Microeconomics ECON 1110 Prelim #2 study guide
Microeconomics ECON 1110 Prelim #2 study guide ECON 1110
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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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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 shiftsànew short run equilibrium quantity and price are both higheràfirms 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 runàprofits emerge in Industry X due to price increase o Demand for good Y decreases when demand for X increases (zero sum game)àlower equilibrium quantity and lower equilibrium priceàlosses 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 enteràprice returns to old equilibrium price but quantity is greateràeconomic 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 leavesàsupply curve contractsànew equilibrium quantity is lower and price returns to original priceàfirms 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 runàeconomic profits generated, attracting investment in long runàultimately 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 concludeàthe 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 àthe “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 deliveredàgave a legal barrier to entry § Unless marked “extremely urgent”àcan 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 curveàno price decision • Price and output decisions – monopoly o Only one firmàsupply and demand faced by marketplace are identical to those faced by monopolist o They get to determine their priceàmaking decision for quantity and price (intertwined togetheràmust be decided together) § To sell moreàmust 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 lossàno 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 quantityàread 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 rivalriesàall 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 competeàgo out of businessàwalmart 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)àfor 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 criminalsàboth 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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