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UGA / Economics / ECON 2106 / Give an example of microeconomics.

Give an example of microeconomics.

Give an example of microeconomics.

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School: University of Georgia
Department: Economics
Course: Principles of Microeconomics
Professor: Till schreiber
Term: Fall 2016
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Cost: 50
Name: Principles of Microeconomics (ECON 2106) Final Exam Study Guide
Description: These notes cover everything that will be on our final exam. Good luck!
Uploaded: 12/06/2016
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Principles of Microeconomics  


Give example of microeconomics.



Dr. Till Schreiber

ECON 2016

Introduction to Microeconomics Final Exam Study Guide  

Microeconomics (ECON 2106) Chapter 1 Notes

Economics is driven by principles of scarcity and incentives. Scarcity is our inability to satisfy all our wants. Because we face scarcity, we must make choices. An incentive is a reward that encourages an action or a penalty that discourages an action.


What is the economic model?



Microeconomics is study of choices that individuals and businesses make, the way  those choices interact in markets, and the influence of governments. It is, more  simply put, the study of economics at an individual, group or company level.  

∙ Example of micro: why are students buying more e-books and fewer hard  copy books?  

∙ Here are four additional examples of microeconomics.  

Macroeconomics is the study of the performance of the national and global  economies.  We also discuss several other topics like What is a watershed?

∙ Example of macro: why is the unemployment rate in the US so high?  

Goods and Services are the objects that people value and produce to satisfy  human wants. A good would be something like a candy bar or a t-shirt. A service  might be a haircut, taxi ride or mail delivery.  


What is economic coordination?



Efficiency and Social Interest  

A resource is efficient if it is not possible to make a person better off without making someone else worse off. For example, Apple sells iPhones to people all around the  world but the conditions their laborers face in factories are far less than ideal.  

Equity is fairness, however “fairness” is subjective, especially among economists.  

Economic Ways of Thinking

1. A choice is a tradeoff  

a. On a Saturday night, will you stay home and study or go out and have  fun? You must make a choice and every choice is a tradeoff.  

2. People make rational choices by comparing benefits and costs  a. Ideally, you’d make a rational choice. A rational choice is one that  compares costs and benefits and achieves the greatest benefit over  cost for the person making the choice.  

3. Benefit is what you gain from something If you want to learn more check out What is the nationality of eva hesse?

Introduction to Microeconomics Final Exam Study Guide  

a. The benefit of something is the gain or pleasure that it brings and is  determined by preferences- by what a person likes and dislikes and the intensity of those feelings.

b. Economists measure this as the most you are willing to give up for  something.

4. Cost is what you must give up to get something  

a. The opportunity cost of something is the highest valued alternative  that must be given up to get it. Say Chipotle is giving out free burritos.  Every student on campus goes to claim their free snack. In order to  actually get the free burrito, you must spend one hour of your time  waiting in line. Alternatively, you could go pay $7.00 for a burrito  somewhere else and use your remaining time to be productive.  5. Most choices are “how-much” choices made at the margin

a. You want to study and play video games, but you must decide how  many minutes to allocate to each activity in an allotted period of time.  You compare the benefit of a little more study time with its cost- you  make your choice at the margin.  

6. Choices respond to incentives  

a. A change in marginal cost or a change in marginal benefit changes the  incentives that we face and leads us to change our choice. The central  idea of economics is that we can predict how choices will change by  looking at changes in incentives. Incentives are also the key to  If you want to learn more check out What is precipitate?

reconciling self-interest and the social interest.  

Economist as a Social Science

Positive Statements: a statement about what is. It may be wrong, but economists  can test it. For example: Higher interest rates will reduce house prices. This may be  right or wrong, but economists can test it by checking it against facts and data.  

Normative Statements: a statement about what ought to be. You may agree or  disagree with it, but you can’t check it. For Example: The U.S. unemployment rate  should be lower.  

Unscrambling Cause and Effect: Economists like to use positive statements about  cause and effect. They can check them using an economic model.  

Economic Model: a description of some aspect of the economic world that includes  only those features that are needed for the purpose at hand. Graphs are often used  to show general relationships among the variables in an economic model.  

Economics as a Policy Advisor  

∙ Economics is a toolkit for advising governments and businesses and for  making personal decisions

∙ It can’t help with the normative part, that’s the policy goal, but it can help to  clarify what the goals are.

Introduction to Microeconomics Final Exam Study Guide  

Factors of Production

1. Land: natural resources like coal, oil, water, etc. Land makes rent.  2. Labor: the work time and work effort that people devote to producing goods  and service. Quality of human labor depends on human capital, the  knowledge and skill that people obtain from education, on-the-job training,  and work experience. Labor earns wages.  If you want to learn more check out What is the benefit of getting an additional unit?

