Introduction to Microeconomics Fall 2015 Final Exam Study Guide
Introduction to Microeconomics Fall 2015 Final Exam Study Guide ECON 1011
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This 28 page Study Guide was uploaded by Caroline Jok on Friday December 11, 2015. The Study Guide belongs to ECON 1011 at George Washington University taught by Foster, I in Fall 2015. Since its upload, it has received 193 views. For similar materials see Principles of Economics I in Economcs at George Washington University.
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Foster – Econ 1011 Fall Final Review: Chapter 1 – Economics: Foundations and Models Vocabulary: - Scarcity: unlimited wants exceed limited resources - Economics: study of choices people make to attain their goals given their scarce resources - Economic Model: simplified version of reality to analyze real-world economic situations - Market: Group of buyers and sellers of a good or service and the institution or arrangement by which they come together and trade. - Marginal Analysis: comparing marginal benefits and marginal costs - Trade-off: because of scarcity, producing more of one good or service means producing less of another good or service - Opportunity Cost: highest-valued alternative that must be given up to engage in an activity. - Centrally planned economy: Economy where the government decides how economic resources are allocated - Market Economy: decisions of households and firms interacting in markets allocate economic resources. - Mixed Economy: most economic decisions result from interactions of buyers and sellers but the government still plays a role in the allocation of resources - Productive efficiency: good or service is produced at the lowest possible cost - Allocative efficiency: production is in accordance with consumer preference; marginal benefit = marginal cost - Voluntary exchange: both the buyer and seller of a product are made better off by the transaction. - Equity: fair distribution of economic benefits - Economic variable: something measurable that can have different values, such as the incomes of doctors - Positive analysis: Analysis concerned with what is - Normative analysis: concerned with what ought to be. - Microeconomics: study of how households and firms make choices, how they interact in markets and how the government attempts to influence their choices - Macroeconomics: study of the economy as a whole including topics such as inflation, unemployment, and economic growth Objectives: - Calculating Net Benefit: o Benefit – Explicit Cost = net benefit o Explicit cost: what you’re paying out of pocket - Determining opportunity cost o The dollar amount and the option o What is the optimal choice? § Choose the one with the highest net benefit § What is the option with the lowest opportunity cost? o If not everything is laid out, make your own systematic table to solve it. o What is the total economic cost? § Total Economic cost = explicit cost + implicit cost (opportunity cost) - Marginal Benefit and Marginal Cost o Marginal Benefit curve § Negative slope § Equivalent to the demand curve, willingness to pay o Marginal Cost § Positive slope o Why is it that the intersection is the optimal point? § Looking at the options cumulatively § Finding the benefit from the EXTRA unit - Relationship between Total Revenue and Marginal Revenue o What is Total Revenue? § Total Revenue = Price*Quantity § Total Expenditure by consumer is the same as the total revenue Chapter 2 – Trade offs, comparative advantage, and the market system Vocabulary: - Scarcity: a situation in which unlimited wants exceed the limited resources available to fulfill those wants - Production possibilities frontier (PPF): A curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology - Opportunity cost: The highest-valued alternative that must be given up to engage in an activity - Economic growth: The ability of the economy to increase the production of goods and services - Absolute advantage: The ability of an individual, a firm or a country to produce more of a good or service than competitors using the same amount of resources. - Comparative advantage: The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors - Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade - Product market: a market for goods – such as computers – or services – such as a medical treatment. - Factor market: A market for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability - Factors of production: The inputs used to make goods and services. - Circular-Flow diagram: a model that illustrates how participants in markets are linked. - Free market: a market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed. - Entrepreneur: someone who operates a business, bringing together the factors of production – labor, capital, and natural resources – to produce goods and services. - Property rights: The rights individuals or firms have to the exclusive use of their property including the right to buy or sell it. Objectives: - Scarcity requires tradeoffs - Production Outside of the Production possibilities frontier only occurs with trade - As the economy moves down the production possibilities frontier it experiences increasing marginal opportunity costs - The more resources already devoted to an activity, the smaller the payoff to devoting additional resources to that activity - Outward shift in PPF is economic growth - Trade allows for maximization of product even with absolute advantage. - The