double or triple? Or will it only
increase by a small proportion such as 10% or 20%? The price elasticity of demand can answer
this question.

Consumers can be very responsive or unresponsive to price changes depending on the

product. Consider the figure below. The graph on the left illustrates a product where if the price
increased from $1.00 to $1.50, the quantity demanded falls from 1,000 to 400. In terms of price,
this is a 50% increase in the price from $1.00 to $1.50. For quantity demanded, a decrease from
1,000 to 400 due to a price increase from $1.00 to $1.50 is a 60% decrease (or -60%). If a given
percentage change in price causes a larger percentage change in quantity demanded, the
product has elastic demand (or the absolute percentage change in price is smaller than the
absolute percentage change in quantity demanded). Consider the graph on the right in the
figure below. In this scenario, if there is a price change from $1.00 to $1.50, there is a smaller
decrease in quantity demanded from 1,000 to 800. The 50% increase in price only results in a
20% (or -20%) decrease in quantity demanded. The percentage change in price causes a
smaller percentage change in quantity demanded (or the absolute percentage change in price is
greater than the absolute percentage change in quantity demanded), the product has inelastic
demand.

Figure 3.1 Elastic and Inelastic Demand Curves.

Source: E. Lun, 2022.

Long Description
Consider ice cream as the product. Consumers will react differently to price changes for ice
cream during the winter or summer months. In the winter, ice cream will have an elastic demand
curve. Since it is cold, a small increase in price will drive away a lot of customers that are fine
not eating ice cream in the winter. A small percentage change will have a large percentage
change in people wanting to eat ice cream or quantity demanded. In the summer, it is hot and
people need ice cream to cool down. The same price increase would have small or no change
to the number of people wanting to eat ice cream because it is hot. Therefore, in the summer,
ice cream has an inelastic demand curve. A large percentage increase in price will only have a
smaller percentage decrease in quantity demanded because people will still want to eat ice
cream in the summer.

Perfectly Elastic and Perfectly Inelastic Demand

There are two extreme cases of demand elasticity. Perfectly elastic demand is when the
demand curve is perfectly horizontal or flat. In this scenario, the price remains constant at all
quantity demanded levels. The price never varies. Consider a farmer who is a price taker for
their crop. A price taker is a producer that has no influence over the market price because the
size of the operation of the producer is insignificant to affect the market. A farmer that is a price
taker would face a perfectly elastic demand curve. If the farmer sells their product for more than
the perfectly elastic price, they lose all demand for their crop. If they sell below that price, they
could do better by increasing their price up to the perfectly elastic price.

The opposite extreme is a perfectly inelastic demand curve. This is referring to a demand curve
that is perfectly vertical. The quantity demanded of the product is unaffected by price.
Regardless of price, there will always be the same amount of quantity demanded. Consider the
case for life saving drugs such as insulin. There is a certain number of people with diabetes that
requires insulin (quantity demanded). Regardless of price, this number of people will need to
buy a certain amount of insulin. This means the demand curve for insulin in perfectly inelastic.
The quantity demanded is determined by the number of people with diabetes and the amount of
insulin each person requires.
Figure 3.2. Perfectly elastic and perfectly inelastic demand curves.

Price Elasticity of Demand and Total Revenue

The price elasticity of demand determines what impact a price change has on total revenue for
a business. Total revenue (TR) is defined as the price of a product (P) multiplied by the quantity
demanded of the product (Qd).

For example, if the price of a product is $5 and the quantity demanded at that price is 100, total
revenue is $500.

Total revenue can change in two ways, price and/or quantity. If price increases by itself, total
revenue rises. However, due to the Law of Demand, as price rises, quantity demanded
decreases which has a negative impact on total revenue. If a firm increases price to increase
total revenue, they also have to consider the opposite impact it has on quantity demanded and
ultimately total revenue. The price elasticity of demand determines which of these two effects,
the change in price and the change in quantity demanded, has the greater influence on total
revenue.

If the demand for a good is elastic, the percentage change in price is smaller than the
percentage change in quantity demanded. If there is a price increase by a small percentage,
there will be an even bigger percentage change in quantity demanded. This will decrease total
revenue. Likewise, if there is a small price percentage price decreases, there will be a large
percentage increase in quantity demanded. This will lead to an increase in total revenue. When
demand is elastic, total revenue as an inverse relationship with price.

Suppose an ice cream vendor faces an elastic demand for ice cream. At a price of $2, the
vendor sells 1,000 ice creams per day. This is equal to a total revenue of $2,000. If the price of
ice cream increases to $3, quantity demanded decreases to 400 per day. This is equal to a total
revenue of $1,200. With a 50% increase in price (($3 - $2)/$2 = 0.5), there is a 60% decrease in
quantity demanded ((400 - 1000)/1000 = -0.6). With an elastic demand, as the price increase
from $2 to $3, total revenue decreased from $2,000 t0 $1,200. The figure below illustrates this
scenario.

Figure 3.3: Revenue changes with elastic demand.

Source: E. Lun, 2022.

Long Description

Inelastic demand is when the percentage change in price is greater than the percentage change
in quantity demanded. A percentage increase in price will lead to a smaller percentage
decrease in quantity demanded. The total revenue will increase. A decrease in the price will
create a decrease in total revenue. Price and total revenue has a direct relationship with an
inelastic demand. Consider the previous example with ice cream except a price increase to $3
will only create a decrease in quantity demanded by 200 to 800 per day. The percentage
change in price remains at 50%. The percentage change in quantity demanded is 20% ((800 –
1000)/1000 = -0.2). The figure below illustrates this scenario. At a price of $2, the vendor is still
making $2,000 in total revenue. With an inelastic demand and an increase to a price of $3, the
total revenue increases to $2,400.

Figure 3.4: Revenue changes with inelastic demand.

Source: E. Lun, 2022.

Long Description

A final version of price elasticity is unit elastic demand where the percentage change in price is
equal to the percentage change in quantity. This means a price change leaves total revenue
unchanged. The revenue that is gained from a price increase is offset by the loss in revenue
due to less quantity demanded. Consider the previous ice cream example where if price
increase from $2 to $3, quantity demanded falls to 500 per day. The percentage change in price
remains at 50% and the percentage decrease in quantity demanded is also 50% ((500 -
1000)/1000 = -0.5).
Factors that Affect Price Elasticity of Demand

Similar to factors that affect supply and demand, certain factors affect the price elasticity of
demand. The four factors are: the portion of consumer incomes used to buy the product,
consumer access to substitutes, where the product is a necessity or a luxury, and the time
consumers have to adjust to price changes.

If the price of a product represents a major portion of consumer incomes, consumers will be
more responsive to price changes. Consider an individual that is deciding on whether to
purchase a new expensive TV (flat screen, OLED, 65”, etc.). A price change will heavily
influence the buying decision of the consumer. If TV prices are cut in half (50% off), quantity
demanded will probably rise, in terms of percentage, more than price (i.e., more than 50%). On
the other hand, consider consumers buying soap, an inexpensive product. A 50% drop in price
will probably have small impact on quantity demanded. Therefore, the demand for big
purchases tend to be more elastic compared to smaller purchases.

If there are many close substitute for a product (i.e., Coke and Pepsi, Sprite and 7-Up,
Playstation and Xbox, Nike and Adidas, etc.), consumers will be more responsive to changes in
the product’s price because they have more options. The many close choices allows consumers
to easily change their buying patterns. Suppose the price of Coke rises by 10%, given that
Pepsi is a very close substitute, it is not hard for consumers to switch to drinking Pepsi creating
large percentage changes in quantity demanded for Coke. The more close substitutes a product
has, the more elastic their demand.

Necessity products are items that are essential for consumers such as bread, milk, eggs, etc.
They satisfy basic wants for consumers. Given these are necessities (and some products are
necessary for survival such as water, food, electricity, etc.), consumers tend to buy the same or
similar amounts regardless of price. Therefore, necessities tend to have inelastic demands.
Luxury items such as travel (i.e., plane tickets, hotel rooms, etc.), expensive cars, front row
seats to events, etc. tend to have elastic demands. Consumers can easily live without them. If
the price of a Ferrari falls by 50%, a consumer can still find more value spending that money
elsewhere.

Finally, demand tends to be more elastic over time. In the short run, consumers tend not to be
strongly responsive to price. Consider an increase in the price of Big Macs. Immediately after
the price increase, consumers will not change their buying habits of Big Macs. Over time,
consumers will change their buying habits. Consumers of Big Macs will slowly reduce their
consumption of Big Macs.

Calculating Price Elasticity of Demand

Price elasticity of demand can be quantified. The larger the numerical value, the more sensitive
consumers are to the price of the product. If price elasticity is greater than 1, then quantity
demanded is sensitive to price changes and demand is elastic. If price elasticity is less than 1,
then quantity demanded is relatively not sensitive to price changes and demand is inelastic. If
price elasticity is equal to 1, then the product is unit elastic.

The formula for price elasticity of demand is,

Qd is quantity demanded and Δ is the Greek letter “delta,” which signifies a change in a
variable.

Comparing the percentage change between price and quantity demanded determines whether
the demand curve was elastic or inelastic. The formula above finds the ratio between
percentage change in quantity demanded relative to the percentage change in price. The
formula in the numerator calculates the percentage change in quantity demanded. The formula
in the denominator calculates the percentage change in price. If the numerator is greater than
the denominator, the percentage change in quantity demanded is greater than the percentage
change in price. This means price elasticity will be greater than one and elastic. If the
denominator is greater than the numerator, then the price elasticity will be less than one and
inelastic. (Remember, since price and quantity demanded have an inverse relationship, one of
the percentage changes will be negative. If there is a positive percentage change in price, there
will be a negative percentage change in quantity demanded. This is the Law of Demand. This
results in a price elasticity of demand number that is negative.)

Consider the previous ice cream example. At a price of $2, the vendor sells 1,000 ice creams
per day. If the price of ice cream increases to $3, quantity demanded decreases to 400 per day.
The vendor faces an elastic demand. To calculate the price elasticity of demand, substitute the
values into the above formula.

The answer to the above equation is -2.143. There are no units attached to this number (i.e.,
dollars, quantity, etc.). It is common practice to define the number of the price elasticity of
demand in terms of the number’s absolute value. Therefore, the negative sign is removed in the
final answer. The number is always considered positive (even though the calculation should
provide a negative number). The price elasticity of demand for the ice cream scenario is 2.143.
Since the number is greater than one, the demand curve is elastic. This also means that a
certain percentage change in price causes a 2.143 times percentage change in quantity
demanded.

Elasticity and Linear Demand Curves

There are different values of price elasticity along a linear demand curve (a demand curve that
is a perfectly straight downward sloping line). The slope of the curve is constant. Consider the
figure below of a linear demand curve. For every dollar increase in price, quantity demanded
decreases by 2 million units. This means the slope of the demand curve is a constant -1/2. It is
important to remember that price elasticity of demand is not the slope of the demand curve.
Along the entire demand curve, the price elasticity of demand will vary. Between the prices $4
and $3, the price elasticity of demand is 7/3 (approximately 2.33) which is elastic. Between the
prices $2 and $1, the price elasticity of demand is 3/7 (approximately 0.429), which is inelastic.

The reason for this difference can be seen on the demand curve. At higher prices (i.e., $5 to
$3), quantity demanded is small and percentage increases from small values will be large. For
example, a price drop from $4 to $3 is only a 25% decrease. But $4 corresponds to only 2
million units of output and increases to 4 million with a $1 drop in price. Quantity demanded has
doubled with a 25% price drop. Compare this change to lower price levels where quantity
demanded values are much larger. For example, consider the price drop from $2 to $1. This is a
50% decrease in price but the low prices corresponds to higher levels of quantity demanded (6
and 8 million units). A 50% drop in price at higher price levels corresponds to only a 33%
increase in quantity demanded.