3. Capital: the tools, instruments, machines, buildings, and other constructions  that businesses use to produce goods and service. Capital earns interest.  4. Entrepreneurship: human resources that organizes the 3 factors of production above. Entrepreneurship earns profit.

∙ PPF (Production Possibilities Frontier): the boundary between the combinations of  goods and services that can be produced and those than can’t

o points outside the PPF and unattainable - the PPF shows what is technologically  feasible to produce

o points within the PPF line are attainable but inefficient 

o we achieve Production Efficiency if we cannot produce more of one good  without producing less of something else 

o outward bowing PPF means that as the quantity produced of each good increases so does its opportunity cost 

o all points on the PPF line are efficient

∙ Opportunity Cost is a ratio 

∙ Preferences: the likes and dislikes of consumers 

∙ Marginal Benefit: the benefit derived from a consumer by consuming one more  unit of something 

o this is measured by how much a consumer is willing to pay for an additional unit  of something

o measure derived from the consumer side 

∙ The Principle of decreasing marginal benefit: general principle that the more  we have of something the smaller its marginal benefit and the less we are willing to  pay for an additional unit of it We also discuss several other topics like What is the difference between civil and criminal cases?

∙ Allocative Efficiency: when we cannot produce more of one good without giving up some other good that we value more highly 

Introduction to Microeconomics Final Exam Study Guide  

o marginal benefit = marginal cost —> efficient quality being produced

∙ All points on the PPF achieve production efficiency but only the one point where  Marginal benefit and Marginal cost intersect achieves both production and allocative  efficiency   

∙ Economic growth

o technological change: the development of new goods and a better way to  produces goods and services Don't forget about the age old question of What is the difference between just asking a question or pursuing it?

o capital accumulation: 

o cost of economic growth: 

PPF and Opportunity  

Costs Production Possibilities and Opportunity 

Cost

∙ The quantities of goods and services  

that we can produce are limited by our  

available resources and by technology  

o Tradeoff: increased production of

1 good = decreased production  

of something else  

∙ Production Possibilities Frontier  

(PPF): the boundary between those  

combinations of goods and services  

that can be produced and those that  

cannot  

∙ The PPF illustrates scarcity because the

points outside the frontier are  

unattainable. However, any point  

inside the PPF is considered attainable

Introduction to Microeconomics Final Exam Study Guide  

Production Efficiency  

∙ We achieve production efficiency if we produce goods and services at the  lowest possible cost

∙ Production efficiency occurs are all points on the PPF

o Points inside the PPF production are considered inefficient, meaning we are giving up more than necessary of a good to produce “x” number of  another good  

∙ Production inside PPF is inefficient because resources are either unused,  misallocated or both

o Resources are unused when they are idle but could be working o Resources are misallocated when they are assigned to tasks for which  they are not the best match (having a chef cut grass all day)  

Tradeoff along PPF and Opportunity Cost

∙ Tradeoffs involve an opportunity cost. The opportunity cost of an action is the  highest-valued alternative forgone

∙ There are only 2 goods along the PPF so there is only 1 alternative foregone o Ex: To produce more pizzas we must produce less cola. The opportunity cost of producing additional pizza is the cola we must forgo  

∙ Opportunity cost is a ratio: decrease∈quantity of good produced increase∈quantity of other good produced

∙ The slope of PPF measure opportunity cost  

Using Resources Efficiently

Introduction to Microeconomics Final Exam Study Guide  

∙ We achieve production efficiency at every point on the PPF, but which is best? o Allocative efficiency: when goods and services are produced at the  lowest possible cost and in the quantities that provide the greatest  possible benefit  

The PPF and Marginal Cost  

∙ The marginal cost of a good

is the opportunity cost of  

producing one more unit of  

it

o Simply put, marginal  

cost is the cost of  

moving from one  

point on the frontier  

to another

∙ On the graph to the right,  

moving from point “Q” to  

point “R”, we can see that  

the marginal cost of going  

from 5 computers to 6 is 1

The expansion of production possibilities is called economic growth. Economic  growth increases our standard of living

The Cost of Economic Growth  

∙ What causes economic growth? Technological change and capital  accumulation  

o Technological Change: development of new goods and of better  ways of producing goods and services

o Capital Accumulation: growth of capital resources, including human  capital

∙ If we use our resources to develop new technologies and produce capital, we  must decrease our production and consumption of goods and services o New technologies and new capital have an opportunity cost

Introduction to Microeconomics Final Exam Study Guide  

Gains from Trade  

Producing only one or a few goods is called specialization. People gain by  specializing the production of the good in which they have a comparative  advantage and trading with others  

Comparative Advantage and Absolute Advantage  

∙ A person has a comparative advantage in an activity if that person can  perform the activity at a lower opportunity cost that anyone else.  ∙ A person has an absolute advantage if that person is more productive than  others

∙ Absolute advantage involves comparing productivities while comparative  advantage involves comparing opportunity costs.

