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Microeconomics ECON 1110 Prelim #2 study guide

by: genehan

Microeconomics ECON 1110 Prelim #2 study guide ECON 1110

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Detailed notes for material that is covered for Prelim #2 for ECON 1110
Introductory Microeconomics
Professor Thomas
Study Guide
50 ?




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This 8 page Study Guide was uploaded by genehan on Saturday January 30, 2016. The Study Guide belongs to ECON 1110 at Cornell University taught by Professor Thomas in Summer 2015. Since its upload, it has received 44 views. For similar materials see Introductory Microeconomics in Economcs at Cornell University.

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Date Created: 01/30/16
Lecture  #14  General  Equilibrium  and  Perfect  Competition  Part  #1  October  15,  2015   • Households  supply  land,  labor,  capital  into  input  markets  and  firms  demand  these     • Firms  supply  goods  and  services  in  the  output  market  as  demanded  by  households   • Partial  equilibrium  analysis  –  individual  markets  that  influence  each  other   o Break  economy  as  a  whole  into  these  partial  markets  (soy,  wheat,  corn,  iron,  gold,  copper   market  etc)     o Have  only  been  looking  at  individual  markets  in  isolation   o For  economy  as  a  whole,  there  is  interplay  between  the  individual  markets   • General  equilibrium  analysis  –  look  at  economy  as  a  whole,  look  at  all  markets  in  equilibrium   o Amazon  comes  out  with  e-­‐books/kindle,  many  changes  in  other  markets  such  as  repair   services,  book  stores,  paper  manufactures,  etc.   • Market  adjustment  to  changes  in  demand     o Industries  in  Equilibrium   o Look  at  industry  X  (kindle  market)  and  industry  Y  (everything  else  in  economy)   § Assume  that  the  firms  that  make  up  these  industries  are  also  in  equilibrium   • Increase  in  demand  for  X  (change  in  preference)   o demand  curve  shiftsànew  short  run  equilibrium  quantity  and  price  are  both   higheràfirms  in  industry  X  who  were  profit-­‐maximizing  are  now  earning  economic  profits   (everything  in  production  is  same  but  price  increases  so  MR  is  now  greater  than  MC)  but   this  cannot  be  sustained  in  the  long  runàprofits  emerge  in  Industry  X  due  to  price  increase   o Demand  for  good  Y  decreases  when  demand  for  X  increases  (zero  sum  game)àlower   equilibrium  quantity  and  lower  equilibrium  priceàlosses  emerge  in  industry  Y  (same  cost   and  production  but  price  is  lower  so  MR  is  now  below  MC)  but  will  not  sustain  in  the  long   run  (can  change  the  scale  of  production)     o Increase  in  supply  for  industry  X  -­‐  In  industry  X  long  run,  supply  curve  increases  as  firms   enteràprice  returns  to  old  equilibrium  price  but  quantity  is  greateràeconomic  profits  are   eliminated  because  more  firms/more  producers  so  everybody  goes  back  to  profit   maximizing  point  where  MC=MR   § Demand  curve  shifts  up  and  the  supply  curve  also  shifts  up  to  a  greater  supply   § Profits  eliminated  in  industry  X  –  when  there  is  the  shift  in  demand  curve,  the  MC   and  ATC  curves  show  the  loss  that  occurs  from  this  shift   o Decrease  in  supply  of  Y  -­‐  In  industry  Y  long  run,  firms  exit  and  supply  leavesàsupply  curve   contractsànew  equilibrium  quantity  is  lower  and  price  returns  to  original  priceàfirms   remaining  in  industry  Y  go  back  to  profit-­‐maximizing  point   § supply  and  demand  curves  will  decrease  while  the  price  still  remains  the  same  and   units  of  Y  decreased   o Losses  eliminated  in  industry  Y  –  when  there  is  a  shift  in  equilibrium  (both  demand  and   supply  curve  shift)  in  such  a  way  that  price  remains  the  same  but  the  units  of  X  increase   and  units  of  Y  decrease     o Short  runàeconomic  profits  generated,  attracting  investment  