ECON 200 Midterm Study Guide
ECON 200 Midterm Study Guide ECON 200
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This 25 page Study Guide was uploaded by Rachel Pollard on Thursday January 28, 2016. The Study Guide belongs to ECON 200 at University of Washington taught by Haideh Salehi-Esfahani in Winter2015. Since its upload, it has received 125 views.
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Intro Tuesday, January 5, 2016 10:29 AM MyEconLab • Drop-in help for MyEconLab on Tuesday January 12 3-5 Savery 311 • MyEconLab weekly exercises • Always due on Mondays at 1pm • The first homework is not graded, it’s a practice Clickers • Channel 30 Quizzes and First and Second Exams • Not multiple choice • Graded on quality of answer given • Drop the lowest scoring quiz • Quizzes held in quiz section • First quiz is January 15 • Quizzes have two or three non multiple choice questions. • Each exams have five non multiple choic e questions • The first and second exams are held in lecture • Second exam is not comprehensive, it only has some of the material from before the first exam CLUE • Sessions held on Wednesdays at 6:30 Introduction to Microeconomics • Study of the market system - dependence on the market • Study of the market and its institutions Overview of principles of microeconomics • Given your constraints, how do you (as consumers) make decisions? o Consumer theory • How do suppliers make decisions in their best self -interest and produce the goods and service that we want without us actually talking to them? How do they make employment decisions? o They are looking for profit o Factors of production: labor, land, production or machinery • How does the market system coordinate the actions o f millions of diverse individuals and what qualifications exist to make it work? o System of support for the market is important, its foundations lie in a system of rights and rule of law • How does the government fit in to this picture? What are the justifica tions for, and, the effects of government policies? Interactions in an economy are: A. Positive sum game (all parties involved may gain) a. Voluntary exchange or voluntary market process Economics is a science. It employs a set of thinking tools (concepts) tha t help explain our economic and social phenomena and also predict the effects of changes in (relevant) constraints on the social and economic outcomes. • Use of economic theory as the foundation Is the following statement a theory? "An increase in wheat subsidy will either increase or decrease wheat output or keep the output constant?" NO • It's not a theory because a theory makes a specific claim. • A theory makes a claim that can be refuted. In line with economic theory, which of the following statements is true? A theory… contains refutable proposition(s). The fundamental axiom in economics (concerning resources) is: • A scarcity (of resources) • The wants of humans exceeds the resources of humans • Time and money are scarcity sources • For the economy, the scarcity sources are labor, capital (available machinery and things in a manufacturing site), and land (everything that is in land such as oil) • This means that you will have to make choices between alternative things • The economy at a whole; make decisions on what to produce • Choice --> tradeoffs • Every resource has an alternative use • Scarcity --> choice (making decision among alternative uses of their scarcity source) Opportunity Cost (of decisions) • The value of the next best alternative foregone (it's what you give up) • It's what you give up that defines the opportunity cost • Ex. You purchase a concert ticket for $40. Someone offers you $60 on the evening of the vent but you refuse. What did the concert ticket cost? o The opportunity cost is $60. o Because… the $40 doesn't mean anything. You could have taken the $60 and given up the concert. The cost of going to the concert was $60. • Ex. You have a baby-sitting job on Saturday night $10 an hour; you will baby -sit for 4 hours. On Friday before, your friend asks you to come over to watch a series of wrestling matches on TV on Saturday for the same 4 Hours. You value the enjoyment of watching the match at $50. o The opportunity cost is $50 • Ex. You have a baby-sitting job on Saturday night earning $10 an hour for four ho urs. You value the enjoyment of attending the performance by the local artist at $70. The cost of entrance fee and drinks is $30. What is your opportunity cost of doing the baby -sitting? o The opportunity cost is $40 The theory of consumer behavior identif ies two sets of influences on our decisions to purchase various quantities of goods: 1. Constraints or opportunities o Examples: income, prices of goods and services, age, location, season, laws and regulations, etc. 2. Tastes (also called Preferences) o Examples: Tastes are the likes and dislikes of different goods and services. • Taste is not measurable. • How can we find regularities of