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ECO 165 Notes

by: Jake Fuemmeler

ECO 165 Notes 40979 ECO 165 - 005

Jake Fuemmeler
GPA 3.8

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These notes cover the entire class as taught by Terrell Galloway. Based on "Microeconomics" 9th edition by Colander
Principles of Microeconomics
Dr. Terrell Galloway
Economics, Microeconomics
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This 1 page Bundle was uploaded by Jake Fuemmeler on Friday March 18, 2016. The Bundle belongs to 40979 ECO 165 - 005 at Missouri State University taught by Dr. Terrell Galloway in Spring 2016. Since its upload, it has received 19 views. For similar materials see Principles of Microeconomics in Economcs at Missouri State University.


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Date Created: 03/18/16
Unit 1 I. What is economics? How to allocate resources for “desires & wants" Wants are unlimited; resources are limited Scarcity provides a model of economy The science of social provision II. Scarcity When there is scarcity, we must make choices Leading to opportunity cost The value of the next best alternative; runner-up III. Benefit-Cost Marginal Analysis We want benefits to out-weigh our costs Marginal Benefits (MB) & Marginal Cost (MC) Marginal=Additional For each unit of something (i.e. dozen of donuts: marginal looks at each extra donut) "What is the benefit and cost of doing one more product?" "Should we do it again?" If cost out-weighs benefits stop process or do less Stop process, or do less Where benefit=cost is the optimal quantity Economic cost always includes opportunity cost Explicit/Accounting costs Things you get a bill for I.e. tuition ($2500), books ($600), etc. Implicit costs Things you don’t get a bill for i.e. missing full-time job ($10,000) Sunk cost Sunk cost is an item or service already paid for Irrelevant in rational decision making Marginal analysis is always forward looking How do we judge on abstractions? We judge if they are helpful, not on their realism IV. Positive vs Normative Statements Positive Statements are “it is what it is" Describes the way things are Does not have to be present tense Normative Statements are “this is what should happen" Describes the way things should be Can be disguised as positive “it is too hot” can mean “it should be colder" V. Macro vs Micro Economics Macro Big picture Aggregate variables i.e. GDP the entire economy i.e. unemployment rates Desires growth of the economy, keep unemployment low, stable pricing Micro Small picture Outweighing the benefit and cost of choices Desires efficiency, equity, and liberty Both want society to be happy VI. Fallacies Fallacy - a way of thinking that cannot be correct Post-hoc Fallacy The incorrect belief that because two variables occurred together, one must have caused the other Difference between science and superstition Thinking a rain dance will cause rain A hypothesis is a prediction. Superstition is judging on the past. Composition Fallacy The incorrect belief that what works for the individual must work for the group If everyone believes leaving the event early to beat traffic will cancel it out VII. Parts of the Economy Goods (and Services) Things one can purchase, things that make one happy Resources Land, Labor, Capital Land: Natural Resources Labor: Those working mentally or physically Capital: Produced goods used in production Financial capital is NOT capital Financial capital is only money/revenue Capital is a tangible thing and is scarce Entrepreneurship: Collect factors of production to create (new) goods and services Institution Institutions are power structures that shape and direct behavior Formal Schools, government, etc. Informal Belief systems, prices, habits of thought Prices Absolute: The definite price of a good or service; no comparison of same product Relative: The price of a good or service compared to the same good or service somewhere else Nominal: Pricing without regards for inflation Real: Pricing adjusted to inflation VIII. The 3 Economic Questions Every society addresses these questions What/How/For Whom to produce? What Includes how much to produce and what to create based on resources Output Mix How Which processes should be used to produce the good? Input Mix Whom Who will buy all these goods/services Distribution Mix Efficiency criteria For what Allocative Efficiency: requires producing an output mix of goods that people want and are willing and able to pay for For how Technical/Productive Efficiency: requires minimizing opportunity cost for a given quantity and quality of a good/services For whom Distributive Efficiency: requires goods go to people who value them relatively the most However is willing to make the biggest sacrifice for the good, should get the good Overall Efficiency Creates a higher predicted profit IX. Allocative Mechanisms Markets The Invisible Hand: If people are free to follow their interest, the invisible hand will guide them to what is best for society Relative prices, markets, social trends create the invisible hand Overall Efficiency is what is best for society While trying to create the best profit, efficiencies are indirectly created Requires people to know their own preferences Brute Force Creating what the craziest person wants I.e. pushing a car out of a parking spot to park your car Queuing Lining up, first come first serve i.e. Parking spaces on campus, event tickets for good seats Opportunity cost of waiting for the good/service Random Selection Inefficient in Distributive Efficiency Tradition Do what people always do I.e. women choosing degrees in nursing and teaching rather than economics and engineering Government Selection Requires information on what people want X. Economic Systems Capitalism Relies on markets, self-interest, private property If we want markets, what is the