∙ You can always have a comparative advantage even if you have no absolute  advantage  

Achieving the Gains from Trade (Liz and Joe example from textbook)  

∙ Liz and Joe produce the good in which they have a comparative advantage:  o Liza produces 30 smoothies and 0 salads

o Joe produces 30 salads and 0 smoothies

∙ Liz and Joe Trade:  

o Liza sells Joe 10 smoothies and buys 20 salads

o Joe sells Liz 20 salads and buys 10 smoothies

∙ After trade:

o Liz has 20 smoothies and 20 salads

o Joe has 10 smoothies and 10 salads

∙ Both trade lines (red) have an equal slope because their exchange was of an  equal ratio

Introduction to Microeconomics Final Exam Study Guide  

Economic Coordination

∙ To reap gains from trade, the choices of individuals must be coordinated  ∙ To make coordination work, four complimentary social institutions have  evolved over the centuries:  

o Firms: an economic unit that hires factors of production and organizes  them to produce and sell goods and services.  

 Ex: Wal-Mart buys or rents large buildings, equips them with  storage shelves and checkout lanes, and hires labor

o Markets: any arrangement that enables buyers and sellers to get  information and to do business with each other.

 A place where people buy and sell goods such as fish, meat,  fruits, and vegetables

o Property rights: the social arrangements that govern the ownership,  use and disposal of anything people value.  

 Real property includes land and buildings  

 Financial property includes stocks and bonds and money in the  bank

 Intellectual property is the intangible product of creative effort o Money: any commodity or token that is generally acceptable as a  means of payment.  

 In the book’s example of Liz and Joe, they didn’t need money  because they exchanged salads and smoothies.  

Circular Flows Through Markets  

∙ The figure below illustrates how households and firms interact in the market  economy

∙ Factors of production and goods and services flow in one direction (red).  Money flows in the opposite direction (green).

Introduction to Microeconomics Final Exam Study Guide  

Example Problem 1: My neighbor and I have the same value of Saturday  afternoon leisure. But, our cars need oil changes and lawns need mowing.  

Time to change oil

Time to mow lawn

Jim

15 minutes

30 minutes

Till

60 minutes

45 minutes

a) Who has an absolute advantage in chores? Jim, he’s better and more  productive at doing both chores.

b) In a no trade scenario, Jim works for 45 minutes, Till works for 105 minutes.  c) What are the opportunity costs?  

a. Jim: 2 oil changes. The opportunity cost of Jim mowing 1 lawn is 2 oil  changes  

b. Till: ¾ of an oil change.  

i. Till has comparative advantage in mowing the lawn because he  has a smaller opportunity cost. Jim has to give up more to mow  the lawn.  

  Till has comparative advantage in mowing lawns    Jim has comparative advantage in changing oil

d) Specialization and Gains from Trade

a. Till mows both lawns; Jim changes oil for both cars

Introduction to Microeconomics Final Exam Study Guide  

b. Till works for 90 minutes; Jim works for 30 minutes  

i. Both are now better off than how they were in part b

Example Problem 2: Suppose Virginia and Nebraska both produce Tobacco  and Corn. Assume that Virginia and Nebraska have the same amount of productive  inputs.  

a) What is the opportunity cost of producing one bushel of corn in both states?  (Opportunity cost can be found by calculating the slope of the PPF. Linear PPF  = constant opportunity cost).  

a. Virginia: 600

400=64=32 tons of tobacco (for every 1 bushel of corn)  

b. Nebraska: 45 tons of tobacco (for every 1 bushel of corn)

b) Nebraska has the comparative advantage in producing corn because it has  lower opportunity cost. Virginia has the comparative advantage in producing  tobacco

c) Suppose they trade. What is the price range of corn you might expect to see  (in terms of tobacco)?  

a. Trade line moves from (0,600) to (1000,0). The slope of this line would  be in between 3/2 and 4/5. The actual location of the point depends on  how good the negotiators from each state are.

Introduction to Microeconomics Final Exam Study Guide  

Example Problem 3: According to the theory of comparative advantage,  country x would find it most advantageous to...?  

Wheat

Corn

X

10

5

Y

8

8

a) Export both wheat and corn

b) Import both wheat and corn

c) Not trade

d) Export wheat and import corn 

e) Export corn and import wheat  

Coordinating Decisions

∙ Markets coordinate decisions through price adjustments

o Suppose a ton of people who want to buy ice cream can’t. To make buying and selling plans the same, more ice cream must be offered or  fewer people can want ice cream. Increasing the price of ice cream will  force this equilibrium

∙ When the price is right, buying plans and selling plans match  

Markets and Prices

∙ Competitive market: market that has many buyers and sellers so no one  individual can influence prices

∙ Money price: the money required to buy something  

∙ Relative price: the ratio of its money price to the money price of its next best  alternative – its opportunity cost  

Demand

∙ If you demand something, you:  

o Want it

o Can afford it

o Have made a definite plan to buy it  

∙ The law of demand states that:

o Other things remaining the same, the higher the price of a good, the  smaller is the quantity demanded  

o The lower the price of a good, the larger is the quantity demanded  ∙ Why does price change affect the quantity demanded?