basis for trade is comparative advantage - It is possible to have one without the other. - Factors of Production o labor o Capital o Natural resources o Entrepreneur - Adam Smith o Individuals usually act in a rational, self-interested way o Firms are the invisible hand § Firms respond individually to changes in prices by making decisions that collectively end up satisfying the wants of consumers o Entrepreneurs: § Central to the working of the market system § Determine what goods and services they believe consumers want § Take risks - If property rights are not well enforced, fewer goods and services will be produced. This reduces economic efficiency, leaving the economy inside its production possibilities frontiers. Chapter 3 – Where Prices Come From: The Interaction of Demand and Supply Vocabulary - Perfectly Competitive market: A market that has many buyers and sellers, all firms selling identical products, and no barriers to new firms entering the market - Demand Schedule: table showing the relationship between the price of a product and the quantity demanded - Quantity demanded: amount of a good/service that a consumer is willing and able to purchase at a given price - Demand curve: curve showing relationship between the price of a product and the quantity of the d=product demanded - Market Demand: the demand by all the consumers of a given good or service - The law of demand: all else constant, when the price of a good falls, the quantity demanded will increase, and vice versa - Substitution effect: change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods that are substitutes - Income effect: the change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power. - Ceteris paribus: all else equal - Normal good: demand increases as income rises and decreases as income falls. - Inferior good: demand increases as income falls and increases as income rises - Substitutes: Goods/services that can be used for the same purpose. - Compliments: goods and services that are used together - Demographics: Characteristics of a population with respect to age, race and gender - Quantity supplied: the amount of a good or service that a firm is willing and able to supply at a given price - Supply Schedule: table showing the relationship between the price of a product and the quantity of the product supplied - Supply curve: curve showing the relationship between the price of a product and the quantity of the product supplied - Law of Supply: all else constant, increasing price increases the quantity supplied and decreases price causes a decrease in the quantity supplied - Technological change: A positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs - Market Equilibrium: A situation in which quantity demanded equals quantity supplied - Competitive market equilibrium: a market equilibrium with many buyers and sellers - Surplus: quantity supplied is greater than quantity demanded - Shortage: quantity demanded is greater than quantity supplied Objectives: - There will be a graphing question, just like the second quiz: o Price is always (y) and Quantity is always (x) o Demand curve: Provide the x and y intercept and the equilibrium coordinates o Scale the axis correctly o Demand curve is always negative o Give the x intercept of the supply curve which is always positive - Law of Demand: o When prices increase, quantity demanded decreases and vice versa o Income Effect & Substitution effect à both look at what happens when Price changes - Movement along vs. Shift of the demand curve o Change in price of the good à Movement along o Income, price of related goods (substitutes vs. Compliments, tastes and preference, future expectations, number of buyers shift of demand curve) - Movement along vs. Shift on the supply curve o Along § Change in Price of the Good o Shift § Price of input § Expectations § Technology § Prices of substitutes in production § Number of sellers - Substitution effect: o Explains the law of demand - Substitutes: o Relates to the demand curve o Only show up in the demand curve - Substitutes in production: o Used in the context of the supply curve - Negative sign for income: inferior Good - Know how the signs in the equations tell you the relationship between the variable. o A minus sign with the substitute à means that they are compliments o Be able to explain why the relationships are as is. An increase in Shifts the demand curve… Because… Income w/normal good Right Consumers spend more of their higher incomes on the good Income w/inferior good Left Consumers spend less of their higher incomes on the good Price of a substitute good Right Consumers buy less of the substitute good and more of this good The price of a complimentary Left Consumers buy less of the good complimentary good and less of this good Taste for the good Right Consumers are willing to buy a larger quantity of the good at every price Population Right Additional consumers means greater demand at every price The expected price of the Right Consumers buy more of the good in the FURTURE good now to avoid the higher price in the future. An increase in… Shifts the supply curve… Because Price of an input Left The costs of producing the good rises Productivity Right The costs of producing the good falls The price of a substitute in Left More of the substitute is production produced and less of the good is produced The number of firms in the Right Additional firms result in a market greater quantity supplied at every price The expected future price of Left