institution you need? Private property (Most likely on test) Laissez-faire: Leaving the market alone, let society deal with it Command Economies (Socialism/Communism) State-controlled resources Government planning Mixed Economy Some private property, some state-controlled Some markets growing from government planning Majority of economies, including United States XI. Production Possibilities Frontier/Curve Scarcity, Choice, Opportunity Costs The PPF shows the maximum goods society can produce in a given time period Assumptions Society has a limited amount of resources, technology, and are efficiently employed Scarcity causes the PPF to be downward sloping (Most likely on test) It is curved because specialized resources; Law of Diminishing Returns What slope represents Absolute value of slope represents the opportunity cost of obtaining one more X good To obtain one more Y good, the opportunity cost is the reciprocal of the slope Dollar values are not shown because opportunity cost is the true cost Law of Increasing Opportunity Cost: As you do more of something, the marginal opportunity cost will increase Law of Diminishing Returns: As you do more of something, it eventually becomes harder to do it XII. Specialization and Exchange More resources, increased labor, increased productivity shift PPFs Assembly line Allowing one person to specialize in a certain aspect of production, allowing for more efficiency Can rob humanity and mental challenges from workers Absolute Advantage Being the best at producing a good Comparative Advantage Having the lowest opportunity cost to produce a good Cannot have comparative advantage in everything Having to sacrifice skill in one thing to perform another Everyone can benefit from specialization and exchange Example: Having products made at other countries have a lower opportunity cost than having it made in the USA XIII. Pieces of the Economy Households Supply land, labor, and capital Demand goods, services, Consumer sovereignty: Consumers running the economy Firms Supply goods and service Demand land, labor, capital Businesses answer the 3 economic questions (What, How, For whom?) Types of Firms Sole proprietorship: owned by one person Goal is to maximize profit Have unlimited liability Difficulty gaining capital Partnership: multiple founders Spreading the liability (risk) Easier to gain capital Unlimited liability amongst all owners Corporation: owned by stockholders Limited liability Allows capital growth Operated by management Principle Agent Problem: Owners want to maximize profit, the agent are those working for the owners/management acting upon personal incentives Role of Government Establish property rights Government help with market failures keep free markets to operate Lack of competition Govt. can break monopolies, enforce competition, prevent mergers Externalities: Cost or benefit that affect third parties and not weighed by decision makers Ex. Car producers causing pollution, landscaping brings up property values XIV. Market Failures Public Goods - Freeloaders on your product A good that once provided, can be enjoyed by multiple people at the same time regardless if payed for (i.e. roads, radio stations) Does not always have to be provided by public sector Charity, truth, justice can be included in public goods Is a market failure because not everyone is paying for it Government taxes to force payment to provide public goods Macro-stability - Government involvement In recession people need to buy more but will not because of economic worries Governmentmight spend that money to bounce back to stability Income Distribution - Difficulty going from poor to rich At the margin, it is easy to make rich people rich and poor people stay poor Government involvement: social security, government healthcare, tax bracketing, etc. XV. International Setting The world Market is more vital to other countries Vast majority of goods in America are made in America Most of American made goods stay in America More imports than exports The Global Economy Post WWII, world trade unions were meant to create more peace and prosperity International Monetary Fund, World Bank, etc. Created by man; adjustable Multi-National Corporations Some companies that exceed GDPs of some countries CHAPTER 4 XVI. Graphs Shows a relationship between two variables Types of relationships Positive/Direct Both variables more in the same direction Positive x direction, positive y. Negative x direction, negative y Negative/Inverse As one decreases, the other increases; opposite movement Reading the graph If one variable changes, it is a movement along the curve To show a third variable, is to draw a completely new line; SHIFTING XV. Demand Curves Demand: Shows the relation of quantities of good consumers are willing to buy at various prices Includes the application of Ceteri’s Paribus (All other things remain the same) A change in prices creates a change in quantity DOWNWARD SLOPE With any given price, there is a given quantity Quantity Demand is a point on the demand curve that has a particular price Law of Demand There is an inverse relationship between price and quantity What causes shifts? A change in a goods own price will never shift the demand curve Income Normal goods With an increase of income, there is an increase of demand Inferior goods With an increase of income, there is a decrease of demand An increase in demand is out and to the right; a decrease in demand is in and to the left Related Goods Complement: goods that go together, an increase in the price of X leads in the decrease for Y Example Price of shoes makes demand for shoe laces decrease Shoes decrease quantity demanded, shoe laces shift to the left Substitute: goods that are similar but do not go together; an increase in the price of x leads to increase of demand for Y Example Price of Coca-Cola goes up, demand for Pepsi goes