Introduction to Microeconomics Final Exam Study Guide  

o Substitution effect: when the opportunity cost/relative price of a  product rises, people look for substitutes – decreases demand for the  original product  

o Income effect: when prices rise relative to income, people cannot  afford what they previously bought so demand increases

∙ Demand Curve and Demand Schedule  

o Demand refers to the entire relationship between the price of a good  and the quantity demanded of the good  

o Demand Curve shows the relationship between quantity demanded of  a good and its price when all other influences on consumers remain  the same  

o Reducing / increasing quantity of good demanded refers to moving  along the demand curve – increasing / decreasing demand refers to  shifting the entire demand curve  

∙ 6 Main Factors that Change Demand

1. the prices of related goods

 A substitute is a good that can be used in the place of another  A compliment is a good that is used in conjunction with another  good

2. expected future prices

 if the price of a good is expected to rise in the future, current  demand increases and the demand curve shifts to the right  

3. income

 when income increases, consumers buy more of most goods and the demand curve shifts to the right  

∙ a normal good is a good for which demand increases  

when income increases

∙ an inferior good is a good for which demand decreases  

when income increases (ex: people eat less at McDonalds  

and more at Chipotle because they can now afford it  

4. expected future income and credit

5. population

6. preferences  

Supply

∙ if a firm supplies a good or service, then the firm:

o has the resources and tech to produce it  

o can profit from producing it

o has made a definite plan to produce and sell it

∙ Resources and technology determine what is possible to produce  ∙ The Law of Supply states that:  

o Other things remaining the same, the higher the price of a good, the  greater is the quantity supplied  

o The lower the price of a good, the smaller is the quantity supplied

Introduction to Microeconomics Final Exam Study Guide  

o The law of supply results from the general tendency for the marginal  cost of producing a good or service to increase as the quantity  produced increases  

∙ 6 Main Factors that Change Supply:

1. the prices of factors of production

2. the prices of related goods produced

3. expected future price  

4. the number of suppliers

5. technology

6. state of nature  

Market Equilibrium

∙ equilibrium price: the price at which the quantity demanded = the quantity  supplied

∙ equilibrium quantity: the quantity bought and sold at the equilibrium price  Price Elasticity of Demand  

∙ As supply decreases, the equilibrium price rises and the equilibrium quantity  decreases

o But does the price rise by a larger amount and the quantity decrease  by a little?

∙ The responsiveness of the quantity demanded of a good to a change in its  price in terms of the slope of the demand curve  

∙ Price elasticity of demand is a units-free measure of the responsiveness of  the quantity demanded of a good to a change in its price when all other  influences on buying plans remain the same  

o Calculating elasticity of demand:

change∈quantity demanded

change∈price

 Example: the price of a pizza is $20.50 and the quantity  

demanded is 9 pizzas per hour. The price of a pizza falls to  

$19.50 and the quantity demanded is 11 pizzas per hour  

∙ $20 average between 2 points, 10 pizzas average  

between 2 points (change in pizzas = 2 so 2/10 * 100 =  

20%) = 20% change in pizzas demanded / 5% change in  

price = 4

o Price goes up, quantity demanded goes down  

Average Price and Quantity

Introduction to Microeconomics Final Exam Study Guide  

∙ By using the average price and average quantity, we get the same elasticity  value regardless of whether the price rises or falls  

o Elasticity means it will change easily. If elastic price changes, elastic  demand changes drastically  

A Units-Free Measure: elasticity is a ratio of percentages, so a change in the units of  measurement of price or quantity leaves the elasticity value the same  

Minus Sign Elasticity: the formula yields a negative value, because price and  quantity move in opposite directions. But it is the magnitude, or absolute value, that reveals how responsive the quantity change has been to a price change.  

Inelastic and Elastic Demand  

∙ Demand can be inelastic, unit elastic, or elastic, and can range from zero to  infinity.  