in  long  runàultimately  get   back  to  new  general  equilibrium     o Example  –  both  kindles  and  nooks  are  E-­‐readers  and  have  the  same  chargers   § But  they  are  actually  not  the  same,  they  use  slightly  different  technologies   Lecture  #15  General  Equilibrium  and  Perfect  Competition  Part  #2  October  20,  2015   • Pareto  efficiency  (pareto  optimality)  –  the  condition  in  which  the  no  change  is  possible  that  will   make  some  members  of  society  better  off  without  making  some  other  members  of  society  worse   off   o Everyone  has  different  view  on  what  “better  off”  is  defined  as   § Possible  utility  –  better  off  in  societal  way,  makes  you  feel  better  because  you  are   doing  something  selfless  (community  service),  better  off  in  a  measurable  economic   sense   o How  can  we  account  for  changes  that  make  some  people  better  off  and  others  worse  off?     § Even  if  society  as  whole  may  benefit,  some  individuals  will  be  worse  off  in  some  way   o A  perfectly  competitive  economy  is  economically  efficient  and  will  lead  to  a  Pareto  efficient   set  of  outcomes   o Equilibrium  is  a  pareto  efficient  situation  on  both  supply  and  demand  sides  –  can’t  make   someone  better  off  without  making  someone  worse  off   • 3  basic  questions  –  perfect  competition   o what  gets  produced?   o How  is  it  produced?   o Who  gets  what  is  produced?   § Resources  are  allocated  among  firms  efficiently   § Final  products  are  distributed  among  households  efficiently   § Price  mechanism  -­‐    system  procures  the  things  that  people  want   • Efficient  allocation  of  resources  –  we  assume:   o Factor  markets  are  competitive  and  open   o All  firms  pay  the  same  prices  for  inputs   o All  firms  maximize  profits   o We  then  conclude  à  The  allocation  of  resources  among  firms  is  efficient   • Efficient  distribution  of  outputs  –  we  assume:     o Everyone  buys  as  much  or  as  little  of  the  goods  and  services  they  desire  in  the  same   markets   o Everyone  pays  the  same  price  for  the  same  good  or  service   o We  then  concludeàthe  distribution  of  outputs  among  households  is  efficient   • If  everyone  shops  freely  in  the  same  markets,  no  redistribution  of  final  outputs  among  people  will   make  them  better  off;  the  distribution  is  Pareto  efficient.     • Efficiency  does  not  guarantee  equity  –  all  we  care  about  is  efficiency,  equity  comes  in  when  we  talk   about  normative  things   o Equitable  –  is  not  equal  but  proportional  based  on  some  set  of  characteristics   • Efficient  mix  of  outputs  –  if  we  assume:   o All  firms  equate  price  and  marginal  cost X P  =X  MC   o We  can  then  conclude  àthe  “right  amount”  of  the  “right  goods  and  services”  will  be   produced   o Society  will  produce  the  efficient  mix  of  output   o If  PX>MC Xthen  society  gains  by  producing  more  X   o If  PX<MC Xthen  society  gains  by  producing  less  X   • Perfect  competition  versus  real  markets   o The  model  of  perfect  competition  is  built  upon  a  series  of  assumptions,  many  of  which  do   not  always  hold  in  the  real  world   • Market  failure   o Occurs  when  resources  are  misallocated,  or  allocated  inefficiently   • 4  sources  of  market  failure   o an  imperfect  market  structure  or  noncompetitive  behavior   o the  existence  of  public  goods   o the  presence  of  external  costs  and  benefits   o the  existence  of  imperfect  information   • imperfect  markets  (example  –  oil  production)   o in  imperfectly  competitive  markets  –  with  fewer  firms  competing  and  limited  entry  by  new   firms  –  prices  will  not  necessarily  equal  marginal  costs   § price  is  not  always  going  to  equal  MC  à  not  guaranteed  a  pareto  efficient  outcome   o free  entry  and  exit  does  not  really  exist  in  imperfect  market   o as  a  result,  in  a  market  with  firms  