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OLEMISS / Engineering / ECON 202 / What is economics, and why does it exist?

What is economics, and why does it exist?

What is economics, and why does it exist?


School: University of Mississippi
Department: Engineering
Course: Principles of Microeconomics
Professor: Cheng cheng
Term: Spring 2017
Tags: Microeconomics, Principles, economist, cheng, supply, demand, elasticity, efficiency, externalities, taxation, resources, costs, production, competitive, and monopoly
Cost: 50
Name: ECON202 - Final Exam Study Guide
Description: This study guide covers ALL of the material we learned this semester. All concepts are explained IN-DEPTH with descriptions, pictures, graphs, examples, etc. Chapters 1, 2, 4, 5, 6, 7, 8, 10, 11, 13, 14, & 15
Uploaded: 05/04/2017
72 Pages 341 Views 26 Unlocks

ECON202 Final Exam Study Guide CHENG

What is economics, and why does it exist?

Chapter 1 Review:

Principles of Microeconomics

● What is Economics and why does it exist?

○ Economics - the study of how human behavior contributes to the supply and demand of its scarce resources​; a social science

■ People (consumers, workers, investors, etc.) are constantly confronted with decisions in their daily lives

■ Rational people try to do the best they can despite

constraints like money, time, energy and information

● What are the two types of economics and how do they relate? ■ Microeconomics​ consists of individual decision-making

What are the two types of economics, and how do they relate?

■ Macroeconomics​ consists of national and international

analysis of market phenomena

○ Economy-wide phenomena (i.e. a rise in unemployment rates) are always due to the individual decision-maker; the behaviors of individuals and firms determine the condition of the overall market

● What are the 4 Principles of Microeconomics for Individual Decision-makers?

1. People face trade-offs.

■ If you want more of one thing, then you have to have less of Don't forget about the age old question of What are the 3 types of businesses?

something else.

■ There is no such thing as a “free lunch”.

■ Efficiency vs Equality Tradeoff:

○ Efficiency​ - the property of society getting the most it

What is the production possibilities frontier?

can from its scarce resources

○ Equality​ - the property of distributing economic

prosperity uniformly among the members of society

● Think about income. If all money in the U.S. was distributed

equally among every member of society, the owners of big

farms wouldn’t have enough money to keep their farms

running. Then we wouldn’t have food. See the problem there?

There will always be a tradeoff between efficiency and


2. Whatever “yes” decision you make, you’re saying “no” to several other options.

■ Making decisions requires comparing the costs and benefits of the alternative courses of action​, too. We also discuss several other topics like Who explained the processes of the earth?

■ These alternative courses of action that you miss out on when you make a decision are known as opportunity costs​.

● These costs can be measured in money, time, energy, etc. 3. Rational people think at the margin.

■ Rational people are people who systematically and purposely do the best they can to achieve their objectives.

● They make choices if the marginal (incremental) benefits exceed the marginal (incremental) costs​.

■ Diminishing Marginal Benefit/Return​ – explains that the more we have of something, the less satisfaction we get from it.

■ EX. Diamond and Water Paradox​:

● Water is essential to life, but we spend very little on it.

Diamonds are just luxuries but we spend a LOT of money on them. If we’re rational people, why do we do this? We also discuss several other topics like What is the outer shell of the brain?

● SCARCITY is the root cause.

4. People respond to economic incentives​.

■ People make decisions based on their self-interest​.

■ Incentives are crucial to analyzing how markets work as the price affects the behavior of buyers and sellers. Because people make decisions by comparing costs and benefits, their behavior may change when the costs or benefits change. Don't forget about the age old question of Who is the founder of the methodist movement?

● What are the 3 Principles of Microeconomics for Market and Economy Decision-making?

1. Trade can make everyone better off​.

■ When people interact with each other in a market to exchange goods and services, the market prospers and the individuals


2. Markets are usually a good way to organize economic ​activity​. ■ Because market economies allocate resources through individuals’ decisions (usually out of self-interest) instead ofDon't forget about the age old question of What is meiosis?

from a centralized decision-maker, an “invisible hand” moves the market and promotes general economic well-being

3. Governments can sometimes improve market outcomes​.

■ When people only us the market out of self-interest, sometimes there is a trade-off that negatively affects other variables;

government can then step in to regulate the economy (i.e.

industrial factories produce quality items at low prices, but they emit pollution that kills animals in the region, so the government gives them rules to follow).

Chapter 2 Review:

Thinking Like an Economist

● What is an economic theory and how do economists use them? ○ Economic models/theories​ – when trying to understand economics, the answer to most economic phenomena is knowing the causation of such phenomena. Economists are required to simplify complex human behaviors by…

● Assuming away unnecessary details

● Understanding the simplest scenario first​ before adding If you want to learn more check out In social interaction, what is the meaning of looking­ glass self?

complexities to it

● Making assumptions ​to make things simple, then relaxing (or specifying) these simple assumptions when analyzing

complicated scenarios

■ The balance of economic models is extremely important.

● If a model is overbroad​ (meaning it includes too many

moving variables and not enough assumptions), an

economist task of explaining a phenomenon will be almost


● If a model is oversimplified​ (meaning it includes too many

assumptions), an economist will not come to an accurate

conclusion when testing his model/theory.

● What is the Production Possibilities Frontier?

○ Production Possibilities Frontier (PPF)

■ This economic model explains efficient production possibilities, or the allocation of 100% of available resources in the most

profitable/beneficial way

● It will demonstrate how a specific choice of action will result in an efficient, inefficient, or unfeasible manner

○ Efficient​ – economy uses ALL available resources to

produce a combination of 2 goods; the PPF is the set of

all efficient output combinations

○ Inefficient​ – economy does NOT have to use all of its

resources to produce it, meaning there are resources

leftover; this point would be plotted BELOW the PPF line

on a graph)

○ Infeasible​ (not possible) – economy cannot produce

the combination of goods, even if all resources are

used (this point would be plotted ABOVE the PPF line on

a graph)

● What does the shape of the PPF line mean?

○ Straight PPF​ - The opportunity cost of one unit of good

1 is constant, as more of good 1 is produced

○ Bow-shaped PPF​ - The opportunity costs of one unit of

good 1 increases, as more of good 1 is produced

● What would cause an outward shift in the PPF line? ○ Higher productivity or more efficient use of inputs

○ Better management of inputs

○ An increase in capital or labor supply

○ Innovation and invention of new products and


○ Discovery/extraction of new natural resources

● How do you compare opportunity costs between

two PPF lines?

○ Flatter PPF line​ - lower opportunity cost

○ Steeper PPF line​ - higher opportunity cost

Chapter 4 Review:

Supply, Demand, and the Market

● What is a market?

○ Markets ​– the environment in which a buyer and seller interact in the exchange of goods, services, and payments

■ Competitive markets ​– environment where multiple buyers and sellers interact; results in the buyers/sellers having little to no impact on market price

● Perfectly competitive markets​ – makes market analysis

simple; they don’t really exist in reality, but it serves as a

benchmark/baseline when we’re evaluating more

complicated market scenarios; characterized by the

following features:

○ Homogenous goods​ – goods in each category are the

exact same (e.g. a laptop is simply a laptop; there’s no

MacBooks, no Microsoft Studio…there are just..laptops)

○ Price takers​ – buyers and sellers have no influence on

the market price of a good

● What is the Law of Demand?

○ Law of Demand​ - states that, when all other variables remain constant, the quantity of a good decreases when its price increases​; there is a negative relationship between price and quantity demanded (downward sloping curve)

■ Quantity Demanded (Q​D​)​ – the amount of a good that buyers are willing and able to purchase

■ Market Demand Curves ​– can be determined when there are multiple consumer’s being analyzed

● Example: Helen buys 8 lattes when they’re priced at $4 a

piece, and Ken buys 4 lattes at $4 a piece; when the lattes

are $5, Helen buys 6 and Ken buys 3. Market demand curve

is determined by adding the quantities of Helen and Ken’s

lattes that they bought at the different price levels. So two of the points on the curve would be (4, 12) and (5, 9).

■ What’s the difference between a Change in Quantity Demanded and a Change in Demand?