up Quantity demanded for Coca-Cola decreases, demand curve for Pepsi shifts right The (Galloway) Law of Smoothing: Similar goods in similar situations will have/make similar prices Prices steadily rise, do not spike intensely Types of Shifters Taste and Preferences Population (Number of Buyers) XVI. Supply Curves Definition: Supply is a relation showing the quantities of a good producers are willing and able to sell at various prices; Ceteri’s Paribus (All other things equal) Direct relationship Price on vertical axis, Quantity supplied on horizontal axis Quantity Supplied: The particular amount producers are willing and able to sell for a particular price Change of is a movement along the curve Law of Supply: There tends to be a direct relation between price and quantity supplied An increase of price leads to an increase in quantity supplied; decreased price leads to decrease quantity What Shifts the Supply Curve The price of the good will NEVER shift the curve, only movement Technology As a business person, will this make the job easier/more difficult? Leads to increase/decrease in supply Leads to a out and rightward shift as technology increases Allows for cheaper production Turn of Profits & Number of Sellers Opportunity cost, If inputs cost more the curve will shift to the left Situation: If profits in one market are greater than another, people will try to switch to the other market The number of sellers increases in the more profitable market; supply shifts right Price of higher profit good decreases Profits fall when price and supply increase Number of sellers in lower market decreases; supply shifts left Price of lower profit good increases Profits rise with higher price and lower supply Once profits become the same as the other market, the number of sellers for one good diminishes Expectations The expectation of inflation can actually cause inflation suppliers hold back and consumers stockpile Changes both supply and demand curves Trying to “beat the market" Government Policies Regulations decrease supply, takes more opportunity cost for suppliers to meet regulations Taxation, subsidies, restrictions, etc. If regulations were more streamlined or intense, supply will shift to the right Less effort to follow said regulations Goals of the Firm Not so much as a shifter, but does illustrate the importance of assumptions in the market Not always maximizes profit Example: Setting hours short and no weekend work to be with family instead of profit Non-profits have supply curves with a lesser slope Other Weather can distort supply/demand of snow cones etc. XVII. Working with Graphs Steps to solve economic problems: 1) Draw a graph 2) Identify which curve will shift 3) Identify which direction the curve will shift 4) Show the shift 5) Note change in price and quantity; answer question Things to keep in mind Supply and Demand are assumed to be independent One curve NEVER causes the other curve to shift Know what, shifts which curve The Invisible Hand: Market does what is best for society Draw. The. Graph. Equilibrium It is the act of balancing out forces, in this case supply and demand Graphically it is where the supply curve intersects with the demand curve Where quantity supplied equals quantity demanded gives a equilibrium price When prices are not at equilibrium Priced above equilibrium For that price there is a lower quantity demanded and a higher quantity supplied (Qs>Qd); creates a SURPLUS With competition, firms lower their prices and return to equilibrium Qs decreases with price; Qd will rise because of lower price. Reestablishes equilibrium Priced below equilibrium For the new price, there is a higher quantity demanded and a lower quantity supplied (Qs<Qd); creates a SHORTAGE With competition, customers are willing to pay more for goods and return to equilibrium Quantity demanded decreases with a price increase, with less demand there will be a higher quantity supplied If we start at equilibrium and there is a shift of one of the curves, that shift will cause a shortage/surplus at the old price and market forces will create a new equilibrium price Government imposed price policies - market forces do not disappear Price Ceiling A maximum statutory (Passed by law) price BELOW equilibrium Side effects Decreases quantity supplied and increases quantity demanded Creates a shortage of said good Can create bribery, waiting-list, black market activity Often in housing market Price Floors A minimum statutory price ABOVE equilibrium Side effects Decreases quantity demanded and increases quantity supplied Creates a surplus of said good Can export and call it charity, pay seller not to sell something Without selling, market forces to decrease quantity supplied cannot act Often in agricultural department, minimum wage Double Shifts When drawing to shifts you will know what happens to one variable, the other ambiguous Four types of combinations Only shift two curves when you have two distinct reasons, draw the graphs, you know what happens to one variable the other is ambiguous XVIII. Elasticity Talking of total revenue it is equal of price times quantity TR=P x Q Elasticity: A measure of responsiveness. How sensitive one variable is to a change in another. How to calculate percentage change Percentage is used because we don’t care about units |Q1-Q2|/Q1 x 100 Midpoint formula: Using the average of two values as the denominator (|Q1-Q2|/Avg Q) / (|P1-P2|/Avg P) (%∆Q) / (%∆P) There will be at least one “do the math” questions Price elasticity of demand How sensitive quantity demanded is with change of price PED=%∆Quantity/%∆Price |PED| > 1: elastic Higher change of quantity than change of price Perfect elasticity When change in price is infinitely close to zero but quantity increases significantly (Horizontal line) Elasticity: Infinite What happens when price changes If prices go down revenue