behavior and theorize about consumers' choice, and "explain" phenomena and "predict" changes when we can not even measure tastes? o We can assume that tastes are fixed • As constraints change what is the response by consumers? o They change their behavior in order to mitigate the adverse consequences of the constraints. • If you observe Americans driving small cars in the late 1970s and large c ars in the late 1990s, you would argue: o None of the above o The constraint, the force, that made us behave the way we did: the price of gasoline was high in the 1970s. The constraint changed Session 2 Thursday, January 7, 2016 10:23 AM Recap of Session 1 • Theory of consumer behavior o Constraints, or opportunities o Tastes (Preferences) • How can we find regularities of behavior and theorize about consumers' choice, and "explain" phenomena and "predict" changes when we can not even measure tastes? o Tastes are fixed and we look at changes in constraints • Clicker Question: Crime rates fell in the 1990s (as compared to 1970s (because) o There were tougher laws instituted against crimes in the 1990s • This is a constraint that changed, th e preference did not change. Postulates of consumer behavior • Postulate 1: People have preferences. o Example: • Bundle 1: 3 slices of pizza and 1 salad per day • Bundle 2: 2 slices of pizza and 2 salads per day • Answers, indifferent between them or prefer 1 to 2 or 2 to 1. These are the options for preferences. You prefer something over something else, or you're indifferent. • Postulate 2: More is preferred to less. o Consumption over a period of time of goods, that y ou would like access to. • Postulate 3: People are willing to substitute one good for another. o There are substitutes everywhere. • How relevant is the idea of "need" to consumer choices? o Need is not part of a choice. Everything that is a need, it is not a choi ce ex. Water/ • Concept of "value" o We cannot measure how much someone likes a good. But we can talk about how much they value a good. o What does it mean to say that you value a pair of jeans at $25? • It means, you are willing to give up $25 worth of other good s and services in order to get the pair of jeans. o Marginal Value: The MV of good x is the amount a consumer is willing to give up of other goods in order to consume an additional unit of good x. • Postulate 4:Marginal value of a good falls as the quantity c onsumed of the good increases. o Diminishing marginal value. o Example: • 1st glass of lemonade -----> $2 (willing to give up $2 of goods and services) • 2nd glass of lemonade ----> $0.50 • 3rd glass of lemonade -----> $0.00 § The marginal value falls o "Variety is the spice of life" • This can explain why the marginal value falls. • People like a variety of things. • You have a limited income but like a lot of goods. • For any single good, when you buy increasing units of the good, you are willing to give up less other goods. • Because income is scarce o Example: People who have their birthday right after or at Christmas feel cheated. Why? • Because of postulate 4; the marginal value of the gifts decreases. • It's the second round, the marginal value of the second celebration has declined. • Total value of good x is the amount a person would be willing to give up of other goods to have all of good x, rather than have none of the good at all. o Clicker question: The marginal value of consuming additional unit of a good, say T - shirt ______ because_____. • Decrease, consumers get bored after consuming certain units • Increases, as this is a good, not a bad • None of the above • They are less willing to give up money for this good over other goods because the marginal value has decreased. • As you are buying more tshirts, you want more of a variety. • Understanding and deriving a consumer's quantity choice at a given market price: Example 1: Sooki's marginal and total value of blue jeans (per year) Q MV($) Total Value ($) 1 50 50 2 40 90 3 30 120 4 20 140 5 10 150 6 0 150 • Supposed the price of a pair of jeans in the market is $30. How many pairs of jeans will Sooki voluntarily buy in a year? o For the first pair, Sooki is willing to give up $50 worth of other goods and services to have this pair of jeans. She is asked (by the market!) to pay $30. Will she buy this first pair of jeans? • Yes! It's a voluntary act. • "Net gain" or "consumer surplus" from the purchase of the first pair of jeans: $20. o For the second pair, Sooki is willing to give up $40 worth of other goods and services to have this pair of jeans. She is asked (by the market) to pay $ 30. Will she buy this second pair of jeans? • Yes! It's a voluntary act. • Net Gain from second pair: $10 o What about the 3rd pair of jeans? • Yes! o What about the 4th pair? • No! Because she would be losing $10 of net gains. o She buys a total of 3 pairs of jeans General rule for the amount of a good a consumer buys at a given market price: • A consumer purchases a quantity per year, such