The higher price end of the demand curve is elastic demand with price elasticity greater than
one and the lower price end is inelastic demand with price elasticity less than 1. Since the
demand curve is continuous (non-broken line), the elasticity number decreases from greater
than 1 to less than 1 along the demand curve as price decreases. At some point along the
curve, there must be a change in price that produces price elasticity equal to one, unit elastic. A
price change from $3 to $2 corresponds to a decrease in quantity demanded from 4 to 6 million.
The price elasticity of demand is equal to 1.
Figure 3.5: Elasticity and the Linear Demand Curve.

Long Description

Source: E. Lun, 2022.

Income and Cross-Price Elasticities

There are other elasticity concepts relating to demand. The elasticity concept can also measure
the extent to which a product’s quantity demanded varies with changes in consumer income or
the price of other products.

Income elasticity is the measure of the responsiveness of a product’s quantity demanded to a

change in the average consumer income. The formula is similar to the price elasticity of demand
but instead of using price, it uses income. It is calculated as the ratio of the changes in quantity
demanded and consumer income, with each change divided by its average value.

For example, if an increase in average consumer income from $20,000 to $40,000 causes a
quantity demanded in computer tablets to rise from 1,000 to 2,000, then the income elasticity of
computer tablets is 1.
Unlike the price elasticity of demand, the sign of the answer is important (do not take the
absolute value). For an inferior product, the income elasticity number will be negative. If
consumer income rises and the quantity demanded of the product decreases, the product is
inferior. This will create a negative income elasticity value (i.e., positive numerator and negative
denominator). Consider instant coffee; as consumer income rises, consumers can afford to buy
fresh coffee beans or brewed coffee from a coffee shop. The quantity demanded of instant
coffee will decrease. If the income elasticity number is positive, the product is a normal good. As
consumer income rises and quantity demanded of the product rises, people want more of the
product as long as they can buy it. This is referred to as a normal good. Necessities such as
milk or bread have relative low income elasticities (between 0 and 1). Luxury goods, typically
with high price tags, have higher income elasticities (greater than 1).

Another form of elasticity is cross-price elasticity of demand. This is defined as the

responsiveness of quantity demanded of one product to a change in price to another product.
Again, the formula is similar to the others with a different variable used in the denominator. The
formula for the cross-price elasticity of demand is the ratio of the change in the quantity
demanded of product x and the price of product y with each divided by its average value.

For example, if a drop in the price of computer tablets from $1,000 to $500 causes the quantity
demanded of laptop computers to fall from 5,000 to 3,000, then cross price elasticity of these
two products is 0.75.

Just like income elasticity, the sign of the answer matters. If product x and y are substitutes for
each other, like tablets and laptops, the cross-price elasticity of demand is positive. If x and y
are substitutes, and the price of y increases (positive denominator), people will demand less y
and demand more of the substitute x (positive numerator). If product x and y are complements,
like coffee and sugar, the cross-price elasticity of demand will be negative.
Elastic and Inelastic Supply

The price elasticity of supply measures the responsiveness of quantity supplied of producers to
changes in the product’s own price.

Elastic supply means a certain percentage change in price leads to a larger percentage change
in the quantity supplied. Consider a producer of corn and the price increases from $1.10 to
$1.20 per kilogram. This corresponds to a quantity supplied increase from 150,000 to 200,000
kilograms per year. There is approximately a 9% increase in the price of corn and approximately
33% increase in quantity supplied.

Inelastic supply means a certain percentage change in price results in a smaller percentage
change in quantity supplied. Consider the previous corn example, but the quantity supplied only
increases from 150,000 to 160,000. The price increase is approximately 9% but the quantity
supplied only increased by approximately 7%.

Figure 3.6: Elastic and inelastic supply.

Source: E. Lun, 2022.

Long Description

Factors that Affect Price Elasticity of Supply

The main factor that impacts the price elasticity of supply is the passage of time. In a
competitive market, the passage of time can be distinguished into three periods: immediate run,
the short run, and the long run. The price elasticity of supply differs in each period.

The immediate run is the period during which the business in a certain industry can make no
changes in the quantities of resources they use. Consider the industry for corn. If the price
suddenly jumps up due to an increase in demand, in the immediate run, farmers are unable to
increase production of corn. Immediate run is a length of time that is too short for the farmer to
acquire more resources to produce more corn. They are restricted to work with what they
already have for production. In this period, the supply curve is perfectly inelastic or a vertical
line. For corn farming, this could be approximately a month.

The short run is the period during which the quantity of at least one of the resources used by
businesses in the industry cannot be varied. Consider the corn farmer from before. Suppose the
price increases due to an increase in demand. During this length of time, the farmer does have
enough time to increase some resources to increase production. For example, to increase
production, the farmer can hire more people and buy more fertilizer to increase the yield.
However, the length of time is not enough to buy more land or purchase farm equipment.
Labour and fertilizer can be acquired in a short amount of time but more land and equipment will
take longer time to acquire than the amount of time available in the short run. The supply curve
can be elastic or inelastic in this length of time, depending on the responsiveness of the
producer to price changes. For corn farming, this could be a single growing season.

The long run is the period during which all resources used by the industry can be varied. Also,
businesses may enter or leave the industry. For corn farming, this can be multiple growing
seasons. During this length of time, an increase in the price of corn can have multiple effects.
The rise in the price of corn can lead to a temporary increase in the earnings of corn farmers.
The increase in earnings will lead to more resources devoted to corn production, expanding
corn farmer operations. The price increase and increase in earnings will also attract other
farmers into the industry increasing overall supply to the market. Two outcomes are possible
from this point forward depending on the future trend of price.

If corn farming is a constant cost industry, one that is not a major user of any resources, the
increase in quantity supplied following a short run rise in the price of corn has no effect on
resource prices. The incentive from increased earnings will keep increasing supply (shifting
market supply curve to the right) and decreasing price (equilibrium price falls) until price returns
back to original levels. The price of corn will always return back to its original levels regardless
of quantity supplied. This means a constant cost industry exhibits a horizontal long run supply
curve. For the long run, supply is perfectly elastic (horizontal supply curve).

If corn farming is an increasing cost industry, it is a major user of at least one resource. A
greater quantity supplied leads to an increase in the price of this single resource, such as land
or farming machinery. A short run rise in the price of corn causes production to grow as farmers
take advantage of the increase in earnings. Price will be driven down to its lowest possible level.
Different from the previous scenario, price will not return to its original levels because farmers
face higher costs. This means the corn industry will have a slightly upward sloping (very elastic)
long run supply curve.

Calculating the Price Elasticity of Supply

The price elasticity of supply is calculated similarly to price elasticity of demand. When the value
is greater than one, quantity supplied is sensitive to price changes and is elastic. If the value is
less than one, than quantity supplied is not sensitive to price changes and is inelastic. If the
value is equal to 1, it is unit elastic.

Consider the corn example from before. If price increases from $1.10 to $1.20, the quantity
supplied increases from 150,000 to 200,000 kilograms per year. Substituting the values into the
formula, we get a price elasticity of supply equal to 3.286.

Therefore, the corn producers face a price elasticity of supply of 3.286. This number is always
positive since there is a direct relationship between price and quantity supplied. The numerator
and denominator will have the same sign. The value also has no units. This value of 3.286
means the percentage change in price is smaller than the percentage change in quantity
suppled (by a factor of approximately 3.286). This means the supply curve is elastic.

Module 4

Introduction
This module focuses on the costs incurred by businesses in production. In business, everything
has a costs. To manufacture products, a company might require labour, utilities, machinery,
equipment, and many other inputs that costs money. This module will focus on how businesses
make decisions about production processes and how they deal with production costs. The
material in this module combined with the previous discussions on revenue will be the basis of
determining profits for businesses.

Topics and Learning Objectives

Topics

This module will cover the following topics:

● Identifying production costs and economic profits

● Short run costs
● Long run costs

Learning Objectives

By the end of this module you will be able to:

● Describe short run products and costs (total, average, and marginal), and the law of
diminishing marginal returns.
● Describe long run production and costs.

Costs of Production

A business is an enterprise that brings individuals, financial resources, and economic resources
together to produce a good or service for economic gains. The process that transforms a set of
resources into a good or service that has economic value is production. The resources that are
used in production (such as natural, capital, or human) are called inputs. Output is the result of
production.

All businesses fall into one of three sectors: primary, secondary, or tertiary (or service). A
business in the primary sector mainly deals with extraction of natural resources such as farming,
mining, fishing, forestry, etc. The secondary sector businesses are involved in fabricating or
processing goods from primary sector resources. Industries such as manufacturing and
construction are in the secondary sector. The tertiary (or service) sector involves trade industries
(both retail and wholesale), such as banking and insurance, and the new information industries.

Productive Efficiency

In producing goods or services, there are two categories of processes a business can choose
from: labour intensive process or capital intensive process. A labour intensive process is one
where more labour is employed than capital to produce output. A capital intensive process uses
more capital compared to labour to produce the same quantity of output.

Consider a company that is producing widgets. The company has the building and space
required to begin production. Before they begin production, the company needs to decide how
to make the output. They are presented with two options that produce the same amount of
output. They can go the labour intensive route and have a large workforce and some equipment
or they can choose the capital intensive route where the workforce is smaller but they have
more equipment. Again, both options provide the same amount of output.

To make this decision, the company must consider productive efficiency. This means the
company should choose the option that provides the highest quantity of output for the lowest
cost. In the case of the company producing widgets, the company will pick the option with the
lowest cost since both options produce the same amount of output. In other words, production
efficiency is a company making a given amount of output at the lowest cost. In the previous
example, the company will determine the cost of workers and equipment for each option and
pick the one that costs the least.

Economic Costs
Businesses face two types of costs: explicit and implicit. Explicit costs are payments made by a
business to businesses or people outside of it. Explicit costs are also referred to as accounting
costs because they include all the costs that appear on a business’ accounting records.
Examples of these costs are rent, wages, cost of machinery or equipment, and materials. In the
previous widget example, explicit costs would equal the total amounts paid as wages to the
workers and the amount spent on buying equipment.

Implicit costs are estimates of what owners give up by being involved with a business. This is
the owner’s opportunity cost. One implicit cost is normal profits. Normal profit is the minimum
return necessary for owners to keep funds and their entrepreneurial skills in their business. To
find normal profit, owners must determine the highest possible return they could have received
by using their funds and entrepreneurial skills in another way. Consider the previous widget
example. Suppose, instead of making widgets, the owner could have spent their money and
skills making t-shirts. The money and skills that are going into making widgets could have been
spent on making t-shirts. The potential profits from the t-shirt business are normal profits.

Economists define costs as opportunity costs (Module 1). The economic costs encountered by a
business are all the opportunity costs involved in production and includes both explicit and
explicit costs.

Economic Costs = Explicit Costs + Implicit Costs

Economic Profit

Accounting profit is found by taking the difference between revenues and explicit costs.
Economic profit is the difference between revenues and economic costs. If this is negative, the
business faces an economic loss or negative economic profit.

Economic Profit = Total Revenue – Economic Costs = Total Revenue – Explicit Costs – Implicit
Costs

When a business’ economic profit is positive, the business has incentive to continue operations.
If economic profits are negative over an extended time period, the business needs to consider
shutting down because they are unable to recover all the costs.

Total, Average, and Marginal Products

From the previous module, short run is a length of time during which quantities of one or more
of a business’ inputs are fixed (or cannot be varied). Consider the manufacturing industry where
businesses cannot change the number of factories or number of heavy machinery in a short
amount of time. The inputs that cannot change quantities in the short run are referred to as fixed
inputs. Inputs that can be adjusted are variable inputs. Typical variable inputs in the short run
are labour and materials. For example, a furniture manufacturer can hire or fire workers and buy
more or less lumber for production in a short amount of time (variable inputs). However, they are
unable to open another factory or install another piece of heavy machinery in the same short
period of time (fixed inputs).

To increase production or increase quantity of output, a business must increase the amount of
variable inputs (i.e., hire more workers, buy more equipment, etc.). Total product is the overall
quantity of output produced with a given workforce. (Typically, labour is the only variable
considered as variable in production but, in reality, businesses also use materials in production.)