goes up If prices go up, revenue goes down |PED| < 1: Inelastic Lower change of quantity than change of price Perfect inelasticity With price changing significantly there is little change in quantity (Vertical line) Elasticity is zero What happens when price changes If prices go down revenue goes down If prices go up, revenue goes up |PED| = 1: Unit elastic Both changes are the same Graph is curved and does not touch axis What happens when price changes Regardless of price going up or down, revenue remains the same Elasticity and Graphs Slope of graphs: ∆P/∆Q Perfectly elastic when there is large ∆Q/ small ∆P; ∞= Occurs at the Y intercept Perfectly inelastic when there is small ∆Q/ large ∆P; E=0 Occurs at the X intercept Y intercept perfectly elastic, Upper half of graph elastic, middle is unit elastic, lower half is inelastic, X intercept perfectly inelastic When graphing, the area under certain price and certain quantity creates a rectangle Price x Quantity = Total Revenue Moving from one price/quantity to another: revenue increases from higher quantity. Revenue decreases when price drops In net: If the larger rectangle is gained revenue and trumps the other then it is determined elastic In net: If the larger rectangle is lost revenue and trumps the other then it is determined inelastic With unit elastic areas of changed revenue have the same area Determining what good is elastic or inelastic Necessities Needed for survival means willing to pay higher price for good: inelastic Availability of Substitutes With lots of substitutes and flexibility there is no need to pay higher price: elastic Narrow and Broad Definitions Narrowly: More substitutes, demand is elastic Broadly: Fewer substitutes, demand is inelastic Proportion of one’s income accounted towards that good If the good is needed but very cheap relative to income: inelastic Good is big part of budgeted income: elastic Long-term and short-term Short term is inelastic: stuck with prices (gasoline) for the time being For gasoline short term: 0.3 elasticity, inelastic Long term is elastic: with development of substitutes the need for said good (gasoline) decreases Price Elasticity of Supply How sensitive quantity supplied is with change of price Same as PED but with supply %∆Qs/%∆P: Positive number Cross-price elasticity How do consumers of one good change their consumption of one good when the price of another good goes up? Formula of XPE XPE = %∆Qx/%∆Py Sign is important If positive: they are substitute goods (+/+, -/-) If negative: they are complement goods (+/-, -/+) Income elasticity Work with normal and inferior goods Formula IE = %∆Qx/%∆I Sign is important If positive: it is a normal good (+/+, -/-) If negative: it is an inferior good (+/-, -/+) Types of normal goods Staple goods Income changes significantly but consumption does not change much Elasticity is less than 1 Leisure goods Income changes significantly and consumption increases greatly Elasticity is greater than 1 Unit 2 I. Types of Effects Substitution Effect The drop in the price of ‘x' Lowers the relative price of x Increases the relative price of all other goods Substitution out of all other goods and into ‘x' The quantity demanded of x increases Caused by the change of relative prices Always an inverse relationship Income Effect The drop in the price of ‘x' Raises the real income If ‘x’ is a normal good Purchase more ‘x' Quantity demanded of ‘x’ increases If ‘x’ is an inferior good Purchase less ‘x' Quantity demanded of ‘x’ decreases Only time an upward demand curve is possible Caused by changes of real income II. Equilibrium and Surplus Consumer surplus The difference between the actual price and the maximum price the consumer is willing to buy the good Graphically The void above equilibrium underneath the demand curve; Right triangle under the curve with bottom at equilibrium Shares bottom side with Producer surplus Producer surplus The difference between the actual price and the minimum price the producer is willing to sell the good Graphically The void below equilibrium above the supply curve; Right triangle above the curve with the top flat at equilibrium Shares bottom side with Consumer surplus Somewhat related to profits For Efficiency For market efficiency we want to maximize the sum of consumer AND producer surplus Graphically If price is too high we are not ‘creating’ full right triangles under/over the curves. Does NOT maximize surpluses Having matching right triangle areas occurs at equilibrium and is maximization III. Utilitarian Theory Utility = Happiness Assumptions: "You are a" REM: Rational Economic Man (Homoeconomicus) That one is rational Ability to rank preferences (ordinal) Ordinal Number: Numbers that only show order (1st, 2nd, 3rd, etc.) A tie is possible; I don’t know is not HM: Hedonistic Maximizer Trying to maximize pleasure Self-Interested Doing what’s best for you Each time you spend a dollar, you are using it to maximize utility Total Utility: The total satisfaction one gets from consuming a particular quantity of a good Often measured in terms of the maximum willingness to pay for that quantity $8 of happiness makes the good worth $8 Total Utility will keep increasing as long as marginal utility is a positive value. It decreases when MU is negative Marginal Utility: The additional satisfaction from consuming one more unit of a good Often measured in terms of the maximum willingness to pay for one more of the good Can be negative, as in having to be paid to do something Law of Diminishing Marginal Utility: As one consumes more units of a good, eventually the marginal utility will start to decline IV. Utility Maximization Rule Marginal utility measured in dollars Generally has a downward slope, and can become negative If it is possible to get happiness cheaper than what it is worth, get the additional good $10 of utility for $5 is worth