Microeconomics Spring 2016
Midterm #1 Study guide
February 23, 2016
“Economics is the study of choice under the conditions of scarcity”
Things that are considered as resources
2. Land (and all its natural resources: oil, iron, etc)
- Physical: tools that are not disposable and used for production
- Human: skills and knowledge
Questions to ask: what is produced? How is it produced? Who gets it?
Methods of allocation
1. Command system (a.k.a. central planning) – orders are given
Ex) Soviet Union, China 30 years ago, and North Korea today
2. Tradition – does whatever they’ve been doing before
Ex) African tribes
3. The market – everyone does whatever they want with what they have (this is the modern way)
Opportunity cost – the cost of what one gives up in order to pursue something else *explicit cost is the actual dollars sacrificed, and implicit cost is the value of everything else sacrificed such as time, pleasure, etc.
Example: Opportunity cost of going to college would be tuition, room & board, books, supplies and the amount of money that one would’ve made if they’ve been working instead of going to college (explicit costs) along with time that could’ve been spent doing something they enjoyed more among other things (implicit costs). Don't forget about the age old question of What are the 3 laws of motion?
Production possibility frontier
A curve that shows the maximum
amount of one good that can be
produced for given amount of
another good; technology and total
resources are held constant.
???? Point A shows the amount of
capital goods that can be produced
(Y axis) and consumption goods
(X axis) given a certain amount of
- Law of increasing opportunity cost – the curve gets steeper at both ends because the more of something you produce, the more opportunity cost of producing it. - It is impossible to operate outside of the curve
- The frontier moves outward with time beause of economic growth and advancement in technology. It is also to move inwards (ex: when a disaster destroys many capital goods needed to produce goods) We also discuss several other topics like What are the behavioral effects of smoking?
- If one is operating within the PPF, it means 1) the economy is in a recession or 2) the market is not operating efficiently
Example of resource allocation: Don't forget about the age old question of What are the 5 determinants that impact health?
National security goods vs everything else
- After the cold war ended, the US became rich in consumer goods because it could put its resources into producing consumer goods rather than national security goods.
- Due to 9/11 US started putting a significant amount of its resources into national security such as more FBI agents, staffs working at the FBI facility, etc. More agents working against terrorism also means less agents working to fight other crimes such as drugs & murder. If you want to learn more check out What is bounded rationality?
Model – an abstract representation of reality
- Simplifying – makes the model simpler but doesn’t change the conclusions. Ex) when a map assumes that a world is 2D or that there are no trees
- Critical – changes the conclusions. Ex) when a map assumes that all roads are available for transportation; if that was true, the most convenient route would change If you want to learn more check out What is microeconomics and macroeconomics?
Market: collection of buyers and sellers with the potential to trade
Market for gasoline in NYC
Demand (QD = number of gallons of gas buyers would like to buy each month given the constraints they face)
QD = D(Pgas, PIncome, wealth)… wealth↑, (ceteris paribus) the demand↑
QD = D(Psubstitute)… price of substitute good (train tickets, plane tickets)↑, demand↑
QD = D(Pcompliment)… price of compliment goods (tires, cars, etc)↑, demand↓ QD = D(Pgasexpected)… expected price↑, demand↑
Demand also depends on population and tastes We also discuss several other topics like What are nematocysts?
Supply (QS = number of gallons gas suppliers would like to sell each month given the constraints they face)
QS = S(Pgas PInputs)… price of input↑, supply↓
QS = S(Palternate)… "alternate" is something that suppliers could easily supply in exchange of the good. Ex: jet fuel is an alternate good for gasoline (same input, different product). Price of alternate good↑, supply↓ because suppliers would want to supply that alternate good instead of that good. Ex: selling gas in NJ is an alternate good for selling gas in NY. Price of gas in NJ↑, supply of gas in NY↓. QS = S(# of firms)… # of firms↑, supply↓
QS = S(Pgasexpected)… expected price↑, supply↓
Supply also depends on technology, government policy (tax, regulation), etc.
Equilibrium…point of rest
- Endogenous variable-- variable determined inside the model; variable determined by the model (price of gas, quantity of gas bought/sold)
- Exogenous variable-- variable given to us outside of our model (all the other variables like income, price of alternative/substitute, etc)
Why would the government want to intervene?