Consider Table 4.1:

Table 4.1. Production in the short run.

The variable input is labour (L). As the quantity of labour increases, total product(q) also
increases. The more people the business hires, the more output they are able to produce (The
final decrease in total product from 5 to 6 workers per day will be discussed later).

Average product is the quantity of output produced per worker and is calculated by dividing total
product (q) by the quantity of labour employed. For example, when 3 workers are employed, the
business has total product of 250. That means average product is 250/3 = 83.3.

Marginal product is the extra output produced when an additional worker is hired. To calculate
marginal product, divide the change in total product by the change in the amount of labour
employed. For example, consider the increase in the number of workers from 3 to 4. Total
product increased from 250 to 270. The change in number of workers is 1 (ΔL = 4 – 3 = 1, the Δ
symbol represents change in a variable) and the change in total product is 20 (Δq = 270 – 250 =
20). This means the marginal product from 3 to 4 workers is 20/1 = 20.

In the table, the marginal product number is placed in between rows. This is because marginal
product is defined as the change from one employment level to another. Therefore, the marginal
product of 20 from 3 to 4 workers is placed between the rows for 3 and 4 workers. If this value
was expressed in a graph, the point representing marginal product of 20 would be placed In
between 3 and 4.

Diminishing Marginal Product

The marginal product values in Table 4.1 (repeated below for reference) illustrate a law that
applies to production in the short run, the Law of Diminishing Marginal Return.

Table 4.1. Production in the short run.

The law states that, as a production process employs more variable inputs with a fixed amount
of fixed inputs, at some point, the marginal product will begin to decrease. This happens
because there is an increasing quantity of variable inputs for an increasingly scarce quantity of
fixed inputs. Consider labour as the variable input and equipment as fixed input. As you hire
more workers (increasing variable input), there will eventually be a point where, due to the fixed
amount of equipment, workers will need to share or split time using the equipment. This will
lower the marginal product of the next additional worker added since they will not have as much
access to equipment as the previously hired worker.

In Table 4.1, diminishing marginal returns sets in when they hire the third worker. When the
business hired the second worker, the marginal product from that additional worker was 120
units. The third worker hired produced a marginal product of 50. This means the addition of the
third worker was not as productive as the second. However, since marginal product is positive,
they are still productive.

Figure 4.1 illustrates the total, average, and marginal products on a graph.
Three Stages of Production
Looking at Figure 4.1 (repeated below for reference), the production process can be divided into
three stages using the marginal product curve.
The first stage of the production process has increasing marginal product. This is the part of the
graph where the marginal product curve is upward sloping. Hiring the first couple workers in
production provided increasing marginal product. Since marginal product is defined as the
increase in total product from an increase in the variable input (labour), the point is drawn in
between values of variable input. For example, hiring the second worker had a marginal product
of 120 and the point was drawn in between 1 and 2 for number of workers. Looking at the same
point on the total product curve, this is the beginning of diminishing marginal returns. Additional
workers beyond this point has lower marginal product creating a downward sloping marginal
product curve.
Eventually, the marginal product curve turns negative (goes below the horizontal axis). This
occurs when the next additional worker decreases total product. Consider a company that has
hired too many workers. The additional workers do not have equipment to use and are actually
getting in the way of other workers decreasing their productivity. This will cause negative
impacts to productivity and ultimate output. In the textbook example, this occurs when the sixth
worker is hired. It could be the case there was no more machinery for the sixth worker to use
and the additional worker was getting in the way of others productivity causing an overall
decrease in output. This point corresponds to the point on the total product curve where its
starts to have a negative slope. The total product curve begins to trend downward.

During the second stage of the production process, the marginal product begins to fall but it is
still positive. This means, although the next additional worker is not as productive as the
previous hire, they are still productive. Total product is still rising but at a lower rate. The
business will pick a production level somewhere in this range. It will not pick a point before this
stage since each additional worker is even more productive. It will not pick a point after this
stage because total product will begin to decrease.

Average vs. Marginal Product

The shape of the average product curve relative to the marginal cost curve illustrates an
important relationship between average and marginal values. The average value rises if the
marginal value is above the average value. The average value stays constant if it equals the
corresponding marginal value. Finally, the average value falls if the marginal value is below the
average value. In other words, the downward sloping portion of the marginal product curve will
always intersect the highest point on the average product curve, as illustrated in Figure 4.1
(repeated below for reference).
To illustrate this relationship between average and marginal values, consider class grades.
Suppose the current class average is 80. The class is getting a new student and their expected
grade is 90. This means the marginal mark from this addition of the new student is 90 (the new
student is marginal product, the class average is average product). Adding this new student will
increase the class average. This is consistent with the relationship between average and
marginal values. The class average is 80 which is less than marginal grade of 90 from the new
student. Since average is less marginal, the inclusion of the new student will raise the class
average.
Similarly, suppose the new student is only expected to get a 70. The marginal mark is 70 which
is less than the class average of 80. Since marginal value is less than average value, the
inclusion of the student will lower class average.

Total Costs
In the short run, production processes have variable and fixed inputs. This means they will face
corresponding variable and fixed costs. Variable costs are economic costs for inputs that vary at
each quantity of output. Variable costs change when the business adjusts the quantity
produced. A business will increase or decrease output by hiring or firing workers. The variable
costs will depend on how many workers are on payroll. Fixed costs are economic costs for
inputs that remain fixed at all quantities of output. Fixed costs do not change when a business
changes its quantity of output. The machinery that the business uses for production costs the
same regardless if they use the machine to produce 1 or 1,000 units.

Total cost is the sum of all fixed and variable costs at each quantity of output.

Total Cost (TC) = Variable Cost (VC) + Fixed Cost (FC)

Consider Table 4.2, which is an extension of Figure 4.1 with additional cost information.

Table 4.2. Short-run costs for Pure ‘n’ Simple T-shirts.

The company has fixed costs of machinery and rent at a constant $825. Workers have a wage
of $100 and the cost of material is $0.50 per unit. Suppose the business currently has 3 workers
with a total product of 250. The fixed costs is $825. The variable costs include the cost of
workers and materials. The 3 workers cost $100 X 3 = $300. The material used to make 250
units cost $0.50 X 250 = $125. The total variable cost is $300 + $125 = $425. Total cost is $825
+ $425 = $1,250.

Marginal Cost
Marginal cost (MC) is the extra cost of producing an additional unit of output. This marginal
variable is slightly different compared to marginal product. It is calculated by finding the change
in total cost when there is an increase in variable inputs and then dividing by the change in total
product from the increase in variable input.
Consider the example in Figure 4.2 where the number of workers increases from 3 to 4. By
increasing the number of workers from 3 to 4, variable costs increased by $535 - $425 = $110.
This also means total costs increased by $110 (fixed costs do not change). The additional
worker also increased output by 270 - 250 = 20 units. Therefore, the marginal cost of an
additional 20 units is $110/20 = $5.50. Figure 4.2 shows the marginal cost curve.

The marginal cost curve will have a “J” shape. The points on the curve, just like marginal
product, are plotted in between the values of output. In the numerical example, a marginal cost
of $5.50 will be plotted at the output value of 260 (halfway between 250 and 270).

Marginal cost rises as long as marginal product falls. The two variables have an inverse
relationship. As total product rises, at some point, marginal product begins to decrease. The
denominator in the marginal cost formula is getting smaller. However, to increase output, more
variable input must be employed. The cost of addition workers remains the same (or can get
more expensive). That means the change in total cost will be constant (or increasing). The
numerator remains constant (or increases) with more output. This leads to marginal cost
increasing with higher levels of output.

Per-Unit Costs
Marginal cost is based on changes in output of the production process. It measures the increase
in total cost given an increase in output. Per-unit costs are expressed in terms of a single level
of output. There are three per-unit costs: average fixed cost, average variable cost, and average
(total) cost.

Average fixed cost is the fixed cost per unit of output and is calculated by dividing the fixed costs
by total product. From Table 4.2, consider the output level of 250 units with 3 workers. The fixed
costs at the output level is 825. Average fixed costs at 250 units of output is $825/250 = $3.30.

Average variable cost is the variable cost per unit of output and is calculated by dividing the
variable costs by total product. Consider the same production level of 250, the variable cost is
$425. Average variable costs at 250 unit of output is $425/250 = $1.70.

Figure 4.3 illustrates the two variables in a graph (the vertical axis is labeled as price because
cost will be compared to price in a later module).
Average fixed cost is always downward sloping. Since fixed costs do not change, as output
increases, average fixed costs will decrease. Average variable cost is a flat “U” shape reflecting
its connection with the associated marginal cost curve. At the initial quantities of output,
marginal cost is below average variable cost, causing average variable cost to decline. Where
marginal cost and average variable cost intersect, the average variable cost curve reaches a
minimum. At higher output levels, marginal cost is above average variable cost, causing
average variable cost to rise.

Average cost (sometimes it is also referred to as average total cost) is the sum of average fixed
cost and average variable cost at each quantity of output. Consider the previous example at
output level 250, average cost is $3.30 + $1.70 = $5.00.

Average Cost (AC) = average fixed cost (AFC) + average variable cost (AVC)

The average cost curve is “U” shaped. It represents the sum of the values plotted for the
average fixed cost curve and average variable cost curve. At lower output levels, average cost
is high because of average fixed costs. Once average cost has passed its lowest point, its rise
is due to the impact of expanding average variable costs. The average cost curve reaches its
lowest point at the intersection with the marginal cost curve. The relationship is similar to the
relationship between average variable cost and marginal cost. Therefore, marginal cost
provides the minimum values for both average variable cost curve and average cost curve.

Increasing Returns to Scale

The long run is the period in which quantities of all resources used in an industry can be
adjusted. The inputs that were previously fixed in the short run (such as machinery, buildings,
land, etc.) can be adjusted in the long run. Since all inputs can vary, the law of diminishing
marginal return no longer apply in the long run.

Increasing returns to scale is a situation in which a percentage increase in all inputs causes a
larger percentage increase in output. For example, suppose a manufacturer of t-shirts doubles
all the inputs used to make t-shirts (labour, machinery, cotton, etc.) and output more than
doubles (i.e., triples, 1.5X, etc.), the production process exhibits increasing returns to scale.
There are three main causes of increasing returns to scale: division of labour, specialized
capital, and specialized management.

If labour is able to divide and perform more specialized tasks, workers will be more efficient in
the tasks they do. For example, consider a small restaurant where workers do everything (i.e.,
waiting tables, washing, bar, etc.). The restaurant expands operations, hires more workers, and
workers now specialize in certain tasks (i.e., bartender, waiter, chef, manager, etc.). With
workers focusing on specialized tasks, they become more efficient in the tasks they do.

In most manufacturing industries, a greater scale of production is associated with the use of
specialized machinery. If a car manufacturer raises the quantity of all its inputs, for example,
capital equipment can have more specialized functions so that it performs fewer tasks more
efficiently than before.

The same principle that applies to the division of labour applies to management. If the operation
is small, there are only a few managers and each is forced to deal with a wide range of duties.
Some managers will be better at performing some tasks than others. If operations were to
expand, more managers are hired and are assigned to the area in which they have the most
expertise, making them more efficient.

Constant Returns to Scale

Constant returns to scale is a situation in which a percentage increase in all inputs results in an
equal percentage increase in output. Constant returns to scale usually results when making
more of an item requires repeating exactly the same tasks used to produce previous units of
output. Consider a manufacturer of stainless steel cookware. If the manufacturer doubles their
inputs (steel, workers, etc.), they will double their output.

Decreasing Returns to Scale

Decreasing returns to scale is a situation in which a percentage increase in all inputs causes a
smaller percentage increase in output. For example, if a production process doubles their
inputs, output only increases by 50%. There are two major reasons for decreasing returns to
scale: management difficulties and limited natural resources.

If a business expands too much and operations gets too large, managers will face problems of
coordination in operations to ensure efficient production. All businesses will reach an output
level above which management difficulties cause decreasing returns to scale top become
dominant.