it MUx>Px BUY MORE Past that price, you reasonably should not buy that good for that price $5 of utility for $10 is not worth it MUx<Px BUY LESS It is possible that MU cost is equal to MC $5 of utility for $5 is reasonable MUx=Px BUY Graphically similar to the Demand Curve The demand curve comes from the downward sloping portion of marginal utility Derived from the Law of Diminishing Marginal Utility Every point on the demand curve shows utility maximization Utility Maximization of Multiple Goods You want only spend money on your favorite things Law of Diminishing MU RULE: MUx/Px compared to MUy/Py Happiness per dollar of one good versus another When > occurs: buy more x When < occurs: buy more y With a table of two good you want to pick the best MU per $ If you have two of x already you can look at the first of y V. Costs and Production Input decision (How much should I hire and use for a good?) Things that affect decisions Price of input Price of labor/capital Efficiency How productive it is to create output Price of output Is the market popular? How valuable the output is Types of cost Opportunity cost Marginal cost The goal of firms is profit maximization Formula of profit π π = TR-TC Example: TR: $200K TC: $170K OPC: $40K 200-170=30K-40K= -10K 30K is accounting profits -10K is economic profits A normal economic profit is zero Is the accounting profit - economic (opportunity) cost Is expected, still able to buy goods, live happy, etc. Fixed and Variable Inputs Fixed input: an input that does not change with production Ex. Factory, restaurant, building Variable Input: an input that does change with production Ex. Human workers to machines in assembly lines Economic time Short run: period of time where at least one input is fixed Long run: period of time where all inputs are variable Build bigger stores, etc. More choices Very long run: Technology and nature of industry changes Economic time is different for every firm VI. Production in the short run Production function: Total Productivity (TP) = ƒ(Capital (k), labor (L)) Implicit function; changes based on production processes IF TP = k^2*L Explicit function One variable is FIXED Variations of production function Total Physical Product (TPP): quantity of outputs; another name of TP Average Physical Product (APP): TPP/L; often products per hour or per worker Marginal Physical Product (MPP): ∆TPP/∆L Law of Diminishing Marginal Productivity SIMILAR TREND AS MARGINAL UTILITY TPP grows (slowly) as MP decreases. When MP goes negative, TPP decreases When adding more of an input, one will eventually lead a point where additional inputs contribute less than previous units The relationship of Marginal and Average production Marginal leads Average: When marginal is above average, it will increase future average. When marginal is below average, it will drag/decrease future average down Example: Semester GPA increase/decrease cumulative Graphically, MP as y-axis, AP as x-axis Curves up initially, drops down due to Law of Diminishing Marginal Productivity (roller coaster hill) Bottle neck effect In short run, there is at least one fixed input which creates a bottle-neck effect in short term production Relationship of MPP and TPP Graphically Rise: Specialization Fall: Law of Diminishing Returns Both of test Test questions: corresponding points between two graphs When marginal is at zero, total peaks MPP(of Labor) = ∆TPP(L)/∆Input(L) Labor=L Slope= ∆TPP/∆Input = MPP(L) Marginal is the slope of TOTAL VII. Fixed, Variable, and Total Costs (FC, VC, TC) FC: Costs that do not change (Ex. Rent) VC: Costs that do change (Ex. Labor, Supplies) Rise with production TC: The sum of FC and VC (total FC+total VC) Graphically FC is a horizontal line; price does not change VC is an upward sloping line; price changes with quantity and starts at origin TC starts at the FC and parallel to VC; FC + VC representation Spacing between TC and VC curve is the Fixed cost AVERAGES AFC FC/Q(output) AVC VC/Q(output) ATC TC/Q(output) or FC+VC/Q or AFC+AVC Graphically AFC: Numerator is constant whereas denominator increases Curved down slope with an asymptote at zero AVC: MARGINAL ∆TC/∆Q Graphically Looks like a checkmark; Mirror image of marginal productivity Initially costs fall due from specialization/division of labor Followed by increase due from law of diminishing returns How marginal affects average costs Marginal leads average Graphically Intersections are minimums of each value Trends only occur in the short run VIII. Marginal Revenue (MR) Additional revenue generated by employing one more unit of input Formula MR= MPP*P(output) If price is constant Optimal Input Rule If MR>P input Increase employment MR< P input Decrease employment MR=P input Amount of employment is good Hire an input as long as it pays for itself If someone is paid $10/hr they should create ≥$10 of revenue Graphically Identical to MPP curve Rises from specialization, drops from Law of Diminishing Returns Axis: Y is cost of input; X is quantity of input The downward sloping portion of MRP is the demand curve for that input Wage should equal MRP Example using all functions Areas where there is shading or different font is where the curve dips graphically VIV. Derived Demand If a shift of the demand curve increases the price of a good, the MRP increases Shift leads to increase ofoutput Plugged into MRP=MPP*P outout MPP DOES NOT CHANGE X. Long-Run Production Law of Diminishing Returns does not exist in long run All inputs become variable Average cost Graphically: A collection of short runs Pick Short-run “option” that best minimizes cost If downsizing, it is best the company picks the smallest average cost curve to follow in business plan To create a long-run average cost curve one traces the minimums of average cost curves Creates an upside-down “umbrella”/envelope curve Truly only touches the very minimum of