Principles of Microeconomics Test 2 Study Guide  

How does the market for an illegal good work?

A Housing Market with a Rent Ceiling  

Price Ceiling / Price Cap: a government regulation that prohibits charging  higher than a specified price

Rent Ceiling: a price ceiling applied to a housing market

∙ When the rent ceiling is set above the equilibrium rent, the market  does not change

∙ When the rent ceiling is set above the equilibrium rent, the market is  powerfully affected  

o 3 things occur when this happens:  

 A housing shortage: because a rent ceiling has been  

enforced, more people can afford housing and demand  

goes up. The quantity of housing demanded exceeds the  

quantity supplied.

What drives international trade?

If you want to learn more check out Which type of interview observes open and closed-ended questions?

 Increased search activity: people spend more time combing through different resources and people with whom to do  

business to find housing (newspaper, catalogs, etc.)

 Black market: renters and landlord still want to make  

money, so they’ll charge rent along the rent ceiling but  

then add unnecessary charges like lock changing services  for $500

Principles of Microeconomics Test 2 Study Guide  

Who wins and who loses from free international trade?

∙ A rent ceiling decreases the quantity of housing supplied to less than the  efficient quantity. As a result, a deadweight loss arises, producer and  consumer surplus shrink, and there is a potential loss from increased  search activity Don't forget about the age old question of How are planets formed?

o So, are rent ceilings fair? No.  

 A rent ceiling decreases the quantity of housing and the  scare housing is allocated by:

Principles of Microeconomics Test 2 Study Guide  

∙ First come, first served: scarce housing is given to  

those who have the greatest foresight and get their  

names on the list first  

∙ Lottery: people who get lucky with housing benefit  

∙ Discrimination: scarce housing is given to friends,  

family members, or those of the selected race or sex  

 None of these outcomes are fair  If you want to learn more check out What is the difference in the definition of genetic divergence and genetic diversity?

A Labor Market with a Minimum Wage  

Price floor: a government regulation that prohibits trading at a price lower  than a specified level

Minimum wage: a price floor for wages in the labor market ∙ If the minimum wage is set above the equilibrium wage rate, it has  powerful effects

o The quantity of labor supplied by workers exceeds the quantity  demanded by employers

o Surplus of labor  

∙ If the minimum wage is set below the equilibrium wage rate, it has no  effect. The market continues to operate as if there were no minimum  wage.  

Taxes

Tax Incidence: the division of the burden of a tax between buyers and sellers ∙ When an item is taxed, its price might rise by the full amount of the  tax, by a lesser amount, or not at all

∙ Example problem: tax on cigarettes in NYC  

o On July 1, 2002, New York City raised the tax on the sales of  cigarettes from almost nothing to $1.50 a pack.

o What are the effects of this tax?

Principles of Microeconomics Test 2 Study Guide  

We also discuss several other topics like Which research type does not observe experimental groups?

o With no tax, the equilibrium price is $3.00 a pack

o $1.50 tax on sellers is introduced

 Supply decreases and the curve S + tax on sellers shows  the new supply curve

o The market price paid by buyers rises to $4.00 a pack and the  quantity bought decreases

o The price received by the seller falls to $2.50 a pack We also discuss several other topics like What are the primary factors that control climate?

o So with the tax of $1.50 a pack, buyers pay $1.00 more per pack  and sellers receive 50¢ less per pack  

If you want to learn more check out What is dominant and dominated strategy?

A Tax on Buyers

∙ Again, with no tax, the equilibrium price is $3.00 per pack ∙ A tax on buyers of $1.50 a pack is introduced

o Demand decreases and the curve D – tax on buyers shows the  new demand curve

Principles of Microeconomics Test 2 Study Guide  

∙ The price received by the seller falls to $2.50 a pack and the quantity  decreases

∙ The price paid by buyers rises to $4.00 per pack

∙ So with the tax of $1.50 a pack, buyers pay $1.00 more per pack and  sellers receive 50¢ less per pack  

Regardless of whether you tax the buyer or the seller, you get the same result

Equivalence of Tax on Buyers and Sellers  

∙ Tax incidence is the same regardless of whether the law says sellers  pay or buyers pay

Tax Incidence and Elasticity of Demand  

∙ The division of the tax between buyers and sellers depends on the  elasticities of supply and demand

∙ To see how, we look at two extreme cases:

o Perfectly inelastic demand: buyers pay the entire tax  

o Perfectly elastic demand: sellers pay the entire tax  

∙ The more inelastic the demand, the larger is the buyers’ share of the  tax  

Perfectly Inelastic Demand (with regard to taxes)

∙ Demand for this good is perfectly inelastic – the demand curve is  vertical

Principles of Microeconomics Test 2 Study Guide  

∙ When a tax is imposed on this good, buyers pay the entire tax

Perfectly Elastic Demand (with regard to taxes)  

∙ The demand for this good is perfectly elastic – the demand curve is  horizontal  

∙ When a tax is imposed on this good, sellers pay the entire tax

Principles of Microeconomics Test 2 Study Guide  

Tax Incidence and Elasticity of Supply  

∙ To see the effect of the elasticity of supply on the division of the tax  payment, we again look at two extreme cases:

o Perfectly inelastic supply: sellers pay the entire tax  

o Perfectly elastic supply: buyers pay the entire tax  

∙ The more elastic the supply, the larger is the buyers’ share of the tax  

Perfectly Inelastic Supply  

∙ The supply of this good is perfectly inelastic – the supply curve is  vertical

∙ When a tax is imposed on this good, sellers pay the entire tax  

Perfectly Elastic Supply  

∙ The supply of this good is perfectly elastic – the supply curve is  horizontal

Principles of Microeconomics Test 2 Study Guide  

∙ When a tax is imposed on this good, buyers pay the entire tax  

Taxes in Practice  

∙ Taxes are usually levied on goods and services with an inelastic  demand or an inelastic supply

∙ Alcohol, tobacco, and gasoline have inelastic demand, so the buyers of  these items pay most of the tax on them

∙ Labor has a low elasticity of supply, so the seller – the worker – pays  most of the income tax and most of the Social Security Tax  