Less of the good will be the product offered for sale today to take advantage of the higher price in the future. Variables that shift market supply: - Price of inputs - Technological change - Prices of substitutes in production - Number of firms in the market - Expected future prices Chapter 4: Economic Efficiency, Government Price Setting and Taxes Vocabulary: - Price Ceiling: legally determined maximum price that sellers may charge; to be effective this must be below the equilibrium - Price Floor: legally determined minimum price that sellers may receive; to be effective, it must be above the equilibrium - Consumer Surplus: The difference between the highest price a consumer is willing to pay for a good or service and the actual price the consumer pays - Marginal Benefit: The additional benefit to a consumer from consuming one more unit of a good or service - Economic Surplus: the sum of consumer surplus and producer surplus - Deadweight Loss: reduction in economic surplus resulting from a market not being in competitive equilibrium - Economic Efficiency: a market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and in which the sum of consumer surplus and producer surplus is at a maximum. - Black Market: a market in which buying and selling take place at prices that violate the government price regulations - Tax Incidence: the actual division of the burden of a tax between buyers and sellers in a market - Tax Imposition: Who is the tax imposed on? Objectives: - Market efficiency: o Is the market more efficient with a tax? o The answer is always NO o There is dead weight Loss - Tax Efficiency: o Compare tax revenue with the deadweight loss - Imposition: o Demand shifts: on Buyers o Supply Shifts: on sellers - Tax Incidence: o Burden On Buyers= price now – price equilibrium o Burden on Sellers = equilibrium price – price receiving now o The more vertical the demand (inelastic) the more that Buyers pay. Chapter 5 – Externalities, Environmental Policy, and Public Goods Vocabulary: - Externality: A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service - Private cost: the cost borne by the producer - Social Cost: The total cost of producing a good or service, including both the private cost and any external cost - Private benefit: The benefit received by the consumer - Social benefit: the total benefit from consuming a good or service, including both the private benefit and any external benefit. - Market failure: a situation in which the market fails to produce the efficient level of output - Property rights: the rights individuals or business have to the exclusive use of their property including the right to buy or sell it. - Transaction costs: The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. - Coase theorem: The argument that if transaction costs are low, private bargaining will result in an efficient solution to the problem of externalities. - Pigovian taxes and subsidies: Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities - Command and control approach: A policy that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices. - Rivalry: The situation that occurs when one person consuming a unit of a good means no one else can consume it - Excludability: The situation in which anyone who does not pay for a good cannot consume it - Private good: a good that is both rival and excludable. - Public good: a good that is both non rival and non excludable - Free riding: benefiting from a good without paying for it - Common resource: a good that is rival but not excludable. - Tragedy of the commons: the tendency for a common resource to be overused Objectives: - Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency o Externalities interfere with economic efficiency of a market equilibrium o When there is a negative externality in producing a good or service, too much of the good or service will be produced at market equilibrium o When there is a positive externality in consuming a good or service, too little of the good or service will be produced at market equilibrium o Governments need to guarantee property rights in order for a market system to function well. o Externalities and market failures result from incomplete property rights or from the difficulty of enforcing property rights in certain situations - Discuss the Coase theorem and explain how private bargaining can lead to economic efficiency in a market with an externality o There is an economically efficient level of pollution reduction o If the marginal benefit of reducing pollution is greater than the marginal cost, further reductions will make society better off. - Generally governments use pigovian taxes to deal with negative externalities in productions - Recommend reviewing graphs for this chapter (cause and effect) Chapter 6: Elasticity: the Responsiveness of Demand and Supply Vocabulary: - Price Elasticity of Demand: The responsiveness of the quantity demanded to a change in price à divide the percentage change in the quantity demanded of a product by the percentage change in the products price. - Elastic Demand: demand is elastic when the percentage change in he quantity demanded is greater than the percentage change in price, so the price elasticity is greater than 1 in absolute value - Inelastic demand: demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price, so the price elasticity is less than 1 in absolute value - Unit-elastic demand: demand is unit elastic when the percentage change in quantity demanded is equal to the