the lowest curve Means in the short run, there is not perfect efficiency Adjustments to Scale, IRS, DRS, CRS Increasing of Returns to Scale (IRS)/Economies to scale If doubling output IRS: TC/Q output-> 2/3 Less than one LRAC is downward sloping Adjustments to scale are caused by indivisible start-up costs Can’t buy half a truck or half a building Decreasing Returns to Scale (DRS)/ Diseconomies to scale If doubling output DRS: TC/Q output-> 2/1.1 Greater than one LRAC is upward sloping Why adjustments to scale, fight DRS Creation of regional/district managers to manage other management; organization pyramids Monitoring cost of small things (check for petty theft, etc.) Fight against lack of team spirit Constant Returns to Scale (CRS) AC=TC/Q If doubling input CRS: TC/Q output-> 2/2 Exactly equal to one LRAC is a horizontal line The entire LRAC curve can be a combination of IRS, DRS, and CRS Economies of Scope Less costly to produce one good when you are already producing another Gas stationsalready have a cashier and register, why not sell other stuff too? Network Externalities The phenomena where the greater use of a product increases the benefit of that product for all users Ex. Fax machine, not worth it if you are the only person to own one. Useful if everyone has one. Optimizing Input Rule (Multiple inputs) MPP /x input x= MPP /yP input y= ….. Additional output for the dollar spent on y “Bang for your buck" If…. MPP/P of x > MPP/P of y More x, less y X is more valuable When ratios are NOT equal you can Rearrange inputs; more output for same money OR same output for less money Same as MB $on x = MB $on y Or MC $ on y MC $ on x XI. Perfect Competition Assumptions Five assumptions 1. Many buyers and sellers Enough that no one buyer or seller is important/vital 2. Produce identical goods Such as crops 3. Free entry and exit Firms entering the industry easily Normal economic profit is zero 4. Perfect information Knowledge of prices, quality is already assumed in #2 Price is the only choosing factor in perfect competition 5. No transactions cost Bother and hassle of making a transaction Price takers A seller cannot even charge a penny more for a good; will not get buyers Those that sell a penny less than everyone will get all the customers Graphically Equilibrium price of market establishes the horizontal demand curve for an individual firm Perfectly elastic; extremely sensitive to price change Each firm can sell at the going rate; not necessary to lower price than equilibrium Profit(π) Maximization Total Generalization to all markets of all industries TR(revenue) is an upward sloping curve that eventually slows down and levels out at higher prices TC(cost) is an upward sloping, eventually reaching a vertical asymptote The vertical distance between is TP (π) The greater distance apart the better profit Tangents are “parallel” Marginal ∆TR/∆Q = MR ∆TC/∆Q = MC MR>MC Move further in curves; do more MR<MC Don’t move further; do less MR=MC Profit maximization; do not do more or less Graphically MR is down sloping, similar to demand curve MC is upwards “check mark" Due to specialization followed by law of diminishing returns XII. Perfect Competition Revenues and Costs With TR/TC TR=P*Q TC=AC*Q AC=TC/Q Short run with price-taker firms The equilibrium price turns into firm’s horizontal demand curve Perfectly elastic demand curve Demand curve gives price; P=AR=MR* AR=TC/Q AR=P*Q/Q MC curve is upward check mark Profit Maximization at intersection of MR=MC When demand cost is $5, AC is $4, Quantity is 100 units TR=500 (P*Q) TC/AC=400 (AC*Q) ∏=100 (TR–TC) Short run equilibrium With an increase of quantity revenue changes but MARGINAL COST increases FASTER This is why it is better to produce at the profit maximization quantity With a firm increasing in economic profit, more firms will expand and more firms to start Occurs when Average Cost curve sits below the demand curve Profit(π) loss/Shut down point Occurs when Average Cost curve sits above the demand curve If you can cover for Variable cost, stay open to pay down fix cost and minimize losses In long run: leave industry P>AVC Stay open in short run P<AVC Shut down; Q=0 Loss=TFC The MC curve above the AVC curve (shut down point) is the firm’s short run supply curve From profit in one industry leading to entry (π->entry) ***** Increases supply, price drops until π=0 Gets closer to average total cost (ATC) π=0 when it intersects with ATC XIII. Perfect Competition: Long run Long run equilibrium is focused only entry and exit of an industry (Short run is finding the ideal quantity) π=0 is long run equilibrium P=ATC, no losses Losses in the long run result in exit; supply drops Increase price until P≥ATC, π=0 QUANTITY DOES NOT CHANGE (within individual firm; all firms produce more) Long run industry supply With industry growth, might affect input costs; impact profits Supply=LRAC Diseconomies to scale, Constant returns to scale, Increasing Returns to scale possibilities Upward, flat, downward sloping possibilities Types of supply curves in short (firm) and long (industry) run Marginal cost above shutdown point is firm’s short-run supply curve Long-run average cost is the industry’s long-run supply curve Test question: Can a firm make economic profits? Yes in short run, no in long run Efficiency in long run (What) Allocated P=MC; (MU=P=MC) Profit and Utility Maximization Price needs to reflect the marginal cost of making the good Price too high chases away customers Price too low waste of resources from production (How) Technical Minimization of ATC MC=ATC (intersection of the two curves) (For Whom) Distributive Overall/Economic/Pareto Efficiency Doing all three efficiencies Pareto efficiency is a situation where no one can be better off without making someone worse off Pareto improvement: make one improve without hurting someone else Efficiency when all