that at that quantity, the marginal value is equal to the price. o Calculating the net gains of this consumer (Calculating the consumer surplus for a consumer!) • Unit by unit § 1st unit: $50-$30=$20 § 2nd unit: $40-$30=$10.00 § 3rd unit: $30-$30=($0.00) • Customer surplus = Total value - Total Expenditure § TV = $120 § TE = Price * Quantity • TE= $30 * 3 = $90.00 $90 § CS = $120-$90=$30 • Marginal Value o For the first pair, Sooki is willing to give up $50 worth of other goods and services fro this pair of jeans. o For the second pair, she is willing to give up $40 worth of other goods and services. o For the third pair, she is willing to give up $30 worth of o ther goods and services. • Total Value o For 2 units, she's willing to give up $90 worth of other goods and services per year. o The total value is the total of all the marginal values o For 3 units, she's willing to give up $120 worth of other goods and services per year. Looking at different market prices: Price Q Total Exp Total value Consumer surplus $50 1 50 50 0 40 2 80 90 10 30 3 90 120 30 20 4 80 140 60 10 5 50 150 100 • What is the effect of a low er price on Consumer Surplus for Sooki? If she could bribe the store owner to buy jeans at $20 a pair instead of $30, what it the maximum amount she would be willing to pay the store owner for this privilege? o How much is a lower price blue jean worth to h er? <--- Really what the question is asking o How much is she willing to pay up to? o What are her net gains? o CS2 - CS1= amount she is willling to pay • $60-$30=$30 o It is worth to her $30 Clicker Question: In the maximization behavior of consumer purchase of a g ood, we consider a consumer to: • Maximize her consumer surplus Example 2 Jack has the following schedule of MV for consumption of steak and pizza per month: Q 1 2 3 4 5 6 MV steak ($) 14 12 10 8 6 4 MV Pizza ($) 18 15 12 9 6 3 The market price of steak is $6 per unit of steak. The market price of pizza is also $6 per unit of pizza. • How many steaks and pizzas does this consumer purchase per month? o 5, o Purchasing such that the marginal value equals the price. • How much does he spend on each good? o Total Expenditure=price times quantity o $6x$5=$30 • Does Jack value his total purchases of pizza and steaks the same? o NO! o TV of steak = $14 +$12 + $10 + $8 + $6 = $50.00 o TV of Pizza = $18 + $15 + $12 + $9 + $6 = $60.00 • How much should Jack be paid (i.e., c ompensated) in order for him to agree to purchase pizza at $9 a piece instead of $6 a piece? o A calculation of consumer surplus o Interpret, what is it worth to him to buy pizza at 6 versus 9 o At P = $6 per unit, quantity = 5 • TV = $60 • TE = $30 • CS1 = $30 o At P = $9 per unit, quantity = 4 • TV = $54 • TE = $36 (9x4) • CS2 = $18 (54-36) o The difference between the two consumer surpluses is $12. The difference between CS1 and CS2 is $12. o The answer is $12. o He requires to be paid at least $12 to agree to buy pizza at $9 a s lice. Session 3 Tuesday, January 12, 2016 10:28 AM Example: Sooki's MV and TV of various quantities of blue jeans per year: Q MV ($) Total Value ($) 1 50 50 2 40 90 3 30 120 4 20 140 5 10 150 6 0 150 • We said that if P=$30, then Sooki will buy __ 3_ pairs of jeans per year. • For the first pair she is willing to forgo $50 worth of other goods to acquire the first pair but she is only asked to forgo $30. • When you buy a pair of jeans, you have to forgo something else because of scarcity. • Rule: You buy a quantity such that you're marginal value equals the price o This rule implies that her consumer surplus is maximized at quantity 3 • She buys three units • At 3 units, the marginal value equals the market price!!!!! Q MV TV Total Exp CS 1 50 50 30 20 2 40 90 60 30 3 30 120 90 30 4 20 140 120 20 5 10 150 150 0 6 0 150 180 -30 • The concept of consumer surplus: CS=Total Value -Total Expenditure • Total Value = Sum of MV up to the quantity we purchase! • Consider the market price at $40 per pair. • What is the CS at different quantities? o At 1 unit, it's $20 o At 2 units, it's $30 o Etc. • At what quantity is her consumer surplus maximized? o At quantity 2 and 3, her CS is maximized. o Why are they the same? o Why does she choose quantity 3? • For our example, with "discrete" numbers, the consumer surplus has a flat top! • Therefore at a quantity where the marginal value = the price, the consumer surplus is maximized. • If the rate of consumption of blue jeans were on a more "continuous" scale: Q MV($) 1 50 1.1 49 1.2 48 1.3 47 . . 