Principles of Microeconomics
Principles of Microeconomics ECON 101
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Economics 101 Fall 2004 Practice Questions 8 Topics Covered Perfect Competition and Monopoly 1 Which of the following statements about perfect competition is false in the short run the number of rms in the industry is xed all rms in the industry produce a standardized product each rm chooses the price at which it will sell its output for each rm marginal revenue is the same as the market price there are no signi cant barriers to entry or exit in the long run that is rms are free to enter or exit this perfectly competitive industry in the long run Answer C In perfect competition rms are price takers taking the market price as the price they can sell their identical standardized product for In the short run there is a xed number of rms no entry or exit in the short run and in the long run rms are free to enter or exit the industry warmr 2 For a competitive rm pro t per unit of output is equal to a P 7 ATC b MC 7 ATC c TR 7 TC d P 7 AVC e MR 7 MC Answer A Pro t per unit of output is simply the difference between the price the rm sells the good for minus the cost per unit of output the ATC Answer B is also correct since for a perfectly competitive rm they produce that quantity where MR MC and since MR P therefore MC P as well 3 In a competitive industry a rightward shift of the market demand curve will cause a positive economic pro t for each rm in the long run b negative economic pro t for each rm in the long run c positive economic pro t for each rm in the short run and entry into the industry in the long run positive economic pro t for each rm in the short run and exit from ths industry in the long run negative economic pro t for each rm in the short run and entry into the industry in the long run Answer C The rightward shift in the market demand curve raises the equilibrium price in the industry and results in short run positive economic pro t In the long run new rms will enter the industry resulting in a rightward shift of the market supply curve a decrease in the equilibrium price 4 When a restaurant stays open for lunch service even though few customers patronize the restaurant for lunch which of the following principles is best demonstrated i xed costs are sunk in the short run 3 1 D in the short run only xed costs are important to the decision to stay open for lunch if revenue exceeds variable cost the restaurant owner is making a good decision to remain open for lunch ii39 a iii is the only correct statement b i and ii are the only correct statements c ii and iii are all correct statements d i and iii are the only correct statements Answer D Fixed costs are sunk in the short run you can t do anything about them and so as long as the restaurant covers their variable cost it is worth being open iii 5 Which of these curves is the competitive rm s supply curve The AVC curve above the MC curve The ATC curve above the MC curve The MC curve above the AVC curve The AFC curve Answer C Check your class notes 6 The exit of existing rms in the long run from a competitive market will 9 0quotm a decrease market supply and increase market prices b decrease market demand and decrease market prices c increase market supply and increase market prices d increase market supply and decrease market prices Answer A When rms exit the industry in the long run this causes the market supply curve to shift to the left which results in the equilibrium market price increasing for a given demand curve 7 When a single rm can supply a product to an entire market at a smaller cost than could two or more rms the industry is called an a oligopoly b exclusive industry c duopoly d government monopoly e natural monopoly Answer EThis is the de nition of a natural monopoly For a monopolist the pro t maximizing output it that output where average revenue is equal to average total cost average revenue is equal to marginal cost marginal revenue is equal to marginal cost total revenue is equal to marginal cost Answer C All pro t maximizing rms nd that their pro t is maximized when they produce that level of output where MR MC 9 A monopolist s marginal revenue is less than price because 996 a In order for the monopolist to sell additional units of the good the price charged on all units must decrease b With the sale of an additional unit the monopolist receives less revenue for each of the previous units it planned to sell c Price is higher than average revenue d Price is lower than average revenue e both answers a and b are correct Answer A Since the monopolist faces the entire market demand curve the monopolist can sell additional units of the good only by dropping the price on all the units of the good they wish to sell 10 For a monopolist rm the average revenue curve starts at the same point on the vertical aXis as the marginal revenue curve is downward sloping in the same as the demand curve only answers a and b are correct e Answersa b and c are all correct Answer E The demand curve is the average revenue curve for the monopolist and it is downward sloping and does share the yintercept with the marginal revenue curve 999 This handout is meant to supplement your notes from lecture and section There is no material here that should not already be in your notebook Some of the material from lecture has been omitted This is meant to be an outline only You will note that no examples are given and no problems are worked In order to do well on the exam you will need to review your lecture notes your section notes and the appropriate material from the book In addition it is necessary to work practice problems This handout should help you focus on major course ideas and ll in some items you may have omitted from your notebook Good luck Introductory Material Positive statement 7 an objective or factual statement Statements of this type can be shown to be true or proven to be false Normative statements 7 subjective or opinion statements These statements are about what should be They are not testable PPF Onnortunitv costs and A J in 39 quot Production Possibilities Frontier PPF 7 a method for modeling scarcity choice and opportunity cost It is a visual depiction of the trade off between consumption or production of two goods Any bundle of goods on the PPF is said to be a result of productive ef ciency That is no more or either good could be produced without producing less of the other good Points below the PPF are said to be inef cient More of one or both goods could be produced with the same inputs Points above the PPF are unobtainable These bundles cannot be produced with the gives inputs Properties of the PPF Downward sloping 7 more of one good is only possible with less of the other goods Bowed outward 7 the specialization of resources in the production of the goods results in the PPF being curve Slope of the PPF 7 the absolute value of the slope of the PPF is the opportunity cost of the good represented on the x7axis in terms of the good on the y7axis