Econ 201 Final Exam Study Guide
Econ 201 Final Exam Study Guide ECON 2010
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ECON 201 Final Exam Study Guide: Chapter 1 : Economics: The study of how households, business firms, governments and the society as a whole attempts to allocate limited resources to satisfy unlimited wants. More simply; the scarcity- (the limited nature of society’s resources) of economic resources. They study of choice under conditions of scarcity. Not every individual can attain the highest standard of living. 1. How do we make decisions/choices? You must take into account individuals, business firms, governments, and the society as a whole. 1) TRADE-OFFS are important!! Examples: sleeping vs. doing homework, going to classes vs. working a job, spending money on food rather than saving etc. The biggest trade-off society faces is between efficiency and equality. Efficiency- the property of society getting the most it can from its scarce resources. Equality- the property of distributing economic prosperity uniformly among the members of society. It is narrowed down to efficiency being the size of the pie and equality referring to how the pie is divided into slices. Government policies cause these two to conflict. The more equality we try to provide to everyone, the “pie” or size of efficiency gets smaller. 2) Opportunity cost- the best alternative you can give up within a choice or decision. It should be considered with every action you take. 3) Rational people- (those who purposefully do the best they can to achieve goals) think and make decisions based off the idea of margins. Marginal change=additional, a small incremental adjustment to plan of action. Example: Company A produces 10 units of food. Total Cost= $100. Add another unit to Total Quantity (11) - (marginal change) and the new Total Cost is $125. Change of TC= 125-100= $25 Marginal Cost. Change in TC / TQ. 4) People respond to incentives! Something that induces a person to act. The public policy makers should never forget about incentives. Many policies change the costs or benefits that people face and as a result change their behavior. Should you raise the quantity and produce more? It narrows down to the relationship between Marginal Cost and Marginal Benefit. It all depends on how much you get in the marketplace= MC > MB= REDUCE/DON’T. MC < MB YES. MC=MB= INDIFFERENT. 2. How/where do people interact economically with each other? Example= the marketplace with both buyers and sellers. A) Trade can make everyone better off. When countries specialize in a certain area- there is more production and lower prices. B) Markets are generally a good way to allocate economic resources efficiently. C) Governments can sometimes improve market outcomes. Example: preventing monopolies, intervene when there is a market failure= a situation where the market fails to allocate economic resources efficiently. One instance would be the existence of an externality- impact of one person’s actions on the well-being of the by stander (smoking, factories near homes and pollution). A second instance would be market power- the ability of a single economic actor (or small group of actors) to have substantial influence on market prices. 3. How does the economy as a whole work? A) A country’s standard of living depends on its ability to provide goods and services. What explains differences in living standards amongst nations? The amount of work and income leads to the important part= PRODUCTIVITY- the quantity of goods and services produced from each unit of labor input. B) Government policies can increase growth of the economy with fiscal policy- actively government engaged spending using tax money. Monetary policy- increases quantity of money in circulation, reduces borrowing. (Interest rates decrease, demand increases) Short Run Trade-Off Inflatio- an increase in the overall level of prices in the econom. The analysis of the business cycle- fluctuations in activi.y Chapter 2: How do we study economics? 1) Attempts to understand human behavior 2) Human behavior is so complex, how do we even begin to understand such a big phenomenon? We begin by theorizing. Economic Theory- a statement or set of statements regarding cause/effect relationships amongst economic variables. Involves a lot of observation, collecting data and testing. Economic Models- abstract version of reality (ex. Road maps) Economists use them to learn about the world. Assumptions- they simplify the complex world and make it easier to understand. A. simplifying assumption= doesn’t change the outcome. B. crucial assumption= affects the conclusion. STEPS TO BUILD AN ECONOMIC MODEL 1. Decide the assumptions in development 2. Formulate a testable hypothesis 3. Use economic data to test the hypothesis 4. Revise the model if it fails to explain the data properly 5. Retain the revised data to help answer similar future questions. CIRCULAR FLOW MODEL HANDOUT- it is a visual model of the economy that shows how dollars flow through markets among households and firms. Firms use factors of production and households own them and consume goods/services that the firms produce. Households and firms interact within two markets, such as the markets for goods/services- houses buy and firms sell. The markets for the factors of production- households sell and firms buy. Example= A country has the following resources! It compares the economic relationship between clothing and food products. 1) Land (natural resources) 1) Labor services 3) Capital (physical- buildings and those that help produce outputs and human- knowledge/expertise) 4) Entrepreneurship. Below is the Production Possibilities Curve (frontier) - shows the various mixes of output an economy can produce. Clothes Food 50 0 40 20 30 30 20 40 10 45 0 50 Point A to Point C on graph expresses the change in Clothing Products over the Change in Food Products. Change in C/F from 50 to 40 is -10/20 *(-1) = ½ unit of clothes. Change in C/F from 40 to 30 is -10/10 *(-1) = 1 unit of clothes. Change in C/F from 20 to 10 is -10/5 *(-1) = 2 units of clothes10 to 0= 2 units. It is curved because not all economic resources are easily adaptable in the production of all goods and services. The Law of Increasing Opportunity Cost- as you move up the curve, the higher the Opportunity Cost. Point Y is unattainable. Point X is attainable but inefficient. What causes production to take place inside the curve or shift left? Unemployment, un-used products and underemployment- hired but not working to your best ability or potential. They are found in both public and private firms. In addition, natural disasters, decrease in resources and man-made disasters like war and spending. Can we produce at point Y? Known as Economic Growth! In the short run, it is NOT possible. In long run, YES, because it can shift to the right on behalf of new technology, increased population, higher employment, discovery of new resources, international trade (everyone benefits) investments in human and physical capital (education). The PPF illustrates: 1. Scarcity and Opportunity Cost 2. Production inefficiency “X” 3. Law of Increasing OC 4. Economic growth 5. Specialization from trade= trade allows specialization in what nations do best- consumption and