• Market isn't working well (later)
• Price is not fair (too high/too low)
• Quantity is not quite right
Ex: if the government doesn't intervene in the education market, too little people would be willing to receive education
Different sort of intervention: fighting the market / influencing the market Fighting the market isn't recommended due to severe side-effects
When the price isn't fair:
Price floor…minimum price for the product.
Mainly used in farm products…why?
2 problems for farmers:
1. Unstable weather -- because of an unusually steep demand curve, without price floors, farmers would actually be making more money with bad weather. However weather is uncontrollable which means total revenue is unstable.
2. Technological advances -- overtime, there will be technological advances which will shift supply curve to the right, lowering prices; total revenue will go down overtime. Small farm's income will go down, while big farm's income will go up due to financial ability to obtain these new technologies.
… Because of such difficulties, farms products needs forceful government intervention. Price floors usually backfires.
If price is forced above the equilibrium, there will be an excessive surplus. In order to sell the surplus, farmers might start selling crops for lower (illegal) prices.
In order to sustain floor
1. Government buys the surplus; stores them until they rot
2. Artificially increase demand ex: got milk? Advertisement, food stamps (issued by agricultural department), ethanol mandate (mandates that percentage of gasoline be made from US corn)
3. Artificially decrease supply (until 2012) -- paid off farmers not to grow crops. However, these payments were usually given to large corporations, while small farms barely received any.
Too many loopholes: family may divide ownership of farm amongst their family members to collect subsidies multiple times. Rich investors in Manhattan can buyout farms in order to receive subsidy not to grow crops.
4. Crop insurance
Price ceiling…maximum price for the product.
Theater tickets in Manhattan
Short run: no theater construction or destruction.
Scalpers -- people who buy tickets and sell them at whatever cost people will be willing to buy it
Long run: theaters will go out of business, causing supply curve to shift leftward, ending up with a significant decrease in supply of tickets.
When the quantity isn’t right
Tax – when the government wants people to buy less of it by increasing price (ex: cigarettes and other unhealthy things)
Tax incidence – the burden of tax falls on both buyers and sellers (at different amount)
Subsidies – when the government wants people to buy more of it, they provide subsidies to lower the cost (ex: education, medical care). The incidence falls on both buyers and sellers for this case as well.
Law of demand: P↑ = Q↓, P↓ = Q↑
Price sensitive – price affects quantity substantially
$1 rise in chocolate bars caused 100 decrease in quantity→price insensitive $1 rise in airplanes caused 100 decrease in quantity→price sensitive
???? need a universal measurement that applies to all goods
Price "elasticity" of demand (ED)
Elasticity = sensitivity
ED = %∆#$
Price per gallon
To calculate %∆ for elasticity, we use "midpoint rule".
%∆�' = ∆�'
�1 + �2
%∆� = ∆�
�1 + �2
�' = 22.2
9.5 = 2.34
…larger the number, the more price sensitive
Categories of elasticity
• Elastic: �' > 1
• Inelastic: �' < 1
• Unit elastic: �' = 1
• Perfectly elastic (a small change in price causes infinite change in quantity): �' → ∞ Ex) a $10 bill would not be sold for anything more than $10
• Perfectly or completely inelastic: �' = 0
Determinants of elasticity
Basic principle: greater ability or willingness to substitute other goods→demand is more elastic
1. Nature of product; luxuries are more elastic than necessities
Ex) electricity: 0.19, medical care: 0.3, movies: 3.69, foreign travel: 1.77
2. Narrowness of market definition; if the market is defined narrowly, it becomes more elastic
Ex) elasticity for "fruit" would be more elastic than "food"
3. Time horizon; the longer we wait after price change, the more elastic is demand Ex) gasoline in short run: 0.26, in long run: 0.58
4. Importance in buyer's budgets; the larger the percentage of our budget spent on a good, the more elastic is demand
Ex) a spike in rent would cause people to look for another apartment or search for a roommate, while people would still buy the same tabasco despite a spike in price Elasticity and total revenue (total expenditure)
P↑ = QD↓ = TR↑
If the price is inelastic→ price goes up by 10%, quantity demanded goes down less than 10%, total revenue will go up.
60-70% of economists say that all drugs should be legal
Illegal drugs are inelastic to price = the higher the price, the higher the revenue Because drugs are illegal:
Drug war rises the price (which rises the total expenditure)
Addicts commit crime to pay for addiction
Turf wars and police corruption happen because so much money is at stake Unnecessary deaths due to impure substances