percentage change in price, so the price elasticity is equal to 1 in absolute value. - Perfectly inelastic demand: the case where the quantity demanded is completely unresponsive to price and the price elasticity of demand equals zero - Perfectly elastic demand: the case where the quantity demanded is infinitely responsive to price and the price elasticity of demand equals infinity. - Total Revenue: Total amount of funds a seller receives from selling a good or service, calculated by multiplying price per unit by the numbers of units sold. - Income Elasticity of demand: A measure of the responsiveness of the quantity demanded to changes in income, measured by the percentage change in the quantity demanded and divided by the percentage change in income - Price elasticity of Supply: The responsiveness of the quantity supplied to a change in price. Measured by dividing percentage change in quantity supplied of a product by the percentage change in the product’s price. Objectives: If demand is… Then the absolute value of Slope is price elasticity is… Elastic Greater than one Less vertical à slope greater than 1 Inelastic Less than one More vertical à Slope less than 1 Unit elastic Equal to one Slope of 1 Perfectly elastic Equal to infinity Horizontal Perfectly inelastic Equal to zero Vertical If demand is … Then… Because.. Elastic An increase in price reduces The decrease in quantity revenue demanded is proportionally greater than the increase in price Elastic A decrease in price increases The increase in quantity revenue demanded is proportionally greater than the decrease in price Inelastic An increase in price increases The decrease in quantity revenue demanded is proportionally smaller than the increase in price Inelastic A decrease in price reduces The increase in quantity revenue demanded is proportionally smaller than the decrease in price Unit elastic An increase in price does not The decrease in quantity affect revenue demanded is proportionally the same as the increase in price Unit elastic A decrease in price does not The increase in quantity affect revenue demanded is proportionally the same as the decrease in price - Key determinants of price elasticity of demand; o The availability of close substitutes to the good § If a product has more substitutes it will have a more elastic demand o Time § The more time that passes the more elastic the demand for a product becomes o Whether the good is a luxury or a necessity § The demand curve for a luxury is more elastic than the demand curve for a necessity o The definition of the market § More narrowly defined a market is the more elastic the demand will be (having fewer alternatives) o The share of the good in the consumer’s budget § The demand for a good will be more elastic the larger the share of the good in the average consumer’s budget - Price elasticity of Demand o If prices change, how much will quantity demanded change? o (%change in Quantity Demanded)/(% change in Price) o (((Q2 – Q1)/((Q1+Q2)/2))*100)/((P2-P1)/((P1+P2)/2))*100 § The 100’s actually cancel out o If Change in price is 5% then when put into the equation, put it in as 0.05 - Mid point of the Demand curve is typically unit elasticity (Price elasticity of demand equals |-1|) o Prices Go up: Quantity Demand Decreases (TR same) At Higher prices, elastic demand à Greater than 1 o If prices increase à Total Revenue decreases b/c decrease in Quantity Demand will be much larger; lower prices have the opposite effect o People are price sensitive - At lower prices, inelastic demand à Less than 1 o Price Increase, Quantity demand decrease, Total Revenue goes up - What is the Total revenue Perfectly Elastic: Horizontal demand EP = infinity Unit Elastic: Slope of 1 (moderately sloped) EP = 1 Relatively INelastic: More vertical/steep EP < 1 Perfectly Inelastic: Vertical Demand EP = 0 Relatively Elastic: More Horizontal, less steep. EP > 1 - Income Elasticity o Percentage change in quantity demand divided by change in Income à Similar formula to above. à Income replaces price o Be able to calculate based on graphs o And determine the types of goods - Necessities and Luxury goods o Luxury (income elasticity >1) o Necessity 0<E<1 Cross price Elasticity - Relationship between: 1 Goods price and the other goods Quantity Chapter 9 – Comparative advantage and the Gains from International Trade Vocabulary: - Tariff: A tax imposed by a government on imports - Imports: goods and services bought domestically but produced in other countries - Exports: Goods and services produced domestically but sold in other countries. - Comparative advantage: the ability of an individual, firm or a country to produce a good or service at a lower opportunity cost than competitors - Opportunity cost: the highest valued alternative that must be given up to engage in an activity. - Absolute advantage: The ability to produce more of a good or service than competitors when using the same amount of resources - Autarky: a situation in which a country does not trade with other countries - Terms of trade: The ratio at which a country can trade its exports for imports from other countries. - External economies: reductions in a firm’s costs that result from an increase in the size of an industry - Free trade: trade between countries that is without government restrictions. - Quota: a numerical limit a government imposes on the quantity of a good that can be imported into the country - Voluntary export restraint (VER): An agreement negotiated between two