● Change in Q​D​ – due to a change in the good’s price; curve itself does NOT shift​, only the point on the curve shifts from one position to another

● Change in Demand​ – due to a change in ANY factors (“other things”), excluding the good’s price; entire curve shifts​ from one location on the graph to another (left or right of its original position)

○ Demand shifters​ – the “other things” that can affect the position of the demand curve; there are 5 demand shifters we should be aware of:

■ Number of buyers​ –

● When there are more buyers present,

there is an increase in demand​, which shifts the demand curve to the right​ (e.g. during

football season, there are more fans in town to buy Ole Miss related goods)

■ Levels of income​ –

● When income increases, demand increases for normal goods​ like new cars (demand

curve shifts to the right​)

● When income increases, demand

decreases for inferior goods​ like public

transit (demand curve shifts to the left​)

■ Prices of related goods​ –

● Substitutes​ (e.g. Coke and Pepsi) – if the

price of one substitute increases, the

demand for the OTHER substitute

increases​ (curve for good 2 shifts to the


● Complements​ (e.g. smartphones and apps) – if the price of a good increases, the

demand for its complement goods

decreases​ (curve for complement good

shifts to the left​)

■ Tastes​ –

● When a consumer’s taste for certain

products changes

■ Expectations​ –

● Sometimes there are events that allow

consumers to make predictions about price

changes (e.g. iPhone 7 comes out in

September, so we assume the price of

iPhone 6s will go down in September)

● What is the Law of Supply?

○ Law of Supply​ - states that, when other factors are held constant, the quantity of a good supplied increases when the price of a good increases​ (sellers want to sell more when they’re selling their goods at a higher price); there is a positive relationship between price and quantity supplied (upward sloping curve)

■ Quantity Supplied (Q​S​)​ – the amount of a good that sellers are willing and able to sell

■ What’s the difference between a Change in Quantity Supplied and a Change in Supply?

● Like quantity demanded, when there is a change in the quantity supplied, there will only be a move ALONG the curve​; the curve itself will not shift

● When there is a change in supply​, it is due to factors other than the price of the good and the entire curve can shift left or right

○ Supply shifters​ – the “other things” that can affect the position of the supply curve; there are 4 supply shifters we should be aware of:

■ Number of sellers​ –

● When there is an increasing number of

sellers in a market (regardless of price)

they will sell more​, so the supply curve will

shift to the right

■ Input prices​ –

● An increase in input prices (cost of

materials/labor to make a product) is less

profitable for the seller, so supply

decreases​; supply curve shifts to the left

■ Technology ​–

● Advanced technology often makes

production easier and more profitable for

sellers, therefore supply increases​ and the

supply curve shifts to the right

■ Expectations

● How do you combine Supply and Demand?

○ Market Equilibrium​ – when sellers produce exactly as many goods as the buyers will purchase; Q​S​ = Q​D 

■ Market Equilibrium Price​/Market Clearing Price (P*) – the price of a good when QS and QD are equal; basically the perfect price that benefits sellers and suppliers equally

■ Market Equilibrium Quantity ​(Q*) – the quantity of goods that are supplied at that perfect price

■ P* and Q* are located at the intersection of the demand and supply curves

● Example: Market research has revealed the following

information about the market for chocolate bars: the

demand schedule/curve can be represented by the equation Qd = 1600 – 300P; the supply schedule/curve can be

represented by the equation Qs = 1400 + 700P. What are

market equilibrium price and quantity?

○ Set each equation equal to one another and solve for P

(price). Then substitute this value of P into one of the

individual equations to determine Q (quantity).

○ What happens when the market is NOT in equilibrium? ■ Surplus​ – excess supply​; occurs when quantity supplied is greater than quantity demanded

■ Shortage​ – excess demand;​ occurs when quantity supplied is less than quantity demanded

■ How does the market overcome shortages and surpluses?

● If it’s bad enough that people are suffering, the government can intervene.

● Most of the time, however, the market will cure itself with

adjustments in price. If there is a surplus of goods, sellers

will lower the price, so people will buy more. If there is a

shortage of goods, the seller will raise the price​ so less

people are interested in the good.

Chapter 5 Review:

Elasticity and its Application

● What is Elasticity?

○ Elasticity (η) ​- refers the degree to which individuals (buyers/sellers) change their demand/amount supplied in response to price or income changes

■ Graphically, it is a quantified relationship between variable X and variable Y

■ Mathematically, it measures the % change in Y due to the % change in X

■ Basic formula for elasticity:

η=​ % change in Y 

% change in X

■ Example questions:

● If X goes up by 10% and Y goes up by 20% accordingly, what is the elasticity between X and Y? (η=2)

● If X goes up by 20% and Y goes down by 10% accordingly, what is the elasticity between X and Y? (η=.5)

■ In Chapter 4 we learned about the laws of supply and demand; an increase in the price of a good will lead to a fall in quantity demanded and a rise in quantity supplied...but by how much? This is where elasticity comes into play.

● Example question: If the price of pizza increases by 10%, will quantity demanded fall by more or less than 10%?

■ How do you calculate a change in elasticity using the midpoint method?

● So how do we interpret this?

○ The sign​ of elasticity tells you whether X and Y have a positive or negative relationship ​.

○ The size​ of elasticity tells you whether the % change in Y is greater than, smaller than, or equal to the %

change in X.

■ When analyzing the ‘size of elasticity’​ we will take the absolute value of η​, meaning we’ll disregard any negative signs.

● Unit elastic​: |η| = 1

○ % Change in Y =​ % Change in X

● Elastic​: |η| > 1 (e.g., η = -1.5)

○ % Change in Y >​ % Change in X

○ Special case: perfectly elastic: |η | = ∞ ● Inelastic​: |η| < 1 (e.g., η = 0.5)

○ % Change in Y <​ % Change in X

○ Special case: perfectly inelastic: |η| = 0 ■ Examples:

● Suppose the elasticity between X and Y is 1.5 ○ Is there a positive or negative

relationship between X and Y?

(POSITIVE relationship, because 1.5 is


○ If X goes up by 10%, how should Y

change? (Y should go UP by 15%,

because 1.5 = 15/10)

○ If Y goes up by 10%, how should X

change? (X should go up by 6.67%

because 1.5 = 10/6.67)

● Suppose the elasticity between X and Y is -0.5.

○ Is there a positive or negative

relationship between X and Y?

(NEGATIVE relationship, because -0.5 is


○ If X goes up by 10%, how should Y

change? (Y should go DOWN by 15%)

○ If Y goes up by 10%, how should X

change? (X should go DOWN by


● What is the Price Elasticity of Demand (PED)?

○ Price Elasticity of Demand (PED; “point elasticity”) ​- relationship between P and QD; term used to describe how responsive consumers are to a change in price; is always negative​; |% △ Q| vs. |% △ P|

■ A change in demand in the long-run vs. the short-run:

● Demand in the long run is more elastic​, because people

have more flexibility to discover other close substitutes

○ Flatter (more elastic) - long run

● Demand in the short run is more inelastic,​ because people have not yet discovered these substitutes

○ Steeper (more inelastic) - short run

■ When comparing the elasticities of two different demand curves (like above),

● The flatter​ demand curve is typically more elastic ● The steeper​ demand curve is typically more inelastic ● A horizontal​ demand curve is perfectly elastic

○ While quantity demanded changes, the % of change in price is zero, so elasticity is infinite

● A vertical​ demand curve is perfectly inelastic

○ While price changes, the % of change in quantity

demanded is zero​, so it is considered to be


● Pizza vs. Electricity example:

○ If both the price of pizza and price of electricity

increase both by 10%, for which good will quantity

demanded decrease more?

■ Pizza has more substitutes, so you’ll have a larger quantity response for pizza. Pizza gets more

expensive, so you’ll find other things to eat so you

can get your electricity back on.

■ Demand for goods that have more close

substitutes will be more elastic! Electricity has

basically no substitutes, so people will pay for it

regardless of the price, making it inelastic.

● Engagement Ring example:

○ When buying an engagement ring you know you’re only going to need one, regardless of the price of it.

There will be a vertical demand curve because quantity is 1 at all prices, giving it a perfectly inelastic, perfectly price-insensitive demand curve.

■ How do you use Price Elasticity of Demand to determine the effects on a company’s revenue?