production trade-off. Two Main Branches of Economics: Microeconomics= studies the behavior of individual households, business firms, and governments in terms of choices they make and specific market interactions. Macroeconomics= study of the economy as a whole. Focuses mostly on 1. Inflation 2. Economic growth 3. Trade deficits/surpluses 4. Unemployment 5. Quantity of money in circulation. Some Specialized Fields of Economics: 1. International Economics 2. Comparative Economic System 3. Labor Economic System 4. History of Economic Thoughts (all over) 5. Economic History of the U.S. 6. Econometrics Positive vs. Normative Analysis: Positive= (descriptive in nature) can be tested and either rejected/accepted (how the world is). Includes data and evidence. Normative= (prescriptive in nature) can be a value judgement (how the world should be) Includes values and views. Why Economists Disagree: They disagree on the validity of alternative theories about the world. What we know is very little relative to what we don’t know. Differences in scientific judgement and values lead to disagreement and the idea of perception vs. reality. Why do you study Economics? To understand a way of thinking and their language, to understand world affairs, to become an economist, prepare for another field, to gain self-confidence and to be an informed voter. Chapter 3 : Gains of Trade Production Possibilities with Specialization and Trade: If two countries can both efficiently produce different products- that is specialization. If they want to invest in each other’s products, then trade will always be beneficial. It is first examined with A. Absolute Advantage- the ability to produce a good using fewer inputs than another producer (i.e. - time, requires less time to produce products than others). B. Opportunity Cost/Comparative Advantage- OC= whatever must be given up to obtain some item, measures the trade-off between two goods that each producer faces. Comparative Advantage- ability to produce a good at a lower opportunity cost than other producers (i.e. - one who gives up less of other goods to produce different goods). C. Comparative Advantage/Trade- ** When each person specializes in the comparative advantage, economic production rises. Trade is beneficial. D. the Price of Trade- for parties to gain from trade, the price at which they trade must lie between 2 opportunity costs close but not exact. Both can’t be buyers or sellers, someone has to take the opposite side. Applications of Comparative Advantage: Example= A. Should Tom Brady mow his lawn? He plays well at football and mows his lawn fast, within 2 hours. However in that time he can film a TV commercial for $20,000. His neighbor John can mow in 4 hours, but earns $40 at McDonald’s. Brady has an absolute advantage in mowing because he uses lower input of time than John. YET, the opportunity cost is $20,000 for mowing the lawn and $40 for John, so John has a comparative advantage in mowing lawns because he gives up the least to mow compared to Brady. B. Should the U.S. trade with other countries? 1) Goods produced abroad and sold domestically are imports. Goods produced domestically and sold abroad are exports. Example= America and Japan produce food and cars. Both can produce 1 car per month. However, America can make 2 tons of food per month, where as Japan can produce only 1 ton of food. Because the opportunity cost of 1 car is 2 tons of food in America but only 1 ton of food in Japan, Japan has a comparative advantage in cars. The opportunity cost of 1 ton of food is 1 car in Japan but only ½ of a car in America, the U.S. has a comparative advantage in food. Specialization : 1reduces the unproductive “downtime” that results from switching from one operation to another. 2. Principle of comparative advantage. Cuts logs Gather food Colleen has an absolute advantage in logs and Bill in food. ∆ ∆ ∆ Collen 7 8 ∆F/ L= 8/7= 1.14 food/log; L/ F= 7/8=0.875 log/food ∆ ∆ ∆ Bill 4 9 Bill: F/ L= 9/4= 2.25 food/log; ∆L/ F= 4/9= 0.44 log/food Comparative Advantages: Colleen- logs, Bill- food. Colleen gives up less food to produce logs, therefore she should specialize in logs. Bill gives up less logs to produce food, therefore he should specialize in food. Paper Wood Canada has AA in paper, and Mexico in paper. ∆ ∆ Canada 5 4 W/ P= 4/5= 0.8 units of wood/paper ∆ ∆ P/ W=5/4=1.25 p/w ∆ ∆ Mexico 3 6 W/ P= 6/3= 2 units of wood/paper ∆ ∆ P/ W= 0.5 papers/wood Comparative Advantages: Canada-paper, Mexico- wood. Apples Bananas Norway 2 hrs 3 hrs ∆ B/∆ A = 1.5 units of apples, ∆ A/∆B = 0.66 units of bananas Sweden 1 hr 4 hrs ∆ B/∆ A= 4 units of apples,∆ A/∆B = 0.25 units of bananas Norway has a comparative advantage in bananas and Sweden does with apples. Here it is almost like you switch the ratios, or do the opposite of the previous two problems. Chapter 4: Market Forces of Supply and Demand A. Market: existence of buyers and sellers for a product. a. Perfectly Competitive Market- large number of buyers/sellers. Each buyer is a price taker. Entry and exit are free. Products produced by all firms are identical or homogeneous. b. Pure Monopoly- Single firm producing where there are not readily made substitutes (gas/water company). You can set your own price, price maker. c. Monopolistic Competition- a large number of buyers and sellers. Each firm has its own brand name. Price maker: can’t be dramatic though (local restaurants). Advertise more than price competing. d. Oligopoly- fewer firms taking over the industry (airlines, auto, shoes) B. Competition (competitive market): market in which there are many buyers/sellers so both have an impact on market price. a. Perfectly Competitive (above) and Monopoly- one seller that sets the price (TV Cable company) C. Demand: Price of commodity and taste/preference are in question. They have an inverse relationship. Quantity demanded: amount of good buyers are willing to or able to purchase. The relationship of price and quantity demanded is so true and pervasive that economists call it the law of demand (Cateris Paribus): the claim that, other things being equal, the quantity demanded of a good falls when the price of the good increases and vice versa. Many demand decisions use a demand schedule: a table that shows the relationship between the price of the good and the quantity demanded. It is accompanied by the demand curve- a graph expressing the same relationship. a. Market Demand vs Individual Demand: the market demand at each price is the sum of the two individual demands. It shows how the total quantity demanded of a good varies as the price of the good varies. You add the two individual quantities on the horizontal line in order to find the total quantity demanded. b. Shifts in the Demand Curve: Demand Curve will shift to the right when the demand for that product is favorable, as an increase in demand. It will shift left if the demand is unfavorable or there is none, as a decrease in demand. There are many variables that cause a shift. i. Income- if the demand for a good falls when income falls (vise versa), the good is called a normal good. Not all goods are normal. If the demand for a good rises when income falls the good is called inferior goods. (bus rides) ii. Price of alternative goods- when a fall in the price