Taxes and Efficiency

Principles of Microeconomics Test 2 Study Guide  

∙ Except in the extreme cases of perfectly inelastic demand or perfectly  inelastic supply when the quantity remains the same, imposing a tax  creates inefficiency  

∙ With no tax, marginal social benefit equals marginal social cost and the tax is inefficient  

∙ Total surplus (the sum of consumer surplus and producer surplus) is  maximized

∙ The market is efficient

∙ The tax decreases the quantity, raises the buyers’ price, and lowers  the sellers’ price  

∙ The tax revenue takes part of the total surplus

Principles of Microeconomics Test 2 Study Guide  

∙ The decreased quantity creates a deadweight loss

Taxes in Fairness  

∙ Economists propose two conflicting principles of fairness to apply to a  tax system:

o The benefits principle:

 The benefits principle is the proposition that people should  pay taxes equal to the benefits they receive from the  

services provided by the government

 This arrangement is fair because it means that those who  benefit most pay the most taxes

o The ability-to-pay principle:

 The ability-to-pay principle is the proposition that people  should pay taxes according to how easily they can bear the burden of the tax  

 A rich person can more easily bear the burden than a poor  person can

 So the ability to pay principle can reinforce the benefits  principle to justify high rates of income tax on high  

incomes  

Production Quotas and Subsidies

∙ Intervention in markets for farm products takes two main forms: o Production quotas:

 A production quota is an upper limit to the quantity of a  good that may be produced during a specific period  

o Subsidies

 A subsidy is a payment made by the government to a  

producer  

Production Quotas

Principles of Microeconomics Test 2 Study Guide  

Inefficiency

∙ At the quantity produced:

∙ With no quota, the price  is $30 a ton and 60  

million tons a year are  produced.

∙ With the production  quota of 40 million tons a year, quantity decreases  to  

40 million tons a year. ∙ The market price rises to  $50 a ton and marginal  cost falls to $20 a ton.

o Marginal social benefit equals the market price which has  increased  

o Marginal social cost has decreased  

∙ Production is inefficient and producers have an incentive to cheat  

Subsidies

∙ With no subsidy, the price is $40 a ton for soybeans and 40 million tons of soybeans are produced a year.

∙ When a subsidy is paid to soybean farmers, the market price of  soybean falls per unit. The quantity of soybean produced increases.  The marginal cost of producing soybean rises on the supply curve.  

∙ With a subsidy of $20 a ton for soybeans, marginal cost minus subsidy  falls by $20 a ton for soybeans and the new supply curve is S –  subsidy.

Principles of Microeconomics Test 2 Study Guide  

∙ The market price falls to $30 a ton and farmers increase the quantity  to

60 million tons a year.  

∙ But farmers’ marginal cost increases to $50 a ton.

∙ With the subsidy, farmers receive more on each ton sold—the price of  $30 a ton plus the subsidy of $20 a ton, which is $50 a ton.

Inefficient Overproduction

∙ At the quantity produced:

o Marginal social benefit equals the market price, which has fallen o Marginal social cost has increased and exceeds marginal social  benefit  

Markets for Illegal Goods  

∙ The U.S. government prohibits trade of some goods, such as illegal  drugs.

∙ Yet, markets exist for illegal goods and services.

∙ How does the market for an illegal good work?

∙ To see how the market for an illegal good works, we begin by looking at a free market and see the changes that occur when the good is made  illegal.

Penalties on Sellers

∙ If the penalty on the seller is the amount HK, then the quantity  supplied at a market price of PC is QP.

∙ Supply of the drug decreases to S + CBL.

∙ The new equilibrium is at point F. The price rises and the quantity  decreases.

∙ Cost of breaking the law is different for different people

Principles of Microeconomics Test 2 Study Guide  

Penalties on Buyers

∙ If the penalty on the buyer is the amount JH, the quantity demanded at a market price of PC is QP.

∙ Demand for the drug decreases to D – CBL.

∙ The new equilibrium is at point G. The market price falls and the  quantity decreases.

∙ But the opportunity cost of buying this illegal good rises above PC because

∙ the buyer pays the market price plus the cost of breaking the law. Penalties on Both Sellers and Buyers

Principles of Microeconomics Test 2 Study Guide  

∙ With both sellers and buyers penalized for trading in the illegal drug, … ∙ both the demand for the drug and the supply of the drug decrease.

∙ The new equilibrium is at point H.

∙ The quantity decreases to QP.

∙ The market price is PC.

∙ The buyer pays PB and the seller receives PS.

Legalizing and Taxing Drugs

∙ An illegal good can be legalized and taxed.

∙ A high enough tax rate would decrease consumption to the level that  occurs when trade is illegal.

∙ Arguments that extend beyond economics surround this choice. How Global Markets work  

Because we trade with people in other countries, the goods and services that we can buy and consume are not limited by what we can produce. ∙ Imports are the goods and services that we buy from people in other  countries

∙ Exports are the goods and services we sell to people in other countries  

International Trade Today

∙ Global trade today is enormous

∙ In 2013, global exports and imports were 1/3 of the value of global  production  

∙ Total U.S. exports were about 14% of U.S. income

∙ Total U.S. exports were about 17% of our expenditure

Principles of Microeconomics Test 2 Study Guide  

What Drives International Trade?  