In primary industries (fishing, farming, etc.), business may only be able to acquire limited supply
of easily available natural resources, even in the long run. In this case, an output level is
reached above which further increases in all inputs lead to a smaller rise in output, resulting in
decreasing returns to scale.

Returns to Scale and Long Run Costs

Figure 4.4 shows a business that expands its production process three times and experiences a
different short run cost curve at each expansion. With each expansion, the short run cost curve
shifts to the right, demonstrating an increase in the level of production.
In its first expansion, the business’ average cost curve falls from AC1 to AC2. This shifts results
from an increasing returns to scale. Almost all businesses experience increasing returns to
scale over the initial ranges of output. Output rises more rapidly compared to total cost of inputs
so the average cost falls as the scale of production increases.

The second expansion shifts the short run average cost curve from AC2 to AC3. This reflects a
constant returns to scale in production. Output and the total cost of inputs rise at the same rate
when the business expands. Therefore, the short run average cost curve moves horizontally as
output increases.

The last expansion shifts the short run average cost curve from AC3 to AC4. This shift reflects
decreasing returns to scale. The businesses output is rising less rapidly compared to total costs
of inputs, the average cost curve rises as production expands.

Long Run Average Costs

Long run average costs of a business is the minimum short run average cost at each possible
level of output. Figure 4.4 (repeated below for reference) shows that the long run average cost
curve is made up of points from the lowest short run average cost curve at each level of output.
This does not necessarily mean it is the lowest point on all the short run average cost curves.
For example, AC1 and AC4 have points that are slightly off to the left or right of the minimum
point. These selected points are the lowest possible point from any short run average cost curve
at that given level of output. Given a wide range of plant sizes, the long run average cost curve
is smooth and “U” shaped, with only one point represented from each short run curve. As Figure
4.4 shows, the long run average cost curve also has a “U” shaped with a flat area at its lowest
point.

Industry Differences

Almost all businesses face a “U” shaped long run average cost curve. However, these curves
are not necessarily symmetrical for all industries. Depending on the industry, one of the three
ranges will dominate the others. Figure 4.5 illustrates the different long run average cost curves.
Manufacturing industries tend to exhibit an extended range of increasing returns to scale due to
the degree to which specialization is possible in the use of both labour and capital. This is
particularly true of companies in which assembly line techniques are used. It is not until output is
very large that the conditions leading to constant returns to scale and decreasing returns to
scale become relevant. The left graph illustrates a typical long run cost curve for businesses in
the manufacturing industry.

Craft industries are dominated by constant returns to scale. Raising output levels of crafts tend
to depend on repeating exactly the method of production, an increase in input usually results in
an equal increase in output. The middle graph in Figure 4.5 illustrates a dominant constant
returns to scale.

Primary industries most commonly exhibit decreasing returns to scale due to the limits of natural
resources. The graph on the right of Figure 4.5 illustrates a dominant decreasing returns to
scale.

Business Size and Returns to Scale

When increasing returns to scale dominate an industry, this raises the chance that businesses in
the industry are large. Big companies also tend to have lower long run average costs, allowing
them to have a competitive advantage over smaller competitors. Increasing returns to scale
does help explain the sizes of some of the biggest companies in the world.

Industries with constant or decreasing returns to scale are dominated by small companies
because there are no cost advantages associated with low levels of output.

Economies of scope refers to the cost advantage associated with a single business producing
different products. Consider a car manufacturer selling multiple variety of car models. Because
all models of cars share aspects of production (a single designer can design a compact or an
SUV, the manufacturing line can produce any model of car), they can be shared among the
company’s various products, so too can the costs of these inputs. For many large companies
with a wide range of products, this provides another competitive edge over smaller rivals.

Summary

Everything has a cost. It takes money to make money. For a business to generate revenue
through sales, a business must incur costs in terms of inputs (i.e., labour, materials, etc.) to
make output. This module looked at how production creates costs for businesses. This module
also looked at how costs differ between economics and accounting. Economists look at explicit
costs but also consider implicit costs that accountants ignore. In the short run, there is the law of
diminishing marginal return and its effects on marginal product and cost. In the long run, the law
no longer applies, all inputs can vary, and three possible returns to scale exists. This is only a
single aspect in determining a businesses profits and future modules will refer back to this
information.

Module 5

Introduction

There exists large corporations such as Rogers Communications, Shopify, and Bombardier and
small local businesses such as restaurants, farmers, and corner stores. The main economic
difference between these businesses (other than their size) is the type of market structure in
which they operate. This module will introduce four main market structures but focus mainly on
one: perfect competition. It will be the market structure where all other types will be compared
when they are discussed in future modules. The module will also examine how businesses can
maximize economic profits by following a profit maximizing output rule.

Topics and Learning Objectives

Topics
This module will cover the following topics:

Market structures
Perfect competition
Learning Objectives
By the end of this module you will be able to:
Analyze the similarities and differences between the four main market structures.
Describe the profit maximizing rule for firms.
Explain how perfectly competitive firms profit maximize in the short run.
Explain how perfectly competitive markets adjust and its benefits in the long run.

Perfect Competition
The optimal market structure allows for the free operation of demand and supply forces. In a
perfectly competitive market, businesses allow the price of the product they sell to be
determined by the forces of supply and demand. The price is determined by the market. This is
most common in primary industries such as fishing, agriculture, forestry, etc., and in financial
markets such as stocks, bonds, and foreign exchange. Perfect competition is not very common
in other industries. In fact, a perfectly competitive market does not and many real world markets
approximate perfect competition but do not fully meet the characteristics exactly. Perfect
competition has three main features: many buyers and sellers, standard product, and easy entry
and exit.

The most important characteristic of a perfectly competitive market is it has many buyers and
sellers. The number of buyers and sellers is large to the point where no one buyer or seller has
the power to influence the market. Consider the wheat industry with many farmers and many
buyers of wheat.

A perfectly competitive market also has a standardized product. Each seller produces a product
that is the same as other sellers. Buyers and sellers cannot tell the difference between different
sellers’ product. For example, buyers and sellers of wheat cannot tell the difference between
one farmer’s wheat compared to another farmer’s wheat.

For a market to be perfectly competitive, businesses (and consumers) must be able to enter and
exit a market freely without any barriers. If a business chooses to move into another market or
shut down their operations and leave the market, they are free to do so. For farmers of wheat,
they can grow any crop they choose on their land. If they choose to grow corn, they can leave
the wheat market freely.

Monopolistic Competition

Monopolistic competition is market structure characterized by many buyers and sellers of

slightly different products and east entry to and exit from the industry. This is a common market
structure most common in the restaurant industry. In a city, there are many restaurants
competing against each other for customers. It is not very difficult to start a restaurant business
(i.e., find a place to rent, apply for licenses and inspections, etc.) allowing for easy entry. A
restaurant can shut down if they choose allowing for easy exit. The product of each restaurant is
their food. There can be many Italian restaurants but the dishes on each menu is slightly
different. Product differences in a monopolistic competition can be due to location, quality, or the
image consumers have of each business’ product.

Oligopoly

An oligopoly is a market structure characterized by only a few businesses offering standard or

similar products and restricted entry to the industry. Oligopolies are common in many economies
around the world. Within Canada, steel, automobile, insurance, and telecommunications are
some examples. These are industries that have barriers in place that make it hard for new
companies to enter and compete. These barriers can come in many forms such as government
regulations, high initial investments, consumer preferences, and much more. The product sold
in oligopolies may or may not vary, depending on the particular market. For example, all major
telecommunications companies offer the same services with almost no variation. In the
automobile industries, there is more variety in their offerings such as different models and
quality level of cars.

Monopoly

A monopoly is a market structure characterized by only one business supplying a product with
no close substitutes and restricted entry to the industry. This market structure is the opposite of
perfect competition. There are several monopolies in Canada. There is usually only one
provider of electricity, water, and natural gas to a city (i.e., Enbridge, Alectra, HydroOne, etc.).
Mail is dominated by the countries postal service (i.e., Canada Post, USPS, etc.). There is only
a single provides of railway travel (i.e., Via Rail, GO Transit, TTC, etc.). There are also
monopolies that can occur in certain scenarios. For example, consider a movie theatre that
does not allow for outside food. The food vendor in the theatre is a monopoly while you are
inside.

Entry Barriers

Entry barriers are economic or institutional obstacles to businesses entering an industry.

Markets such as oligopolies and monopolies require businesses to overcome these barriers
before they can compete. There are eight main entry barriers: increasing returns to scale,
market experience, restricted ownership of resources, legal obstacles, market abuses,
advertising, the network effect, and the lock-in effect.
Companies that have operated in a market for a long time and benefit from increasing returns to
scale (and therefore, decreasing average costs when output increases in the long run) can
charge lower prices for their products. Newly entering (small) competitors will be unable to
obtain that level of production and charge similarly low prices. Since new operations require
large initial investments (and non-refundable) and businesses want to recoup those
investments, the risk of entering an industry against an established company with production
and price advantages seem high.

In an extreme case referred to as a natural monopoly (the monopoly does not occur “naturally”),
increasing returns to scale means that it makes sense to have only one supplier of a product,
given the size of the market. Consider public utilities such as electricity, water, and natural gas.
Having more than one supplier of these utilities would require a city to have multiple lines
supplying these resources. If each utility provider had their own lines supply to only a portion of
the city, the average cost would be high, leading to higher prices of essential goods that some
households might not be able to afford. Therefore, it is more economical for a city to have only a
single provider of public utilities to keep prices down. However, some public utility industries are
evolving, like electricity. There is an expansion of new means of power generation (i.e., solar,
wind, hydro, etc.). This could mean the industry’s natural monopoly features are limited to power
transmission and not power generation.

A business that has existed in a market for a long time has gained valuable experience
operating in the market. They would develop cost advantages over potential rivals simply
because they have more experience. A business can use their experience to develop more
efficient methods to produce their product and lower their average costs. New firms have no
experience when they first enter a market.

When one or a few businesses control supplies of a resource to make a product, effectively bar
other businesses from entering the industry. If new business cannot get access to supplies to
produce the product, they cannot operate. One example of such control has been the South
African company De Beers, which until recently owned or controlled over 75 percent of the
world’s supply of diamonds.

Laws relating to patents, licenses, or copyrights are forms of entry barriers. A patent gives
exclusive rights to produce, use, or sell an invention for a given period (20 years in Canada).
This right allows an individual to benefit from their invention for an amount of time. If other
companies cannot produce this product, the individual has become a monopoly until the patent
time period is over. In some industries, companies must have government licenses to operate.
Canada Post has the legal right to provide regular mail service making them a monopoly. Only a
certain number of Canadian television and radio stations have broadcast rights within different
regions of the country, making these broadcasting industries oligopolies.

Some businesses that have operated in a market for a while might take advantage of their large
size and dominant position to use unfair practices to maintain their dominance. Suppose a
market monopoly is threatened with competition by a new entrant. The new firm try to steal
market share away from the monopolist. The monopolist can lower the price of its product well
below average costs and incur losses. At this low price, the new entrant cannot compete
because they need higher price to stay in business. Also, customers are happier with the low
prices and will not switch to the new entrant. With low prices and no customers, the new entrant
cannot survive for long and leaves. If the new entrant knows the monopolist will employ this
strategy, they might never enter in the first place. Predatory pricing is an unfair business practice
of temporarily lowering prices to drive out competitors in an industry. This is illegal in Canada.

The use of advertising as an entry barrier is most common in oligopolies, especially if consumer
preferences for these products are heavily dependent on advertising. Established companies
with large advertising budgets can often stop small competitors from gaining significant market
share. Consider the soft drink market. Coca Cola and Pepsi are the dominant companies and
have very large advertising budgets. With their products being similar, advertising “battles” occur
to maintain or gain market share. However, small soft drink companies (with smaller advertising
budgets) trying to compete with these giants will have a hard time getting their brand exposure.