that  have  some  market  power  –  where  firms  do  not   behave  as  price  takers  –  we  cannot  be  assured  of  an  efficient  mix  of  output   • public  goods   o public  goods  (or  social  goods)  are  those  goods  and  services  that  bestow  collective  benefit   on  members  of  society   o generally  speaking,  we  cannot  exclude  people  from  consuming  (pay  $0  since  we’re  going  to   get  protected  by  national  guard  anyway)   • externalities     o costs  imposed  or  benefits  bestowed  on  an  individual  or  a  group  that  is  outside,  or  external   to,  the  transaction  (pollution,  second  hand  smoke)   o market  can’t  account  for  them   o example  –  teacher  not  getting  measles  because  students  were  vaccinated     • imperfect  information   o absence  of  full  knowledge  concerning  product  characteristics,  available  prices,  etc.     Lecture  #16  Monopoly  and  Antitrust  Policy  Part  #1  October  22,  2015   • Perfect  competition   o Many  small  firms   o Homogenous  products   o “price  taker”  –  can  sell  as  many  as  they  want  as  long  as  they  charge  same  price   o free  entry  and  exit   • monopoly   o single  large  firm   o homogenous  products     o “price  maker”  –  determines  price  and  quantity   o entry  blocked   • oligopoly   o few  large  firms   o homogenous  or  differentiated     o “price  maker”     o significant  barriers  to  entry   • monopolistic  competition   o many  firms   o differentiated   o “price  maker”     o free  entry  and  exit   • Example  of  pure  monopoly  –  USPS  (legal  barrier  to  entry)   o Law  restricts  anyone  else  from  opening  a  company  that  delivers  first  class  mail   o Private  Express  Statute  gave  USPS  exclusive  rights  to  deliver  letters  for  a  fee  à  USPS   controls  price  of  letters  deliveredàgave  a  legal  barrier  to  entry   § Unless  marked  “extremely  urgent”àcan  use  other  delivery  services   • Price  and  output  decisions  –  perfect  competition   o Downward  demand  curve  ,  upward  supply  for  the  market  as  whole   o But  an  individual  firm  faces  a  horizontal  demand  curveàno  price  decision   • Price  and  output  decisions  –  monopoly   o Only  one  firmàsupply  and  demand  faced  by  marketplace  are  identical  to  those  faced  by   monopolist   o They  get  to  determine  their  priceàmaking  decision  for  quantity  and  price  (intertwined   togetheràmust  be  decided  together)   § To  sell  moreàmust  decrease  price    (law  of  demand)   § MR  no  longer  equal  to  price  and  no  longer  equal  to  demand  for  monopoly  (no  longer   a  straight  line)   o At  every  level  of  output  (except  1  unit),  the  monopolist’s  MR  is  below  price  à  because  in   order  to  sell  more  units  of  output,  the  monopolist  must  lower  price   o demand  –  downward  slope  ,  MR  -­‐  steeper  downward  slope  ,  TR  –  inverse  parabola  (don’t   want  to  produce  past  Q*  because  would  be  making  less  TR)   § a  monopoly’s  MR  curve  bisects  the  quantity  axis  between  the  origin  and  the  point  at   which  the  demand  curve  hits  the  quantity  axis   § a  monopoly’s  MR  curve  shows  a  change  in  TR  that  results  as  the  firm  moves  along   the  segment  of  the  demand  curve  that  lies  exactly  above  it   o MC=MR  is  ALWAYS  profit  maximizing  point   § Find  quantity  (MC=MR)  first  and  then  read  vertically  up  to  demand  function  to  find   the  price     § At  5  units  –  TR  =  P  x  Q     • TC  =  ATC  x  Q   • Profit  (P  -­‐  ATC)  x  Q   o No  independent  supply  curve   § A  monopoly  firm  has  no  supply  curve  that  is  independent  of  the  demand  curve  for   its  product     § A  monopolist  sets  both  price  and  quantity,  and  the  amount  of  output  it  supplies   depends  on  its  MC  curve  and  the  demand  curve  that  it  faces   o Comparing  perfect  competition  and  monopoly     § Quantity  produced  by  the  monopoly  will  be  less  than  the  perfectly  competitive  level   of  output  – MQ  <PC     à  dead  weight  