∙ If the quantity demanded doesn’t change when the price changes, the price  elasticity of demand is zero and the good has a perfectly inelastic  demand.  

o A perfectly inelastic demand curve is vertical  

Unit Elastic Demand: if the percentages change in the quantity demanded equals  the percentage change in price. The price elasticity of demand equals 1 and the  good has unit elastic demand

Introduction to Microeconomics Final Exam Study Guide  

If the percentage change in the quantity demanded is smaller than the percentage  change in price,  

∙ The price elasticity of demand is less than 1 and the good has inelastic  demand  

If the percentage change in the quantity demanded is greater than the percentage  change in price,  

∙ The price elasticity of demand is greater than 1 and the good has elastic  demand

If the percentage change in the quantity demanded is infinitely large when the price barely changes

∙ The price elasticity of the demand is infinite and the good has a perfectly  elastic demand  

Factors that influence the Elasticity of Demand:  

∙ The closeness of substitutes

o The closer the substitutes for a good or service, the more elastic is the  demand for the good or service

o Necessities, such as food or housing, generally have inelastic demand  o Luxuries, such as exotic vacations, generally have elastic demand  ∙ The proportion of income spent on the good

o The greater the proportion of income consumers spend on a good, the  larger is the elasticity of demand for that good  

∙ The time elapsed since a price change  

o The more time consumers have to adjust to a price change, or the  longer that a good can be stored without losing its value, the more  elastic is the demand for that good

Introduction to Microeconomics Final Exam Study Guide  

Total Revenue and Elasticity

∙ The total revenue from the sale of a good or service equals the price of the  good multiplied by the quantity sold. Revenue is the total sold (price x  quantity)  

∙ When the price changes, total revenue also changes

∙ But a rise in price doesn’t always increase total revenue  

The change in total revenue due to a change in price depends on the elasticity of  demand:  

∙ If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent, and total revenue increase

∙ If demand is inelastic, a 1 percent price cut increases the quantity sold by  less than 1 percent, and total revenues decrease  

∙ If demand is unit elastic, a 1 percent price cut increases the quantity sold by  1 percent, and total revenue remains unchanged  

The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a price change (when all  other influences on the quantity sold remain the same).

∙ If a price cut increases total revenue, demand is elastic.

∙ If a price cut decreases total revenue, demand is inelastic.

∙ If a price cut leaves total revenue unchanged, demand is unit elastic.

Your Expenditure and Your Elasticity

∙ if your demand is elastic, a 1% price cut increase the quantity you buy by  more than 1% and your expenditure on the item increases.  

∙ If your demand is inelastic, a 1% price cut increases the quantity you buy by  less than 1 percent and your expenditure on the item decreases. ∙ If your demand is unit elastic, a 1% price cut increases the quantity you buy  by 1% and your expenditure on the item does not change.  

Income Elasticity of Demand  

∙ The income elasticity of demand measures how the quantity demanded of a  good respond to a change in income, other things remaining the same.  

percentage change∈quantity demanded

percentage change∈income

Introduction to Microeconomics Final Exam Study Guide  

∙ If the income elasticity of demand is greater than 1 (positive), demand is  income elastic and the good is a normal good.  

∙ If the income elasticity of demand is greater than zero but less than 1,  demand is income inelastic and the good is a normal good.  

∙ If the income elasticity of demand is less than zero (negative) the good is an  inferior good.  

Cross Elasticity of Demand  

∙ The cross elasticity of demand is a measure of the responsiveness of  demand for a good to a change in the price of a substitute or a complement,  other things remaining the same.

∙ The formula for calculating the cross elasticity is:

percentage change∈quantity demanded

percentage change∈price of substitute∨compliment

∙ The cross elasticity of demand for  

o A substitute is positive

o A compliment is negative

Price elasticity of demand = % change quantity demanded / % change in price

Introduction to Microeconomics Final Exam Study Guide  

Quantity: ∆ Q

Qave=14.5=22.2

Price: ∆P

Pave=43.5=66.7

Revenue at Point A = Qa * PA = $3.5 = $15

Revenue at Point B = Qb * PB = $6.4 = $24

Elastic demand: when price changes by 1% and demand changes by more than 1%  Elastic price: when the price goes up, customers buy much less

Elasticity of Supply  

∙ When the demand for a good increases, its equilibrium price rises and the  equilibrium quantity of the good increases  

o Does price rise by a large amount and the quantity increases for a  little?

o Does the price barely rise and the quantity increases by a large  amount?  

 This depends on the responsiveness of the quantity supplied of a good to a change in its price  

 Depends on the elasticity of supply of the good  

Elasticity of Supply measures the responsiveness of the quantity supplied to a  change in the price of a good, when all other influences on selling plans remain the  same.  