The network effect refers to the fact that many information products become more valuable as
more people use them. For example, word processing software, new programming languages,
social networks, text messaging protocols (Google Chat, iMessage, Whatsapp, etc.). These are
products that become more valuable as more people adopt and use them. A reason why so
many people use iMessage and iPhone is probably due to the fact that a lot of their friends,
family, and colleagues use that messenger. This is an entry barrier because new products that
do not have large networks at launch might not be able to survive due to consumers
unwillingness to try something new. There is no reason for users of iMessage to switch to a new
messaging application if everyone else in there network does not change.

The lock-in effect refers to the reluctance to buy a new information product once time has been
spent learning a similar one. People will consider the time and energy spent with a product as a
cost and are unwilling to spend the same cost ono a new product. Consider the Kindle, an
e-reader from Amazon. If a person chooses to use the Kindle, they will create a library of books
that is only accessible through the Kindle. Other reading tools or applications will not have
access to those books. The time, energy, and money spent curating the library locks the person
into the Kindle. Consider music applications such as Spotify. A person will spend time (and
money) curating a music library and playlists only accessible through Spotify. They will not want
to switch to Apple Music to recreate everything that already exists on Spotify. New products
entering these spaces will have a hard time attracting customers.

Market Power

Market power is a business’ ability to affect the price of the product it sells. Businesses in a
perfectly competitive market are referred to as price takers. They are forced to sell the product
at the price that the market dictates (by demand and supply forces). This means they have no
market power. The other market types mentioned in this module have varying degrees of market
power. They all have some level of influence over the price of their products. A business’ market
power will depend on how easy it is for consumers to find substitutes for their products.

A monopoly has the most market power. There are no competitors for a monopoly and it
therefore has the largest market size (or the monopoly is the entire market). Since there is no
substitute for the monopolist’s product, the product’s demand curve tends to be less elastic.

An oligopoly market has a small number of competitors and the businesses operating are large
enough to still influence price. They do not have as much market power compared to a
monopoly.

Businesses in a monopolistic competition market have less market power compared to an

oligopolist (a competitor in an oligopoly market). This market type faces more competitors
relative to an oligopoly market, which means more substitutes. More competitors also means
the size of the firm is smaller. This will lower the market power of a firm compared to an
oligopolist. Since there are more competitors, the product’s demand curve is more elastic.

A business in a perfectly competitive market has no market power. They face many competitors,
the product is standardized, and firms can enter and exit the market freely. There are many
competitors, which makes the firm size small. Standardized products means every business
sells the same (or very similar) product. A small increase in price will cause large losses in
customers. Free entry and exit will cause prices to return to equilibrium prices (the price that all
competitors must sell at).

Business Demand Curve

If a business needs to make an operating decision, they compare revenues and costs. They
want to make the decision that gives the largest difference between the revenues and costs of
the operation. In other words, the operation that provides the largest amount of profits.
Regardless of the type of market, type or product, or any other factors, all businesses use the
same method in maximizing profits. However, depending on the market structure, business will
apply the methods differently.

For a business in a perfectly competitive market, they are price takers. They accept the price
given by the market that is determined by demand and supply forces. This means the individual
business demand curve is different compared to the market demand curve.
Figure 5.1 illustrates the market and business demand curves. The market demand curve for a
product is downward sloping due to the Law of Demand. The upward sloping supply curve and
the intersection with the market demand curve determines the equilibrium. A business in this
market is a perfect competitor and is one of many businesses in this market. The quantity that
the business chooses to supply has no effect on the price or quantity of the market. No matter
how many units of product the business chooses to produce, they will sell all of it at the
equilibrium price determined by the market. Consider the market for plain white t-shirts or blue
ball point pens. These are markets that approximate perfect competition.

Revenue Conditions

A business’ total revenue is calculated by multiplying the product’s price with the quantity of
output. Given the business’ horizontal demand curve, the price is the equilibrium price.

Suppose a business produces 500 units of blue pens and sells them at price of $2, the total
revenue is 500 X $2 = $1,000.

Average revenue is the business’ total revenue per unit of output.

Consider the previous example with blue pens; total revenue was $1,000 and the quantity of
output was 500. This means average revenue is $1,000/500 = $2. Notice that average revenue
is equal to price. Regardless of market structure in which a business operates, price will equal
average revenue. This can be seen when compared the formulas for total revenue and average
revenue. If the total revenue formula was divided by q, average revenue will be on the left hand
side of the formula and it is equal to price on the right hand side of the formula. Another way to
look at it, if all output is sold at the same price, the revenue generated from each unit is the
same, which is average revenue.

Marginal revenue is the extra total revenue earned from an additional unit of output. This is
calculated as the ratio of the change in total revenue and the change in quantity of output.

Consider the previous examples with blue pens. If production increases to 600 units of output,
the total revenue would be 600 X $2 = $1,200. The change in total revenue from 500 to 600
units of output is $200. The change in quantity of output from 500 to 600 is 100. The marginal
revenue is $200/100 = $2. This makes sense that it is equal to price again. Since all units must
be sold at $2, each additional unit sold will increase total revenue by $2.

Relationship Between Revenue Conditions and Demand

Consider the previous example with blue pens, average and marginal revenue are always equal
for a perfectly competitive business. This stems from the fact that average revenue is constant
at all quantities of output. An earlier module used class grades as an example to illustrate the
relationship between average and marginal values. Suppose the class average was 80 and all
future students that will join the course are expected to receive a grade of 80. The class
average will stay at 80 since every student added to the course are expected to get 80. Since
each student added is expected to get 80, the marginal grade added to the class is also 80.
Therefore, for a perfectly competitive business, price is equal to average revenue which is equal
to marginal revenue.

Price = Average Revenue = Marginal Revenue.

Profit Maximization
A business’ profits is the difference between revenues and costs.

Profit = Revenues - Costs

A business has a single profit maximizing role regardless of the type of market they are
operating in. The profit maximizing output rule is to produce at the level of output where
marginal revenue is equal to marginal cost. To illustrate the profit maximizing output rule, the
business produces the output quantity where the marginal revenue curve intersects the
marginal cost curve.

Marginal Revenue (MR) = Marginal Cost (MC)

Why is does this rule hold? First, consider the definitions of marginal revenue and marginal cost.
Marginal revenue is the additional revenue the business can receive from an additional unit of
output. Marginal cost is the additional cost incurred from an additional unit of output. Suppose
marginal revenue ($3) is greater than marginal cost ($2). If the business produces one more unit
of output, the unit will bring in more revenue than it costs to make ($3-$2=$1). Therefore, that
unit is profitable and the firm should make it (in other words, increase quantity of output). This
also means, the production level they are at is not maximizing profits since there is another level
that gives them more profits. Suppose marginal revenue ($3) is less than marginal cost ($4). If
the firm produces one more unit of output, that unit will cost more than the revenue it generates
($3-$4 = -$1). The extra unit decreases profits. The business should scale back production and
see if the production level they were at previously was also decreasing profits. If marginal
revenue being greater than or less than marginal cost is not maximizing profits, marginal
revenue equals to marginal cost should be profit maximizing. Consider a firm producing where
marginal revenue ($3) is equal to marginal cost ($3). The next unit of production brings in the
same amount of revenue as it costs to make ($3-$3=$0). The business does not need to
produce that output because it does not change profits. The business does not need to increase
production levels.

Graphically, marginal revenue is constant (horizontal line). Marginal cost is rising with production
(upward sloping line). Given these two curves, plotted on the same graph, they will intersect.
The intersection point provides the firm with its quantity of output. If the business increases
production from this point (move to the right), it will enter the level of production where marginal
revenue (curve) is less than marginal cost (curve) and the business should scale back
production. If the business scales back production from the intersection, marginal revenue
(curve) is greater than marginal cost (curve) and the business should increase production.

Consider the example from Figures 5.2 and 5.3. Figure 5.2 illustrates the demand curve for the
t-shirt business, while Table 5.1 illustrates the demand schedule.
Table 5.1. Revenues (schedule) for a perfect competitor.

The price of t-shirts is $6 for all quantities of output. Plotting the price of $6 at all quantity levels
gives us a demand curve. Since this is a perfectly competitive firm, the demand curve (which
represents the price) is equal to the average revenue curve which is also equal to the marginal
revenue curve, Db = AR = MR.

Figure 5.3 illustrates the cost curves for the t-shirt business, while Table 5.2 shows the
corresponding schedule.
Table 5.2. Profit maximization (schedule) for a perfect competitor.

The curves are similar to the curves discussed in a previous module. Incorporating the demand
curve illustrates where marginal revenue intersects/equals marginal cost (at point a). The
intersection points to how much output the business should produce (going down vertically from
point a to the horizontal axis, 270). The output quantity of 270 corresponds to point b on the
average cost curve. Point b represents the average cost per t-shirt if the firm produces 270
units. Since point a is the price per t-shirt and point b is the cost per t-shirt, the difference
between the two values (the vertical distance) is the profit per t-shirt ($6-$5.04=$0.96). The
horizontal distance from the vertical axis (quantity of zero) to point a or b is the quantity of
output, 270. The profit of the t-shirt business is the quantity of output (270) multiplied by the
profit per t-shirt (0.96) which is 270 X $0.96 = $259.20. Notice, when multiplying the quantity
(horizontal length) to the profit per t-shirt (vertical height), it is the formula for the area of a
rectangle. The area of the rectangle created by the distance between points a and b and the
horizontal distance of 270 units of output is the profit of the business. The profit maximization
rule provides the largest rectangle possible. Figure 5.3 provides the total revenue, total cost,
and profit at each level of production to show that maximum profit is reached at 270 t-shirts.

Figure 5.3 also illustrates another important point: whether or not the business is making an
economic profit. When the price ($6, MR=AR) exceeds average cost at the profit maximizing
level of output, the business is making short run economic profit. If price is less than average
cost, the business is making an economic loss (if the demand curve falls below AC, point a will
be below point b and the distance is loss per unit, the profit maximizing rule will create the
smallest rectangle possible). If the business is at the profit maximizing level of output and price
is equal to average cost, the business is making zero economic profit. In other words, they are
breaking even and this point is referred to as the breakeven point (Price = Average Cost at profit
maximizing output). Note, however, that at this point the business is still making a normal profit
so that the owners are paid enough to keep funds and entrepreneurial skills tied up in the
business. Since the breakeven point is associated with the profit maximizing level of output, this
can only occur at a certain point on the graph, where price is equal to the minimum average
cost (where MC intersects AC).

Given that a business can make an economic loss, the next logical question to answer is: when
should a business close? A business should remain operational as long as it earns enough
revenue to cover variable costs (i.e., wages). Any fixed costs would have to be paid regardless
of whether the business is operational or not (i.e., a business buys machinery to operate, if the
business shuts down, they are still required to pay for the machinery). As long as revenue can
cover variables costs, it is more “profitable” to remain in business than to shut down (the
business loses less while remaining operational compared to shutting down). If the revenue
cannot cover variable costs, they are unable to fund even its day-to-day operations and would
have no choice but to shut down (i.e., the revenue cannot even cover daily wages).

It was previously shown that total revenue is taking price multiplied by output, TR = P X q.
Average variable cost is dividing variable cost by output AVC = VC/q. This means variable costs
can be re-written as VC = AVC X q. According to the shut down scenario above, a business
should shut down (or close) when TR < VC. This means the shutdown point occurs when, TR =
VC. This can further to simplified to P = minimum AVC.
At the profit maximizing output where total revenue and variable costs (or average variable
costs and price) are equal, the business reaches its shutdown point, which occurs at the point of
minimum average variable cost.

Why does the shutdown point occur where price equals the minimum point in the average
variable cost curve? Because at this point, the profit maximizing output rule, MR=MC, is met at
the same time as total revenue equals variable costs.

Figure 5.4 illustrates different possible output levels depending on price for a perfectly
competitive business. Table 5.3 represents the corresponding schedule.

Table 5.3. Supply schedule for a perfect competitor.