possible improvements have been completed Allocative Example: Switching from useless products to good ones, no one upset of the changes of outputs XIV. Monopolies Assumptions One firm Produce a unique product; no close substitutes Significant barriers to entry (possible to have profits in the long run)* Barriers to entry Deliberate policies Policy allowing only one firm to operate Patents, Copyrights, Trademarks, etc. Protecting ideas, allowing profit Cost of: gives ability to charge too high for products; promote inefficiency by hurting customers Control over resources Deliberately erected barriers/rent-seeking Economic rent: return to circumstance Not getting profit because of skill, getting return because it is a monopoly Create market power, passing laws for own benefit Threat of law-suit Cost advantages Better access to technology, research-development, already being experts, etc. Increasing returns to scale, bigger firms have less cost Marginal Revenue & Price Downward sloping demand curve, because the firm IS the market MR is a separate curve P>MR When the firm lowers their price, they have to lower the price on all the goods, even ones they could sell for higher Lowering the price for every good With the Demand and MR when Demand is linear, the MR curve is exactly half the horizontal distance to the demand curve Total revenue increases, plateaus, and drops; zero at both intercepts of cuve If marginal is positive, total revenue increases. If marginal is negative, total revenue decreases WHEN MR=0; TOTAL REVENUE IS MAXIMIZED Marginal revenue is the slope of total revenue Graphically The monopolist does not have a supply curve Intersection of MC and MR gives best quantity DIRECTLY ABOVE said intersection at point on Demand curve gives best price MC can be a flat horizontal line in the case where MC=ATC Short-run equilibrium Identical to long run equilibrium Due to barriers to entry, no other firm will enter industry to decrease product price Profits can consist in long run If average cost is above MR curve the monopolistic firm is at a loss Price and quantity is one decision, not two Monopoly and Efficiency Allocative P=MC* Occurs on DEMAND curve D=P Technical MC=AC Occurs on intersection of ATC and MC curves In monopoly, they are not efficient in the long run. It is IMPOSSIBLE to be both Allocative and Technically efficient Distributive efficiency will not be studied Monopoly vs. Perfect Competition Consumer Surplus The scenario in which someone pays less than what they are willing to for a good Graph points Deadweight/Welfare loss Created by producing too little, away from the best quantity FOR SOCIETY Occurs by monopolies hiking prices via constricting quantity Area found=1/2b*h Net benefits lost; no one gains benefits MB≠MC Price Discrimination Monopoly charging different people different prices Conditions of Firm needs control over price (not possible for PC, price-takers) Must be able to segregate customers and prevent resale Different groups of people must have different price elasticities of demand High prices for those who need it Low/Decent prices for those who want it Price hike eliminates some consumer surplus, turns said void into profit Price drop eliminates some welfare loss, turns void into profit. Better for one isolated group Perfect price discrimination When the monopolist is able to charge EACH CUSTOMER their exact willingness to pay Demand becomes Marginal Revenue; D=MR ZERO CONSUMER SURPLUS AND ZERO WELFARE LOSS; Only profits Similar to perfect competition in a sense and is Pareto Efficient Unit 3 I. Natural Monopolies Definition: Monopolistic firm that shows economies to scale over market demand; Falling costs Properties of Cheaper to use one firm rather than using a selection of and switching when prices are cheaper Beneficial for customers Splitting market into more firms rise the average cost for all the firms Best to try and regulate costs Attempts to regulate monopoly Having to get permission to set prices US Postal service has to ask congress to raise price of stamps Forces price where Demand meets marginal cost Price is below average costs, firm is making losses Have to choose between allocative and technical efficiency Allocative: P=MC; the addition of a “flat fee” and marginal cost pricing Technical: P=AC Normal rate of return Overcapitalize firm and make returns larger There is no perfect way to regulate a natural monopoly Last bit on monopolies Have the ability to constrict quantity in order to raise prices Larger companies vs local shops Large companies advertise aggressively; marketing II. Monopolistic Competition Assumptions Many buyers, many sellers Free entry and exit; no barriers to entry Perfect competition Similar but different products Short run equilibrium Properties of Downward sloping demand curve MR curve is below price, half distance to demand curve P>MR Similar to monopoly Curves Demand Marginal Revenue Marginal Cost Average Cost Profit Maximization MR=MC; price is set where it meets on demand curve No economic profit Other firms enter/exit market Entry -> More substitutes -> Dfirm decreases Price down, quantity down Long run equilibrium Same curves as short run Properties Average costs curve eventually runs tangent with Demand curve P=AC No entry into market No economic profit Efficiency Allocative P=MC Technical MC=AC Cost minimization Properties of Is not automatically efficient Identical to monopoly Excess capacity The quantity of actually made vs quantity of sold Example: Restaurant with empty tables, gas pumps not being used Average cost would be lower if you had fewer firms EACH selling a higher quantity Measure of inefficiency Graphically Horizontal distance between profit maximization and cost minimization “The price we pay for variety" III. Oligopolie(All-lah-gawp-o-lees) Assumptions Few, large firms dominate (Oli) Barriers to