of one good reduces the demand for another good, the two goods are called substitutes, or if the increase in the price of one leads to an increase in the demand for another. Complements are goods that go together almost like pairs, like ice cream and fudge. When a fall in the price of one good raises the demand for another good, the two are complements. iii. Tastes- what you favor or what you want to buy, mostly based on psychological forces. iv. Expectations- the future affects the demand for the good/service today. Income increase in the future will make you save now and spend more later. v. Number of Buyers- behavior of individual buyers within a group impacts demand. vi. Advertisements- Informative or Persuasive vii. Population- the size of people increases or decreases quantity demanded. c. Prices of products won’t change the demand for that product, it changes the quantity demanded. D. Supply: Quantity supplied: the amount of a good that sellers are willing and able to sell. The relationship between price and quantity supplied is known as the Law of Supply: the claim that, other things being equal, the quantity supplied of a good rises when the price of the good rises. The supply schedule is the table that shows the relationship between the price of a good and quantity supplied. The supply curve is in relation, being a graph of the relationship between the price of a good and the quantity supplied. Market Supply vs Individual Supply is the same as demand above. a. Shifts in the Supply Curve: i. Input Prices-when the price of one or more inputs rises, producing the good is less profitable and firms supply less. ii. Technology- by reducing firm’s costs, advances in technology and reducing the amount of labor to make the product will be more efficient in supply. iii. Expectations- If firms decide to rise prices later, it will put current production into storage and supply less to the market today. iv. Number of Sellers- Least amount of sellers (retirement) means the market supply will fall. v. Price change of substitute products in production or another, unit tax on producer, weather, and the cost of production. E. Supply and Demand Together a. Equilibrium: the point at which the supply and demand curves intersect. The price at which they intersect is called the equilibrium price (market clearing price)- the quantity of the good that buyers are willing and able to buy EXACTLY balances the quantity that sellers are willing and able to sell. The quantity is called the equilibrium quantity. All sellers and buyers are satisfied, there is no upward or downward pressure on the price. i. There is a surplus of a good when the quantity supplied is greater than the quantity demanded. Supply exceeds demand. Here suppliers are unable to sell all they want at the going price. So, they cut their prices to lower their excess supply. These changes represent movements along the curves. ii. There is a shortage when the quantity demanded is greater than quantity supplied. Demanders are unable to buy all they want at the going price. Also known as excess demand. b. Three Steps to Analyzing Changes in Equilibrium: it depends on the position on the curves. i. We decide if it shifts either of the curves. ii. We decide whether the curve shifts left or right. iii. We use the supply-and-demand diagram to compare the initial and new equilibrium. 1. Shifts in Curves vs Movements along the Curves- Supply refers to the position of the supply curve, whereas the quantity supplied refers to the amount of suppliers wish to sell. When the price rises, the quantity supplied rises. “Change in demand/supply” are SHIFTS in the curves. “Change in quantity demanded/supplied” are MOVEMENTS along curve. F. If the price decreases later, sell more now and less in the future. If the price increases later, sell less now and more in the future. G. When Quantity Supplied = Quantity Demanded, there is an equilibrium. The price at which the equilibrium point stands is called the price equilibrium or the market clearing price. The quantity at which the equilibrium point stands is called the quantity equilibrium. This means that consumers are buying all the products they want and suppliers are selling all they want. H. The points above the equilibrium price/quantity, when Quantity Supplied exceeds or is greater than Quantity demanded, it is called disequilibrium or usually an excess supply (surplus). In this case, the price should decrease to be more efficient. I. The points below the equilibrium price/quantity, when Quantity Supplied is less than the Quantity demanded, it is called disequilibrium or usually an excess demand (shortage). In this case, the price should increase to be more efficient. J. What happens to the equilibrium price and quantity if…? a. Demand changes while supply remains constant: demand shifts left or right b. Supply changes while demand remains constant: supply shifts left or right c. If both demand AND supply change simultaneously i. Both demand and supply increase ii. Both demand and supply decrease iii. Demand increases while supply decreases iv. Demand decreases while supply increases Chapter 5: Elasticity and Its Application The Elasticity of Demand: Elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants. Elastic- the demand is elastic if the quantity demanded responds substantially to changes in the price. Inelastic- demand is inelastic if the quantity demanded responds only slightly to changes in price. Price Elasticity of Demand- the responsiveness of quantity demanded due to some change in the price of the good/commodity in question. A measure of how much the quantity demanded of a good responds to a change in the price of that good. E= % Change in Quantity/% Change in Price E= Change in Q/Q times P/Change in P as you move down the curve from point A to B. Switch Q1 and Q2 along with P1 and P2 to find E moving from point B to A. Moving up the curve you switch. What determines the size or magnitude of price elasticity of demand? 1) Availability of substitutes (highly elastic) 2) A necessity or luxury item 3) Length of time that elapses after the price change, before the quantity demanded is measured 4) Long and short run elasticities 5) The percentage of your income devoted to the good. Small %= “the importance of being unimportant” 6) Definition of the market (narrowly or broadly defined). Midpoint Elasticity-= You do the same thing from above moving from point A to B and B to A. They may end up being the same answer for both parts. Absolute value of E > 1, demand is price elastic= %Change of Q > % Change of P. Highly substituted products like coffee and tea or beef and pork. They are like most luxury items. Absolute value of E < 1, demand is price inelastic= %Change of Q < %Change of P. Unresponsive, water price, most necessities. Absolute value of E = 1, demand is of unit elasticity= %Change of Q = %Change of P. Absolute value of E = 0, demand is perfectly inelastic= %Change of Q = 0, %Change of P= (+/-), Medications Absolute value of E = infinity, demand is perfectly elastic= %Change of Q (+/-), %Change of P= 0 1. Relationships between price, total revenue/expenses and Elasticity. P * Q= total expenditures= TR by producers. Price * Quantity= Total Revenue by producers. Total