∙ The fundamental force that generates trade between nations is  comparative advantage

∙ The basis for comparative advantage is divergent opportunity costs  between countries

∙ National comparative advantage is the ability of a nation to perform an activity or produce a good or service at a lower opportunity cost than  any other nation

∙ The opportunity cost of producing a t-shirt is lower in China than in the  U.S. giving them a comparative advantage for t-shirts  

∙ The opportunity cost of producing an airplane is lower in the United  States than in China, so the United States has a comparative  advantage in producing airplanes

∙ Both countries can reap gains from trade by specializing in the  production of the good in which they have a comparative advantage  and then trading

∙ Both countries are better off  

Remember:  

∙ Consumer Surplus is the excess of the benefit received from a good  over the amount paid for it  

∙ Producer Surplus is the excess amount received from the sale of a  good over the cost of producing it  

Why the United States Imports T-Shirts  

∙ U.S. firms produce 40 million t-shirts a year and U.S. consumers buy 40 mill t-shirts a year  

∙ The price of a t-shirt is $8

Principles of Microeconomics Test 2 Study Guide  

∙ This figure shows the market in  

the United States with  

international trade

∙ World demand and world supply  

of t-shirts determine that the  

world price of a t-shirt is $5

∙ The world price is less than $8,  

so the rest of the world has a  

comparative advantage in  

producing t-shirts  

∙ With international trade, the  

price of a t-shirt in the United  

States falls to $5  

∙ At $5 a t-shirt, U.S. consumers  

buy 60 million t-shirts a year

∙ The United States imports 40  

million t-shirts a year

Why the United States Exports Airplanes  

Principles of Microeconomics Test 2 Study Guide  

∙ The price of an  

airplane is $100  

million

∙ Boeing produces  

400 airplanes a  

year a U.S. airlines  

buy 400 a year  

∙ This figure shows  

the market in the  

US with  

international trade

∙ World demand and  

world supply of  

airplanes  

determine the price

of an airplane at  

$150 million

∙ The world price  

exceeds $100  

million, so the US  

has a comparative  

advantage in  

producing airplanes

Principles of Microeconomics Test 2 Study Guide  

∙ With international  

trade, the price of  

an airplane in the  

United States rises  

to $150 million

∙ At $150 million,  

U.S. airlines buy  

200 jets a year

∙ At $150 million,  

Boeing produces  

700 planes a year  

∙ The US exports 500

planes a year  

Winners, Losers, and the Net Gain from Trade  ∙ International trade lowers the price of an imported good and raises the  price of an exported good

∙ Buyers of imported goods benefit from lower prices and sellers of  exported goods benefit from higher prices

∙ But some people complain about international competition: not  everyone gains  

∙ Who wins and who loses from free international trade?

Gains and Losses from Imports  

∙ This figure shows  

the market in the  

US with no  

international trade

∙ Total surplus from t

shirts is the sum of  

the consumer  

surplus and  

producer surplus

Principles of Microeconomics Test 2 Study Guide  

∙ This figure shows  

the market in the  

US with  

international trade

∙ The world price of a

t-shirt is $5

∙ Consumer surplus  

expands from area  

A to the area A +  

B+ D

∙ Producer surplus

∙ The area B is transferred from producers to consumers ∙ Area D is an increase in total surplus

∙ Area D is the net gain from imports  

Gains and Losses from Exports  

Principles of Microeconomics Test 2 Study Guide  

∙ This figure shows  

the market in the  

US with no  

international trade

∙ Total surplus from  

airplanes is the  

sum of the  

consumer surplus  

and producer  

surplus  

∙ This figure shows  

the market in the  

US with  

international trade

∙ The world price of  

an airplane is $150  

million

∙ Consumer surplus  

shrinks to the area  

A  

∙ Producer surplus  

expands to the  

area C + B + D

∙ The area B is transferred from consumers to producers ∙ Area D is an increase in total surplus

∙ Area D is the net gain from exports  

International Trade Restrictions  

Principles of Microeconomics Test 2 Study Guide  

∙ Governments restrict international trade to protect domestic producers from competition  

∙ Governments use four sets of tools

o Tariffs

o Import quotas

o Other important barriers

o Export subsidies  

Tariffs

∙ A tariff is a tax on a good that is imposed by the importing country  when an imported good crosses its international boundary ∙ For example, the government of India imposes a 100% tariff on wine  imported from the US  

∙ So when an Indian wine merchant imports a $10 bottle of California  wine, the merchant pays the Indian government a $10 import duty,  making the bottle of wine $20  

The Effects of a Tariff

∙ With free international trade, the world price of a t-shirt is $5 and the  US imports 40 million t-shirts a year

∙ Imagine that the US imposes a $2 tariff on each t-shirt imported

∙ The figure above shows the market before the government imposes  the tariff

∙ The price of a t-shirt in the US rises by $2

Principles of Microeconomics Test 2 Study Guide  Winners, Losers, and Social Loss from a Tariff

∙ This figure shows the  effect of a tariff on  

imports  

∙ The tariff of $2 raises  the price in the US to $7 a t-shirt

∙ US imports decrease to  10 million a year (now  30 million)

∙ US government collects  the tariff revenue of $20 million a year

∙ When the US government imposes a tariff on imported t-shirts: o US consumers of t-shirts lose

 US buyers of t-shirts now pay a higher price (the world  price of $5 plus the tariff of $2)

 The combination of a higher price and a smaller quantity  bought decreases consumer surplus

 The loss of consumer surplus is the loss to US consumers  from the tariff  

o US producers of t-shirts gain

 US garment makers can now sell t-shirts for a higher price  (the world price plus tariff), so they produce more t-shirts  But the marginal cost of producing a t-shirt is less than the  higher price, so the producer surplus increases

 The increased producer surplus is the gain to US garment  makers from the tariff  

o US consumers lose more than US producers gain  Consumer surplus decrease and producer surplus increases

Principles of Microeconomics Test 2 Study Guide  

 This figure shows the total surplus with free international  trade

∙ The world price of a t-shirt is $5  

∙ Imports are 40 million shirts a year

∙ Consumer surplus is the area of the green triangle

∙ Producer surplus is the area of the blue triangle  

∙ The triangle above world price between the supply  

and demand curve is the gains from trade  

∙ Total surplus is the sum of the green and blue areas

Principles of Microeconomics Test 2 Study Guide  

 This figure shows the winners and losers from a tariff

o The $2 tariff is added to the world price, which  

increases the price of a t-shirt to $7 in the US  

o The quantity of t-shirts produced in the US  

increases and the quantity bought by the US  

decreases  

o Imports decrease

o Tariff revenue equals the square area in the  

middle of the graph between world price and  

world price plus tariff: imports of t-shirts  

multiplied by $2 a shirt  

o Society loses: a deadweight loss arises  

 Some of the loss of consumer surplus is transferred to  producers and some is transferred to the government as  tariff revenue