2 40 2.1 39 Choose Q* in a way such that the consumer surplus is maximized CS= TV-TE (TE=P*Q) d(CS) = d(TV) - d(P*Q) = 0 dQ dQ dQ MV - P = 0 Q* ----> MV - P = 0 ----> MV=P Using the continuous rule, we choose quantity three. The continuous numbers are the correct ones. Consider the market price for a good to be $40 per unit. At quantity W where MV = $40. A consumer maximizes his consumer surplus. Concept of Demand: • Explains the regularity of behavior among people who buy goods and services. o The demand of a particular good • A demand curve, shows the quantities of a good that consumers are willing to buy at different prices (keeping everything else constant). • Example: o Deriving Sooki's demand curve! o Go to the original table of MV and TV o Suppose that the market price is $50 per pair. How many pairs of jeans does she buy per year? 1 unit. At this price, price = marginal value o If P = $40, Q= 2. CS= $10 o If P = $30, Q= 3, CS =$30 o If P = $20, Q =4, CS= $60 • She's maximizing at each different rice • Drawing the MV curve against Quantity per year and fin d out what her "Demand" is. o At each price, it's telling me what to purchase • MV curve when market prices are improved conditions. • The law of demand: Keeping all else (income, prices of other goods and services, etc.) constant, if the price of the good per unit increases, then the quantity purchased will fall. • If the price decreases, then the quantity will go up. • We understand it's a downward sloping curve. • Quantity is dependent on the market price. • Sooki's demand curve for blue j eans: • Which area shows the total expenditure on 3 pairs of blue jeans per year? o The area is OACG (rectangle) • Which area shows the total value of purchase of 3 pairs of blue jeans per year? o The area is OBCG (trapezoid) • CS is the area between the price and the demand. o Area is ABC (Triangle) • Clicker question: If the price of a good falls, the consumer will purchase more according to the P = MV rule • How can you tell that consumers usually retain some CS? • Example of law of demand: donations to charity as an application of the law of demand o They say people are less charitable now than some 60 years ago. Did people just become less charitable or has there been a change in some constraint? o In the US, charitable donations are deducted from income before taxes ar e calculated. o In the 1950s and 60s, the top tax bracket was 70%. So a dollar given to charity would cost only 30 cents since $1 less of income would be reported ( and 70 cents tax on it would have been paid). o Then in 1980s tax codes changed and fell to ab out 34%. Did giving to charity cost more or less than before? It went down o After 1980, the opportunity cost of giving to charity caught 68 cents. • Deriving the market demand from individual demand curves. o Just adding Jane and Jack's quantity at a given mar ket price. Session 4 Thursday, January 14, 2016 10:23 AM Water-Diamond Paradox • Diamonds are much more highly priced than water. Does it mean that we "value" diamonds more than water? • It is the applications of concepts of marginal value and total value • Back to the example of blue jeans. o We diminishing marginal values. o As the quantity becomes large, the total value grows larger. o With the increasing quantity, the marginal value decreases, but the total value increases. • Diamonds have a much higher price. However, the price of a good reflects Marginal Value, not Total Value. • The Marginal Value of a good depends on the amount of that good already available. • While the Marginal value of an extra unit of water may be small - due to large supply water - its TOTAL VALUE is much larger than that of diamonds. Also, the amount of Consumer Surplus is much larger in consumption of water relative to consumption of diamonds. • If you take the total value, we see that water is valued more. • Just because the price of diamonds is so high, it doesn't mean that we value them more than water. • The amount of consumer surplus is much larger in consumption of water relative to consumption of diamonds. • Therefore, while diamonds are highly priced, implying that they have a high Marginal Value, their Total Value is less than water, the more essential good. • Suppose both the producers of diamonds and the City Water Authority threaten to cut off supplies unless we pay them a bribe. o We are willing to pay off the supplier not to reduce their supply? Water • Clicker question: The total value of all the quantities of a good you purchase is reflected fully in the amount you paid for that good. False • The Insights: o Neither the Price nor the Total Expenditure on a good me asure the Value of the quantity of that good for the consumers. o There is some consumer surplus • Applications: o Of plumbers and nurses, which one earns a higher salary? • Plumbers • Does this mean that people care more about their kitchen sinks than their health? § No. We pay plumbers more but that doesn't mean we value them more. The marginal value of the services of a nurse is lower. But that is not the total value. The wages reflect how much we MARGINALLY value a service, not totally value. o Would you expect univ ersity professors to earn the same salary across all fields? • No. • Does the lower salary of humanities professors reflect the fact that we do not value them as much as computer science professors? • Humanities professors are like water Application