Revenue- the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold. Price Quantity Total Revenue E 10 * 1 10 - 9 2 18 6.33 8 3 24 3.40 E > 1 7 4 28 2.14 6 5 30 1.44 5 6 30 1 E = 1 4 7 28 0.69 3 8 24 0.47 2 9 18 0.29 E < 1 E > 1, Price Decreases, Total Revenue Increases E > 1, Price Increases, Total Revenue Decreases Demand is PRICE ELASTIC, P and TR go in opposite directions E < 1, Price Decreases, Total Revenue Decreases E < 1, Price Increases, Total Revenue Increases Demand is PRICE INELASTIC, P and TR go in same direction Either way, when E = 1, TR will remain constant Income Elasticity: almost the same as Price elasticity but you use Income instead of Price. A measure of how much the quantity demanded of a good responds to a change in consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in income. Income elasticity can be either negative or positive. If elasticity of income is positive and greater than 1, it is a luxury good. If income is positive and less than 1, it is a necessity. The Cross-Price Elasticity of Demand: measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good. Whether the cross-price elasticity is a positive or negative number depends on whether the two goods are substitutes or complements. The schedule can include either complements or substitutes. E of A/B represents the equation in comparison of schedule/good A or B. An example would be coffee (A) and tea (B). They are substitutes. The equation would look like this: (Q2 –Q1/Q2+Q1) of A * (P2+P1/P2-P1) of B Price Elasticity of Supply: a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price. The price of elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce. Examples of elastic: manufactured goods, cars, books, and TV’s. Inelastic: beachfront land. The equation is the exact same as for demand but you include supply and base it off of the supply schedule. Absolute value of E > 1, supply is price elastic= %Change of Q > % Change of P. Excess capacity- too many buildings or machines not being used. Absolute value of E < 1, supply is price inelastic= %Change of Q < %Change of P. Absolute value of E = 1, supply is of unit elasticity= %Change of Q = %Change of P. Absolute value of E = 0, supply is perfectly inelastic= %Change of Q = 0, %Change of P= (+/-). Parking spaces and seats in the classroom. Absolute value of E = infinity, supply is perfectly inelastic= %Change of Q (+/-), %Change of P= 0 Chapter 6: Supply, Demand, and Government Policies Direct Controls on Prices: Because buyers of any good always want a lower price while sellers want a higher price, the interests of the two groups conflict. The government can impose a legal maximum on the price for the products to be sold. Because the price is not allowed to rise above this level, the legislated maximum is called a price ceiling. In contrast, the government can impose a legal minimum on the price. Because the price cannot fall below this level, the legislated minimum is called a price floor. Price Ceilings: If the equilibrium price is below price ceiling, price ceiling is NOT BINDING. Market forces naturally move the economy to the equilibrium, and the price ceiling has no effect on the price or quantity sold. If the equilibrium price is above the price ceiling, price ceiling is a BINDING CONSTRAINT. Once it hits the ceiling, it can’t by law rise any further. If equilibrium is at $3 an ice cream cone, it would be NOT BINDING at $4 price ceiling and BINDING at $2 price ceiling. At this point, if Quantity demanded exceeds Quantity Supplied, there is a shortage. **When the government imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers** Price Floors: like ceilings, price floors are an attempt by the government to maintain prices at other than equilibrium levels. Unlike ceilings, a price floor places a legal minimum price. If the equilibrium is above the price floor, price floor is NOT BINDING. If the equilibrium is below the floor, the price floor is a BINDING CONSTRAINT. Once it hits the floor, it can’t go lower. **A binding price floor causes a surplus** Evaluating Price Controls: One of the Ten Principles of Economics states why economists usually oppose price ceilings and floors. Prices to them, are the result of business and consumer decisions that lie behind the supply and demand curves. Prices balance supply and demand, coordinating economic activity. Price controls are also usually aimed at the poor, such as the rent- control laws and the minimum wage laws. Taxes: important tool used to raise revenue for public projects, like roads, schools and national defense. A tax incidence shows how a tax is divided to take the burden on either the suppliers or buyers. How taxes on sellers affect market outcomes: Suppose the local government passes a law requiring sellers of ice cream cones to send $.50 to the government for each cone they sell. How are buyers and sellers affected? 1) Decide whether the law affects the supply curve or demand curve 2) Decide which way the curve shifts 3) Examine how the shift affects the equilibrium price and quantity. 1) Demand remains the same, however the supply curve shifts because the tax is on the sellers and it makes the ice cream business less profitable at any price 2) The tax reduces the quantity supplied at every price, supply curve shifts to the left. It moves upward as well because of the $.50 tax (slightly). Price must be $.50 higher. 3) Price increases and quantity supplied decreases. Tax reduces the size of the ice cream market. Who pays the tax? (Tax incidence)- Both buyers and sellers share the burden, the market price rises and buyers pay $.30 more for each cone. Sellers get a higher price from buyers than before, but what they get to keep after paying the tax is $2.80 compared to the $3 before tax. How taxes on buyers affect market outcomes: Now a tax is levied on buyers of a good. They have to send $.50 to the government for each cone they buy. 1) Supply is not affected but the demand curve is affected. 2) Buying ice cream is less attractive with a tax, demand curve shifts to the left. It shifts downward as well because of the $.50 tax. 3) Price decreases for the sellers from $3.00 to $2.80 but rise for the buyers to $3.30. (+$.50). The quantity demanded of cones decreases as well. Both the buyers and sellers share the burden. Elasticity and Tax Incidence: The tax burden is rarely shared equally, how do we figure it out? The relative elasticity of supply and demand. When supply is elastic, sellers are very responsive to changes in price, whereas buyers aren’t very responsive. When the tax is imposed, the price received by sellers doesn’t fall much, so they carry a small burden. However, the price paid by buyers rises substantially, the buyers end up bearing the most burden of the tax. The more elastic supply or demand is, the lesser amount of burden you have. The elasticity measures the willingness of buyers or sellers to leave the market when conditions become unfavorable. A small elasticity of demand means that buyers do not have good alternative to consuming this particular good. A small elasticity of supply means that sellers do not have good alternatives to producing this good. When the good is taxed, the side of the market with fewer good alternatives is less willing to leave the