countries that places a numerical limit on the quantity of a good that can be imported by one country from the other country. - World trade Organization (WTO): An international organization that oversees international trade agreements - Globalization: the process of countries becoming more open to foreign trade and investment - Protectionism: The use of trade barriers to shield domestic firms from foreign competition. - Dumping: selling a product for aa price below its cost of production. Objectives: - Discuss the role of international trade in the U.S. Economy o NAFTA: north American free trade agreement o Exports and imports of goods and services as a percentage of total production – measured by GDP – show the importance of international trade to an economy. o Differentiated: many different types of tires are produced. - Understand the difference between comparative advantage and absolute advantage in international trade à See definitions - Explain how countries gain from international trade o Countries gain from specializing in producing goods in which they have a comparative advantage and trading for goods in which other countries have a comparative advantage. o Why don’t we see complete specialization? § Not all goods and services are traded internationally § Production of most goods involves increasing opportunity costs § Tastes for products differ o Where does comparative advantage come from? § Climate and natural resources § Relative abundance of labor and capital § Technology § External economies o Once a country loses its comparative advantage in producing a good its income will be higher and its economy will be more efficient if it switches from producing the good to importing it. - Analyze the economic effects of government policies that restrict international trade. o International trade helps consumers but hurts firms that are less efficient than foreign competitors à these firms and their workers are often strong supporters of government policies that restricts trade. § Tariffs § Quotas § Voluntary export restraints o Tariffs: taxes imposed by the government on goods imported into the country § Increases the cost of selling a good. o Quota: limit on the quantity of a good that can be imported. o The U.S. economy would gain in economic surplus from the elimination of tariffs and quotas even if other countries did not reduce their tariffs and quotas - Protectionism o Saving jobs o Protecting high wages o Protecting infant industries o Protecting national security Chapter 10 – Consumer Choice and Behavioral Economics Vocabulary - Utility: The enjoyment or satisfaction people receive from consuming goods and services - Marginal Utility (MU): The change in total utility a person receives from consuming one additional unit of a good or service. - Law of diminishing marginal utility: The principle that consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time - Budget constraint: The limited amount of income available to consumers to spend on goods and services. - Income effect: the change in the quantity demanded of a good that results from the effect of a change in price on consumer purchasing power, holding all other factors constant. - Substitution effect: the Change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power. Objectives: - Define Utility and explain how consumers choose goods and services to maximize their utility o Utility can be negative o Optimal decisions are made at the margin o Rule of equal marginal utility per dollar spent § As you decide how to spend your income, buy up to the point where the last purchase gives you equal increases in utility per dollar o Conditions for maximizing Utility § MU/P (for one good) =MU/P (for another good) § Spending on one + Spending on another = amount available to be spent When price… Consumer purchasing The income effect The substitution power… causes quantity effect causes the demanded to opportunity cost of consuming a good to… Decreases, Increases Increase, if a normal Decrease when the good, and decrease if price decreases, an inferior good which causes the quantity of the good demanded to increase Increase, Decreases Decrease, if a normal Increase when the good, and increase, if price increases, an inferior good which causes the quantity of the good demanded to decrease. Chapter 11 – Technology, Production, and Costs Vocabulary - Technology: The processes a firm uses to turn inputs into outputs of goods and services. - Technological change: a change in the ability of a firm to produce a given level of output with a given quantity of inputs - Short run: The period of time during which at least one of a firm’s inputs is fixed - Long run: The period of time in which a firm can vary all its inputs, adopt new technology, and increase or decrease the size of its physical plant - Total cost: the cost of all the inputs a firm uses in production - Variable costs: costs that change as output changes. - Fixed costs: costs that remain constant as output changes - Opportunity cost: the highest-valued alternative that must be given up to engage in an activity - Explicit cost: cost that involves spending money - Implicit cost: a nonmonetary opportunity cost - Production function: the relationship between the inputs employed by a firm and the maximum output it can produce with those inputs - Average total cost: total cost divided by the quantity of output produced - Marginal product of labor: the additional output a firm produces as a result of hiring one more