 But the increase in production costs and the loss from  decreased imports is a social loss

 A tariff decreases the gains from trade. In the  

United States, the quantity of imports decreases and a  

deadweight loss arises

Principles of Microeconomics Test 2 Study Guide  

 The cost of producing a t-shirt in the US increases and  creates a social loss shown by area C

 The decrease in the quantity imported t-shirts creates a  social loss shown by area E  

 The tariff creates a social loss (deadweight loss) equal to  area C + E  

Import Quotas  

∙ An import quota is a restriction that limits the maximum quantity of a  good that may be imported in a given period  

∙ For example, the US imposes import quotas on food products such as  sugar and bananas and manufactured goods such as textiles and paper  

The Effects of an Import Quota  

∙ This figure shows the market before the government imposes an import  quota on t-shirts

∙ The world price is $5  

∙ The US imports 40 million shirts a year

Principles of Microeconomics Test 2 Study Guide  

∙ This figure shows the  

market with an import  

quota of 10 million  

shirts

∙ With the quota, the  

supply of shirts in the  

US becomes S + quota

∙ The price rises to $7  

∙ The quantity produced

in the US increases  

and the quantity  

bought decreases

∙ Imports decrease

Winners, Losers, and Social Loss from an Import Quota  ∙ When the US government imposes an import quota on imported t shirts:

o US consumers of shirts lose

o US producers of shirts gain

o Importers of shirts gain

o Society losses: a deadweight loss arises  

Principles of Microeconomics Test 2 Study Guide  

∙ The import quota (blue arrow) raises the price of as shirt to $7  ∙ Area B is transferred from consumer surplus to producer surplus ∙ Importers’ profit is the sum of the two areas D  

∙ The area C + E is the loss of total surplus – a deadweight loss created  by the quota  

Other Import Barriers  

∙ Thousands of detailed health, safety, and other regulations restrict  international trade

Export Subsidies  

∙ An export subsidy is a payment made by the government to a  domestic producer of an exported good

Principles of Microeconomics Test 2 Study Guide  

∙ Export subsidies bring gains to domestic producers, but they result in  overproduction in the domestic economy and underproduction in the  rest of the world and so create a deadweight loss

The Case Against Protection

∙ Despite the fact that free trade promotes prosperity for all countries,  trade is restricted

∙ Seven arguments for restricting international trade are that protecting  domestic industries from foreign competition:

o Helps an infant industry grow

 Comparative advantages change with on-the-job  

experience called learning by doing

 When a new industry or new product is born – an infant  industry – it is not as productive as it will become with  

experience

 It is argued that such an industry should be protected from  international competition until it can stand alone and  

compete  

 Learning by doing is a powerful engine of productivity  

growth, but this fact does not justify protection  

o Counteracts dumping

 Dumping occurs when a foreign firm sells its exports at a  lower price than its cost of production  

 This argument does not justify protection because

∙ It’s virtually impossible to determine a firm’s cost  

∙ It is hard to think of a global monopoly, so even if all  

domestic firms are driven out, alternatives would still

exist  

∙ If the market is truly a global monopoly, it is better to

regulate the monopoly rather than restrict trade  

o Saves domestic jobs

 The idea that buying foreign goods costs domestic jobs is  wrong

 Imports destroy some jobs but create jobs for retailers that  sell the imported goods and for firms that service these  

goods

 Free trade also increases foreign incomes and enables  

foreigners to buy more domestic production

 Protection to save particular jobs is very costly  

o Allows us to compete with cheap foreign labor

 The ideas that a high wage country cannot compete with a  low wage country is wrong

 Low wage labor is less productive than high wage labor

Principles of Microeconomics Test 2 Study Guide  

 And wages and productivity tell us nothing about the  

source of gains from trade, which is comparative  

advantage  

o Penalizes tax environmental standards

 The idea that protection is good for the environment is  wrong

 Free trade increases incomes and poor countries lower  

environmental standards than rich countries

 These countries cannot afford to spend as much on the  environment as a rich country can and sometimes they  

have a comparative advantage at doing “dirty” work,  

which helps the global environment achieve higher  

environmental standards  

o Prevents rich countries form exploiting developing  countries

 By trading with people in poor countries, we increase the  demand for the goods that these countries produce and  

increase the demand for their labor

 The increase in the demand for labor raises their wage rate  Trade can expand the opportunities and increase the  

incomes of people in poor countries  

o Reduces offshore outsourcing that sends US jobs abroad   Offshore outsourcing occurs when a firm in the US buys  finished goods, components, or services from firms in other countries

 Despite the gain from specialization and trade that offshore outsourcing brings, many people believe that it also brings  costs that eat up the gains. Why?  

 Americans, on average, gain from offshore outsourcing, but some people lose

 The losers are those who have invested in the human  

capital to do a specific job that has now gone offshore

Why is International Trade Restricted?  

∙ The key reason why international trade restrictions are popular in the  US and most other developed countries is an activity called rent  seeking  

∙ Rent seeking is lobbying and other political activity that seeks to  capture gains from trade

∙ You’ve seen that free trade benefits consumers but shrinks the  producer surplus of firms that compete in markets with imports  ∙ Those who gain from free trade are the millions of consumers of low cost imports  

∙ But the benefit per individual customer is small

Principles of Microeconomics Test 2 Study Guide  

∙ Those who lose are the producers of import-competing items ∙ Compared to the millions of consumers, there are only a few thousand  producers

∙ These producers have strong incentive to incur the expense of  lobbying for a tariff and against free trade  

The Firm and Its Economic Problems  

A firm is an institution that hires factors of production and organizes them to  produce and sell goods and services.  