lossàno  maximization  of  consumer  or   producer  surplus  so  monopoly  is  inefficient   § Price  charged  by  monopoly  will  be  higher  than  the  perfectly  competitive  price   • P M  > PC     o Perfect  competition     § Supply  function  is  summation  of  all  individual  firm’s  supply  curves     § P=D=MC=minimum  SRAC  =  tangent  to  horizontal  LRAC   o Monopoly  (P  > MP   PC    Q M  <  PC   )   § Profit  maximizing  level  of  production  =  MR=MC   • Get  equilibrium  quantityàread  up  to  demand  function  to  find  equilibrium   price  à  at  this  point,  the  monopolist  IS  the  industry   • Supply  curve  is  really  the  MC  curve   o Monopoly  in  long  run   § Monopolies  can  exist  in  long  run  because  of  barriers  to  entry   o Barriers  to  entry   § factors  that  prevent  new  firms  from  entering  and  competing  in  imperfectly   competitive  industries   § Natural  monopoly  –  an  industry  that  realizes  such  large  economies  of  scale  that   single-­‐firm  production  of  that  good  or  service  is  most  efficient  (tap  water)   • Have  huge  increasing  returns  to  scale   § Patent  –  a  barrier  to  entry  that  grants  exclusive  use  of  the  patented  product  or   process  to  the  inventor   § Government  rules  –  government-­‐imposed  entry  restrictions  on  firms  as  a  way  of   controlling  activity  (USPS)   § Ownership  of  scarce  factor  of  production  -­‐  if  production  requires  a  particular  input   and  one  firm  owns  the  entire  supply  of  that  input,  that  firm  will  control  the  industry   • Example  –  Iron  man  created  a  new  element  and  has  ownership  over   Lecture  #17  Monopoly  and  Antitrust  Policy  Part  #2  October  27,  2015   • Profit  maximizing  in  monopoly   o Identify  where  MR=MC  move  up  to  demand  function  and  over  to  get  profit  maximizing   price  (D=Q )M   • Social  cost  in  monopoly   o Costs  $2  to  make  but  charges  $4  so  consumer  surplus  is  lost   o Demand  –  approximate  benefits  to  consumers  of  raising  output  above  2000  units     o ABC  approximates  the  net  social  gain  of  moving  from  2000  (monopoly  level)  to  4000  units   (PC  level)  of  output  (the  net  social  loss  when  monopoly  reduces  output  from  4000  to  2000   units)     o Monopoly  is  inefficient  –  there  is  a  social  cost     o Can’t  calculate  producer  surplus  because  there  is  no  supply  function  –  the  producer  choice   about  how  much  to  supply  cannot  be  separated  from  the  price  decision     • Rent  seeking   o Rent  seeking  behavior  –  actions  taken  by  households  or  firms  to  preserve  economic  profits     § Firms  may  sue  new  companies  entering,  buying  all  suppliers  to  restrict  supply  to   other  firms,  firms  want  to  be  the  only  one   o Government  failure  –  occurs  when  the  government  becomes  the  tool  of  the  rent  seeker  and   the  allocation  of  resources  is  made  even  less  efficient  by  the  intervention  of  government     o Public  choice  theory  –  an  economic  theory  that  the  public  officials  who  set  economic   policies  and  regulate  the  players  act  in  their  own  self  interest,  just  as  firms  do   • Price  discrimination  –  charging  different  prices  to  different  buyers  for  identical  products   • Perfect  price  discrimination  –  occurs  when  a  firms  charges  the  maximum  amount  that  buyers  are   willing  to  pay  for  each  unit   • Price  discrimination   o Consumer  A  is  willing  to  pay  $5.75  when  price  is  $4     o A  monopolist  who  cannot  price  discriminate  will  maximize  profit  by  setting  price  at  $4   § Firm  earns  $2  in  profit  and  consumer  A  enjoys  a  consumer  surplus  of  $1.75   o For  a  perfectly  price  discriminating  monopolist,  the  demand  curve  is  the  same  as  marginal   revenue     o The  firm  will  produce  as  long  as  MR>MC  up  to  the  perfectly  competitive  quantity     § At  c ,  profit  is  the  entire  shaded  area  and  consumer  surplus  is  0     • Examples  of  price  discrimination     o Movie  discounts  for  different  ages     o Kids  eat  free  all  weekend   o Free  parking  every  night  and  every  weekend     • Optimal  price  discrimination  strategy   o The  firm  segments  the  market  into  different  identifiable  groups,  each  with  a  different   elasticity  of  demand     o The  optimal  pricing  strategy  for  a  firm  that  can  sell  in  more  than  one  market  is  to  charge   higher  prices  in  markets  with  low  demand  elasticities     • Antitrust  policy   o Sherman  Act  of  1890   o Clayton  Act     • What  happens  when  you  google?   