worker. - Law of diminishing returns: The principle that, at some point, adding more of a variable input, such as labor, to the same amount of a fixed input, such as capital, will cause the marginal product of the variable input to decline. - Average product of labor: The total output produced by a firm divided by the quantity of workers - Marginal cost: the change in a firm’s total cost from producing one more unit of good or service. - Average fixed cost: fixed cost divided by the quantity of output produced - Average variable cost: Variable cost divided by the quantity of output produced. - Long run average cost curve: a curve that shows the lowest cost at which a firm is able to produce a given quantity of output in the long run, when no inputs are fixed. - Economies of scale: The situation when a firm’s long-run average costs fall as it increases the quantity of output it produces - Constant returns to scale: The situation in which a firm’s long-run average costs remain unchanged as it increases output - Minimum efficient scale: the level of output at which all economies of scale are exhausted - Diseconomies of scale: the situation in which a firm’s long-run average costs rise as the firm increases output. Objectives: - Define technology and give examples of technological change o Inputs: workers, machines, natural resources o Technology: skills, training, speed and efficiency of machinery and equipment. o Can go backwards - Distinguish between the economic short run and the economic long run o Total cost = fixed cost + Variable cost o Economic depreciation: difference between what someone paid for their capital at the beginning of the year and what they would receive if they sold the capital at the end of the year. o Accounting costs = explicit costs o Economic costs = both accounting cost and implicit costs o Short run: time period is too short to increase or decrease costs. o The main difference between long run and short run costs is that there are no fixed factors in the long run; there are both fixed and variable factors in the short run. o Long run: general price level, contractual wages, and expectations adjust fully to the state of the economy. - Understand the relationship between the marginal product of labor and the average product of labor. o Division of labor and specialization can increase productivity o Marginal product can be negative: the level of total output declines o The average product of labor is the average of the marginal products of labor (sum of all) o The marginal product of labor = average product of labor at the quantity of workers for which the average product of labor is at its maximum. - Explain and illustrate the relationship between marginal cost and average total cost o Shape of average total cost curve is determined by the shape of the curve that shows the relationship between marginal cost and the level of production. o When the marginal product of labor is rising, the marginal cost of output is falling. o When the marginal product of labor is falling, the marginal cost of output is rising. o Marginal product of labor rises and then falls o When marginal cost is above average total cost, average total cost rises. o Marginal cost equals aver total cost when average total cost is at its lowest point. - Graph average total cost, average variable cost, average fixed costa, and marginal cost o Formulas: § ATC = TC/Q § AFC = FC/Q § AVC = VC/Q § ATC = AFC + AVC o The marginal cost, average total cost, and average variable cost curves are all “U” shaped and the marginal cost curve intersects both the average variable cost curve and the average total cost curve at their minimum points o As output increases, average fixed cost gets smaller o As output increases the difference between average total cost and the average variable cost decreases. - Understand how firms use the long-run average cost curve in their planning o There are no fixed costs in the long run. In the long run, all costs are variable. o Diseconomies of scale apply only in the long run, when the firm is free to vary all its inputs, can adopt new technology, and can vary the amount of machinery it uses and the size of its facilities. o Diseconomies of scale explain why long-run average cost curves eventually slope upward. Chapter 12 – Firms in perfectly competitive markets Vocabulary - Perfectly competitive market: a market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market - Price taker: A buyer or seller that is unable to affect the market price. - Profit: total revenue minus total cost - Marginal revenue (MR): The change in total revenue from selling one more unit of product - Sunk cost: a cost that has already been paid and cannot be recovered. - Shutdown point: The minimum point on a firm’s average variable cost curve; if the price falls below this point, the firm shuts down production in the short run - Economic profit: a firm’s revenues minus all its costs, implicit and explicit - Economic loss: the situation in which a firm’s total revenue is less than its total cost, including all implicit costs - Long-run competitive equilibrium: the situation in which the entry and exit of firms has resulted in the typical firm breaking even. - Long-run supply curve: a curve that shows the relationship in the long run between market price and the quantity supplied. - Productive efficiency: The situation in which a good or service is produced at the lowest possible cost. Allocative efficiency: A