market and has the bigger burden. Chapter 7: Consumers, Producers, and the Efficiency of Markets Welfare Economics: the study of how the allocation of resources affects economic well-being. To start we examine the benefits that buyers and sellers receive from engaging in market transactions. In any market, the equilibrium of supply and demand maximizes the total benefits received by all buyers and sellers combined. Consumer Surplus Willingness to Pay: the maximum amount that a buyer will pay for a good. Consumer Surplus- is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. It measures the benefit buyers receive from participating in a market. Using the Demand Curve to Measure Consumer Surplus: The area below the demand curve and above the price measures the consumer surplus in a market. Total expenditure + Consumer Surplus= Total Benefit How a Lower Price Raises Consumer Surplus: the less that you spend compared to what you are willing to spend will always raise consumer surplus. What does Consumer Surplus Measure: To make judgements about the desirability of market outcomes. It is a good measure of economic well-being if policy makers want to respect the preferences of buyers. Rational decisions represent consumer surplus the best. Producer Surplus: Cost and the Willingness to Sell: Cost- the value of everything a seller must give up to produce a good. Producer Surplus- is the amount a seller is paid minus the cost of production. It measures the benefit sellers receive from participating in a market. Using the Supply Curve to Measure Producer Surplus: The area below the price and above the supply curve measures the producer surplus in a market. The height of the supply curve measures seller’s costs, and the difference between the price and the cost of production is each seller’s producer surplus, thus the total area is the sum of the producer surplus of all sellers. How a Higher Price Raises Producer Surplus: the more the producers sell compared to the cost of production, the higher the producer surplus. Total Surplus= Consumer Surplus + Producer Surplus Marginal Cost > Marginal Benefit which is inefficient on the Right side of the graph of total surplus. Market Efficiency and Market Failure: I. To conclude that markets are efficient, we made several assumptions about how the market worked. a. Perfectly competitive market b. No externalities II. When these assumptions do not hold, the market equilibrium may not be efficient. III. When markets fail, public policy can potentially remedy the situation. Chapter 8: Application: The Costs of Taxation The Deadweight Loss of Taxation: When a tax is levied on sellers, the supply curve shifts upward by the size of the tax; when it is levied on buyers, the demand curve shifts downward by that amount. In the end, the elasticities of supply and demand determine how the tax burden is distributed between producers and consumers. A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls. In total, a tax on a good causes the size of the market for the good to shrink. How a Tax Affects Market Participants: Consumer and producer surplus for the buyers and sellers. However, there is a third party- the government. The government earns the tax revenue of the size of the tax (times) the quantity of the good sold. T*Q=tax revenue. These revenues can be spent on public services like, roads, police, public education or helping the needy. It is represented on the graph as the area of the rectangle between the supply and demand curves. Welfare with NO Tax: It is at normal equilibrium, the consumer surplus is ABOVE equilibrium price and producer surplus is BELOW the price. Total Surplus is both producer and consumer. Welfare WITH Tax: With a tax the price rises. So from the new higher price, consumer surplus is the upmost area-below the demand curve but above buyer’s price. Producer surplus is the lower most area-above the supply curve and below the seller’s price. Changes in Welfare: The tax makes buyers and sellers worse off and the government better off. The change includes the change in consumer surplus (negative), the change in producer surplus (positive) and the change in tax revenue. Thus, the losses to buyers and sellers from a tax exceed the revenue raised by the government. The fall in total surplus that results from a market distortion, such as a tax, is known as a deadweight loss. Deadweight Losses and the Gains from Trade: Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade. The Determinants of the Deadweight Loss: The price elasticities of supply and demand. When supply or demand is relatively inelastic, the deadweight loss of a tax is small. When it is elastic, the deadweight loss is larger. Deadweight Loss and Tax Revenue as Taxes Vary: As the size of a tax raises, the deadweight loss grows larger and larger. Deadweight loss of a tax rises more rapidly than the size of the tax. The higher the tax, tax revenue falls because the higher the tax reduces the size of the market. Laffer Curve: As the size of a tax increases, its deadweight loss quickly gets larger. Tax revenue first rises with the size of the tax, but as the tax increases further, the market shrinks so much that the tax revenue starts to fall. However, deadweight loss continuously increases below Chapter 13 Notes: The Costs of Production The Law of Supply is all you need to know about firm behavior. Part of economics called: industrial organization- the study of how firm’s decisions about prices and quantities depend on the market conditions they face. What are Costs? Total Revenue, Total Cost, and Profit: The amount that the firm receives for the sale of its output is called its total revenue (Q times P). The amount that the firm pays to buy inputs is called its total cost. Profit is a firm’s total revenue – its total cost. Costs as Opportunity Costs: It is important to keep in mind one of the Ten Principles of Economics- opportunity cost- refers to all those things that must be forgone to acquire that item. Explicit costs- input costs that require an outlay of money by the firm. Implicit costs- input costs that do not require an outlay of money by the firm. Total Cost= Implicit + Explicit Costs. The Cost of Capital as an Opportunity Cost: An important implicit cost of almost every business is the opportunity cost of the financial capital that has been invested in the business. Economists and accountants treat costs differently, especially with capital. Economists take into account BOTH implicit and explicit costs, however accounting costs only include the explicit costs. Economic Profit vs. Accounting Profit: An economist measures a firm’s economic profit- as the firm’s total revenue minus total cost, (TR-TC (ec+ic)) including both explicit and implicit costs. An accountant measures the accounting profit- total revenue minus total explicit costs, (TR-Explicit). From here you will notice that accounting profit is usually larger than economic profit. Making a positive economic profit will keep the business in the market, it is covering all its opportunity costs and has some revenue left to reward the firm owners. When a firm is making economic losses (negative), the business owners fail to earn enough revenue to cover costs of production. Production and Costs: Firms