● Revenue = (P*Q​D​)

● Typically, you’d think that when a seller raises the price or produces a larger quantity of his good, his company will earn more revenue. However, this is not always the case.

○ On an elastic demand curve, a company would have to reduce their selling price to increase revenue

○ On an inelastic demand curve a company would likely have to increase their selling prices to increase revenue

■ Example: Good weather means that wheat

production increases (supply goes up; supply

curve shifts left, so price goes down while quantity

goes up.) Does the price effect or quantity effect

dominate? If wheat demand is elastic, demand will

go up; if it’s inelastic, demand will go down. Wheat

is inelastic because it has few substitute goods, so

consumers are not price-sensitive (price effect

dominates, and revenue is driven down.)

■ Example: Cops go out looking to track down and

arrest all the drug dealers (supply of illegal drugs

goes down; supply curve shifts left, giving a higher

price and lower quantity). Which effect

dominates? Is the demand for illegal drugs elastic

or inelastic? It’s very inelastic because addicts

want SPECIFIC drugs, meaning the price effect will

dominate because no matter the price, these

addicts will keep buying it. Revenue for drug

dealers will increase. Crime rates will probably

increase also, but that’s a whole other story.

■ What is the relationship between income and quantity demanded?

● When income changes, the effect on the quantity demanded depends​ on whether the good is a normal good or an inferior good

○ Normal goods​: positive relationship between income and quantity

■ Example: For a normal good with an elasticity of

2.0, when income rises by 10%, quantity

demanded will increase by 20%.

○ Inferior goods​: negative relationship between income and quantity

■ Example: For an inferior good with an elasticity of

-0.7, when income rises by 10%, quantity

demanded will decrease by 7%.

■ What happens to the Elasticity of Demand along a linear demand curve?

● An increase in price reduces the quantity demanded, and a reduction in price increases the quantity demanded. The question is, how much? Because total revenue = P*Q​D​, it is not clear whether a change in price will cause total revenue to rise or fall.

● At high prices, a reduction in price will have an elastic price response

● Lower prices cause total revenue to rise

■ What is the Cross-Price Elasticity of Demand? ● Cross-Price Elasticity of Demand​ - the change in quantity demanded of one good, as the price of another​ good changes

● Positive elasticity​ means the 2 goods are substitutes ● Negative elasticity​ means the 2 goods are complements

○ Example: Elasticity = 1.5 (substitutes), so when price1

goes up by 10%, quantity demanded of good2 will go

up by 15%

○ Example: Elasticity = -1.2 (complements), so when price1

goes up by 10%, quantity demanded of good2 will go

up by 12%.

● What is the Price Elasticity of Supply (PES)?

○ Price Elasticity of Supply​ - the relationship between price and quantity supplied (P and QS); the ability of sellers to change the amount of the good they produce; is always positive

■ If supply is elastic (PES > 1)​, then producers can increase output without a rise in cost or a time delay​ (flatter curve)

■ If supply is inelastic (i.e. PES <1),​ then firms find it hard to change production in a given time period​ (steeper curve)

Chapter 6 Review:

Supply, Demand, and Government Policies ● What are Price Control Policies?

○ Price control policies​ - regulations on public markets created by the government to prevent market price from getting too high or too low ■ Price ceiling​ -

● A legal maximum on the price​ at which a good can be sold

● Sets an upper boundary of the price range

● Designed to help low income consumers

● Only effective when it is below the market equilibrium


● Can result in a shortage

● Ex. Rent control

○ Rent control:​ The equilibrium is $800 for rent at 300

apartments. When the government sets a price ceiling

at $500, there is a shortage in the market, because

landlords will only supply 250 apartments at $500,,

while people demand 400 apartments. 150 families

can’t get an apartment. So even when the government

tries to help the poor by setting a rent control price

ceiling, a shortage/surplus may arise as a result,

hurting the poor​ even more than they were hurting in

the first place. (Compare without price ceiling, with price

ceiling, and then the shortage/surplus, to determine

whether the policy is good or not.)

■ Price floor -

● A legal minimum​ on the price of at which a good can be sold ● Sets a lower boundary of the price range

● Designed to help producers

● Only effective when it is above the market equilibrium price

● Can result in a surplus

● Ex. Minimum wage law

○ Minimum wage law​: In the labor market, the equilibrium is $6.00 when 500 laborers are employed. When the

government sets a binding price floor at $7.25, there is

a surplus in the market of 150 because employers will

provide only 400 job positions, while 550 laborers are

looking for a job. (Laborers are on the supply curve

because they’re “selling” their labor.) This surplus of 150

means that 150 laborers are unemployed.

○ What is the difference between a binding and a non-binding policy constraint?

■ Binding constraints​ - when a policy affects market outcome ■ Non-binding constraints​ - when a policy has no effect on the market outcome

■ If the price ceiling is above P* (price equilibrium), it is non-binding ● No surplus or shortage exists

■ If the price ceiling is below P*, it is binding

● Shortage exists

■ If the price floor is above P*, it is binding

● Surplus exists

■ If the price floor is below P*, it is non-binding

● No shortage or surplus exists

○ What is a black market?

■ Black Markets​ - a sector of the economy where transactions occur without the knowledge of the government and usually involve the breaking of certain laws

● Typically arises when the government sets a binding control policy (like a price ceiling) which makes producers sell a

large supply of goods at a low price, which increases

demand. When a black market forms, the willing buyers can purchase those goods at a price that will generate a larger

marginal profit. This is illegal because the producers are

selling their products at a price that’s higher than the

government-imposed price ceiling.

● What are tax policies and why do we have them? ○ Tax​ - a wedge between the price buyers pay and the price sellers receive; helps America pay for public projects​ that specific businesses can’t provide our society like roads or national defense

■ A tax raises the price buyers pay and lowers the price sellers receive​.

■ A tax reduces the quantity bought & sold​.

○ Tax policy definitions:

■ Unit Tax​ ($T)​ - the amount of tax imposed by the government per 1 unit bought/sold; (TaxB + TaxS)

■ P*​ - market equilibrium price BEFORE tax policy

■ P*’​ - market equilibrium price AFTER tax policy

■ P​B​- the price buyers pay after tax; (Market price + tax)

■ P​S​- the price sellers receive after tax; (Market price - tax)

■ Tax​B ​- Effective tax (buyers) - taxes paid by buyers; NOT the same as the unit tax the government collects from buyers

● PB- P* (or) TaxB + (P*’ - P*)

■ Tax​S​- Effective tax (sellers) - taxes paid by sellers; NOT the same as the unit tax the government collects from sellers

● P* - PS(or) TaxS - (P*’ - P)

■ Q​T​ - quantity supplied/demanded after tax; AKA “post-tax market size”

■ Tax Incidence​ - the manner in which the burden of a tax is shared among buyers and sellers; this is when the government imposes taxes unevenly among buyers and sellers

○ How does the government tax buyers and sellers differently and what does this cause?

● Although buyers are the ones to pay taxes, not sellers, we’ll determine how buyers and sellers are affected by taxes in similar ways.

○ When there are NO taxes involved, buyers pay P*

(equilibrium price) to sellers, who receive P*​.

○ When there ARE taxes imposed, buyers will pay P​B 

(market price + tax) to the sellers, who receive price

+ tax​. Then the government takes back a nominal tax

from buyers and a nominal tax from sellers.

■ When the government splits up the unit tax among buyers and sellers differently, the tax incidence actually has NO effect on market outcomes​.

● Inelastic curves and tax burden:

○ According to inelastic demand curves, buyers don't

adjust their behavior, so the prices can change more

significantly than the quantity. Inelastic demand

curves carry more of the tax burden on the buyers​.

● Elastic curves and tax burden:

○ Elastic demand curves tell us buyers adjust their behavior according to price, so the sellers have to adjust greater than buyers. Elastic demand curves carry more of the tax burden on the sellers​.

■ Buyers will have a bigger tax burden when supply is more elastic than demand​, because buyers are less willing and able to leave the

market facing that tax.

■ Sellers will have a bigger tax burden when demand is more elastic than supply​, because they’re less willing and able to leave the market when facing that tax.

■ Whichever group (sellers or buyers) is more price

sensitive will have to pay less tax​.