Lecture  #  18  Oligopoly  October  29,  2015   • Market  structure  with  few  large  firms   • Can  have  homogenous  or  differentiated  products     • Determines  both  price  and  quantity  and  are  usually  significant  barriers  to  entry   • Oligopolists  compete  with  one  another  not  only  in  price,  but  also  in:   o Developing  new  products   o Market  and  advertising  those  products   o Developing  complements  to  use  with  the  products   • Five  Forces  Model  (Michael  Porter)   o Suppliers,  potential  entrants,  buyers,  substitutes,  existing  rivalriesàall  play  role  in   industry  competition   o About  who  is  the  most  profitable  not  who  is  the  biggest   • Concentration  ratio   o The  share  of  industry  output  in  sales  or  employment  accounted  for  by  the  top  firms   o CR m=  1  2  s3  +  s …     o Most  common  ratios  we  look  at  are  4R  and 8  CR   o No  concentration  0%  -­‐  perfect  competition  or  monopolistic  competition   o low  0-­‐50%  -­‐  perfect  competition  or  oligopoly   o medium  50-­‐80%  -­‐  likely  an  oligopoly   o high  80-­‐100%  -­‐  oligopoly  to  monopoly   o total  concentration100%  -­‐  extremely  concentrated  oligopoly     • contestable  markets   o markets  in  which  entry  and  exit  are  easy  enough  (the  threat  of  entry)  to  hold  prices  to  a   competitive  level,  even  if  no  entry  actually  occurs   o threat  of  entry/possibility  that  some  entry  may  actually  happen  is  enough  to  hold  prices  at   competitive  level  and  below  monopoly  level   • oligopoly  models   o collusion  model,  price-­‐leadership  model,  cournot  model   • Collusion  model   o Cartel  –  a  group  of  firms  that  gets  together  and  makes  joint  price  and  output  decisions  to   maximize  join  profits     § Example  –  OPEC  (organization  of  petroleum  exporting  companies)  –  fix  quantities  to   maximize  profits  of  OPEC     o Collusion  –  occurs  when  price  and  quantity  fixing  agreements  among  producers  are  explicit     o Tacit  collusion  –  occurs  when  price  and  quantity  fixing  agreements  among  producers  are   implicit     • Price  leadership  model   o Form  of  oligopoly  in  which  one  dominant  firm  sets  price  and  all  the  smaller  firms  in  the   industry  follow  its  pricing  policy   o One  dominant  firm  leads  the  path,  other  firms  voluntarily  follow  the  price  leader   o One  danger  is  predatory  pricing     § Walmart  is  price-­‐leader  and  charge  prices  so  low  that  local  grocery  stores  couldn’t   competeàgo  out  of  businessàwalmart  becomes  main  employer  (not  always   outcome  but  is  a  potential  danger)   • Cournot  model   o Duopoly  –  a  two  firm  oligopoly   o Price  and  competition  are  intertwined  with  one  another   o Rather  than  showing  price  and  quantity  on  graph,  show  quantity  of  output  for  firm  A  and   firm  B  are  shown  on  axes   § We  plot  each  firm’s  reaction  function   o Combine  reaction  functions  together  (face  same  market  D  function)àfor  any  given  price,   the  quantity  demanded  by  market  at  that  price  will  be  allocated  between  firm  A  and  B   based  on  reaction  functions   o Each  firm  produces  to  maximize  profits  subject  to  constraints  by  decisions  of  the  other  firm   o As  firm  A’s  production  decreases,  firm  B’s  production  increases  (vise  versa)     • Monopoly  vs  duopoly     o In  duopoly,  output  produced  