entry Homogenous or Differentiated Products Are interdependent Strategies will vary, much more complicated. No single model. Depend on what other firms in the market too Collusion and Cartels Collusion is the act of restricting outputs to set piece, price agreements amongst firms Cartels: A group of firms that work together and collude, try to establish a monopoly Examples: Drug cartels, OPEC Reason why they are not common Illegal to form Unstable; Incentive to cheat MR=MC, which different MC each firm has a different optimal price Maverick: One who cheats on agreements Dropping price against agreements, huge surge of profit for said firm Price Leadership Tacit (Implied) collusion One oligopolist sets price, others follow suit Could eventually set monopoly like pricing; hurts consumer Characteristics of Not-necessarily illegal Very short-term Incentive to cheat Possible price-wars Kinked Demand Assumptions One firm drops price, others follow suit If one firm raises price, others ignore Sticky pricing Prices that seem to be fixed Graphically Demand After a certain price drop, curve becomes more inelastic When price increases, consumers go to those who do not follow price hike Forms an elastic section of the demand Two demand curves that cross, one elastic, one inelastic Marginal Revenue Marginal revenue has a “gap” Downward slope, vertical drop, downward slope Marginal Cost Multiple scenario costs IV. Game Theory Definition Set of mathematical tools used to analyze different situations and strategies Strategy Definition: An operational plan; course of action Pay Off Matrix A table showing all possible outcomes of mutual strategies between firms Dominant Strategy Having the best strategy regardless of the other firm(s) Not always present Nash Equilibrium An equilibrium where no firm has incentive to change their strategy unless the other firm does Possibility of none to multiple Nash equilibrium Types of “games" Prisoners Dilemma Strategy: Be quiet or snitch? Payoff Matrix: Four combinations Both quiet, quiet/snitch, snitch/quiet, snitch/snitch Come with different results for each 1 year jail/1 year jail, free/life, life/free, 20 years jail/20 years jail (respectively) If both “players” follow their dominant strategies, both are worse off Applicable to microeconomics with dominant strategies for pricing Cartel Pricing Subdivisions of cartels using their individual dominant strategy against kingpins or higher subdivision Moving First Scenario: 2 firms, 2 strategies each for added safety in vehicles for side collisions Side airbags or door beam SA/SA (20/30), SA/DB (-10/-10), DB/SA (-10/-10), DB/DB (30/20) If firm one picks first: SA/SA (20/30) If firm two picks first: DB/DB (30/20) Maximum-Minimum Firm wants to pick strategy that picks maximum profit If that occurs, it is assumed opponent (Firm 2) will try to sabotage by lowering their price Occurs in less profit for Firm 1 and win for Firm 2 Creates selection between best worst case scenarios V. Behavioral Economics Mixed Strategies Use of dominant strategies Trying to guess opponents move proves difficult Vickery Auction Must size up competition People will not bid highest willingness to pay; try to bid $1 more than someone else’s willingness to pay Try to create consumer surplus Highest bid wins; but pays amount of 2nd highest bid To give every bidder to reveal true maximum willingness to pay Framing Effect One’s preferences is affected by how the question is worded and/or by alternative choices even if irrelevant Example: 600 people in 3rd world country, dying of strange disease Option A: Save 200 people confirmed, 400 die Alternative saying: 400 die confirmed, rest are saved Option B: 1/3 Chance of saving 600, 2/3 chance of saving none Alternative saying: 2/3 all might die, 1/3 chance none will die When saving was the subject, people chose A When death was the subject, people chose B Creating intermediate products to cause consumers to buy more or spend more Concentration Ratio Measure spectrum of perfect competition and monopolistic firms Monopolistic Competition and Oligopolies are somewhere in middle Studied by market share Four firm concentration ratio Study market share of four largest firms in industry Example: 86% for breakfast cereals Oligopoly If 10%; monopolistic competition Issues with: Only shows four firms Does not show individual firm concentration Closer to 100% means closer to monopoly Herfindahl Index Look at percentage of market share by each firm and square it One firm have 100, leads to 10,000 score: Highest possible; monopoly No units The further towards 10,000 the more the industry is oligopolistic or monopolistic VI. Taxes Why government Save from market failures Promote competition Bring efficiency into market Antitrust laws More often prevent monopolies rather than busting Prevent externalities Cost/benefit of actions that affect third party firms rather than those in negotiation Example: Pollution from driving cars Establish stable institutions Public goods (schools, roads) Property rights, create a civil state Market failures Public goods: Goods that you can enjoy without paying Taxes enforce payment of public goods Prediction of market crashing Government willing to spend to create stimulus in economy Distributive Issues Government redistributes income Address undesirable market outcomes; correcting externalities Example: Telemarketing, Sweatshops Laws to minimize (do not call lists) Child labor laws prevent sweatshops Worker safety laws Who should pay? Ability to pay principle Definition: The rich should have to pay more; those who have more should pay more Progressive Income tax structure Benefit principle Definition: The more you benefit/use the more you should pay Gasoline tax (Have not been changed since 1986) Preferred method Believed to be best way to


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