Point a, where demand intersects the MC curve, the business has positive economic profits. At
point b, price is where MC=AC and this is the breakeven point. If price is between the levels of
point a and b, the business makes positive economic profits. If price falls to point c, price is
where MC=AVC, which is the shutdown point. If price is between the levels of point b and c, the
business is making negative economic profits but will continue to operate since price is still
greater than AVC. If price falls below point c (for example, point d), the price is below AVC and
the business cannot cover its variable costs. The business will shut down if price falls below
point c.

Figure 5.4 also provides information on the production levels of the business depending on
price. This is the concept of supply. The points along the marginal cost curve, above point c, tell
the business its profit maximizing level of output at each price level. This means, the business
will only operate in the portion of the MC curve that is above AVC (below point c the business
does not operate). For example, if price is $6, the t-shirt business will want to maximize profits at
$6 per shirt. The MC curve says it should produce 270 to maximize profits. On the business
supply curve, there should be a point at $6 and 270 quantity supplied. This is the same for all
points along the MC curve. This means, that the portion of the MC curve above AVC is the
business supply curve. The business supply curve is a curve that shows the quantity of output
supplied by a business at every possible price.

The market supply curve for a perfectly competitive industry is created using the supply curve
for all businesses in the market. Creating the market supply curve is covered in an earlier
module. In short, the market supply curve can be created by adding all the profit maximizing
quantity supplied of all the businesses at each price level. Since all the businesses are the
same in a perfectly competitive market, total quantity supplied can be found by taking a single
output quantity and multiplying it by the number of firms in the market.

Figure 5.5 illustrates the market supply curve for the t-shirt market if there were 100 businesses.
Table 5.4 represents the corresponding schedule.
Table 5.4. Supply schedules for a perfectly competitive business and market.

At a price level of $6, profit maximizing level of output is 270. If there are 100 businesses, at a
price of $6, there is total quantity supplied of 270 X 100 = 27,000. This is repeated for all price
levels.

Perfect Competition in the Long Run

One of the main differences between long and short run is free entry and exit of businesses into
the market. This will play a crucial role in the outcome of perfect competition in the long run.
Firms making profit or losses in the short run will drive the market into long run equilibrium.
Suppose, in the short run, businesses in a perfectly competitive market are making positive
economic profit. Firms considering this market will wish to join because they want to make profit
too. On the other hand, if businesses are making economic losses, firms in the market will wish
to leave. This entry and exit of firms will drive the market price (and quantity) to a long run
equilibrium. The long run equilibrium is a point where all businesses are breaking even, with
price equaling average cost and a normal profit is being made.
Figure 5.6 illustrates this scenario. Consider a constant cost industry as discussed in an earlier
module where input prices are fixed regardless of the quantity of output.

Figure 5.6 illustrates a t-shirt business and is currently in a long run equilibrium with a price level
of $5 (point a). The price of $5 is determined by the demand and supply (perfectly competitive
market) curves of the t-shirt market (point c). At a price of $5, the t-shirt business produces 250
units of output. Since price is equal to AC (and MC), the business is breaking even. Suppose
demand for t-shirts increases from D0 to D1 (i.e., the new trend is t-shirts, really hot weather,
etc.) and the conditions for a long run equilibrium are temporarily broken. The shift of demand
has increased the price from $5 to $6 (point d). At a price of $6, the t-shirt business is making
positive economic profits (point b). Companies that are considering the t-shirt market see that
businesses in this market are making positive profits and would also like to make positive
profits. Businesses entering the t-shirt market will increase the supply curve (i.e., increasing the
number of producers). This shifts the supply curve to the right. Businesses will continue to enter
(and continue shifting the supply curve) until economic profits for businesses return to zero or
price returns to $5 (S0 to S1). With long run equilibrium restored as point e, businesses return to
an economic profit of zero.

Benefits of Perfect Competition

Perfectly competitive markets benefit the buyers or consumers. By the “invisible hand” of
competition, consumers ultimately benefit when competitive producers act in their own self
interests. This is because a perfectly competitive market in the long run equilibrium meets two
requirements: minimum cost pricing and marginal cost pricing.

Minimum cost pricing is the practice of setting price where it equals minimum average cost.
Suppose a firm is charging a price above minimum average cost, the production level
associated with the higher price also has a higher average cost. By reducing production, a
business can lower average costs to further maximize profits. By charging the long run
equilibrium price, a business chooses the least costly combination of inputs. The business is
making zero economic profit, so that all these cost savings are passed on to the buyers. Buyers
can the product at the cheapest price possible, increasing their purchasing power.

Marginal cost pricing is the practice of setting the price that consumers are willing to pay equal
to marginal cost. The fact that businesses charge a price equal to marginal cost follows from the
equality of marginal revenue and price for a perfectly competitive business (P=MR). The profit
maximizing output rule states that profit is maximized when they are producing at an output
level where marginal revenue is equal to marginal cost (MR=MC). For a perfectly competitive
business, combining the two conditions gives P=MR=MC or P=MC. Suppose the current price of
t-shirts is $6 and the marginal cost of production is $3. More resources should be directed
towards t-shirt production. At a marginal cost of $3, there are consumers that are willing to pay
less than $6 for the t-shirt but cannot get one. For example, someone can be willing to pay $5
for a t-shirt (but cannot get one) and it only costs $3 to make, that is profit. Production can
increase (which increases marginal cost) until marginal costs equal $6. If marginal cost is $9,
the opposite should occur and resources should be directed away from t-shirt production until
MR=MC. Only if marginal cost and equilibrium price are the same will resources be distributed
to this industry in a way that maximizes the value to consumers.

Summary

This module discussed different market structures and focused on perfectly competitive markets
as a benchmark for comparison for the other types. The main differences between the market
types are how many businesses there are, the standardization of the product, and the degree of
freedom of entry and exit into the market. The module also discussed the profit maximizing
output rule that all firms, regardless of market type, use to maximize economic profits. Perfectly
competitive markets are price takers, they take the price as determined by demand and supply
forces, they only have to determine the quantity of output to produce to maximize profits. In the
short run, it is possible to make positive (or negative) economic profits but in the long run,
economic profits are driven to zero by the free entry and exit of firms into the market. In later
modules, when delving deeper into the other market types, comparisons will be made back to
the perfectly competitive market. The modules will look at how the differences will impact
business profit maximization.
Module 6

Introduction

Perfect competition is a market structure that is not commonly observed in reality; however it is
a good baseline for comparison for the more observed market structures: monopoly,
monopolistic competition, and oligopolies. In the Canadian economy, there are several
monopoly markets such as utilities (i.e., Enbridge, Alectra, etc.) and public transit (i.e., TTC, GO
Transit, Via Rail, etc.). Monopolistic competition exists within the taxi/Uber/Lyft industry and
coffee chains. The “Big Three” telecommunications companies (Rogers, Bell, and Telus) are an
example of an oligopoly. Pricing decisions in all these markets use similar tools as discussed in
Module 5. This module will analyze how market forces faced by business in each market type
differ compare to perfect competition and how it impacts their business decisions. Furthermore,
the module will discuss how the idea of the “invisible hand” of competition does not necessarily
apply in all real-world markets.

Topics and Learning Objectives

Topics
This module covers the following topics:

Monopoly
Monopolistic competition
Oligopoly
Learning Objectives
By the end of this module, you should be able to:

Describe the market conditions faced by monopolists, monopolistic competitors, and oligopolists
Explain how the firms maximize profit under different market structures

Monopoly

Perfectly competitive markets can be found in reality under specific conditions (i.e., market for
white t-shirts or blue ball point pens, etc.) but it is not the most common market structure. Most
markets in reality have characteristics taken from the four main market types: perfect
competitions, monopoly, monopolistic competition, and oligopoly.
Consider the demand curve a business faces under perfect competition. Since it is a price taker,
the demand curve the business faces is a horizontal line at the equilibrium price. A monopolist is
the only supplier in the market. They are essential to the market itself. Therefore, the monopolist
faces the same demand curve as the market demand curve, a downward sloping demand
curve. This means a monopolist has significant market power to influence the price of its
product.

Monopolistic Competition

Monopolistic competition is a market structure characterized by many buyers and sellers of

slightly different products and easy entry to and exit from the industry. This is a market structure
most common in the restaurant industry. All restaurants can use the same ingredients in a dish,
but they can all be cooked differently to create a slightly different end product. The slight
difference provides a business with some market power (not as much as a monopoly) to
influence its price (i.e., every restaurant can have a beef dish but it is cooked differently and
priced differently). The difference in market power of a business gives it a different demand
curve.

Consider several ice cream stands, and they all sell only one flavour of ice cream (i.e., one stall
sells vanilla, another chocolate, another strawberry, etc.). Suppose the vanilla ice cream stand
raises prices from $1 to $2. The ice cream stand will lose some customers due to the increase
in price, but not all of them. If the stand lowers the price from $1 to $0.50, it will attract some
customers but not all of them. Since customers see each ice cream stand as substitutes for
each other, a given percentage change in the price of an ice cream causes an even greater
percentage change in quantity demanded. In other words, the ice cream stand’s (monopolistic
competitor) demand curve is elastic. As a general rule, the demand curve for a monopolistic
competitor is more elastic than the demand curve for a monopolist.

Oligopoly

An oligopoly is a market structure characterized by only a few businesses offering standard or

similar products and restricted entry to the industry. Oligopolies are common in many economies
around the world. Within Canada, steel, automobile, insurance, and telecommunications are
some examples. These are industries that have barriers in place that make it hard for new
companies to enter and compete. The fact that each business makes up a considerable part of
the market leads to mutual interdependence. This is a situation where the actions of an
oligopolist will depend on the actions of their competitors, and vice versa. Mutual
interdependence is the relationship among oligopolists in which the actions of each business
affect the other businesses. Due to this relationship, oligopolists can operate as rivals to each
other, or operate as partners.

Oligopolists that are rivals to one another are concerned with market share, the proportion of the
total market sales they control. Since the actions of one business impacts another, each
oligopolist must take into account the reactions of competitors if they change actions (i.e.,
change output levels, change price levels, etc.). The business must then predict how those
reactions will impact their market share. Consider the Canadian telecommunications market of
Rogers, Bell, and Telus. If Rogers lowers prices on their cellphone plans, they will attract
customers from the other two, increasing Rogers’ market share. If the other two do not wish to
lose market share, they will need to lower prices as well. If Rogers increases price on their
cellphone plans, they will lose market share to the other two. The other two companies can
maintain their price levels. Since Rogers is now considered as “high priced”, their market share
will fall and the customers will move to their substitutes, Bell or Telus, without the competitors
needing to do anything.
Consider an oligopoly with a demand curve as illustrated in Figure 6.1. Suppose they are
currently priced at price level A and the quantity demanded is QA. A price increase up to PB will
cause the business to lose some customers. However, its competitors will not change their
prices. The demand curve in the portion where price increased will be relatively flat. If the
business lowers prices from PA to PC, its competitors will also lower prices to maintain their
market shares. A drop in price will attract more customers, but since its competitors are also
decreasing prices, the percentage change in customers will not be as great compared to the
percentage change from increasing its price. Thus, the portion of the demand curve for a price
drop will be relatively steeper compared to increasing its price. The result is a kink in the
demand curve. A kinked demand curve is typical of oligopolies in which businesses compete
with one another for profit and market dominance.

Instead of competing against each other, oligopolists can cooperate with each other to increase
profits. These actions typically are not in the best interest of the consumers. There are several
ways oligopolists can cooperate with each other. Price leadership is an understanding among
oligopolists that one business will initiate all price changes in the market and the other will follow
by adjusting their prices and output accordingly. They could take this further and cooperate
together as if they were a monopoly. This is the practice of collusion, oligopolists acting together
as if they were a monopolist to maximize profits. For collusion to work, the businesses must
estimate the most profitable level of output and then agree to maintain this level of market
output and its associated price. If this arrangement is a formal agreement, the oligopolists have
formed a cartel, a union of oligopolists who have a formal market-sharing agreement. The best
known example of a cartel is the Organization of Petroleum Exporting Countries (OPEC).