Calculating the Elasticity of Supply: change∈quantity supplied

change∈price

Introduction to Microeconomics Final Exam Study Guide  

Factors that Influence the Elasticity of Supply:  

∙ Resource substitution possibilities  

o The easier it is to substitute among the resources used to produce a  good or service, the greater is its elasticity of the supply  

∙ Time frame for supply decision  

o The more time that passes after a price change, the greater is the  elasticity of supply  

o Momentary supply is perfectly inelastic. The quantity supplied  immediately following a price change is constant  

o Short run supply is somewhat elastic

o Long run supply is the most elastic  

Resource Allocation Methods

∙ Market price: like college in the US  

∙ Command: like college assignment system in Germany. Resources are  allocated by the order of someone in authority  

∙ Majority rule:  

∙ Content: getting picked for a job over someone else  

∙ First come, first serve: wait in line the longest  

∙ Lottery: random  

∙ Personal characteristics: restrictions of allocation on what people of certain  gender/race could do/buy/etc.  

∙ Force: if you want something you have to take it  

Benefit, Cost, and Surplus

Demand, Willingness to Pay, and Value  

∙ Value: what we get

Introduction to Microeconomics Final Exam Study Guide  

o The value of one or more unit of a good or service is its marginal  benefit  

 A demand curve is a marginal benefit curve

o We measure value as the maximum price that a person is willing to pay  Willingness to pay determines demand  

∙ Price: what we pay  

Individual Demand and Market Demand  

∙ Individual demand is the relationship between the price of a good and the  quantity demanded by one person  

∙ Market demand is the relationship between the price of a good and the  quantity demanded by all buyers  

∙ The market demand curve is the horizontal sum of the individual demand  curves  

Lisa’s marginal benefit is $1 for the 30th slice

Introduction to Microeconomics Final Exam Study Guide  

Nick’s marginal benefit is $1 for the 10th slice  

For society overall,

∙ The white rectangle under the pink line is the amount she pays. She still gets  that value out of the pizza.  

∙ Consumer surplus: (the triangle area under Lisa’s and Nick’s individual  demand curve and above the pink line). This represents the extra money the  consumer would’ve been willing to pay to receive the amount of pizza that  they each purchased  

Supply and Marginal Cost  

∙ To make a profit you need to sell at a price higher than your production costs  ∙ Firms are in business to make a profit

∙ Firms distinguish between cost and price  

Supply, Cost, and Minimum  

∙ Cost is what the producer gives up, price is what they receive  ∙ Marginal cost: the cost of one more unit of a good or service  o Marginal cost is the minimum price that a firm is willing to accept, but  minimum supply-price determines supply  

∙ A supply curve is a marginal cost curve  

Individual Supply and Market Supply

Introduction to Microeconomics Final Exam Study Guide  

∙ The relationship between the price of a good and the quantity supplied by  one producer is called individual supply.

∙ The relationship between the price of a good and the quantity supplied by all  producers in the market is called market supply.

Producer Surplus

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

∙ To calculate the producer surplus,  

price received forthe good−supply price (marginal cost)

Is the Competitive Market Efficient?  

Efficiency of Competitive Equilibrium  

∙ In equilibrium, the quantity demanded = the quantity supplied  ∙ When production is:

o Less than the equilibrium quantity, MSB > MSC

o Greater than the equilibrium quantity, MSC > MSB  

o Equal to the equilibrium quantity, MSC = MSB

Introduction to Microeconomics Final Exam Study Guide  

∙ Resources are used efficiently when marginal social benefit social benefit  equals marginal social cost  

∙ When efficient quantity is produced, total surplus (the sum of consumer  surplus and producer surplus) is maximized  

The Invisible Hand  

∙ Adam Smith’s invisible hand idea in the Wealth of Nations implied that  competitive markets send resources to their highest valued use in society  ∙ Consumers and producers pursue their own self-interest and interact in  markets  

∙ Market transaction generate an efficient- highest value – use of resources  

Market Failure

∙ Markets don’t always achieve an efficient outcome

∙ Market failure arises when a market delivers an inefficient outcome ∙ Market failure can occur because  

o Too little of an item is produced (underproduction) OR  

o Too much of an item is produced (overproduction)  

Underproduction  

∙ The efficient quantity is 10,000 pizzas per day. If production is restricted to  5,000 pizzas a day, there is underproduction and the quantity is inefficient ∙ A deadweight loss equals the decrease in total surplus

Overproduction

Introduction to Microeconomics Final Exam Study Guide  

∙ Again, the efficient quantity is 10,000 pizzas per day. If production is  expanded to 15,000 a day, a deadweight loss arises from overproduction

Sources of Market Failure

∙ In competitive markets, underproduction or overproduction arise when there  are  

o Price and quantity regulations

o Taxes and subsidies

o Externalities

o Public goods and common resources

o Monopoly

o High transaction costs  

Price and Quantity Regulations

∙ Price regulations sometimes put a block on the price adjustments and lead to  underproduction  

∙ Quantity regulations that limit the amount that a farm is permitted to produce also lead to underproduction  

Taxes and Subsidies

∙ Taxes increase the prices paid by buyers and lower the prices received by  sellers

o So taxes decrease the quantity produced and lead to underproduction  ∙ Subsidies lower the prices paid by buyers and increase the prices received by sellers

o So subsidies increase the quantity produced and lead to  

overproduction  

Externalities  

∙ An externality is a cost or benefit that affects someone other than the seller  or the buyer of a good