of Diminis hing Marginal Value • Why do people attempt to "smooth out" their consumption over time, leading to the phenomenon of lending and borrowing? • Smooth consumption: as income an age change, the consumption stays constant. • Example: o Suppose you get paid in pizzas every two days! o On the pay day, today, you get two fresh -off-the oven pizzas o You are not getting any pizza tomorrow. o Do you consume both pizzas today, or, do you keep one for tomorrow? o Consumption smoothing! • You keep one for today and one for tomorrow o Use the Postulate of diminishing MV (or law of Demand) to explain why people tend to save (and lend) or dis-save (borrow) in various phases of their lifetime. o Consider the Marginal Value of the follow two choices. In which case is the MV of consumption higher? a. Consuming the second pizza today b. Keeping the second pizza and consuming it tomorrow. • B has the higher marginal value. Meaning that you're better off if you eat the pizza tomorrow. • Present consumption versus future consumption • The Marginal Value of present consumption is: What a consumer is willing to give up of future consumption to consume today • Erratic consumption versus smooth consumption • People in engage in lending and borrowing because of smooth consumption. • Clicker Question: When inc ome (and therefore) consumption today is low relative to future income its MV is relatively high. 23. According to the law of demand, if vacations become cheaper, people should take more vacations. However, most people take exactly one vacation per year, whate ver the cost. Does the law of demand not apply here? Aspects of the Law of Demand: understanding the difference between relative versus dollar price • Law of demand: keeping all else constant, as the Price rises, then the Quantity demanded falls and vice versa. • The prices of goods and services generally do not stay constant • Inflation • Example: Alfredo buys only two goods and spends all his incomes on the two goods; salad and pizza. The prices of these goods in 2014 and 2015 are: Price 2014 Price in 2015 Salad $2 per LB $4 per LB Pizza $12 $18 o The price of both of these goods is rising. o Suppose Alfredo has enough income in 2015 to buy the same amounts as in 2014. Will Alfredo buy more, less or the same number of pizzas in 2015 (as compared with 2014)? • He will be buy more pizza in 2015 compared to 2014. • The relative price (or opportunity cost) of a pizza in 2014 is 6 ($12/$2) salads foregone. This means that for every additional pizza consumed Alfredo has to give up 6 salads. In 2015 the opportunity cost of a pizza is 4.5. According to the law of demand as the opportunity cost of a good decreases, the quantity of that good purchased increases. • So pizza is relatively cheaper even though its dollar price has increased! • What matters to the law of demand is the relative price of a good. Session 5 Tuesday, January 19, 2016 10:22 AM The degree of sensitivity of price changes • What matters to the law of demand: o The relative price of a good • Example: Year Price of all consumer goods (CPI) Price of gasoline Relative price of gasoline (*100) 1983 100 $1.20 1.20 2004 187 $1.79 0.95 2005 195 $2.50 1.28 2013 233.5 $3.29 1.41 2015 238.6 $2.60 1.09 o Base year: 1983 --> that is 100 (CPI) o From 1983 to 2004, the price of gasoline increased by 87 percent o CPI: indicative of changes in price o Relative price: Price divided by the CPI, multiplied by 100. o The relative price is called the real price. o In 2004, the dollar price of gasoline was higher than in 1983. o Would you say that in 2004 people bought less, the same, or more gasoline than in 1983? • They relatively buy more gasoline because the relative price fell. Price Elasticity of Demand • It measures how sensitive is the quantity demanded of the price • Applications of Demand: Introduction to the concept of elasticity and the price elasticity of demand • The Relative Elasticity of demand between two goods: Take the demand of 2 goods: beef and chicken. Suppose the seller of each good faces the demand curves drawn in figure below: the market demand for chicken and the market demand for beef: o Consider a price of $3 per lb. At this price the quantities of beef and chicken sold are equivalent. If the price for each good now drops by $1, which good will exhibit a larger change in its quantity demanded? We call this good to be “relatively elastic” compared to the other good. We will next measure the price elasticity of demand. A good with a relatively elastic demand will have a higher price elasticity measure than another good with a lower price elasticity of demand. In our graph above, for a given price, the relatively elastic demand will have a higher price elasticity measure. o Beef is more relatively elastic o The one that has a bigger quantity change, is more elastic. o Elastic means expansion: beef is expanding more • Example: o Consider a T-Shirt producer who faces the following market