The Firm’s Goal  

∙ A firm’s goal is to maximize profit (while confirming to basic rules and  laws of society)  

∙ If the firm fails to maximize its profit, the firm is either eliminated or  taken over by another firm that seeks to maximize profit  

Accounting Profit  

∙ Accountants measure a firm’s profit to ensure that the firm pays the  correct amount of tax and to show its investors how their funds are  being used

∙ profit=totalrevenue−total cost

∙ Accountants use IRS rules based on standards established by the  Financial Accounting Standards Board to calculate a firm’s depreciation cost  

Economic Accounting  

∙ Economists measure a firm’s profit to enable them to predict the firm’s  decisions, and the goal of these decisions is to maximize economic  profit  

∙ Economic profit=totalrevenue−total cost (when total cost = the opportunity cost of production)  

A Firm’s Opportunity Cost of Production

∙ A firm’s opportunity cost of production is the value of the best  alternative use of the resources that a firm uses in production (sum of  implicit and explicit cost)

∙ A firm’s opportunity costs of production are the sum of the cost of  using resources:

o Bought in the market

o Owned by the firm

o Supplied by the firm’s owner

Resources Bought in the Market

Principles of Microeconomics Test 2 Study Guide  

∙ The firm incurs an opportunity cost when it buys resources in the  market

∙ The firm incurs an opportunity cost of production because the firm  could have bought different resources to produce some other good or  service  

Resources Owned by the Firm

∙ If the firm owns capital and uses it to produce its output, then the firm  incurs an opportunity cost

∙ The firm incurs an opportunity cost of production because it could have sold the capital and rented capital from another firm

∙ The firm implicitly rents the capital from itself

∙ The firm’s opportunity cost of using the capital it owns is called the  implicit rental rate of capital

o The implicit rental rate of capital is made up of  

 Economic depreciation: is the change in the market value  of capital over a given period  

 Forgone interest: the return on the funds used to acquire  the capital

Resources Supplied by the Firm’s Owner  

∙ The owner might supply both entrepreneurship and labor ∙ The return to entrepreneurship is profit  

∙ The profit an entrepreneur can expect to receive on average is called  normal profit  

o Normal profit is the cost of entrepreneurship and is an  

opportunity cost of production  

∙ In addition to supplying entrepreneurship, the owner might supply  labor but not take a wage  

∙ The opportunity cost of the owner’s labor is the wage income forgone  by not taking the best alternative job  

Economic Accounting: A Summary

∙ Economic profit=a fir m'stotalrevenue−total opportunity cost of production

Principles of Microeconomics Test 2 Study Guide  

Decisions:  

∙ To maximize profits, a firm must make five basic decisions: o What to produce and in what quantities

o How to produce

o How to organize and compensate its managers and worker o How to market and price its products

o What to produce itself and what to buy from other firms  

The Firm’s Constraints

∙ The firm’s profit is limited by three features of the environment: o Technology constraints

o Information constraints

o Market constraints  

Technology Constraints  

∙ Technology is any method of producing a good or service ∙ Technology advances over time  

∙ Using the available technology, the firm can produce more only if it  hires more resources, which will increase its costs and limit the profit of additional output  

Information Constraints  

∙ A firm never possess complete information about either the present or  the future

∙ The firm is constrained by limited information about the quality and  effort of its work force, current and future buying plans of its  customers, and the plans of its competitors  

∙ The cost of coping with limited information limits profit

Principles of Microeconomics Test 2 Study Guide  

Market Constraints  

∙ What a firm can sell and the price it can obtain are constrained by its  customers’ willingness to pay and by the prices and marketing efforts  of other firms

∙ The resources that a firm can buy and the prices it must pay for them  are limited by the willingness of people to work for and invest in the  firm

∙ The expenditures that a firm incurs to overcome these market  constraints limit the profit that the firm can make  

Technological and Economic Efficiency

∙ Technological efficiency occurs when a firm uses the least amount of  inputs to produce a given quantity of output  

o Different combinations of inputs might be used to produce a  given good, but only one of them is technologically efficient  o If it is impossible to produce a given good by decreasing any one  input, holding all other inputs constant, then production is  technologically efficient  

∙ Economic Efficiency occurs when the firm produces a given quantity of  output at the least cost  

o The economically efficient method depends of the relative costs  of labor and capital

∙ The difference between technological and economic efficiency is that  technological efficiency concerns the quantity of inputs used in  production for a given quantity of output, whereas economic efficiency  concerns the cost of inputs used  

o An economically efficient production process also is  

technologically efficient

o A technologically efficient process may not be economically  efficient  

∙ Changes in the input prices influence the value of the inputs, but not  the technological process for using them in production  

Information and Organization

∙ A firm organizes production by combing and coordinating productive  resources using a mixture of two systems:

o Command systems

o Incentive systems  

Command Systems

∙ A command system uses a managerial hierarchy

∙ Commands pass downward through the hierarchy and information  (feedback) passes upward

Principles of Microeconomics Test 2 Study Guide  

∙ These systems are relatively rigid and can have many layers of  specialized management  

Incentive Systems  

∙ An incentive system is a method of organizing production that uses a  market-like mechanism to induce workers to perform in ways that  maximize the firm’s profit  

Mixing the Systems

∙ Most firms use a mix of command and incentive systems to maximize  profits

∙ They use commands when it is easy to monitor performance or when a small deviation from the ideal performance is very costly  

∙ They use incentives whenever monitoring performance is impossible or too costly to be worth doing

The Principal-Agent Problem

∙ The principal-agent problem is the problem of devising compensation  rules that induce and agent to act in the best interests of a principal  ∙ For example, stockholders of a firm are the principals and the  managers of the firm are their agents  

∙ For example, Mark Zuckerberg (a principal) must induce the designers  who are working on the next generation Facebook (agents) to work  efficiently  

Coping with the Principal-Agent Problem

∙ Three ways of coping with the principal agent problem are o Ownership

o Incentive pay

o Long-term contracts  

Ownership, often offered to managers, gives the managers an incentive to  maximize the firm’s profits, which is the goal of the owners, the principals  

Incentive pay links managers’ or workers’ pay to the firm’s performance and  helps align the mangers’ and workers’ interest with those of the owners, the  principals  

Long-term contracts can tie managers’ or workers’ long-term rewards to the  long-term performance of the firm. This arrangement encourages the agents  to work in the best long-term interests of the firm owners, the principals  