incur costs when they buy inputs to produce the goods and services they plan to sell. Production= the process of combining inputs (economic resources) to make goods and services. Firms should use technology= methods used by firms to convert inputs into outputs (same as the production function which is expressed mathematically). Q= (K-Capital, Labor, Raw Material, Energy) which also equals maximum output. The Production Function: The relationship between the quantity of inputs (workers) and quantity of output (cupcakes). Rational people think at the margin. The third column in the table gives the marginal product of a worker. The marginal product of any input in the production process is the increase in the quantity of output obtained from one additional unit of that input. When the number of workers goes from 1 to 2, the cupcake production increases from 50 to 150. It represents the change in output as the number of workers increases from one level to another. As the number of workers increases more, the marginal product begins to decline, this is known as the Law of Diminishing Marginal Product or the Law of Variable Proportions. This can be seen in the last two rows of the table. The more workers that crowd the workplace can decrease the cupcake production from 610 to 580= -30 marginal product. The marginal product of labor that first increases is called the increasing returns to labor and when it decreases due to higher workforce is known as the decreasing returns to labor. Cupcake Production Fixed Factors # of Workers Total Product Marginal Average (L) of Labor (TPL) Product of Product of Labor (MPL) Labor (APL) 15 0 0 - - 15 1 50 50 50 15 2 150 100 75 15 3 300 150 100 15 4 400 100 100 15 5 480 80 96 15 6 540 60 90 15 7 580 40 83 15 8 610 30 76 15 9 610 - 68 15 10 580 -30 58 From the Production function to the Total-Cost Curve: The last 3 columns express the cost of producing the cupcake. It shows how the number of workers is related to the quantity of the good produced and to her total cost of production. The MOST important relationship in the table is between quantity produced and total cost- with QP on the horizontal axis and the TC on the vertical axis= total cost curve. When comparing the total cost curve and the production function a) these two curves are opposite sides of the same coin. The TC curve gets steeper as the amount produced rises, whereas the production function gets flatter as production rises. These changes occur for the same reason=high production means the workplace is crowded. The more crowded, the less efficient in production of that good. Therefore, when it is crowded, producing an additional product requires a lot of additional labor and is VERY COSTLY. When the quantity produced is large, the total cost curve is relatively steep. Marginal Product of Labor and Total Product of Labor RelationshipMPL and APL Relationship With these TPL curve on the left, when MPL > 0, TPL Increases. When MPL = 0, TPL reaches maximum output. When MPL < 0, TPL Decreases. With APL curve on the right when MPL > APL, APL Increases. When MPL = APL, it is constant. When MPL < APL, APL Decreases. Unit Costs: Q= f(K (line over K), L) K are the fixed costs (don’t change with units produced) and L are the variable (change) costs. Average Fixed Costs (AFC) = TFC/Q. Average Variable Costs (AVC) = TVC/ Q or VC* Wage/Q. AVC is a U-Shaped curve. APL AND APC. As APL increases, APC decreases. As APL decreases, APC increases. Average Total Cost (ATC) = TC/Q or AFC + AVC. Marginal Cost (MC) = Change in Total Cost/Change in Quantity or Wage/MPL. The graph starts out decreasing then it increases (supply curve). Fixed and Variable Costs: Fixed costs- costs that do not vary with the quantity of output produced. They are incurred even if the firm produces nothing at all. Variable costs- change as the firm alters the quantity of output produced. Total Cost is the sum of fixed + variable costs. Average and Marginal Cost: When deciding how much to produce, consider how the level of production affects his firm’s cost. To find the cost of the unit produced, we divide the firm’s costs by the quantity of output it produces (ATC= TC/Q) = average total cost. It is also the sum of the average fixed cost- fixed cost divided by the quantity of output (AFC= FC/Q), and the average variable cost- variable cost divided by the quantity of output. Average total cost tells us the cost of a unit, but not how much total cost will change as the firm alters its level of production. The amount that total cost rises when the firm increases production (MC=Change in TC/Change in Quantity produced) is called marginal cost. Cost Curves and Their Shapes: We will find graphs of average and marginal cost useful when analyzing the behavior of firms. Horizontal axis= quantity, vertical axis= marginal and average costs. The graph includes ATC- Average Total Cost, AFC- Average Fixed Costs, AVC- Average Variable Costs, and MC- Marginal Costs. Rising Marginal Cost: Marginal cost rises as the quantity of output produced increases. This reflects the diminishing marginal product. The more workers, more equipment is being used. Therefore when the quantity of a product produced is already high, the MP of an extra worker is low, and the MC of an extra product is large. U-Shaped Average Total Cost: ATC is the sum of average fixed and variable costs. Average fixed cost always declines as output rises because fixed cost is spread over a larger number of units. ATC typically rises as output increases because of diminishing marginal product. The bottom of the U-Shape occurs at the quantity that minimizes ATC, which is usually called the efficient scale. The two forces are balanced to yield the lowest average total cost. The Relationship between MC and ATC: Whenever MC is less than ATC, ATC is falling. Whenever MC is greater than ATC, ATC is rising. Example: your grade. When taking a test it can increase or decrease your average grade. Here, the MC curve crosses the ATC at its minimum. Typical Cost Curves: Marginal Cost eventually rises with the quantity of output, the ATC curve is U shaped, and the MC curve crosses the ATC curve at the minimum of ATC. Costs in the Short Run and the Long Run The Relationship between Short Run and Long Run ATC: The division of total costs between fixed and variable costs depends on the time horizon. In the short run- at least 1 economic resource is fixed while the others are variable. (BSU assets) Long run- all economic resources will be variable, NO fixed items. The curves definitely differ. The long run ATC curve is much flatter U shape than the short run ATC. Short run lies on or is above the long run. There is more flexibility in the long run. In essence, in the long run, the firm gets to choose which short run curve it wants to use. But in the short run, it has to use whatever short run curve it has, based on past decisions. Economies and Diseconomies of Scale: The ATC curves tell us how costs vary with the scale-the size- of a firm’s operations. When long run ATC declines as output increases, there are said to be economies of scale. When ATC rises as output increases, there are diseconomies of scale. When long run ATC does not vary with the level of output (stays the same) there are constant returns