● Extreme cases:

○ Buyers pay ALL of effective tax:

■ Demand curve will be vertical (perfectly inelastic),

and the supply curve will be flatter.

■ Sellers pay nothing because P* = PS 

○ Sellers pay ALL of effective tax:

■ Supply curve will be vertical (perfectly inelastic),

and the demand curve will be flatter. Economic


■ Buyers pay nothing because P* = PB 

Chapter 7 Review:

Consumers, Producers, and Market Efficiency ● What is Welfare Economics and how is it measured? ○ Welfare Economics​ - the study of how the allocation of resources affects economic well-being; how the good/market benefit buyers and sellers

○ Economic Well-Being​ - how a good or a market benefits the whole society

● What is consumer surplus (CS) and how is it calculated? ○ Consumer Surplus ​- the benefit buyers receive from participating in a market

■ Willingness to pay (reservation price; WTP)​ - the maximum amount that a buyer will pay for a good

● For example, if you’re willing to pay up to $350 for a

smartphone, your WTP is 350.

○ To calculate consumer surplus, you determine a buyer’s willingness to pay and subtract the actual amount they paid (price; P); (CS = WTP - P) ■ If price decreases, CS increases.

■ If price increases, CS decreases.

○ How do Price and Willingness to Pay affect a buyer’s actions? ■ When price is less than a buyer’s WTP​:

● There will be a positive consumer surplus, and the buyer would buy the good.

■ When price is more than a buyer’s WTP​:

● Consumer surplus will be zero, because the buyer would not buy the good.

● If the buyer DID buy, consumer surplus would be negative. ■ When price is equal to a buyer’s WTP​:

● A buyer could choose to buy or not buy, but either way, consumer surplus would be zero.

● In this case, the buyer would be considered a marginal buyer​.

○ What is total consumer surplus and how is it calculated? ■ Total Consumer Surplus​ - total amount of surplus for all consumers in the economy

■ Example: There is a market made up of 5 buyers who are looking to buy a certain product that costs $5..

○ Buyer 1 is willing to pay $20, so his CS is $15.

○ Buyer 2 is willing to pay $16, so his CS is $11.

○ Buyer 3 is willing to pay $10, so his CS is $5.

○ Buyer 4 is willing to pay $8, so his CS is $3.

○ Buyer 5 is willing to pay $5, so his CS is 0.

● To get total consumer surplus we add these values up, so

$15+$11+$5+$3=$34. The total consumer surplus in this

economy is $34.

● What is producer surplus (PS) and how is it calculated? ○ Producer Surplus​ - the benefit sellers receive from participating in a market

■ Cost ​- the least amount that sellers would be willing to sell a product for; the value of everything a seller must give up to produce a good

○ To calculate producer surplus, you determine the amount a seller is paid (price; P) for a product and then subtract the seller’s cost of producing the good; (PS = P - C)

■ If price increases, PS increases.

■ If price decreases, PS decreases.

○ How do Cost and Price affect a seller’s willingness to sell? ■ When a seller’s cost is less than the price​ they’re willing to sell the product for:

● There will be a positive producer surplus, so the producer will sell.

■ When a seller’s cost is more than the price​ they’re willing to sell the product for:

● Producer surplus will be zero and the producer should not sell. If the producer did sell, his producer surplus would be negative.

■ When a seller’s cost is equal to the price​ they’re willing to sell the product for:

● The producer would choose whether or not they wanted to sell; either way, his producer surplus would be zero.

● In this case, the producer would be considered a marginal seller.

○ What is total producer surplus and how is it calculated? ■ Total Producer Surplus​ - total amount of surplus for all producers in the economy

■ Example: There is a market made up of 5 sellers who are looking to sell their product, when the market price is $30.

○ Seller 1 (Engelbert) is only willing to sell for $45, so his

PS is -$15; he would NOT sell in this market.

○ Seller 2 (Donna) is only willing to sell for $35, so her PS is -$5; she would NOT sell in this market.

○ Seller 3 (Carlos) is willing to sell for $25, so his PS is $5. ○ Seller 4 (Betty) is willing to sell for $15, so her PS is $15. ○ Seller 5 (Andrew) is willing to sell for $5, so his PS is $25.

● To get total producer surplus we add these values up, so $5+$15+$25=$45. The total consumer surplus in this economy is $45.

● What is total surplus (TS) and how do you find the most efficient allocation in the market?

○ Total Surplus​ - measures the welfare of the whole economy (buyers AND sellers)

■ Total Surplus = Consumer Surplus + Producer Surplus

○ Market efficiency - the property of a resource allocation to maximize the total surplus received by ALL members of society

■ On a supply/demand graph, the most efficient allocation of consumer surplus and producer surplus is at the market

equilibrium price and quantity​.

● For example, to maximize total surplus in this case, the

efficient quantity (Qefficient) and efficient price are 15 units at

$1.50 a piece.

■ The supply curve represents private cost (the costs directly incurred by sellers)​.

■ The demand curve represents private value (the value/price that buyers are willing to pay)​.

Chapter 8 Review:

The Costs of Taxation

● How does taxation affect tax revenue?

○ When the government imposes a tax on a good or a market, it generates a revenue (R) that is equal to the size of the tax ($T) times the quantity supplied/demanded after the tax (QT)

○ R = $T * Q​T 

○ With no tax imposed, the government receives no tax revenue. ○ When tax size increases, QT decreases, and vice versa.

○ When tax size is small​, %change in tax size >​ % change in QT. ■ Change in tax revenue is dominated by change in tax size​.

○ When tax size is large​, % change in tax size <​ % change in QT. ■ Change in tax revenue is dominated by change in Q​T​.

● How does taxation affect Consumer Surplus, Producer Surplus, Total Surplus, and Deadweight Loss?

○ A government-imposed tax will cut into consumer, producer, and total surplus, because it reduces the equilibrium quantity to QT 

○ Deadweight Loss (DWL)​ - a fall in (maximized) total surplus that results from a market distortion (e.g., tax)

■ When demand and supply curves are straight lines, DWL = ½ × Tax Size × ΔQ

■ The maximized​ TS is achieved when Q = Q​efficient​.

■ If Q is not the efficient quantity, Q​T​ will be less than the efficient quantity, and deadweight loss will strictly increase​ because this means that the units between QE and QT will not be sold.

● The value of these units to buyers is greater than the cost of producing them, so the tax has prevented some mutually

beneficial trades.

○ What determines the size of the Deadweight Loss, and why? ■ The govt needs tax revenue to finance roads, schools, police, etc., so it must tax some goods and services. But which ones?

● The government should tax the goods or services with the smallest DWL​.

■ The size of Deadweight Loss depends on the elasticities of supply and demand​. Recall: The price elasticity of demand (or supply) measures how much quantity demanded (or supplied) changes when the price changes.

● When supply or demand is inelastic, DWL from a tax is small​.

● When supply or demand is elastic, DWL from a tax is large​. ○ Elastic demand: Price sensitive consumers can easily leave the market (turning to close substitutes) if price

goes up.

○ Elastic supply: Price sensitive producers can easily

leave the market (producing something else) if price

goes down.

○ Why does Elasticity Affect the Size of DWL?

■ A tax distorts the market outcome​: consumers buy less and producers sell less, so equilibrium Q is below the

surplus-maximizing quantity​.

● Elasticity​ measures how much buyers and sellers respond to changes in price, and therefore determines how much the

tax distorts the market outcome​.

○ How does the size of the tax affect Deadweight Loss? ■ When tax size is small​, raising taxes does not cause much harm​, and lowering them does not bring much benefit​.

● If the government were to increase the size of a tax​, the

DWL will also increase​, but at a slower rate at first​.

■ When tax size is large, raising them is very harmful and cutting them is very beneficial​.

● The larger the tax, the faster Deadweight Loss will


○ What is the Laffer Curve, and how does the size of a tax effect tax revenue?

■ When the tax is small, increasing it causes tax revenue to rise.

■ When the tax is larger, increasing it causes tax revenue to fall.

■ The Laffer curve​ - shows this relationship between the size of the tax and tax revenue.

● Optimal tax (t*)​: the tax level that maximizes tax revenue is

at the highest point in the curve.