Types of Business Organization

∙ There are three types of business organization

o Proprietorship

Principles of Microeconomics Test 2 Study Guide  

o Partnership

o Corporation  

Proprietorship  

∙ A proprietorship is a firm with a single owner who has unlimited  liability, or legal responsibility for all debts incurred by the firm – up to  an amount equal to the entire wealth of the owner

∙ The proprietorship also makes management decisions and receives the firm’s profit

∙ Profits are taxed the same as the owner’s other income  

Partnership

∙ A partnership is a firm with two or more owners who have unlimited  liability  

∙ Partners must agree on a management structure and how to divide up  the profits

∙ Profits from partnerships are taxed as the personal income of the  owners  

Corporation

∙ A corporation is owned by one or more stockholders with limited  liability, which means the owners have legal liability only for the initial  value of their investment

∙ The personal wealth of the stockholders is not at risk if the firm goes  bankrupt  

∙ The profit of corporations is taxed twice, once as a corporate tax on  firm profits, and then again as income taxes paid by stockholders  receiving their after-tax profits distributed as dividends  

Markets and the Competitive Environment  

Economists identify four market types:

1. Perfect competition

2. Monopolistic competition

3. Oligopoly

4. Monopoly  

Perfect Competition is a market structure with  

∙ Many firms and many buyers

∙ All firms sell an identical product

∙ No restrictions on entry of new firms to the industry

∙ Both firms and buyers are all well informed about the prices and  products of all firms in the industry

∙ Examples include world markets in wheat and corn

Principles of Microeconomics Test 2 Study Guide  

Monopolistic Competition is a market structure with  

∙ Many firms

∙ Each firm produces similar but slightly different products – called  market differentiation

∙ Each firm possesses an element of market power

∙ No restrictions on entry of new firms to the industry  

Oligopoly is a market structure in which

∙ A small number of firms compete

∙ The firms might produce almost identical products or differentiated  products

∙ Barriers to entry limit entry into the market  

Monopoly is a market structure in which

∙ One firm produces the entire output of the industry

∙ There are no close substitutes for the product

∙ There are barriers to entry that protect the firm from competition by  entering firms  

To determine the structure of an industry, economists measure the extent to  which a small number of firms dominate the market.  

Measures of Concentration

∙ Economists use two measures of market concentration: o The four-firm concentration ratio

 The four-firm concentration ratio is the percentage of the  total industry sales accounted for by the four largest firms  in the industry  

o The Herfindahl-Hirschman Index (HHI)  

 The HHI is the square of the percentage market share of  each firm summed over the largest 50 firms in the industry (or all firms if fewer than 50)

N

 H=∑ i=1

s i2  

∙ where n = number of firms  

∙ s(i=1 to n) = market shares  

 As market concentration increases, the amount of  competition in the industry decreases

 HHI range:



Limits of Measures of Concentration

Principles of Microeconomics Test 2 Study Guide  

∙ The main limitations of only using concentration measures as  determinants of market structure are  

o The geographical scope of the market

o Barriers to entry and firm turnover  

o The correspondence between market and an industry  

To produce any good or service factors of production must be hired and their  activities coordinated  

Firm Coordination  

∙ Firms hire labor, capital, and land, and by using a mixture of command  systems and incentive systems they organize and coordinate their  activities to produce goods and services  

Market Coordination

∙ Markets coordinate production by adjusting prices and making the  decisions of buyers and sellers of factors of production and  components consistent

∙ See chapter 3 to explain how demand and supply coordinate the plans  of buyers and sellers

∙ Outsourcing – buying parts or products from other firms – is an  example of market coordination of production

∙ Firms coordinate more production than do markets, but why?  

Why Firms Coordinate More Production Than Do Markets ∙ Firms coordinate production when they can do so more efficiently than  a market

∙ Four key reasons make firms more efficient. Firms can achieve: o Lower transaction costs

 Transaction costs are the costs arising from finding  

someone with who to do business, reaching agreement on  the price and other aspects of the exchange, and ensuring  that the terms of the agreement are fulfilled  

o Economies of scale

 Economies of scale occur when the cost of producing a unit of a good falls as its output rate increases

o Economies of scope

 Economies of scope arise when a firm can use specialized  inputs to produce a range of different goods at a lower cost than otherwise

o Economies of team production  

 Firms can engage in team production, in which the  

individuals specialize in mutually supporting tasks

Principles of Microeconomics Test 2 Study Guide  

Decision Time Frames

∙ The firm makes many decisions to achieve its main objective: profit  maximization

∙ Some decisions are critical to the survival of the firm; others are  irreversible (or very costly to reverse)  

∙ All decisions are placed in two time frames:  

o The short run is a time frame in which the quantity of one or  more resources used in production is fixed

∙ For most firms, capital, or the firms plant, is fixed in the  short run

∙ Labor, raw materials, and energy may be varied

∙ Most short run decisions are easily reversed

o The long run is a time frame in which the quantities of all  resources – including the plant size – can be varied.  

∙ All variables can be varied in the long run time frame

∙ Long run decisions are not easily reversed

∙ Sunk cost: cost incurred by the firm that cannot be  

changed

∙ If a firm’s plant has no resale value than it is a sunk  

cost

∙ Sunk costs are irrelevant to the firm’s current  

decisions

Short-Run Technology Constraints

∙ To increase the output in the short-run, a firm must increase its labor  force

∙ The relationship between output and quantity of labor employed: ∙ Total product: the total output produced in a given period  ∙ Marginal product (of labor): change in total output resulting from a one unit increase in the quantity of labor employed

∙ Average product (of labor): total product divided by the quantity of  labor employed

∙ As the quantity of labor employed increases:

∙ Total product increases

∙ Marginal product increases initially, but eventually decreases ∙ Average product increases at first, then decreases

∙ Product curves show how the firm’s total product, marginal product, and  average product change as the firm varies the quantity of labor  employed.  