is  greater  than  the  profit  maximizing  quantity  for  the   monopoly   § PC  Q  =  4000   § Duopoly  –  2666     § Monopoly  A  =  2000  (inefficient)     o PC  >  oligopoly  >  monopoly  (PC  generates  most  consumer  surplus)     • Herfindahl-­‐Hirschman  Index  HHI   o Index  of  market  concentration  found  by  summing  the  square  of  percentage  shares  of  firms   in  a  market   Lecture  #19  Oligopoly  and  Game  Theory  November  3,  2015   • Efficiency  –  optimal  allocation  of  factors  of  production  and  outputs  along  households     • Equity  –  normative  question  –  is  current  distribution  of  income  in  US  equitable?  (do  we  agree   from  justice  perspective?)   • Perfect  price  discrimination  is  when  you  charge  every  consumer  the  maximum  they  are  willing  to   pay   • Price  discrimination  –  when  you  group  people  together  and  charge  them  a  different  price     • Oligopoly   o Oligopolists  compete  with  one  another  not  only  in  price  but  also  in     § Developing  new  products,  marketing  and  advertising  those  products,  and   developing  complements  to  use  with  the  products   • Cournot  model   o Duopoly     o Plot  each  firm’s  reaction  function  by  putting  quantity  of  output  for  firm  A  and  firm  B  on  the   axes  instead  of  price  and  quantity   o Tells  us  how  we  are  going  to  allocate  the  Q  between  the  two  firms     • Game  Theory     o Analyzes  the  choices  made  by  rival  firms,  people,  and  even  governments  when  they  are   trying  to  maximize  their  own  well  being  while  anticipating  and  reacting  to  the  actions  of   others  in  environment     o Focuses  on  how  agents  interact  with  each  other     • Prisoner’s  dilemma   o This  is  a  game  in  which  the  players  are  prevented  from  communicating  and  cooperating,   and  in  which  each  has  a  dominant  strategy  that  leaves  them  both  worse  off  than  if  they  had   cooperated   o Dominant  strategy  –  a  strategy  that  is  best  no  matter  what  the  opposition  does   § Betray  the  other  prisoner     • Nash  Equilibrium     o Resulting  outcome  when  all  game  participants  play  their  best  strategy,  given  what  their   competitors  are  going     § Both  prisoners  betray  each  other     • Tit-­‐for-­‐tat  –  repeating  prisoner’s  dilemma   o Assume  A  stayed  silent  but  B  betrayed  A     o A  sentenced  to  3  years  while  B  goes  free   o Career  criminalsàboth  arrested  again  shortly  after  A’s  release  from  jail  and  once  again  find   themselves  in  the  same  situation  for  the  new  crime     o In  a  pure  tit-­‐for-­‐tat  strategy,  whatever  the  other  person  did  to  you  last  round,  you’re  going   to  do  the  same  in  the  next  round   • Payoff  matrix  for  advertising  game   o Each  player  has  a  dominant  strategy  –  advertise     § Both  advertise  -­‐  $10,000  each     § Both  don’t  advertise  -­‐  $50,000  each   • Payoff  matrix:  left/right  –  top/bottom   o C  can  choose  top  or  bottom   o D  can  choose  left  or  right   o C  doesn’t  have  a  dominant  strategy   § If  D  plays  left,  C  plays  top     § If  D  plays  right,  C  plays  bottom     o D  has  a  dominant  strategy     § D  will  play  right  regardless  of  what  C  does   o If  C  believes  that  D  is  rational,  C  will  predict  D  will  play  right.  C  concludes  that  D  will  play   right  and  C  will  play  bottom     § C’s  strategy  depends  on  what  D  does   o Result  is  a  Nash  equilibrium  because  each  player  is  doing  the  best  that  it  can  given  what  the   other  is  doing   • In  Game  2  –  C  must  be  very  certain  that  D  will  play  right  because  if  D  plays  left  and  C  plays  bottom,   C  loses  $10,000   o C  will  probably  play  top  to  minimize  potential  loss  if  the  probability  of  D’s  choosing  Left  is   at  all  significant     o MINIMAX  STRATEGY  –  minimizing  likelihood  of  maximum  loss   • John  Nash  –  game  theory  stuff  


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