state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Objectives: - Industry characteristics: o The number of firms in the industry o The similarity of the good or service produced by the firms in the industry o The ease with which new firms can enter the industry Characteristic Perfect Monopolistic Oligopoly Monopoly Competition Competition Number of Many Many Few One Firms Type of product Identical Differentiated Identical or Unique differentiated Ease of entry High High Low Entry blocked Examples Wheat, Apples Clothing stores, Manufacturing First-class mail restaurants computers, delivery, tap manufacturing water automobiles - Explain what a perfectly competitive market is and why a perfect competitor faces a horizontal demand curve. o Price takers: consumers are price takers. o A firm in a perfectly competitive market is selling exactly the same product as many other firms – therefore it can sell as much as it wants at the current market price, but it cannot sell anything at all if it raises the price. o The demand curve for a perfectly competitive firm’s output is a horizontal line. - Explain how a firm maximizes profit in a perfectly competitive market o Profit = Total revenue – Total cost o Marginal revenue = change in total revenue / change in quantity o For a firm in a perfectly competitive market, price is equal to both average revenue and marginal revenue. o The marginal revenue curve for a perfectly competitive firm is the same as its demand curve o Optimal decisions are made at the margins o The profit maximizing level of output is where the difference between total revenue and total cost is the greatest o The profit-maximizing level of output is also where marginal revenue equals marginal cost (MC=MR) o For a firm in perfectly competitive industry P= MR therefore: P=MC - Use graphs to show a firm’s profit or loss o Profit = (P – ATC)*Q o P > ATC à Firm makes a profit o P = ATC à firm breaks even o P < ATC 00> firm experiences a loss - Explain why firms may shut down temporarily (Short Run) o Sunk costs are treated as irrelevant to short run decision making o The firm will shut down if producing would cause it to lose an amount greater than its fixed cost o Whether total revenue is greater or less than variable costs is the key to deciding whether to shut down in the short run. As long as total revenue is greater than variable costs, it should continue to produce no matter how large or small its fixed costs are. o Market supply curve can be derived by adding up the quantity that each firm is willing to supply at each price. - Explain how entry and exit ensure that perfectly competitive firms earn zero economic profit in the long run. o In the long run, unless a firm can cover all its costs, it will shut down and exit the industry o Economic profit leads to the entry of new firm § The more firms there are in the industry the further to the right o Economic losses lead to exit of firms § As long as price is above average variable cost, they will continue to produce in the short run, even when suffering losses, but in the long run, firms will exit an industry if they are unable to cover all their costs. o Long run equilibrium in a perfectly competitive market: § The long run average cost curve shows the lowest cost at which a firm is able to produce a given quantity of output in the long run. o Cycle of the market: Effect of Exit on Economic Losses § Demand for product x declines causing the market price to fall § Causing representatives in the firm to suffer a loss § Losses cause some firms to exit the industry, which causes the market supply curve to shift to the left § And raise the market price allowing the representative to break even. o Long Run Increase in demand § Temporarily increases the price and allows firms to earn economic profits § attracts new firms to enter the industry increasing supply, driving down the price and eliminating economic profit o Long-run effect of a decrease in demand § Decrease in demand temporarily decreases the price and causes firms to suffer economic losses § Which leads some firms to exit the industry, decreasing supply, driving up the price, and eliminating economic losses. o In the Long run, a perfectly competitive market will supply whatever amount of a good consumers’ demand at a price determined by the minimum point on the typical firm’s average total cost curve. o If there are economies of scale in producing a product, the average cost of producing it will fall and competition will result in its price falling as well. The price decline will lower the average cost of producing the new microwave. Competition will force the price of the microwave to fall to the level of the typical firm’s new lower average cost. à industries with downward-sloping long run supply curves are called decreasing-cost industries. - Explain how perfect competition leads to economic efficiency o Allocative efficiency § The price of a good represents the marginal benefit consumers receive from consuming the last unit of the good sold § Perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last unit § Therefore, firms produce up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Chapter 15 – Monopoly and Antitrust policy Vocabulary - Monopoly: A firm that is the only seller of a good or service that does not have a close substitute - Patent: The exclusive right to a product for a period of 20 years from the date the patent is filed with the government - Copyright: a government-granted exclusive right to produce and sell a