Chapter 10 Review:


● What are externalities and why do they cause market failures? ○ Recall the principle from chapter 1 that states: Markets are usually a good way to organize economic activity.

■ In absence of market failures, the competitive market outcome is efficient and maximizes total surplus.

○ Externalities​ - a type of market failure; the uncompensated impact of one person’s actions on the well-being of a bystander

■ Externalities can be negative or positive​, depending on whether impact on bystander is adverse or beneficial.

■ Market mechanisms fail to allocate resources in a “desirable” way

● Market equilibrium allocation ≠ efficient allocation

● Market equilibrium quantity (Q*) ≠ efficient quantity (Qefficient; the quantity that maximizes total surplus)

■ Self-interested buyers and sellers neglect the external costs or benefits of their actions​, so the market outcome is not efficient. ■ In presence of externalities, public policy CAN improve efficiency​. ■ Examples of Negative Externalities:

● Air pollution from a factory

● The neighbor’s barking dog

● Late-night stereo blasting from the dorm room next to yours ● Noise pollution from construction projects

● Health risk to others from second-hand smoke

● Talking on cell phone while driving makes the roads less safe for others

■ Examples of Positive Externalities

● Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce

section after you.

● People going to college raise the population’s education,

which reduces crime and improves government.

● How do externalities affect the supply and demand curves? ○ The supply curve represents the private cost curve and the demand curve represents the private value curve. When externalities are present​, these private cost/value curves will represent everyone in society, thus making them social cost and social value curves. ■ Social value curve:​ social value = private value + external value ■ Social cost curve:​ social cost = private cost + external cost ○ If negative externality:

■ Market quantity larger than socially desirable

○ If positive externality:

■ Market quantity smaller than socially desirable

○ To remedy the problem, “internalize the externality”

■ Tax goods with negative externalities

■ Subsidize goods with positive externalities

○ In the presence of externalities, the benefits/costs of the good to the private market are no longer the same as the benefits/costs to the society.

■ Negative Externality Analysis Example:​ The gasoline market causes negative externalities by emitting pollutants, which would lead to smog and greenhouse gases. Suppose the external cost to the society is $1 per gallon of gasoline.

○ In the presence of a positive externality, the social value of a good

includes private value (the direct value to buyers) and external benefit (the value of the positive impact on bystanders).

○ The socially optimal Q maximizes welfare:

■ At any lower Q, the social value of additional units exceeds their cost.

■ At any higher Q, the cost of the last unit exceeds its social value. ○ Positive Externality Analysis Example:

● How do economists internalize externalities?

○ Internalizing the externality - the solution to the externality problem; altering incentives so that people take account of the external effects of their actions; restores the efficient allocation by making a change in a company's private costs or benefits in order to make them equal to the company's social costs or benefits

○ When market participants must pay social costs, market equilibrium = social optimum. (Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q​.)

● What Public Policies affect and control Externalities in the economy?

○ Two approaches to controlling externalities:

■ Command-and-control policies​ - regulate behavior directly. ● Examples: limits on quantity of pollution emitted from large factories, and requirements that firms adopt a particular

technology to reduce emissions

■ Market-based policies​ - provide incentives so that private decision-makers will choose to solve the problem on their own. ● Examples: corrective taxes and subsidies, and tradable

pollution permits

● Corrective Taxes and Subsidies:

■ Purpose: ​to align private incentives with society’s

interests, to make private decision-makers take

into account the external costs and benefits of

their actions, and to move economy toward a

more efficient allocation of resources.

○ Corrective tax​ - a tax designed to induce private

decision-makers to take account of the social costs that

arise from a negative externality​; also called

Pigouvian taxes​ after Arthur Pigou (1877-1959).

■ The ideal corrective tax = external cost

■ For activities with positive externalities, ideal

corrective subsidy = external benefit

■ Example: The gas tax targets three negative


● Congestion - the more you drive, the more

you contribute to congestion.

● Accidents - larger vehicles cause more

damage in an accident.

● Pollution - burning fossil fuels produces

greenhouse gases.

○ Corrective Subsidies -​ a subsidy designed to induce private decision-makers to take account of the social benefits that arise from a positive externality

● Tradable Pollution Permits:

○ Purpose: ​to allow firms to voluntarily trade the right (“permit”) to pollute; reduces pollution at lower cost than regulation.

■ Firms with low cost of reducing pollution sell

whatever permits they can.

■ Firms with high cost of reducing pollution buy permits.

■ Result: Pollution reduction is concentrated among those firms with lowest costs.

● Why do tradable permits and corrective taxes lead to the efficient outcome and solve the problem of negative externality?

○ Both policies utilize market power to obtain the efficient outcome​.

○ Both policies create an incentive for firms to pay to pollute ​(though in different forms)

○ Through paying to pollute, external costs are internalized​.

○ A corrective tax raises this price and thus reduces the quantity of pollution firms demand​. A tradable permits system restricts the supply of pollution rights, has the same effect as the tax.

○ When policymakers do not know the position of this demand curve, the permits system achieves pollution reduction targets more precisely​.

● What are Private Market Solutions and are they effective in solving externalities and leading to the efficient outcome? ○ Private Market Solutions​ - relying on the self-interest of the relevant parties to solve the externality problem

○ Effectiveness:

■ When related transaction costs are low enough, private market solutions are very effective​, as stated in the Coase Theorem. ■ Transaction cost​ - cost incurred in the process of making a transaction

■ Coase Theorem ​- if private parties can bargain without cost over the allocation of resources, they can solve the problem of

externalities on their own, and restore efficient outcomes

Chapter 11 Review:

Public Goods and Common Resources ● How do economists analyze a market of goods that do not have price tags?

○ Up until this point, we’ve been learning about priced goods.

■ Prices are the signals that guide decisions​ of buyers and sellers which leads to an efficient allocation of resources.

○ A market will fail (due to positive or negative externalities) if a good lacks a price tag.

■ When goods are available for free, the market forces that normally allocate the resources become absent.

■ Examples of goods without prices:

● Goods from nature:

○ Clean water/air, mountains, oceans, etc.

● Goods from the government:

○ Parks, fireworks, parades, etc.

○ A good can be described using two criteria: excludability & rivalry in consumption

■ Excludability​: the property of a good whereby a person can be prevented from using it; lack of excludability causes externalities ● If you don’t pay for a good, you don’t get the right to

consume it

■ Rivalry in consumption​: the property of a good whereby one person’s use diminishes other people’s use; determines whether externalities are positive or negative

● Your consumption leaves others with fewer choices

○ There are 4 types of goods that can fall under the two criteria above: ● Public Goods​ - goods that are neither excludable nor rival in consumption; tend to be under-provided​ (e.g. Fourth of July


● Common resources​ - goods that are rival but not excludable; tend to be over-consumed​ (e.g. clean air)

● Club goods​ - goods that are excludable but not rival (e.g.

Netflix subscription)

● Private Goods​ - goods that are both excludable and rival in consumption; the market works best for these goods​ (e.g. your cell phone)

■ A road can be any of the 4 types of goods.

● Uncongested non-toll road: public good

● Uncongested toll road: club good

● Congested non-toll road: common resource

● Congested toll road: private good

○ Why do markets generally fail to provide the efficient amounts of these goods, and how might the government improve market outcomes in the case of public goods or common resources?

■ Non-excludable goods​ (goods without a price tag​ like public goods and common resources):

● Implies that we can get access to these goods free of charge (price = 0)

○ Private decisions about consumption and production

can lead to an inefficient outcome, so public policies

are implemented to raise economic well-being

● Property rights​ are not well-established.

○ Nobody owns the air, so no one can charge polluters.

■ Result: too much pollution.

○ Nobody can charge people who benefit from national defense.

■ Result: too little defense.

● Zero price leads to externalities​, which are uncompensated external effects.

● Public goods are associated with positive externalities ○ Free riders ​benefit from public goods without paying anything.

■ Firms cannot prevent non-payers from

consuming​ these goods, which results in the

good not being produced​, even if buyers

collectively value the good higher than the cost of providing it.

○ Example: Fourth of July fireworks, tornado sirens ● Common resources could lead to negative externalities​. ○ Your consumption reduces mine, and I don’t get compensated.