Total Product Curve –– it is efficient to produce ON the TPC

Principles of Microeconomics Test 2 Study Guide  

∙ The total product curve is similar to the PPF

∙ It separates attainable output levels from unattainable output levels in  the short run  

o Marginal Product Curve –– to get from TPC to MPC, take the first  derivative

o Increasing marginal returns initially, followed by diminishing  marginal returns

o Average Product Curve

Law of Diminishing Returns

o As a firm uses more of a variable input with a given quantity of fixed  inputs, the marginal product of the variable input eventually  diminishes

∙ Total Cost:

o Total cost (TC): the cost of all resources

o Total Fixed Cost (TFC): the cost of the firm's fixed inputs – these  do not change with output

o Total Variable Cost (TVC): cost of the firm's variable  inputs – these do change with outputs

o TC = TFC + TVC  

What is Perfect Competition  

Perfect competition is a market in which

 Many firms sell identical products to many buyers.

 There are no restrictions to entry into the industry.

 Established firms have no advantages over new ones.

 Sellers and buyers are well informed about prices.

How Perfect Competition Arises

Perfect competition arises when

Principles of Microeconomics Test 2 Study Guide  

 The firm’s minimum efficient scale is small relative to market  demand, so there is room for many firms in the market.

 Each firm is perceived to produce a good or service that has no  unique characteristics, so consumers don’t care which firm’s  good they buy.

Price Takers

∙ In perfect competition, each firm is a price taker.

∙ A price taker is a firm that cannot influence the price of a good or  service.

∙ No single firm can influence the price—it must “take” the equilibrium  market price.

∙ Each firm’s output is a perfect substitute for the output of the other  firms, so the demand for each firm’s output is perfectly elastic.

Economic Profit and Revenue

∙ The goal of each firm is to maximize economic profit, which equals  total revenue minus total cost.

∙ Total cost is the opportunity cost of production, which includes normal  profit.

∙ A firm’s total revenue equals price, P, multiplied by quantity sold, Q,  or P × Q.

∙ A firm’s marginal revenue is the change in total revenue that results  from a one-unit increase in the quantity sold

Principles of Microeconomics Test 2 Study Guide  

∙ The demand for a firm’s product is perfectly elastic because one firm’s  sweater is a perfect substitute for the sweater of another firm. ∙ The market demand is not perfectly elastic because a sweater is a  substitute for some other good.

Principles of Microeconomics Test 2 Study Guide  

The Firm’s Decisions

∙ A perfectly competitive firm’s goal is to make maximum economic  profit; given the constraints it faces.

∙ So the firm must decide:

o How to produce at minimum cost

o What quantity to produce

o Whether to enter or exit a market

∙ A perfectly competitive firm chooses the output that maximizes its  economic profit.

∙ One way to find the profit-maximizing output is to look at the firm’s  total revenue and total cost curves.

∙ Part (a) shows the  

total revenue, TR,  

curve.

∙ Part (a) also shows  

the total cost  

curve, TC.

∙ Total revenue  

minus total cost is  

economic profit (or  

loss), shown by the

Principles of Microeconomics Test 2 Study Guide  

∙ At low output levels, the  

firm incurs an economic  

loss – it can’t cover its  

fixed cost  

∙ At intermediate output  

levels, the firm makes an  

economic profit

Principles of Microeconomics Test 2 Study Guide  

∙ At high output levels, the firm  

again incurs an economic loss –

now the firm faces steeply  

rising costs because of  

diminishing returns

∙ The firm maximizes its  

economic profit when it  

produces 9 sweaters a day

The Firm’s Output Decision  

Marginal Analysis and Supply Decision

∙ The firm can use marginal analysis to determine the  

profit-maximizing output.  

∙ Because marginal revenue is constant and marginal cost eventually  increases as output increases, profit is maximized by producing the  output at which marginal revenue, MR, equals marginal cost, MC.

∙ Shows the marginal analysis that determines the profit-maximizing  output.

Principles of Microeconomics Test 2 Study Guide  

If MR > MC, economic  

profit increases if output  

increases.

If MR < MC, economic  

profit decreases if output  

increases.

If MR = MC, economic  

profit decreases if output  

changes in either  

direction, so economic

Temporary Shutdown Decision

∙ If the firm makes an economic loss, it must decide whether to exit the  market or to stay in the market.

∙ If the firm decides to stay in the market, it must decide whether to  produce something or to shut down temporarily.  

∙ The decision will be the one that minimizes the firm’s loss.

Loss Comparisons

∙ The firm’s loss equals total fixed cost (TFC) plus total variable cost  (TVC) minus total revenue (TR).

∙ Economic loss = TFC + TVC – TR  

 = TFC + (AVC − P) x Q

∙ If the firm shuts down, Q is 0 and the firm still has to pay its TFC. ∙ So the firm incurs an economic loss equal to TFC.

∙ This economic loss is the largest that the firm must bear.

The Shutdown Point

∙ A firm’s shutdown point is the price and quantity at which it is  indifferent between producing the profit-maximizing quantity and  shutting down.

∙ The shutdown point is at minimum AVC.

∙ This point is the same point at which the MC curve crosses the AVC curve.

∙ At the shutdown point, the firm is indifferent between producing and  shutting down temporarily.

∙ At the shutdown point, the firm incurs a loss equal to total fixed cost  (TFC).

Principles of Microeconomics Test 2 Study Guide  

The Firm’s Supply Curve  

∙ A perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing

∙ This figure shows the shutdown point  

∙ Minimum AVC is $17  a sweater  

∙ At $17 a sweater, the profit-maximizing  

output is 7 sweaters  a day  

∙ The firm incurs a loss equal to the red  

rectangle  

∙ If the price of a  sweater is between  $17 and $20.14:

∙ the firm produces  the quantity at which marginal cost equals  price.  

∙ The firm covers all its variable cost and  

some

of its fixed cost.

output varies as the market price varies, other things remaining the  same.

∙ Because the firm produces the output at which marginal cost equals  marginal revenue, and because marginal revenue equals price, the  firm’s supply curve is linked to its marginal cost curve. ∙ But at a price below the shutdown point, the firm produces nothing.

Principles of Microeconomics Test 2 Study Guide  

Figure 12.5 shows how the firm’s supply  curve is constructed.

If price equals minimum AVC, $17 a  

sweater, the firm is indifferent between  

producing nothing and producing at the  

shutdown point, T.