demand for her product: o If this person charges $100 for t-shirts she will sell 0. o If she charges $90, she will sell 10. o If she charges $20 per tshirt, she will sell 80 per day. o At Q=10, P=$90, Total Revenue= $900 (P*Q) The sellers call it total revenue, the buyers call it total expenditure o Suppose she increases her output by 1 unit, price falls by one unit (one dollar). This is due to the slope of 1. o Q=11, P=$89, TR=$979 o She gets $79 dollars more per day by dropping the pri ce o A: At Q=80, P=$20, TR=$1600 o B: As the quantity goes up to 81, Q=81, P=$19, TR=$1539 • In A, As the price drops, the total revenue rises • In B, as the price drops, the total revenue drops too o From 90 to 89, this is a small change percentage wise, 1.1% drop in price • 10 to 11, is a 10% change o It's the percentage change that matters • 20 to 19, 5% drop • 80 to 81 is about a 1% change o The price elasticity of demand is the "percentage" change in quantity demanded as Price changes (in percentage change) • Price elasticity of demand: e § E= percent change in Q demand/percent change in price • E= ΔQ/Q / ΔP/P § Δq = Q2-Q1 § Δp= P2-P1 • E= dQ/Q / dP/P ---> E= Dq/Dp * P/Q • Using 2 (not shown above) • P=90 Q=10 (A) o P1=$90 o P2=$89 o Q1=10 o Q2=11 o 11-10/10/89-90/90 ---> -9 o A 1% drop in the price will raise the quantity demanded by 9%. • Using 4 • E=dQ/dP * P/Q o dQ/dP=-1 o P/Q = -90/10 = -9 o -1*-9=9 o If you change the price by 1%, you change the quantity by 9% change in the other direction by the consumers. This makes the demand elastic • E=dQ/dP * P/Q o Quantity=0 it is infinite, infinitely elastic • At Another point, C o E=-1*50/50= -1 (unitary elasticity) This is at the midpoint of the demand curve • At Another point, B o P=$20 Q=80 o E=-1 *20/80 = -.25 • A 1$ drop will lead to .25% increase in quantity • This is inelastic • The quantity changes less than the price change o At another point, H • Q=100, P=0 • E=0 • This is called perfectly inelastic • There is no change in the quantity o In order to interpret the measure of price elasticity of demand easily, we consider the "absolute value" of E. • At point G, when Q=0 and P=100 we say |E| = infinite • At point A, |E|= 9 • At C|E|=1 • At B |E|=.25 • At H |E| = 0 • It starts with very large elasticity • The price of elasticity changes along the demand curve o When |E|>1, it is elastic • This is at points G and A and C o When |E|< 1, it is inelastic • This is at points B and H o It changes at point C because at C |E|=1 • Where demand is inelastic, if the seller raises the price of his product, what happens to his total revenue? o It will rise, because the quantity is a smaller percentage than the percentage in the price o Total Revenue goes up • Where the demand is elastic, if the seller raises the price of his product, what happens to his total revenue? o The total revenues fall • At unitary elasticity, there is n o change. • Example: A seller increases the price of its product by 10% and the quantity sold falls by 20%. What is the price elasticity of demand for this product? o It's larger than 1. o E=-20%/+10% = -2 o |E|=2 o The quantity is very sensitive • Clicker Question: When demand is inelastic, a small increase in the price of the good results in a smaller percentage decrease in quantity, leading to increased revenues of the seller Example • Here look for the midpoint of each line. • The midpoint shows where |E|=1 • An elastic demand" Q changes are very responsive to P changes. • As P falls by one percentage, Q increase y a larger percentage so the total revenue of the seller rises. • As P rises by one percent, Q falls by a larger percentage so that total revenue of the seller will fall. • An inelastic demand, Q changes are not so responsive to P changes. • As P falls by one percent, Q increases by a smaller percentage so that total revenue of the seller will fall. • As the P rises by one percentage, Q falls by a smaller percentage so the total revenue of the seller will rise. Applications 1. When the OPEC countries meet for decision on their (joint) production, what is their objective? • They want to increase revenue Should they cut or increase their output? If demand for oil is inelastic, then in order to increase revenues they should --------- production of oil. • Cut. If you decrease by a little bit, the price change shoots up. If demand for oil is elastic, in order to increase revenues, they should --------- production of oil. • Increase. 