■ Example: clean air

○ The government’s role is to ensure that these common resources are provided to society and that they are not overused.

● What is the Tragedy of the Commons and how does it relate to negative externalities?

○ The Tragedy of the Commons​ is a parable that illustrates why common resources get used more than is socially desirable.

■ Setting: a medieval town where sheep graze on common land.

■ As the population grows, the # of sheep grows. ■ The amount of land is fixed, so the grass begins to disappear due to overgrazing.

■ The private incentives​ (using the land for free) outweigh the social incentives ​(using it carefully), which results in the people no longer being able to raise sheep.

○ The tragedy is due to an externality​:

■ Allowing one’s flock to graze on the common land reduces its quality for other families.

■ People neglect this external cost, resulting in

overuse of the land

○ What policy options are available to prevent the over-consumption of common resources?

■ The government could…

● Regulate use of the resource

● Impose a corrective tax​ to internalize the


○ Example: hunting & fishing licenses,

entrance fees for congested national


● Auction off permits​ allowing use of the


○ Example: spectrum auctions by the

U.S. Federal Communications


● If the resource is land, convert to a private

good by dividing and selling parcels to


Chapter 13 Review:

The Costs of Production

● What are a firm’s costs of production?

○ Remember:

■ Profit = Total Revenue - Total Costs

● The goal of any firm is to maximize profit

■ Total Revenue = Price x Quantity

■ Total Costs = Fixed Costs + Variable Costs

■ (OR) Total Costs = Explicit Costs + Implicit Costs

● Total Costs​ - market value of all the resources a firm uses in production

● Fixed Costs​ - costs that do not vary with the quantity​ of

output produced; only matters in the short run (e.g. Factory

rent, security costs, marketing costs, and research and

development costs)

● Variable Costs​ - costs that vary with the quantity​ of output produced; all costs are variable in the long run (e.g. cost of

raw materials and labor costs)

● Explicit Costs​ - costs that require a direct outlay of money by the firm’s owner

● Implicit Costs​ - costs that do not require an outlay of cash

○ Examples of Implicit Costs:

■ You own a restaurant and you work eighteen

hours a day in it

● You could have worked elsewhere and

earned a wage. This lost income is an

implicit cost.

■ You have invested $20,000 of your own savings in

your restaurant

● You could have earned interest had you put

that money in a bank instead. This lost

interest income is an implicit cost.

● What is the difference between Economic Profit and Accounting Profit?

○ Economic profit​ =

■ total revenue – total cost

■ total revenue – (explicit costs + implicit costs)

○ Accounting profit​ =

■ total revenue – explicit costs (does not include implicit costs​) ○ As a result, accounting profit > economic profit; when economic profit is 0, accounting profit is positive

○ Example: Caroline’s Cookie Factory

■ total revenue = $700 per hour

■ total explicit costs = $650 per hour (for labor and raw materials) ■ total implicit costs = $110 per hour (in wages Caroline could have earned as a computer programmer)

● Accounting profit = $50 per hour (indicates short-run

financial viability)

● Economic profit = – $60 per hour (indicates a dire long-run future)

■ Dissatisfied with the $50 per hour profit, Caroline will eventually shut down the firm and take a programming job

● What do the shapes of different cost curves mean for a firm in the short run?

○ Production Function​ - shows how the quantity of output of a good depends on the quantity of inputs used to make that good; the relationship between quantity of inputs used to make a good and the quantity of outputs of that good

■ A typical firm’s production function gets flatter as the quantity of input increases​, displaying the property of diminishing marginal product

○ Marginal Product (MP) ​- the increase in output that arises from an additional unit of input, holding all other inputs constant

■ MP Formula: Marginal Product = ∆output / ∆input

■ Diminishing Marginal Product​ - the property whereby the marginal product of an input decreases as the quantity of the input increases​.

● Example: As more and more workers are hired at a firm, the output produced would increase by less and less because the firm has a limited amount of equipment that all workers must share.

■ Production Function/MP Graph:

■ A general production function has 3 phases:

● Phase 1: Additional worker increases output more than the previous worker.

○ In this phase, there are few workers to begin with, which allows for specialization and comparative advantage​.

○ Marginal Product is greater than 0, and it is


● Phase 2: Additional worker still increases output, but not as much as the previous worker.

○ In the short run, some inputs (e.g., plant size) cannot be varied. Because of this, after certain point the

potential of additional workers cannot be fully


○ Marginal Product is greater than 0 and is decreasing because of the principle of diminishing marginal


● Phase 3: Additional worker decreases output.

○ When too many workers are added, an additional

worker does more harm than good​.

○ At this point, marginal product becomes negative​.

○ Average Fixed Costs (AFC) - a per-unit-of-output of fixed costs ■ AFC Formula: Average Fixed Costs = Fixed Costs / Quantity ■ As the quantity produces increases, the fixed costs are spread over

larger quantity of output so average fixed cost decreases and approaches zero​.

■ The AFC curve slopes downward as the quantity produced increases.

○ Marginal Costs (MC) ​- the increase in total cost that arises from producing an additional unit of output; entirely due to the use of additional raw materials and labor, so it can be defined as an increase in total variable cost that arises from an additional unit of production

■ MC Formula: Marginal Cost = ∆Total Cost / ∆Quantity​ (OR) ∆Variable Cost / ∆Quantity

■ Marginal cost always rises with the quantity of output​. ■ Always crosses the average-total-cost curve at the minimum of ATC​.

■ There is an inverse relationship​ between Marginal Cost and Marginal Product, making the MC graph a U shape

● MP↑ and MC↓

○ Consider Phase 1 of the production process.

■ When the additional workers increase

efficiency, it requires fewer inputs to produce

one more good.

● MP↓ and MC↑

○ Consider Phase 2 of the production process.

■ When the additional workers decrease

efficiency, it requires more inputs to produce

one more good

■ Whenever marginal cost is less than average total cost, average total cost must be decreasing​ (negatively sloped). ■ Whenever marginal cost is more than average total cost, average total cost must be increasing ​(positively sloped). ■ Whenever marginal cost is equal to average total cost, average total cost must be constant​ (horizontal).

■ The marginal-cost curve crosses the average-total-cost curve at the efficient scale output​.

● Efficient scale output is the quantity that minimizes average total cost.

○ Average Variable Costs (AVC)​ - most important to the analysis of a firm's decision to shut down production in the short run

■ AVC Formula: Average Variable Costs = Variable Costs / Quantity

■ Average Variable Cost Curve:

■ Average Variable Cost decreases when it’s greater than Marginal Cost

■ Average Variable Costs increases when it’s less than Marginal Cost

■ MC curve intersects AVC curve at its minimum

■ If price is greater than AVC:

● A firm may or may not be receiving an economic profit, but it is better off producing in the short run than shutting down production. Shutting down production entails a loss equal to total fixed cost. However, with price greater than average variable cost, sufficient revenue is generated to pay ALL

variable cost and some fixed cost, making the operating loss less than fixed cost​.

■ If price is less than AVC:

● A firm incurs a loss greater than total fixed cost by

producing​. Its operating loss includes both fixed cost, plus part of the variable cost not covered by the price. As such, the firm is better off shutting down​ production and awaiting better times.

○ Average Total Costs (ATC)​ - the overall relationship between the quantity a firm can produce and its costs; tells us the cost of a typical unit of output

■ ATC Formula: Average Total Costs = Total Costs / Quantity ​(OR) Average Fixed Costs + Average Variable Costs

■ Average Total Cost Curve:

■ At the minimum of the Average Total Cost curve, the Marginal Cost curve intersects the Average Variable Cost curve.

○ Example incorporating all costs:

● What is the difference between short-run and long-run Average Total Costs?

○ In both the short-run and the long-run, costs depend on the firm’s level of output, the costs of factors, and the quantities of factors needed for each level of output​.

○ The chief difference between long-run and short-run costs is there are no fixed costs in the long-run, so Average Total Cost = Average Variable Cost.