of scale. There is an economies of scale when higher production levels allow specialization. Diseconomies of scale occurs because of coordination problems (can’t keep costs down), that are inherent in any large organization. Unit Costs and their graphs: AFC= TFC/Q, This is spreading costs over units produced (pricing purposes) AVC= TVC/Q or can be simplified to be VC times Wage/ Q or further to Wage/Average Product of Labor ATC= TC/Q or further to AFC + AVC. Cost per unit to produce, finds price. MC= (additional cost by increasing production by _ units) Change in Total Variable Cost/ Change in Quantity Change in Labor times Wage/ Change in Quantity OR W/MPL AVC When MC < AVC, AVC decreases. MC = AVC @ RED DOT MC > AVC above red dot, AVC increases Red Point is minimum point for AVC ATC When MC < ATC, left of ORANGE DOT, ATC decreases MC = ATC @ ORANGE DOT MC > ATC, above orange dot, ATC increases Orange Point is minimum point for ATC Relationship between APL/MPL and AVC/MC: They are mirror images of each other. They have inverse relationships with one another. Whenever MPL increases, MC is decreasing. When comparing both charts you can notice the directions each curves go in relation to the opposite graph. Rectangular Hyperbola= Q decreases, AFC increases Division of labor, specialization (W/APL) Chapter 14: Firms in Competitive Markets What is a Competitive Market? The Meaning of Competition: A competitive market, sometimes called a perfectly competitive market, has two MAJOR characteristics= 1) there are many buyers and many sellers in the market 2) the goods offered by the various sellers are largely the same. That means that they are perfect substitutes and there is no need for advertisements. However there are more characteristics!! 3) Free entry into and exit from the industry 4) Buyers and sellers well informed 5) each firm/buyer is a price taker 6) each firm can choose the level of output that would maximize its profit or minimize its loss 7) profit maximizing or loss minimizing output is determined at a point where MR=MC 8) MR= Change in TR/ Change in Q or Change in Q times P/ Change in Q. As a result, the actions of any single buyer or seller in the market have a negligible impact on the market price. Buyers and sellers in competitive markets must accept the price the market determines and therefore are said to be price takers. The free entry and exit in a competitive market is a powerful force shaping the long run equilibrium. The Revenue of a Competitive Firm: A firm here, like any other, tries to maximize profit (TR-TC). TR= P TIMES Q. Total revenue is proportional to the amount of output. Costs are also helpful wen figuring out revenue. The table includes Quantity, Price, Total Revenue, and Average Revenue- total revenue divided by the quantity sold. It tells the revenue a firm receives for the typical unknit sold. (P times Q)/Q. Therefore for all firms, average revenue equals the price of the good. The last column shows Marginal Revenue- which is the change in total revenue from an additional unit sold. Marginal revenue equals the price of the good. Profit Maximization and the Competitive Firm’s Supply Curve A Simple Example of Profit Maximization: The first way to find profit maximization is examining the highest profit. Where ever there is the highest profit, you find to produce at that quantity that produces the highest profit. You can also find the profit maximizing quantity by comparing the MR and MC from each unit produced. As long as MR > MC, increasing the quantity produced raises profit. At that point you can increase production because it will put more money in your pockets than it takes out. If MR < MC, you need to decrease production. If you think at the margin and make incremental adjustments to the level of production, you end up producing the profit-maximizing quantity. The Marginal-Cost Curve and the Firm’s Supply Decision: MC is upward sloping, ATC is U-Shaped, MC crosses the ATC curve at the minimum of ATC, horizontal line at the market price P. It is horizontal because a competitive firm is a price taker: the price of the firm’s output is the same regardless of the quantity that the firm decides to produce. P=AR=MR. Whether the firm begins with production at a low level or high level, the firm will eventually adjust production until the quantity produced reaches Qmax. This analysis yields 3 general rules for Pmax: 1. If MR > MC, the firm should increase its output 2. If MC > MR, the firm should decrease its output 3. At the profit-maximizing level of output, MR and MC are exactly equal 4. P = ATC, normal rate of return, P > ATC, keep producing in short run (minimize losses), P < ATC, SHUTDOWN, you can’t cover the costs. Supply curve is show above the shutdown point. These rules are key to rational decision making by any firm. Not only competitive but more you will see. In essence, because the firm’s MC curve determines the quantity of the good the firm is willing to supply at any price, the MC curve is also the competitive firm’s supply curve (below). The Firm’s Short Run Decision to Shut Down: A shutdown refers to a short run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to a long run decision to leave the market. A firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits the market does not have to pay any costs at all, fixed or variable. For example, the land is one of the farmer’s fixed costs. If the farmer decides not to produce any crops one season, the land lies fallow and he can’t recover this cost. When making a short run decision, of whether to shut down for a season, the fixed cost of the land is said to be a sunk cost. But, if he decides to leave farming altogether, he can sell the land and it is not sunk. ***Shut down if TR < VC or write as TR/Q < VC/Q. Shut down if P < AVC. The competitive firm’s short run supply curve is the proportion of its MC curve that lies above the AVC. Spilt Milk and other Sunk Costs: A sunk cost- a cost that has already been committed and cannot be recovered. In the shut-down decision, we assume that the firm can’t recover its fixed costs by temporarily stopping production. Regardless of the quantity of output supplied, even at 0, the firm still pays its fixed costs. As a result, the fixed costs are sunk in the short run and they should be ignore when deciding how much to produce. The firm’s short run supply curve is the part of the MC curve that lies above AVC and the size of the fixed cost does not matter for this supply decision. The Firm’s Long Run Decision to Exit or Enter a Market: If a firm exits, it will lose all revenue from the sale of its product, it will save not only its VC but also FC. The firm exists the market if the revenue it would get from producing is less than its total costs. Exit if TR < TC or Exit if TR/Q < TC/Q or P < ATC. You should enter if P < ATC, trying to be profitable. The competitive firm’s long run supply curve is the portion of its MC curve that lies above ATC. Measuring Profit in our Graph for the Competitive Firm: Profit= TR-TC or (TR/Q-TC/Q) times Q. Another way to write it is Profit= (P-ATC) times Q. The Supply Curve in a Competitive Market: Two cases to consider: First, we examine a market with a fixed number of firms. Second, we examine a market in which