∙ An electric utility crates an external cost by burning coal that creates acid  rain

o The utility doesn’t consider this cost when it chooses the quantity of  power to produce. Overproduction results  

∙ An apartment owner would provide an external benefit if she installed a  smoke detector

o But she doesn’t consider her neighbor’s marginal benefit and decides  not to install a smoke detector. Underproduction results  

Public Goods and Common Resources

Introduction to Microeconomics Final Exam Study Guide  

∙ A public good benefits everyone and no one can be excluded from its benefits ∙ It is in everyone’s self-interest to avoid paying for a public good (free-rider  problem) which leads to underproduction  

∙ A common resource is owned by no one but can be used by everyone  o It is in everyone’s self-interest to ignore the costs of their own use of a  common resource that fall on others (tragedy of the commons which  leads to overproduction  

Monopoly

∙ A monopoly is a firm that is the sole provider of a good or service ∙ The self-interest of a monopoly is to maximize its profit. It sets a price to  achieve its self-interested goal  

∙ As a result, a monopoly produces too little and underproduction results  High Transactions Costs

∙ Transactions costs are the opportunity cost of making trades in a market.  ∙ To use the market price as the allocator of scarce resources, it must be worth  bearing the opportunity cost of establishing a market.

∙ Some markets are just too costly to operate.

∙ When transactions costs are high, the market might under produce. ∙ Information gathering about hard-to-observe quality can lead to high  transactions costs

Is the Competitive Market Fair?  

Ideas about fairness can be divided into two groups:  

∙ It’s not fair if the result isn’t fair

∙ It’s not fair if the rules aren’t fair  

It’s not fair if the result isn’t fair  

∙ The idea that only equality brings efficiency is called utilitarianism. ∙ Utilitarianism is the principle that states that we should strive to achieve “the greatest happiness for the greatest number.”

∙ If everyone gets the same marginal utility from a given amount of income,  and if the marginal benefit of income decreases as income increases, then  taking a dollar from a richer person and giving it to a poorer person increases the total benefit.  

∙ Only when income is equally distributed has the greatest happiness been  achieved.

The Big Tradeoff

Introduction to Microeconomics Final Exam Study Guide  

∙ Utilitarianism ignores the cost of making income transfers.

∙ Recognizing these costs leads to the big tradeoff between efficiency and  fairness.

∙ Because of the big tradeoff, John Rawls proposed that income should be  redistributed to the point at which the poorest person is as well off as  possible.  

It’s Not Fair If the Rules Aren’t Fair

∙ The idea that “it’s not fair if the rules aren’t fair” is based on the symmetry  principle.

∙ The symmetry principle is the requirement that people in similar situations be treated similarly.

Principles of Microeconomics Test 2 Study Guide  

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.

▪ 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  

∙ 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

o So, are rent ceilings fair? No.  

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

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

the greatest foresight and get their names on the list first

Principles of Microeconomics Test 2 Study Guide  

∙ 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  

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?

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

Principles of Microeconomics Test 2 Study Guide  

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

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

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  

∙ 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

Principles of Microeconomics Test 2 Study Guide  

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

Principles of Microeconomics Test 2 Study Guide  

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  

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

Principles of Microeconomics Test 2 Study Guide  

Perfectly Elastic Supply  

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

Principles of Microeconomics Test 2 Study Guide  

Taxes and Efficiency

∙ 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

∙ The decreased quantity creates a deadweight loss

Principles of Microeconomics Test 2 Study Guide  

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

∙ 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.

Principles of Microeconomics Test 2 Study Guide  

Inefficiency

∙ At the quantity produced:

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.

∙ 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.

Principles of Microeconomics Test 2 Study Guide  

∙ 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  

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.

Principles of Microeconomics Test 2 Study Guide  

∙ 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

∙ 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

Principles of Microeconomics Test 2 Study Guide  

∙ 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

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

Principles of Microeconomics Test 2 Study Guide  Why the United States Exports Airplanes  

∙ 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  

∙ The price of an airplane  

is $100 million

∙ Boeing produces 400  

airplanes a year a U.S.  

airlines buy 400 a year

Principles of Microeconomics Test 2 Study Guide  Winners, Losers, and the Net Gain from Trade  

∙ 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  

∙ 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

∙ 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  

Principles of Microeconomics Test 2 Study Guide  

∙ 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  

∙ 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 shrinks  

from are B + C to area C

∙ 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  

Principles of Microeconomics Test 2 Study Guide  

Gains and Losses from Exports  

∙ 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  

∙ 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

Principles of Microeconomics Test 2 Study Guide  

International Trade Restrictions

∙ 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

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

∙ 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

▪ 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  Winners, Losers, and Social Loss from an Import Quota  