If the price is $25 a sweater, the firm  

produces 9 sweaters  

a day, the quantity at which  

P = MC.

If the price is $31 a sweater, the firm  

produces 10 sweaters a day, the quantity  at which  

P = MC.

The blue curve in part (b) traces the firm’s  short-run supply curve.

Principles of Microeconomics Test 2 Study Guide  

Output, Price, and Profit in the Short Run  

Market Supply in the Short Run  

∙ The short-run market supply curve shows the quantity supplied by  all firms in the market at each price when each firm’s plant and the  number of firms remain the same.

∙ The picture below shows the market supply curve of sweaters, when  there are 1,000 sweater-producing firms identical to Campus Sweater.

Short-Run Equilibrium  

∙ Short-run market supply and  

market demand determine the  

market price and output  

∙ The picture bellows shows a  

short-run equilibrium

A Change in Demand

∙ An increase in demand brings a rightwards shift of the market demand  curve: the price rises and the quantity increases  

∙ A decrease in demand brings a leftward shift of the market demand  curve: the price falls and the quantity decreases

Principles of Microeconomics Test 2 Study Guide  

Profits and Losses in the Short Run

∙ Maximum profit is not always a positive economic profit. ∙ To see if a firm is making a profit or incurring a loss compare the firm’s  ATC at the profit-maximizing output with the market price.  ∙ The picture below shows the three possible profit outcomes:  o A: price equals average total cost and the firm makes zero  economic profit (breaks even)  

o B: price exceeds average total cost and the firm makes a positive economic profit  

o C: price is less than average total cost and the firm incurs an  economic loss – economic profit is negative  

Output, Price, and Profit in the Long Run  

∙ In short-run equilibrium, a firm might make an economic profit, break  even, or incur an economic loss

Principles of Microeconomics Test 2 Study Guide  

∙ In long-run equilibrium, firms break even because firms can enter or  exit the market  

Entry and Exit

∙ New firms enter an industry in which existing firms make an economic  market

∙ Firms exit and industry in which they incur an economic loss  

A Closer Look at Entry  

∙ When the market price is $25 a sweater, firms in the market are  making economic profit  

∙ New firms have an incentive to enter the market

∙ When they do, the market supply increases and the market price falls  ∙ Firms enter as long as firms are making economic profits  ∙ In the long run, the market price falls until firms are making zero  economic profit

Principles of Microeconomics Test 2 Study Guide  

A Closer Look at Exit  

∙ When the market price is $17 a sweater, firms in the market are  incurring economic loss  

∙ Firms have an incentive to exit the market

∙ When they do, the market supply decreases and the market price rises  ∙ Firms exit as long as firms are incurring economic losses ∙ In the long run, the price continues to rise until firms make zero  economic profit  

Changes in Demand and Supply as Technology Advances  

An Increase in Demand  

∙ An increase in demand shifts the market curve rightward  ∙ The price rises and the quantity increases

∙ Starting from long-run equilibrium, firms make economic profits  ∙ The market demand curve shifts rightward, the market price rises, and  each firm increases the quantity it produces

Principles of Microeconomics Test 2 Study Guide  

∙ The market price is now above the firm’s minimum average total cost,  so firms make economic profit  

∙ Economic profit induces some firms to enter the market, which  increases the market supply and the price starts to fall  

∙ As the price falls, the quantity produced by all firms starts to decrease  and each firm’s economic profit starts to fall  

∙ Eventually, enough firms have entered for the supply and increased  demand to be in balance and firms make zero economic profit. Firms  no longer enter the market  

∙ The main difference between the initial and new long-run equilibrium is the number of firms in the market

∙ More firms produce the equilibrium quantity  

∙ With a rising price, each firm increases its output as it moves along up  its marginal cost curve (supply curve)  

∙ A new long-run equilibrium occurs when the price has risen to equal  minimum ATC  

∙ Firms make zero economic profit, and firms have no incentive to exit  the market

Principles of Microeconomics Test 2 Study Guide  

∙ In the new equilibrium, a smaller number of firms produce the  equilibrium quantity  

Technological Advances Change Supply  

∙ Starting from a long-run equilibrium, when a new technology becomes  available that lowers production costs, the first firms to use it make  economic profit.  

∙ But as more firms begin to use the new technology, market supply  increases and the price falls.  

∙ The picture below illustrates the effects of an increase in supply ∙ “a” shows the market

∙ “b” shows a firm using the original old technology

o With the lower price, old-technology firms incur economic losses o Some exit the market; others switch to new technology  ∙ “c” shows a firm using new technology and making an economic profit  o Economic profit induces some new-technology firms to enter the  market  

o The market supply increases and the price starts to fall

∙ Eventually all firms are using new technology

∙ The market supply has increased and firms are making zero economic  profit  

Competition and Efficiency

Efficient Use of Resources

∙ Resources are used efficiently when no one can be made better off  without making someone else worse off

∙ This situation arises when marginal social benefit equals marginal  social cost.

Principles of Microeconomics Test 2 Study Guide  

Choices, Equilibrium, and Efficiency

∙ We can describe an efficient use of resources in terms of the choices of consumers and firms coordinated in market equilibrium.

Choices

∙ A consumer’s demand curve shows how the best budget allocation  changes as the price of a good changes.

∙ If the people who consume the good are the only ones who benefit  from the good, the market demand curve is the marginal social benefit ∙ A competitive firm’s supply curve shows how the profit-maximizing  quantity changes as the price of a good changes  

∙ So at all points along their supply curves, firms get the most value out  of their resources  

∙ If the firms that produce the good bear all the costs of producing it,  then the market supply curve is the marginal social cost curve  

Equilibrium and Efficiency

∙ In competitive equilibrium, resources are used efficiently—the quantity  demanded equals the quantity supplied, so marginal social benefit  equals marginal social cost.

∙ The gain from trade for consumers is measured by consumer surplus. ∙ The gain from trade for producers is measured by producer surplus. ∙ Total gains from trade equal total surplus.

∙ In long-run equilibrium total surplus is maximized