Revenue Conditions

Unlike a perfectly competitive business, a monopolist is a price maker. Since the monopolist is
the sole supplier in the market, they have market power to set the price as they wish and
establish the amount of output for the market. Therefore, the monopolist will select a price and
an output level to maximize profits. They will use the same profit maximizing rule as discussed
in the previous module with some slight differences.

Consider Figure 6.2. It illustrates the revenue curve for a computer business. Table 6. 1
illustrates the revenue schedule.
Table 6.1. Revenues (schedule) for a monopolist.

Source: Lovewell, 2020.

The first two columns of the table are the demand schedule and the revenue information (TR,
MR, and AR) can be calculated (from a previous module). First, price and average revenues are
the same for a monopolist, P=AR. This means that the demand curve is the average revenue
curve. Compared to perfect competition where P=MR=AR, the marginal revenue for a
monopolist is no longer the same as price (or average revenue). Recall from a previous module,
if the average value gets smaller, the marginal value is smaller than the average value. Since
we have a decreasing average revenue as quantity demanded increases, marginal revenue will
also decline and the value is smaller, thus the marginal revenue curve is below the average
revenue curve.

Consider the price of $160 (millions per computer) for a computer. The business sells 1
computer. Its total revenue is $160 million and average revenue is $160 million/1=$160 million.

To sell two computers, the business must lower its price to $120 million. The business must sell
both computers at $120 million. It cannot sell one computer at $160 million and the other at
$120 million (more on this in future modules). At two computers, the total revenue is $120
million X 2 = $240 million, marginal revenue from one to two computers is $240 million-$160
million=$80 million, and average revenue is $240 million/2=$120 million. The graph illustrates
the two demand points and the marginal revenue point plotted in between the quantity values of
one and two (as discussed from a previous module). The other demand and marginal revenue
points are plotted using the same methodology.

The marginal revenue curve only intersects at the vertical axis where quantity demanded is zero
and the marginal revenue curve continues into the negative portion of the graph. As quantity
increases (and price falls), as seen from a previous module, total revenue increases and
eventually begins to decrease. At the maximum revenue point, the marginal revenue turns from
positive to negative (as seen from quantity value 2 to 3 in Figure 6.2. The maximum total
revenue point is where the marginal revenue curve crosses the horizontal axis. In the negative
position of the marginal revenue curve, as quantity increases, revenue is decreasing.

Profit Maximization

A monopolist has the ability to choose the price of its product (price maker). To maximize profits,
a monopolist will first determine the quantity of output and then, using the quantity of output,
determine the highest possible price it can charge. Figure 6.3 illustrates this process. Table 6. 2
illustrates the revenue schedule.
Table 6.2. Profit maximization (schedule) for a monopolist.

The figure illustrates the monopolist’s demand curve (D), marginal revenue curve (MR),
marginal cost curve (MC), and average cost curve (AC). All these curves are required to
determine the monopolist’s output, price, and profit levels.
Using the profit maximization rule, the monopolist will maximize profits when MR=MC. This point
occurs as point a. Point a tells the monopolist the profit maximizing output level. The output
level is found by going vertical down from point a to the horizontal axis (2). The monopolist now
needs to determine how much to sell its output for. To find the maximum price the monopolist
can charge for 2 computers, they go to the demand curve. Going vertically from point a until
they hit the demand curve gives point b. Going horizontally from point b to the vertical axis gives
the monopolist the maximum price (120) they can sell the profit maximizing level of output (2).
Points a and b tell the monopolist that, to maximize profits, they should produce two computers
and sell for $120 million each.

Similar to a perfectly competitive business, a monopolist can be making a positive or negative

economic profit or break even. The amount of profit will depend on the location of the average
cost curve. Finding profit will use the same methodology as for a perfectly competitive business.
The profit “rectangle” is created by multiplying the profit per unit and quantity demanded at the
profit maximizing level. The quantity demanded is the output level of the monopolist when it is
profit maximizing (2). The profit per unit is the vertical height at the profit maximizing quantity
level between price and average cost. To find average cost at the profit maximizing output level,
go vertically from the horizontal axis until the average cost curve, point c. The profit per unit is
the difference between price, point b, and average cost, point c (120-90=30). Therefore the
profit rectangle is $30 million X 2 = $60 million.

A monopolist does not satisfy the two conditions for consumer benefit like perfectly competitive
businesses: minimum cost pricing and marginal cost pricing. At the profit maximizing output
level, the price is not equal to the marginal cost or the minimum average cost. Due to a
monopolist having no competitors (due to high entry barriers), it can keep its price constant in
the long run at the profit maximizing level.

Monopoly vs. Perfect Competition

To see the impact of price and quantity in a monopoly market, they can be compared to the
price and quantity in a perfectly competitive market. Consider a perfectly competitive market in a
long run equilibrium transforming into a monopoly market.
Figure 6.4 illustrates the market supply and demand for a business. Equilibrium for a perfectly
competitive market occurs at point A, the intersection of demand and supply. Suppose the
businesses in the perfectly competitive market combine together to form one large businesses.
The market demand curve remains the same even though the market structure has changed
into a monopoly. Since the monopoly is the entire market, it still faces the same demand as the
perfectly competitive market. However, a monopoly no longer has P=AR=MR and has a
separate marginal revenue curve. In terms of supply, there is also no change. Recall that a
market supply curve is the summation of all the quantity supplied from all businesses at each
price level. Given that all the perfectly competitive business just combined into a single
business, the total quantity supplied does not change. Therefore, the supply curve does not
change.

A monopolist profit maximizes using the profit maximizing rule and produces the quantity where
MR=MC, which occurs at point B. Moving vertically onto the demand curve from point B will give
the profit maximizing price for the monopolist, point C. The result of comparing price and
quantity in a perfectly competitive market to a monopoly is that goods are more expensive, and
quantity is lower in a monopoly market.
Regulation of Natural Monopolies

In an extreme case referred to as a natural monopoly (the monopoly does not occur “naturally”),
increasing returns to scale means that it makes sense to have only one supplier of a product,
given the size of the market. Consider public utilities such as electricity, water, and natural gas.
To ensure that these savings are passed onto the consumers, governments tend to intervene
with natural monopolies. The government can either provide the service through a government
owned corporation (i.e., Canada Post) or regulate the monopoly in the market (i.e., set a price
cap on utilities, regulation of telecommunications business, etc.).

Regulators of monopolies must estimate a business’ costs and try to choose an “appropriate”
price to charge its customers. Usually, regulators use average cost pricing so that the
monopolist can break even without public funds. Average cost pricing the is the practice of
setting price where it equals average cost. To simplify the process, regulators do not estimate
demand and supply curves or cost curves but instead they control profits directly. A business’
accounting profit rate (or rate of return) is its accounting profit divided by the owner’s equity,
expressed as a percentage. A regulator can impose a ceiling, for example 8%, on the profit rate
the business can earn. The fair rate of return is arrived at by estimating how much the business
needs to cover both explicit costs (such as wages, materials, etc.) and implicit costs (in
particular, the business’ normal profits).

Setting a fair rate can lead to inefficiencies. With profit controls, there is little incentive for the
business to control costs. If the business wants to raise prices, the business can inflate costs.
Inefficient ways to raise costs is to increase payroll and spend towards irrelevant expenses such
as nicer offices. These are all paid for by consumers in the form of higher prices for the same
goods and services. Regulators try to overcome this problem by implementing performance
standards where higher costs should be due improvements in production technologies, for
example.

Alternatively, governments can create publicly owned corporations to perform a monopolist’s

task with the understanding that the corporations will charge a fair rate of return. This is
commonly used in Canada. At the federal level, there are Crown corporations such as Canada
Post and Via Rail. Publicly owned corporations also exist at the provincial and municipal levels
in the form of public transit companies such as TTC and GO Transit.

Monopolistic Competition
Monopolistic competition and oligopoly markets have characteristics that put them somewhere
in between monopoly and perfect competition. Similar to monopolists, they are both price
makers, which means they must decide on the quantity of output and the price in which they will
sell their output to maximize profits. The main difference is how they operate, how they go about
picking quantity and price to maximize profits.

Monopolistic competition markets have a mix of some characteristics from monopoly and perfect
competition that highlight the differences between the short run and long run. Figure 6.5
illustrates the revenue curves for a monopolistic competitor (a restaurant). Table 6.3 illustrates
the corresponding schedule.

Table 6.3. Revenues (schedule) for a monopolistic competitor.

Similar to a monopoly, the average revenue curve and the marginal revenue curve are
downward sloping and are not the same (price makers) with MR below AR. Similar to the other
revenue graphs, the MR and AR only intersect at the vertical axis.

Figure 6.9 in the textbook illustrates the profit maximization of a monopolistic competitor in the
short and long run.

In the short run, the monopolistic competitor maximizes profits in the same manner as all other
businesses. First the business finds the optimal level of output by using the profit maximization
rule, MR=MC. Using the profit maximizing level of output, the demand curve is used to find the
profit maximizing price. The maximum profit can be found be creating the profit “rectangle”
where the height is the distance between the price and average cost at the profit maximizing
level of output. The length is the profit maximizing level of output. This is illustrated on the left
graph in Figure 6.6. Again, the business can be making a positive or negative economic profit or
break even depending on the location of the average cost curve. In the case of Figure 6.6, the
business is making a positive economic profit.

In the long run, a characteristic of monopolistic competition plays an important role in

determining profit: the free entry and exit of competitors. If short run economic profits are
positive, businesses enter the market in the long run. The graph on the right in Figure 6.6 shows
how more competition shifts the demand curve from D0 to D1 (to the left) for established or
existing businesses in the market. As more competitors enter a monopolistic competition
market, consumers have more choice, and each business will have less customers at each
possible price level.

Consider the restaurant market where all restaurants are competitors to each other but serve a
different menu. As more restaurants enter the market, customers have more choice, and some
customers will move from the established restaurants to the new competitors. With less
customers, the demand curve for existing and established restaurants shift to the left (similar to
a decrease in population). The new demand curve (D1) is also more elastic compared to the old
demand curve (D0) because there are more close substitutes with the entry of new competitors.

With a new demand curve, there is a new marginal revenue curve and a new profit maximizing
level of output and price. Similar to perfect competition, firms will continue to enter until
economic profits are zero for all businesses or everyone breaks even. This occurs when P=AC.
Notice that the condition is not P=min AC. This is because the demand curve is not horizontal
which means it can never have MR=MC and P=min AC occur simultaneously. The only point
where price can equal average cost is where the demand curve is tangent to the average cost
curve, point e. This is illustrated in the right graph in Figure 6.6.

A monopolistic competitor does not meet minimum cost pricing or marginal cost pricing
conditions in the long run equilibrium. As stated previously, since the demand curve is not
horizontal, the demand curve cannot tangent the AC curve at the minimum point and also
satisfy the profit maximizing rule of MR=MC. It is also shown in the graph that price is greater
than marginal cost at point e. This means the output quantity is lower compared to a perfectly
competitive market. Typically, in reality, for monopolistic competition markets, the long run price
does not differ from marginal cost or minimum average cost by much.

Oligopoly

Earlier in this module, it was explained that oligopolies have a kinked demand curve, a demand
curve with a “corner” in the middle.

Figure 6.7 shows the marginal revenue for a kinked demand curve for an automobile business.
Table 6.4 illustrates the corresponding schedule.
Table 6.4. Profit maximization (schedule) for an oligopolist.
Given the demand curve has two distinct segments, so will the marginal revenue curve.
However, there is a discontinuity or a “break” in the marginal revenue curve at the point of the
kink. The marginal revenue curve continues on at a different point at the kinked point of the
demand curve. The values of the curves are shown in the profit maximization Table 6.4.

Just like all other businesses, oligopolists maximize profits using the profit maximization rule,
MR=MC. On the graph, the oligopolist should produce the amount of output where MR=MC.
Looking at Figure 6.7, the MC curve intersects the MR curve at the “break” in the MR curve,
point a. This means the oligopolist should produce at the quantity that corresponds to point a.
Finding price uses the same methodology of moving vertically from the profit maximizing level of
output util the demand curve, point b. To calculate profit and find the profit “rectangle”, the height
of the rectangle is the difference between price and average cost at the profit maximizing output
level (point c) and the length is the profit maximizing output level. Multiplying the two values
(finding the area of the rectangle) gives the maximum profit level.