2. Drug interdictions causes the price of drugs to --rise----- (rise/fall) Since demand for drugs is ----inelastic---------- (elastic/inelastic) total expenditures by addicts --increase-------- (increases/decreases) Therefore the number of crimes committed is likely to -----go up ----------- (go up/go down) Law enforcement expenditures will also have to rise. Legalizing drugs will force the price ---go down----- and with it expenditures will -----go down----- --------(go down/go up) and so will the number of crimes committed --fall---- (rise/fall) Session 6 Thursday, January 21, 2016 10:27 AM Example: Why do some retailers give discounts to students? • Higher price sensitivity: Students • Students have a higher price elasticity of demand compared to professionals. • By lowering the price a little bit for students, the quantity will dramatically increase. • This is a revenue increasing policy. Dimensions of the concept of elasticity • A coffee table has a higher price elasti city of demand than furniture because it has substitutes. • Brand names tend to have a high price elasticity of demand Elasticity changes over time: Is the price elasticity of demand for gasoline higher in the short run or the long run? • Answer: over the long run • There's time to adjust to the changes. Limiting Cases E=dQ/dP * P/Q On Graph A: the Quantity is fixed ---> Perfectly Inelastic Graph B: The Price is fixed ---> Perfectly Elastic • Point of view: In a highly competitive market where there's lots of bu yers and lots of sellers perfectly elastic demand Empirical Evidence of price elasticity of demand for selected goods: Example of the price elasticity of demand: • The price elasticity of demand for coffee is estimated to be -.16. If the quantity demanded was 4 billion lbs. per year when the price of coffee is $3.60 per lb., how much coffee would be demanded at $2.4 per lb.? o Q2=? o Elasticity=-0.16 o Q1= 4 billion lbs o P1= $3.6 per lb o P2= $2.4 per lb E= qz-q1/q1/p2-p1/p1 -.16=-0.16 qq2-4/4/2.4-3.6/3.6 Q2-4/4//-.333=-.16 Qz-4/4=-.16 (-.333)=.053 Qz-4=4(.053) Q2= 4+4(.053)=4.213 Shipping Out the Good Apples • Why are the good watermelons shipped out? • The high quality goods are exported because of the law of demand There has been a significant drop in the number of smokers in the US in the last few decades. How does the law of demand help explain this phenomenon? • Smoking becomes more costly as life expectancy increases • The price of smoking includes both the market price of cigarettes and the cost of foregone years of life. Using the law of demand, how do we explain the increase in the obesity rates in the US? • The production of sugary things: lots of substitutes, it's become cheaper • Quantity of calories consumed versus price per calorie Session 7 Tuesday, January 26, 2016 10:23 AM Supply in pure exchange: supply without production Exchange takes place until all the mutual gains are exhausted The source of mutual gains from exchange and derivation of the supply behavior in pure exchange An Example: • Trevor doesn't have any shirts and would like buy one! He values a shirt at $20 (M V=$20). • Sunil ahs received an accumulated a lot of shirt. He values a shirt at $0 (MV=$0) • Trevor would be happy to buy a shirt from Sunil for anything less than $20 and Sunil would be happy to get anything from Trevor. • If P=$10, Trevor gains $10 and Sunil gains $10 • If P= $12, Trevor gains $8 and Sunil gains $12 • If P= $5, Trevor gains $15 and Sunil gains $5 • What common attribute do all these calculations have in common? The sum of the gains is always $20. • What is the sum of their gains from trade? o $20, no matter what the price is • The source of mutual benefit is the differences between marginal evaluations of a good by different people • Mutual gains from trade: o Trade takes place until a ll the mutual gains from trade are exhausted • A table of MVs for A and B for shirts • We assume that A has no shirts at all. B has 11 shirts o Quantity MV ($) for A MV ($) for B 1 12 20 2 10 18 3 8 16 4 6 14 5 4 12 6 2 10 7 0 8 8 0 6 9 0 4 10 0 2 11 0 0 • For Q=1, A is willing to forego $12, and B is willing to forego $20 • Trade takes place until there are no more gains • An exchange that has the biggest difference between marginal values For the 1st item that B gives up, A would be willing to pay $12. So the difference in MVS is $12 and the maximum amount of mutual gains from this trade is $12. The next item is valued by B at $2, If B is offered $3 for the shirt, will she give it up and se ll it to A? Yes, A values the 2nd shirt at $1 -. The maximum mutual gains from this trade is $8. o For the 3rd shirt, there's a $4 gain. For the 4th shirt, there's a break point, the MVs are the same. • Either three units or four units are traded. The total gains from trade are $12+$8+$4+$0=$24 • We conclude that trade takes place until all the gains from trade are exhausted. Clicker Question • The price they agree upon may change the distribution of the gains between the buyer and the seller, but the total gains will be $24 for nay set of mutually agreed prices. • Two major insights about trade: Some trade is better than none More trade is n ot necessarily preferred by all (to less trade) as some groups may lose when trade expands. Evidence of mutual gains from trade: • Banning trade in certain goods o Countries sometimes ban imports of certain goods. o These goods can still be found in th ose countries through smuggling: it is dangerous and