■ In the long run, a firm has more flexibility​ and can choose the best output/cost combination that minimizes cost in order to maximize profit

○ The Short Run Versus The Long Run in Production Decisions: ■ Short run: Quantity of labor is variable but quantity of capital and production processes are fixed (i.e. taken as given)

■ Long run: Quantity of labor, quantity of capital, and production processes are all variable (i.e. changeable)

○ The Short Run Versus The Long Run in Measuring Costs: ■ Short run: Fixed costs are already paid and are unrecoverable (i.e. "sunk")

● When output is zero, cost is positive because fixed

(unavoidable) cost has to be incurred, regardless of


■ Long run: Fixed costs have yet to be decided on and paid, and are thus not truly "fixed"

○ The Short Run Versus The Long Run in Market Entry and Exit: ■ Short run: The number of firms in an industry is fixed (even though firms can "shut down" and produce a quantity of zero)

■ Long run: The number of firms in an industry is variable since firms can enter and exit

○ Microeconomic Implications of the Short Run Versus the Long Run ■ The Short Run:

● Firms will produce if the market price at least covers variable costs, since fixed costs have already been paid and, as such, don't enter the decision-making process.

● Firms' economic profits can be positive, negative or zero. ■ The Long Run:

● Firms will enter a market if the market price is high enough to result in positive economic profit.

● Firms will exit a market if the market price is low enough to result in negative economic profit.

● If all firms have the same costs, firm profits will be zero in the long run in a competitive market. (Those firms that have

lower costs can maintain positive economic profit, even in the long run.)

● What is the relationship between long-run Average Total Cost and the scale of production (Q)?

○ Economies of scale​ - benefits which occur when a firm increases output, which leads to a reduction in average cost of production

■ Long-run Average Total Cost falls as Quantity increases

■ Occur when increasing production allows greater specialization​. ● Workers are more efficient when focusing on a narrow task.

■ More common in firms where production quantity is low​.

○ Diseconomies of scale​ - occur when a firm increases output, which leads to an increase in average cost of production

■ Long-run Average Total Cost rises as Quantity increases

■ Due to coordination problems​ in large organizations.

● As management becomes stretched, it becomes hard for

managers to effectively keep costs down.

■ More common when production quantity is high​.

○ Constant Returns to scale - occurs when increasing the number of inputs leads to an equivalent increase in the output

■ Long-run Average Total Cost stays the same as production quantity increases​.

Chapter 14 Review:

Firms in Competitive Markets

● What are Perfectly Competitive Markets & Competitive Firms? ○ Perfectly Competitive Market - ​a market in which there is so much competition that it doesn’t make sense for a firm to single out any of its competitors as an opponent

○ A perfectly competitive market is defined by 3 characteristics: ■ Homogenous goods:​ products that vie with each other in a market but which (from the consumer's viewpoint) have little or no

differentiation in terms of features, benefits, or quality​ and are, therefore, forced to compete on price or availability​.

■ Price takers:​ There are many buyers ​and many sellers​ in the market, so the market price is unaffected​.

● A firm in a perfectly competitive market cannot stay in business if its price is ​higher​ than what the other firms are charging.

● No firm could raise the market price​ by reducing production and attempting to create a shortage​.

● Conversely, a firm couldn’t drive the market price down by producing too much​.

● Therefore, no firm would want to charge a price lower than what the others are charging.

● In short, each firm takes the prevailing market price​ as a given—like the weather—and charges that price.

○ A firm’s revenue is proportional to the amount of output it produces

○ The price of the good equals both the firm’s average revenue and its marginal revenue

■ Free entry/exit:​ Firms can easily enter or exit the market. ● Makes it is easy for a buyer to switch from one supplier to another

● There should be no​ obstacles in the form of government regulations​ or limited access to to key resources to prevent new producers from entering the market​. (e.g. taxi cabs in NYC, prescription drugs)

● There must also be no additional costs associated with shutting down and leaving an industry​.

● This feature matters in analyzing the long-run equilibrium ■ What does the supply/demand graph look like for a perfectly competitive market and an individual competitive firm within it?

● Example of a Competitive Firm​:

○ Farming​: There are thousands of farmers and not one

of them can influence the market or the price based

on how much they grow​. All the farmer can do is grow

the crop and accept whatever the current price is​ for

that product. They do not get to determine the price

they want to sell the crop for​.

● How does a competitive firm decide the quantity of good they sell in order to maximize their profit?

○ To maximize profit in a perfectly competitive market, a producer must determine the Quantity from one of four factors:

■ Market Price, Average Revenue, Marginal Revenue, or Marginal Cost

■ Why? Just remember: a firm is maximizing its profit at the corresponding quantity where P = AR = MR = MC

○ Demand factors​ the firms need to analyze:

■ Total Revenue​ = Price x Quantity Sold

■ Average Revenue​ = Total Revenue / Quantity Sold

● Average Revenue = (Price x Quantity Sold) / Quantity Sold

● Average Revenue = Price

○ All units sold are sold at the same price​.

■ Marginal Revenue​ = ∆Total Revenue / ∆Quantity

● Marginal Revenue is the increase in total revenue when an additional unit is sold

● In a perfectly competitive market​, Price = Average

Revenue = Marginal Revenue

■ Total Costs​ = Opportunity costs of all factors of production: land, capital, labor and other inputs supplied by the firm’s owner(s)

■ Profit/Loss​ = Total Revenue - Total Costs

= (Price - Average Total Cost) x Quantity sold

○ Supply factors​ the firms need to analyze:

■ The analysis of supply in perfect competition depends on whether it is the short run or the long run.

■ The quantity of a resource used by a firm may be fixed in the short run but NOT in the long run​.

● Example: If a firm currently has three custom-made

machines and if it takes six months to get new machines, then the firm is stuck with its three machines for the next six months.

■ All fixed costs are sunk costs in the short run but NOT in the long run

■ The number of firms in an industry is fixed in the short run but NOT in the long run

○ Before a firm decides how much to supply, it must decide whether or not to stay in business. What can the firm do in the short-run and the long-run?

■ A shutdown refers to a short-run decision to stop production temporarily​, perhaps because of poor market conditions. ● A firm will shut down​ (temporarily) if…

○ Total Revenue​ ​is less than Variable Cost

○ (Total Revenue / Quantity) is less than (Variable

Cost / Quantity)

○ Price is less than Average Variable Cost

○ ...No matter what Quantity the firm produces

● In the short run, if firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost​.

■ Fixed costs do not matter​, because...

● Fixed costs are sunk costs in the short run

○ Sunk costs​ are defined as costs that

will have to be paid even if the firm

shuts down.

● Therefore, fixed costs cannot affect a firm’s decision on whether to stay open or shut


■ Example of a firm’s short-run decision to shut down:

○ Total Revenue = $1000 per month

○ Variable Cost = $800 per month

○ Fixed Cost = $400 per month

○ Profit = –$200 per month (a loss)

● Should this firm stay in business or should it shut down for the time being?

○ It should stay in business, because if it

shuts down, the fixed cost (say, rent

owed to the landlord) will still have to

be paid—because it is sunk!—and the

loss will then be even higher, $400 per


■ An exit from the market refers to a long-run decision to end production permanently;

● Exit​ the market (firm’s quantity produced (Q) = 0) if… ○ Total Revenue is less than Total Costs (Fixed Costs + Variable Costs)

○ Market price (P) is less than the minimum Average Total Costs

● If the Price equals the minimum of average total cost (profit = 0)​, the market supply curve will be horizontal​ at this price

○ How/why do competitive firms stay in business if they make zero profit?

■ Profit = TR – TC

■ Total cost = explicit cost + implicit cost.

■ Zero profit implies that Total Revenue = Explicit cost + Implicit cost

■ In the zero-profit equilibrium, the firm earns enough revenue to compensate the owners for the time and money they spend to keep the

business going.

● A new firm will enter the industry if it can expect to be profitable.

○ A new firm will enter if…

■ Total Revenue is greater than Total Cost for some value of Q

■ Market Price (P) is greater than the minimum Average Total Cost

● What are the short-run and long-run effects of a shift in demand?