The kinked demand curve applies to both the short and the long run because there is no free
entry and exit into this market. Looking at the marginal revenue curve also provides an
explanation for why competitors do not change price even if costs change. If marginal costs
change (move up or down), there is a portion of the curve (the “break”) that for a range of costs,
the profit maximizing level of output will always be the same. Since output levels do not change,
the price will not change. If costs change significantly to the point where marginal cost intersects
the top segment (the downward sloping section), then price will change accordingly (marginal
cost will never intersect the negative portion of marginal revenue because marginal costs
cannot be negative).

Oligopolist also do not meet the conditions of minimum cost pricing or marginal cost pricing in
short or long run. In fact, there is a possibility for very large discrepancies between price and
minimum AC and MC. Due to limited competition created by entry barriers, an oligopolist that
faces competitors can remain indefinitely at one price. At this price, the business is making
positive economic profits and fails to reach an output level where average cost is the lowest. If
oligopolists decide to collude, the prices the “monopolist” can charge will be even higher.

Game Theory

The economic model with the kinked demand curve is useful in showing why oligopolists are
reluctant to change price. However, it cannot explain how the initial price and output levels
(point b in Figure 6.7) are established. There are other economic models that can answer these
questions and they fall into a field called game theory; an analysis of how mutually
interdependent actors try to achieve their goals through the use of strategy. Consider the game
of chess. Every action a player makes takes into consideration how the opponent will retaliate
while the opponent is doing the same thing.
Prisoner’s dilemma is a tool in game theory and a good introduction into game theory. It is a
classic example of how players’ self-interested actions can be self-defeating. Consider 2
criminals that committed a crime and were caught by the police. They are both put into separate
interrogation rooms. The police provide each criminal a choice: confess to the crime and
implicate their partner or stay silent.

Figure 6.8 illustrates a version of the prisoner’s dilemma game. The matrix outlines the possible
strategies available to each criminal along with the prison time each criminal will face under the
different conditions. For example, consider the cell on the top right with the values (0,5). In this
cell, the scenario is that Criminal 1 confessed and implicated Criminal 2 while Criminal 2 stayed
silent. The first number in the cell (and all other cells) is the prison time Criminal 1 receives in
this scenario. Since they confessed and implicated their partner while their partner stayed silent,
they were released (zero prison time). Criminal 2 got implicated and stayed silent so they got
the largest sentence of 5 years. The second number is the prison time of Criminal 2 under each
scenario. If only a single criminal confesses, the one that confesses is released and the other
gets 5 years. If both confess, they each receive 3 years. If they both stay silent, they each
receive 1 year.

Each criminal’s action will depend on what the other criminal does. Suppose Criminal 2 chooses
to confess. Criminal 1 can get 3 years if they also confess and 5 years if they stay silent.
Criminal 1 is better off confessing if Criminal 2 confesses. If Criminal 2 chooses silent, Criminal
1 gets zero years if they confess or 1 year if they stay silent. Confessing is the better choice if
Criminal 2 stays silent. Therefore, regardless of what Criminal 2 does (confess or silent),
Criminal 1 is better off always confessing. Since the punishments are symmetric, the same
conclusion is reached for Criminal 2. The outcome of this scenario is both criminals confess and
they both receive 3 years in prison.

The reason that this is called a dilemma is because each criminals self-interest lead to a worst
outcome. Under all potential choices of their partner, a criminal is better off confessing.
Choosing confess is in their self interest because they get lesser years. This lead to the
outcome of 3 years in prisoner for each criminal. However, looking at the matrix, the bottom right
cell has both criminals only serving 1 year in prisoner only if they both stayed silent. By following
a self-interested strategy that minimizes their own prison term, the strategy ends up being
self-defeating since they could be better off staying silent.

Why is the outcome not both criminals staying silent? This is not the outcome because both
criminals are rational and perform actions that are only beneficial to them. Suppose both
criminals stayed silent. Criminal 1 can change their action to confess and get 0 years rather
than 1 if their partner stays silent. There is incentive for Criminal 1 to change their action from
silent to confess if both criminals stay silent. The same applies for Criminal 2. If there is
incentive for both criminals to change their action to Confess, they both end up confessing and
get 3 years in prison.

The prisoner’s dilemma tool can be applied to an oligopoly situation. Suppose an oligopoly has
two competitors (Firm 1 and 2) and they have a “handshake” agreement to both set the same
high price in the market for their products. Each firm has 2 possible strategies: honour the
agreement, stay at the high price, and share the market or break the agreement, charge a low
price, and steal more market share (if the other stays at high price, otherwise, both share the
market at low price). Figure 6.9 illustrates this scenario. All values are in millions of dollars.
If both firms honour the agreement and charge the high price, they each make a profit of $50
million. If a firm breaks the agreement and deviates to a low price while the other stays at a high
price, the low price firm obtains more market share and makes $70 million and the high price
firm makes $10 million. If both firms charge a low price, they each make $20 million.

Similar to the classic prisoner’s dilemma game, each firm has an incentive to deviate away from
high price and charge a low price. Each firm will follow a self-interested strategy and sacrifice
the mutually beneficial outcome of high prices. This game illustrates a potential scenario that
can occur in reality. First, there are incentives for firms to engage in illegal forms of collusion
such as price fixing. Second, these relationships might not be long lasting as there is always an
incentive of more profits for a firm to deviate away from collusion.

Anti-Combines Legislation in Canada

Due to the inefficiencies that oligopolies can cause, their activities are subject to laws aimed at
preventing industrial concentration and abuses of market power, which are known as
anti-combines legislation. The Competition Act of 1986 was a major reform of Canada’s
anti-combines legislation. It offered a combination of criminal and civil provisions, strengthened
penalties, and built on the almost century long experience of applying anti-combine legislation.
The Act covers business practices that prevent or lessen competition, including the practices of
conspiracy, bid-rigging, predatory pricing, abuse of dominant position, and mergers.
Businesses that conspire or agree to fix prices, allocate markets, or restrict entry to markets can
be charged under the Competition Act. For a business to be found guilty, its actions must be
proven to significantly restrain competition. Violators can face fines up to $10 million or prison
terms of up to five years.

Bid-rigging is when companies bid on contracts and illegally arrange among themselves which
will win each contract and at what price. By taking turns at winning bids and by inflating prices,
all conspirators are winners.

Predatory pricing is when a competitor drops the price of its products below its average cost to
drive a new competitor out of the business. This is a criminal offence. An established business
can see a new competitor emerging into the market. Since the business is established, it can
potentially take a loss by charging low prices for its products. The new competitor cannot afford
to such low prices, does not gain any market share, and eventually has to leave due to no
customers. Once the competition leaves, the established firm can increases prices back to profit
maximizing levels.

Abuse of dominant position is when companies that control most of the sales in a market are not
allowed to use their dominant position to engage in anti-competitive behaviour.

A merger is the combining of two companies into one. The Competition Tribunal has the power
to prohibit a merger in Canada if the merger could prevent or substantially reduce competition.
Exceptions could be made if a merger will increase efficiency and pass on savings to
consumers. Mergers can be of three forms: horizontal, vertical, or conglomerate. A horizontal
merger is a combination of former rivals. An example of horizontal merger is the purchase of
Canada Trust by its rival TD Bank to form TD Canada Trust. Vertical mergers are a combination
of a business and its supplier. For example, consider a steel production business purchasing an
iron ore mining company. Canadian media distribution companies BCE and Rogers
Communications purchased majority ownership in Maple Leafs Sports and Entertainment
(MLSE) so that MLSE sports teams can provide these companies with an assured supply of
media content. Conglomerate merger is a combination of businesses in unrelated industries.

Non-price Competition

Besides price, imperfect competitors can compete in other ways. Non-price competition refers to
the efforts of imperfect competitors to increase demand for their products by swaying consumer
preferences. The two main strategies used are product differentiation and advertising.

Product differentiation is a company’s attempt to distinguish its product from competitors’

products. Different specifications in smartphones and different flavours of potato chips are
examples of product differentiation. Product differentiation can come in many forms such as
aesthetics, performance, or quality to name a few. Regardless of the method, product
differentiation has two main goals: increase demand (increasing quantity demanded as all price
levels) and decrease demand elasticity (prices can be increased without losing many customers
to competitors). Both goals increase profits and market power.

Advertising plays two roles: provide customers with information and promote consumer
preferences for a product. Advertising has the same two goals as product differentiation.

Non-price competition is a double edge sword for businesses. Product differentiation and
advertising will increase the revenues of the business, however both are not free. A business
can invest money into a Super Bowl commercial in the hopes of increasing sales. If the revenue
that the commercial generates is greater than the cost of the commercial, then profits will
increase. If the commercial was ineffective (i.e., wrong messaging, wrong platform/venue, etc.)
and does not generate the revenue to cover costs, then the strategy was a failure. Whether or
not profits are made depends on how easy it is to influence consumer preferences.

For consumers, product differentiation leads to higher prices. For a business to differentiate their
products, they might need to go through research, development, testing, and other steps to
ensure they have a good product. This all costs money and to recoup the costs, the business
might need to increase prices. The benefit is that consumers will have more variety and choices
if more businesses differentiate their products.

Advertising also has its benefits and costs to the consumer. Advertising is sometimes seen as
anti-competitive because larger firms have larger advertising budgets. A larger budget means
the message is seen more often compared to smaller companies with smaller budgets.
Sometimes the smaller companies’ messages are drowned out by the large companies.
However, advertising allows smaller companies to get their message out there for the public to
see. Advertising provides information to the public and gives consumers more choice.

Industrial Concentration

A perfectly competitive market or monopoly is easy to recognize in reality. The other forms are
hard to identify. Most markets fall on a spectrum between perfectly competitive and monopoly. A
common indicator of the type of market is a concentration ratio. It is the percentage of total
sales revenue earned by the largest business in the market.

Concentration ratios are commonly measured for the four largest business firms in any market.
A market can be considered as monopolistically competitive if its ratio falls below 50%. If it is
above 50%, the industry is considered an oligopoly. Suppose the top four firms in an industry
have the following total sales revenues: 45 million, 32, million, 97 million, and 51 million. Total
sales revenue for the market is 300 million. The concentration ratio is:
The effect of market power on the economy can be studied using the idea of industrial
concentration, which refers to the domination of a market by one of a few large companies. Due
to their small number and large sizes, these companies have significant market power. Are their
benefits to consumers from industrial concentration? In many industries, only large businesses
with significant market share can produce the quantities necessary to take advantage of
increasing returns to scale. As a result, these businesses have lower per-unit costs compared to
other competitive firms in the industry. These savings can potentially be passed on to
consumers. However, the market power these firms have also allow them to charge higher
prices. Another benefit of big firms to the economy is innovation. Some argue that big
businesses are required to drive innovation and technological advances which can benefit
consumers and society. Big businesses have the capital and resources to achieve this.
However, some argue that big businesses do not innovate because their business is built on
current technology and they do not want to change the thing that is driving their profits.

Summary

This module looked at how the profit maximizing procedure differs when a business is a
monopoly, monopolistic competitor, or oligopolist compared to a perfect competitor. When a
business that is not in a perfectly competitive market profit maximizes, they create inefficiencies
in the market by breaking the minimum cost and marginal cost rules. The rise of these
inefficiencies forces governments to step in to regulate and create anti-combines legislation.
However, some regulation and legislation are up for debate as to their effectiveness in
preventing illegal or inefficient behaviour. Canada has several industries that fall into the
monopoly and imperfect competition categories. Utilities and public transportation are common
monopolies in Canada. Monopolistic competition and oligopolies are even more common in the
Canadian economy with farming, natural resources, telecommunications, and media
broadcasting being major industries.