the number of firms can change as old firms exit the market and new firms enter. Both are important, for each applies to a specific time horizon. Short run- fixed number of firms is appropriate and long term the number can be adjusted to changing market conditions. Short Run: Market Supply with a Fixed Number of Firms: As long as price is above AVC, the MC is its supply curve. The quantity supplied to the market equals the sum of the quantity supplied by each firm. The market supply reflects the individual firm’s MC curves. The Long Run: Market Supply with Entry and Exit: Entry will expand the number of firms, increase the quantity of the good supplied, and drive down prices and profits. Exit will reduce the number of firms, decrease the quantity and drive up prices and profits. At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit. P= P-ATC times Q. The operating frim has a zero profits if and only if the price of the good equal the ATC. If price is above ATC, profit is positive, which encourages new firms to enter. If the price is less than ATC, profit is negative, which encourages some firms to exit. The process of entry and exit ends only when price and ATC are driven to equality. The level of production with the lowest average total cost is called the firm’s efficient scale. Therefore, in the long run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale. In this market, there is only one prices consistent with zero profit-the minimum ATC. Why Do Competitive Firms Stay in Business If They Make Zero Profit? Economic profit is zero, but accounting profit is positive or negative. If it is positive and economic is zero, you can stay in business. Total cost includes the time and money that the firm owners devote to the business. Here the firm’s revenue must compensate the owners for these opportunity costs. Why the Long Run Supply Curve Might Slope Upward: The long run market supply curve is horizontal at the minimum of ATC. When the demand for the good increases, the long run result is an increase in the number of firms and in the total quantity supplied, without any change in the price. 2 reasons as to why the supply curve slopes upward: 1) resources used in production may be available only in limited quantities. Quantity of land is limited, more farmers= land price increases, which raises costs for farmers in the market. Thus an increase in demand for farm products can’t induce an increase in quantity supplied without also inducing a rise in farmer’s cost, which in turn means a rise in price. 2) Firms may have different costs. Some people work faster than others and some have better alternative uses of their time than others. Higher costs for firms means price must rise to make entry profitable for them. The price in the market reflects the ATC of the marginal firm- the firm that would exit the market if the price were any lower. Entry does not eliminate this profit because would-be entrants have higher costs than firms already in the market. Higher-cost firms will enter only if the price rises, making the market profitable for them. With that, a higher price may be necessary to induce a larger quantity supplied, in which case the long run supply curve is upward sloping rather than horizontal. Because firms can enter and exit more easily in the long run than in the short run, the long run supply curve is typically more elastic than the short run supply curve. Graphs below. Chapter 15: Monopoly Monopolies have the power to influence the market price of its product. A competitive firm is a price taker and a monopoly is a price maker. A monopoly charges prices that exceeds marginal costs. Monopolies generally charge high prices and customers might have little choice but to pay whatever the monopoly charges. A monopoly firm can control the price of the good it sells, but because a high price reduces the quantity that its customers buy, the monopoly’s profits are not unlimited. The goal is to maximize profit as well but it has a few ramifications that are different, because monopoly firms are unchecked by competition, the outcome in a market with a monopoly is often not in the best interest of society. Why Monopolies Arise: A firm is a monopoly if it is the sole seller of its product and if its product does not have close substitutes. The fundamental cause of monopoly is barriers to entry: a monopoly remains the only seller in its market because other firms cannot enter the market and compete with it. Barriers to entry, in turn, have three main sources. 1. Monopoly resources: a key resource required for production is owned by a single firm. Examples: ALCOA, DeBeers, and Nickel Company of Canada. 2. Government regulation: the government gives a single firm the exclusive right to produce some good or service. Government enforced barriers such as patent laws, copyright laws and public franchises. 3. The production process: a single firm can produce output at a lower cost than can a larger number of firms. Monopoly Resources: The simplest way for a monopoly to arise is for a single firm to own a key resource. Regardless of marginal cost, some monopolies like water wells in local areas command a high price no matter what. Government-Created Monopolies: Sometimes the monopoly arises from the sheer political sheer political clout of that would be monopolist. At other times the government grants a monopoly because doing so is viewed to be in the public interest. The patent and copyright laws are two important examples. The effects of patent and copyright laws are easy to see. Because these laws give on producer a monopoly, they lead to higher prices than would occur under competition. The laws create incentives. Natural Monopolies: An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output. In this case, a single firm can produce any amount of output at the least cost. That is for any given amount of output, a larger number of firms lead to less output per firm and higher average total cost. Club goods- are excludable but not rival in consumption. Example: a bridge that gets used so infrequently it is never congested. It is excludable because a toll collector can prevent someone from using it, and not rival because use of the bridge by one person does not diminish the ability of others to use it. Because there is a large fixed cost of the building and a negligible marginal cost of additional users, the ATC of a trip across the bridge (TC/Q) falls as the number of trips rises. When a firm is a natural monopoly, it is less concerned about new entrants eroding its monopoly power. There is trouble maintaining a monopoly position without ownership of a key resource or protection from the government. Monopolist’s profit attracts entrants into the market, and these entrants make the market more competitive. Sometimes size of market can determine being a monopoly or not. How Monopolies Make Production and Pricing Decisions Monopoly vs. Competition: the key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output. A competitive firm is small relative to the market in which it operates, and therefore, has no power to influence the price of its output. It takes the price as given by market conditions. By contrast, because a mono
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