creation - Public franchise: A government designation that a firm is the only legal provider of a good or service. - Network externalities: a situation in which the usefulness of a product increases with the number of consumers who use it. - Natural monopoly: A situation in which economies of scale are so large that one firm can supply the entire market at a lower average total cost that can two or more firms. - Market power: the ability of a firm to charge a price greater than marginal cost: - Collusion: an agreement among firms to charge the same price otherwise not to compete - Antitrust laws: Laws aimed at eliminating collusion and promoting competition among firms. - Horizontal merger: A merger between firms in the same industry - Vertical merger: a merger between firms at different stages of production of a good. Objectives: - Define Monopoly: o There are actually monopolies – provided that the substitutes are not close substitutes o True monopolies can ignore the prices other firms charge - Explain the four main reasons monopolies arise: o To have a monopoly, barriers to entering the market must by high o Barriers to entry: § Government action blocks the entry of more than one firm into a market • By granting a patent (20 years), copyright, or trademark (grants a firm legal protection against other firms using its product’s name) to an individual or a firm, giving it the exclusive right to produce a product • By granting a firm a public franchise, making it the exclusive legal provider of a good or service § One firm has control of a key resource necessary to produce a good § There are important network externalities in supplying the good or service • Network externalities can set of a virtuous cycle: if a firm can attract enough costumers initially, it can attract additional customers because the value of its product has been increased by more people using it, which attracts even more consumers and so on. § Economies of scale are so large that one firm has a natural monopoly. • One firm can supply the entire market at a lower average total cost than can two or more firms (only room in the market for one firm) • Natural monopolies are most likely to occur in markets where fixed costs are very large relative to variable costs. - Explain how a monopoly chooses price and output o Monopoly maximizes profit by producing where marginal revenue equals marginal cost o Monopoly’s demand curve is the same as the market demand curve for the product o Firms in a perfectly competitive markets face horizontal demand curves § Price takers o All other firms (including monopolies) are Price makers – if they raise their prices, they will lose some, but not all of their customers. *both a downward sloping demand curve and a downward sloping marginal revenue curve o When a firm cuts the price of a product: § It sells more units of the product; it receives less revenue from each unit than it would have received at a higher price. - Formulas: o Total Revenue = Price * Quantity o Average Revenue = Total Revenue /Quantity o Marginal Revenue = Change in Total Revenue/Change in Quantity - Use Graphs to illustrate how a monopoly affects economic efficiency o Equilibrium in a perfectly competitive market results in the greatest amount of economic surplus, or total benefit to society, from the production of a good or service o A monopoly will produce less and charge a higher price than would be a perfectly competitive industry producing the same good o Effects of monopoly: § Causes a reduction in consumer surplus § Causes an increase in producer surplus § Deadweight loss which represents a reduction in economic efficiency. o Because few markets are perfectly competitive, some loss of economic efficiency occurs in the market for nearly every good or service - Discuss government policies toward monopolies o Anti Trust laws § Sherman act (1890): Prohibited “restraint of trade” including price fixing and collusion. Also outlawed monopolization. § Clayton Act (1914): Prohibited rims from buying stock in competitors and from having directors serve on the boards of competing firms. § Federal Trade Commission act (1914): Established the Federal Trade commission (FTC) to help administer antitrust laws § Robinson-Patman Act (1936): Prohibited firms from charging buyers different prices if the result would reduce competition § Cellar-Kefauver Act (1950): Toughened restrictions on mergers by prohibiting any mergers that would reduce competition. o FTC and Merger Guidelines: § Market definition • All firms making products that consumers view as close substitutes § Measure of concentration • Concentrated if a relatively small nuber of firms have a large share of total sales in the market. • Herfindahl Hirschman Index (HHI): Sum of the (market share of each firm^2) § Merger standards • Postmerger HHI below 1,500: markets are not concentrated so mergers are not challenged • Postmerger HHI between 1,500 and 2,500: moderately concentrated. Mergers that raise the HHI by fewer than 100 points probably will not be challenged. May be challenged if they raise the HHI by more than 100 points. • Postmerger HHI above 2,500: highly concentrated. Mergers that increase the HHI by fewer than 100 points will not be challenged, 100 – 200 points may be challenged, more than 200 points will likely be challenged § Regulatory commissions usually set the prices for natural monopolies, such as firms selling natural gas or electricity.
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