costly, but there are sufficiently high mutual gains that it does take place • The Khunjerab Pass between China and Pakistan on the Ancient Silk Road • When a country desires to punish another with out going to war with them. Deriving the supply behavior from the MV schedule in pure exchange. • Let's consider Meena with an endowment of 8 comic books. We can think of a scenario where she will voluntarily offer a quantity of her books for sale, giv en a market price for comic books. o $12 At Q 1, A's MV=$12, At Q11, B's MV=$0 Marginal Value ($) Quantity of Comic Books 14 1 12 2 10 3 8 4 6 5 4 6 2 7 0 8 • We derive the supply behavior for Meena from her marginal value (demand) behavior for comic books. • This table shows that at the market price of $14 per book, she will demand a quantity such that her MV=market price. Therefore at the market price of $14, Meena will demand 1 book. • Since she has 8, how many will she offer for sale? o7 She only "values" the second book at $12 of other goods and services given up, not $14. • Suppose now the market price is $12 per book. How many books does she demand? She keeps 2 and keeps 6 Market Price per Book ($) Meena’s Quantity Demanded Meena’s quantity of books supplied 14 1 7 12 2 6 10 3 5 8 4 4 6 5 3 4 6 2 2 7 1 0 8 0 • This table is Deriving Meena's Supply Schedule • The first and third column above show the supply schedule for Meena. • Suppose the market price is $8 per book. She will sell 4 • Her total revenue is price times quantity so 8*4=$32 • The supply graph is upward sloping • Revenues-Cost=Sellers Surplus • Does a seller have a Seller's Surplus? • To give up her first book, Meena requires to be paid $2. • As a seller, she values her first book to sell at $2. • When she gives up something that she values, at $2, she incurs a cost. • This is called the marginal cost of the first book = $2 • She values her second book at $4 • So the marginal cost of the second book is $4. • TheMCofthe3rd=$6. • TheMCofthe4th=$8 • The total cost of selling 4 books at the price of $8 is 2+4+6+8=20 • $20 is the total cost • The total revenue is price times quantity ---> $8*4=$32 • Her surplus is $12. • If the market price is P=$8, the seller supplies a quantity such that P=MC. • In the graph of the supply curve: o The area below the price and above the supply curve pertains to producer surplus, or seller's rent. o The area below the supply curve up to the quantity offered for sale is seller's total cost of selling o The whole square is the total revenue Session 8 Thursday, January 28, 2016 10:30 AM Meena's Supply behavior • If the market price is P=$8, the seller supplies a Quantity such that P=MC. • Rent=seller's surplus Derivation of the Market Supply Curve • Adding the quantities on the x -axis, add the quantities across the suppliers Market Equilibrium and Economic Efficiency: • Putting the market supply and market demand together. • For the 1st unit, the marginal cost is $6 and the marginal value of the buyer is $14 so the trade will take place. • For the 2nd unit, the marginal cos t is $8 and the marginal value is $12 so the trade will take place. • As long as MVs are different, exchange will be mutually beneficial. • Trade will stop where the marginal cost of the seller is equal to the marginal value of the buyer. So at Qe, trade will not take place. • At Pe, the market is in a Pareto Optimal or efficient situation. Here, the gains from exchange are maximized. These gains are the CS and seller's rents together the triangle to the left of Qe units. • Quantity demanded=Quantity supplied = Quantity equilibrium Important features of the organized markets: • In a modern economy with organized markets, there is a single price for most goods. • Image two adjacent markets for apples. One market price is $1 per pound and the other price is $2 per pound. Everyone would purchase apples from the lower price store Haggling • Suppose you value a good at $12 and the price is $10. However, since thi s is a "haggling" market, you entertain the idea of haggling to reduce the price, like other consumers. • What is the cost of haggling for 15 minutes if your job pays $20 hour? • Will you haggle? No • Haggling is costly. (negotiate) Clicker Question: In explaining how the equilibrium price and quantity are reached, we can reason that if the starting price is too high, a surplus develops and the sellers will compete with each other thus reducing the price. Transactions costs are characteristics o r attributes that exist in some markets where mutually beneficial trade is difficult to achieve. Transaction costs include: • Information cost about the buyer/seller is (where the goods are) • Costs of establishing the salient features/properties of goods traded • Cost of reaching an agreement over the price of the good or service to be traded (haggling) • Cost of establishing and enforcing property rights over the goods and services trad ed.
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