∙ 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

∙ 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

∙ 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

Principles of Microeconomics Test 2 Study Guide  

▪ 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  

▪ 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

Principles of Microeconomics Test 2 Study Guide  

▪ 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

∙ 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

∙ ������������ = ���������� �������������� − ���������� ��������

∙ 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

Principles of Microeconomics Test 2 Study Guide  

∙ ���������������� ������������ = ���������� �������������� − ���������� �������� (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  

∙ 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

∙ ���������������� ������������ = �� ��������′�� ���������� �������������� −

���������� ���������������������� �������� ���� ��������������������

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  

∙ 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

Principles of Microeconomics Test 2 Study Guide  

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  

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

Principles of Microeconomics Test 2 Study Guide  

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  

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

Principles of Microeconomics Test 2 Study Guide  

∙ 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)

����=1 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

∙ 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

Principles of Microeconomics Test 2 Study Guide  

∙ 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  

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

Principles of Microeconomics Test 2 Study Guide  

∙ 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

∙ 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

Principles of Microeconomics Test 2 Study Guide  

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

▪ 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 curve EP in part  

(b).

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  

The Firm’s Output Decision  

Marginal Analysis and Supply Decision

∙ 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 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  Temporary Shutdown Decision

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  profit is maximized.

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

∙ 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.

∙ It incurs a loss that is less than TFC.

∙ 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

Principles of Microeconomics Test 2 Study Guide  

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

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

Principles of Microeconomics Test 2 Study Guide  

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  

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

Principles of Microeconomics Test 2 Study Guide  

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.

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.

Principles of Microeconomics Test 2 Study Guide  

∙ 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

Monopoly and How It Arises

A monopoly is a market:

∙ That produces a good or service for which no close substitute exists

∙ In which there is one supplier that is protected from competition by a barrier preventing  the entry of new firms  

How Monopoly Arises

∙ A monopoly has two key features:

o No close substitute

o Barriers to entry  

No Close Substitutes  

∙ If a good has a close substitute, even if it is produced by only one firm, that firm  effectively faces competition from the producers of the substitute

∙ A monopoly sells a good that has no close substitutes  

Barriers to Entry  

∙ A constraint that protects a firm from potential competitors is called a barrier to entry ∙ Three types of barriers to entry are  

o Natural

▪ Natural barriers to entry create natural monopoly

▪ A natural monopoly is a market in which economies of scale enable one  firm to supply the entire market at the lowest possible cost  

▪ In a natural monopoly, economies of scale are so powerful that they are  still being achieved even when the entire market demand is met

▪ The LRAC curve is still sloping downward when it meets the demand  

curve

o Ownership

▪ An ownership barrier to entry occurs if one firm owns a significant  

portion of a key resource

▪ During the last century, De Beers owned 90 percent of the world’s  

diamonds  

o Legal

▪ Legal barriers to entry create a legal monopoly

▪ A legal monopoly is a market in which competition and entry are  

restricted by the granting of a:  

∙ Public franchise (like the U.S. postal service, a public franchise to  

deliver first-class mail)

∙ Government license (like a license to practice law or medicine)  

∙ Patent or copyright  

Monopoly Price-Setting Strategies  

∙ For a monopoly firm to determine the quantity it sells, it must choose the appropriate  price.

∙ There are two types of monopoly price-setting strategies:

o A single-price monopoly is a firm that must sell each unit of its output for the  same price to all its customers  

o Price discrimination is the practice of selling different units of a good or service  for different prices. Many firms price discriminate, but not all of them are  monopoly firms

A Single-Price Monopoly’s Output and Price Decision  

Price and Marginal Revenue

∙ A monopoly is a price setter, not a price taker like a firm in perfect competition  ∙ The reason is that the demand for the monopoly’s output is the market demand ∙ To sell a larger output, a monopoly must set a lower price

∙ Total revenue, TR, is the price, P, multiplied by the quantity sold, Q.  

∙ Marginal revenue, MR, is the change in total revenue that results from a one-unit  increase in the quantity sold  

∙ When firms were price takers in perfect competition, marginal revenue was equal to the  price

∙ Now it’s different. For a single-price monopoly, marginal revenue is less than price at  each level of output. That is, MR < P

∙ This figure illustrates the  relationship between  the price and marginal  revenue and derives the  marginal revenue curve  

∙ Suppose the monopoly  sets a price of $16 and  sells 2 units  

∙ Now suppose the firm  cuts the price to $14 to  sell 3 units  

∙ It loses $4 of total  revenue on the 2 units it  was selling at $16 each

∙ And it gains $14 of total  revenue on the 3rd unit ∙ So total revenue  

increases by $10, which  is marginal revenue

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