○ In the short-run​:

■ An increase in demand raises the price and quantity​ (for the firm and the industry as a whole)

● Firms earn positive profits​, because price now exceeds

average total cost

● News firms enter the market

● Market supply increases (shifts right)

● Price decreases​, gradually returning to minimum ATC

● Profits decrease​, gradually returning to zero

○ In the long-run:

■ Demand has no effect on price, and no effect on the quantity produced by a firm, but it does affect the quantity produced​ by the industry, and does affect the number of firms in the industry​. ● An increase in demand​ in the long-run increases the

number of firms in the industry and increases the

industry’s output

■ The number of firms adjusts to drive the market back to the zero-profit equilibrium

● Adjustment process:

○ Increase in demand

○ Price goes up

○ Profit becomes positive

○ Other firms enter the market

○ Increase in supply

○ Price goes down

○ Profit goes down until profit = 0 in equilibrium

Chapter 15 Review:


● What is a monopoly and why do they arise in markets? ○ Monopoly - a firm is a monopoly if it is the sole seller of its product that does not have close substitutes​; economic assumption: firms have market power that permits them to earn extraordinary profits for an extended period of time

○ Competitive Markets vs. Monopolistic Markets

■ Market power: price taker vs. price maker​.

■ Number of firms: multiple firms vs. single firm

■ Price: price equals marginal cost vs. price is greater than

marginal cost

○ Causes of Monopolies:

■ The fundamental cause of monopoly is barriers to entry​ which are based on...

● A key resource is owned by a single firm​.

● The government gives a single firm the exclusive right​ to produce some good.

○ In some cases, there are benefits and costs such as

patents and copyrights.

○ In other cases, there are few benefits such as taxi and trucking licenses.

● How can costs of production make a single producer more efficient than a large number of firms?

○ Natural monopoly​ - arises because a single firm can

supply a good or service to an entire market at a

smaller cost than could two or more firms; is often

influenced by the size of the market

■ Governments​ regulate natural monopolies by

controlling the prices they charge​.

■ Tends to form in industries where there are high

fixed costs​; a firm with high fixed costs requires a

large number of customers in order to have a

meaningful return on investment

■ Natural monopoly's cost structure is very

different​ from that of most industries:

● Industry cost structure​:

○ The marginal cost initially decreases

due to economies of scale, then

increases as the company experiences

growing pains (as employees become

overworked, the firm's bureaucracy

expands, etc.)

○ The average total costs of production

decreases and then increases.

● Natural Monopoly cost structure​:

○ Marginal cost that is constant or


○ The average total cost continues to

shrink as output increases​.

○ Example: Electricity services.​ Fixed costs of building

the necessary infrastructure are high. The cost of

constructing a competing transmission network and

delivering service will be so high that it effectively bars

potential competitors from entering the monopolist's


○ Effects of Monopolies:

■ A monopoly decreases Consumer Surplus

■ Increases Producer Surplus

■ Causes a Deadweight loss​, which represents a reduction in economic efficiency.

● What happens when a monopoly faces competition? ○ While the competitive demand curve is horizontal,​ the demand curve facing the monopolist is the negatively sloped market demand curve​.

○ In a monopoly, there is no supply curve. A supplier is able to determine the price of the product without fear of competition from other sources or through substitute products​.

■ A supply curve tells us the quantity that firms choose to supply at any given price. A monopoly firm is a price maker, not a price taker, so it is not meaningful to ask what such a firm would

produce at any price because the firm sets the price at the same time it chooses the quantity to supply.

○ We assume that the monopolist’s goal is to maximize profit ● How does a monopoly make its profit-maximization decision? ○ To determine profit, a firm must first determine its revenues and its costs because (Profit = Revenue - Cost)

■ A Monopoly’s Revenues:

● Assuming that a monopoly must charge each customer the same price for its good​, the monopoly faces a downward

sloping marginal revenue curve​ — meaning that each

additional unit the firm sells brings in less revenue than

the unit before​.

○ the output effect (more output is sold)

○ the price effect (but at a lower price)

■ A competitive firm does not have a price effect.

● The reason for this declining marginal revenue is that the

firm must reduce the price it charges for its product if it

wants to sell more units​. And that new lower price would

apply to all units sold — including all the units sold to buyers

who would have been willing to pay a higher price

● Marginal revenue has the same intercept and twice the slope of the demand curve​.

■ A Monopoly’s Costs:

● A monopolist produces his product at a fixed cost.​ The cost is the same no matter how many units the monopolist

makes​. The number of units he sells, however, depends on the price he charges​. The number of units he sells at a given price depends on the demand.

■ The golden rule does not change: The profit-maximizing quantity is where marginal revenue equals marginal cost (MR = MC) ● The Marginal Revenue curve for a monopoly is different from MR curve for a competitive firm, where MR = P

■ A monopoly chooses BOTH price and quantity​.

● The firm will always set output quantity at a level where marginal cost equals marginal revenue​, so the quantity is found where these two curves intersect. Price​, however, is determined by the demand​ for the good when that quantity is produced. Because a monopoly's marginal revenue is always below the demand curve, the price will always be above the marginal cost at equilibrium​, providing the firm with an economic profit.

● Efficient quantity (Qe) in the monopolistic market: ○ Q​e​is the intersection between the demand curve and the Marginal Cost curve

■ Social value curve: demand curve

■ Social cost curve: MC curve

○ Monopoly causes Deadweight Loss (DWL) because Q* < Q​e​, due to its power in the market

● Why would a monopoly practice price-discrimination by not charging the same price to all its consumers? ○ Price Discrimination​ - the business practice of selling the same good at different prices, depending on the consumers’ willingness to pay (WTP)​; due to a

monopoly’s self-interest

■ It requires four conditions:

● Market power.

● The ability to separate markets.

● No arbitrage,​ meaning a consumer can’t

buy a good in one market at a low price

and then sell it in another market at a

higher price​ to profit from the price


● Different elasticities in the markets.

○ The more inelastic the group’s

demand, the higher the price that

they pay​.

○ The more elastic the group’s

demand, the lower price that they


■ Example of Price Discrimination:

● Airline prices: businessmen vs. tourists​.

○ Perfect Price Discrimination​ - the monopoly is able to charge each consumer a different price that is equal to the consumer’s WTP​; all the consumer surplus is transferred to the supplier

■ In reality, while perfect price discrimination might not be possible, the monopoly can at least

identify different consumer groups.

● What public policies affect monopolies?

○ Because monopolies cause market inefficiency​, the government can respond to this market failure by adopting different policies

○ Public Policies Controlling Monopolies:

■ Increasing Competition with Antitrust Laws -

● Antitrust Laws​ - laws aimed at eliminating collusion and

promoting competition​ among firms

○ They allow government to prevent mergers​ (a deal to

unite two existing companies into one new company).

○ They allow government to break up companies​.

○ They prevent companies from performing activities

that make markets less competitive.

○ For example, Microsoft was prevented from buying

Intuit in 1994, and AT&T was split into eight smaller

companies in 1984.

● Two Important Antitrust Laws established by the Federal

Trade Commission:

○ Sherman Antitrust Act​ (1890) -

■ Reduced the market power​ of the large and

powerful “trusts” of that time period

■ Outlawed price fixing, collusion, and


■ Promoted competition

○ Clayton Act​ (1914) -

■ Strengthened the government’s powers and

authorized private lawsuits

■ Prohibited firms from buying stock in

competitors ​and from having directors serve on

the boards of competing firms​.

■ A merger was illegal​ if its effect was

"substantially to lessen competition, or to tend to

create a Monopoly."

● Downside of Antitrust laws: potential cost of losing


○ Synergies​ - the potential financial benefit achieved

through the combining of companies

■ Regulation of monopolist behavior -

● The government may regulate the prices that the monopoly charges​, but will allow monopolists to keep some of the benefits​ from lower costs in the form of higher profit

○ Downside of price regulations: there is always a


● The regulator may force the monopolist to implement the efficient outcome

○ Recall that the allocation of resources is efficient when price is set to equal marginal cost (P = MC).

○ But it might be difficult for government regulators to force the monopolist to set P = MC, because P = MC is often unrealistic.

● The government may choose to run the the natural monopoly​ that is currently run by a private firm; this is called public ownership

○ For example, in the U.S., the government runs the U.S. Postal Service

○ Downside of turning a private monopoly into a public enterprise: government bureaucracy

● Government may do nothing at all​ if the market failure is deemed small compared to the imperfections of public policies.

○ Downside of doing nothing to regulate monopolist behavior: the Deadweight Loss still exists

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