Growth in an economy results in the PPF moving away from the origin This expands the set of feasible bundles that can be produced and results in the economy being able to produce more of both goods Opportunity cost 7 production or consumption forgone when we make decisions to produce or consume something else Absolute advantage 7 when a country person has greater productivity than another country person in the production of all goods Productivity 7 amount of output produced per unit of input used to produce it labor productivity total output of units of labor used Comparative advantage 7 exists when a country person can produce a good at a lower opportunity cost than anyone else Economic Systems Traditional or barter Planned or command economies Market economies 7 characterized by property rights and are demand and supply driven Demand The law of demand 7 holding everything else constant the quantity of a good or service demanded is an inverse function of its price The demand curve equation QD aP b where a b are constants with a lt 0 gives the relationship between the quantity demanded and the own price of the good For a change in the own price of a good the demand curve does not shift We say that the change in own price causes a movement along the demand curve Changes in the price of related goods cause the demand curve to shift We identify two relationships between goods that cause demand curves to shift Each is discussed below Complements 7 good that are consumed together Consider good A and good B A s complement If the price of good B rises the demand curve for good A shifts to the left To see why this is true note that the individual s income has not changed The price of B rises and as B is a normal good less will be consumed As the individual liked to consume goods A and B together when his consumption of good B decreases he will also want to consume less of good A Thus the demand curve of good A shifts to the left Substitutes 7 good that are consumed for similar reasons Consider good A and good B A s substitute If the price of good B rises the demand curve for good A shifts to the right To see why this is true note that the price ofB rises and as B is a normal good less will be consumed As the individual liked to consume either good A or B when his consumption of good B decreases he will want to consume more of good A Thus the demand curve of good A shifts to the right Changes in income also shift the demand curve We have identi ed two categories of goods whose demand is affected by changes in income Each is discussed below Normal goods 7 goods that are consumed at greater quantities as income rises For an increase in income the demand curve for a normal good shifts to the right People consume a greater amount of a normal good at all prices as their incomes rise Inferior goods 7 goods that are consumed at decreasing quantities and income rises For and increase in income the demand curve for an inferior good shifts to the left People consume a smaller amount of a normal good at every price as their income rises It should also be noted that changes in population and changes in preferences can shift a demand curve Increases in population tend to shift the demand curve to the right A greater number of people tends to mean that more of a good is demanded Since the aggregate demand curve is a summation of individual demand curves an increase in the number of people must shift the aggregate demand curve to the right Changes in preferences or taste also shift the demand curve An increase in the popularity of a good indicates that more of the good is demanded at every price Thus the demand curve shifts to the right for an increase in popularity of a good The market demand curve is the horizontal summation of the individuals demand curves Supply The law of supply 7 holding all other variables constant the quantity of a good or service supplied is usually a positive function of its own price exceptions Totally inelastic supply curve 7 no matter what the price the same amount is supplied Decreasing cost industry 7 it is less expensive to produce a larger amount of the good or service Backward bending supply curve 7 this maybe a feature of the labor supply curve The supply curve equation Qs aP b where a b are constants with a gt 0 gives the relationship between the quantity supplied to the market by producers and the own price of the good For a change in the own price of a good the supply curve does not shift We say that for a change in own price there is movement along the supply curve A changes in the price of a factor of production and a change in technology cause the supply curve to shift Each shift is discussed below Change in the price of a factor of production 7 increases in the price of factors of production cause the supply curve to shift to the left The supply curve contains information about the cost of producing the good For an increase in the in the cost of manufacturing the good it is intuitive that the rm would need to receive a higher price for each unit it sold in order to cover the higher costs Thus for an increase in the price of factors of production the supply curve shifts to the left indicating fewer units supplied at every price Change in technology 7 an increase in the level of technology shifts the supply curve to the right Economists think of an increase in technology as a change in the production process This change allows more output be manufactured for any level of inputs used Manufactures will supply more of the good at every price as it is easier to produce good after an increase in technology This is modeled as a rightward shift in the supply curve Two relationships between goods are singled out for their ability to cause shifts in the supply curve The two relationships we consider in detail are complements and substitutes in production Each is discussed below It should be noted that not all goods share one of these relationships with another good Substitutes in production 7 goods for which producing more of one requires producing less of the other Consider good A and good B A s substitute in production If the price of good B rises then the supply cure for good A must shift to the left To see why this is true recall that if the price of good B rises and the supply curve has not shifted the demand curve must have shifted to the right This results in the price of B being higher and a greater quantity demanded In order for the producer to meet the higher demand he must produce less of good A at every price Thus the supply curve for good A shifts to the left To be sure that you understand substitutes in production work the example for a decrease in the price of good B Complements in production 7 pairs of goods that must be produced together Consider good A and good B A s complement in production Ifthe price of good B rises then the supply curve for good A must shift to the right To see why this is true recall that is the price of good B rises and the supply curve has not shifted the demand curve must have shifted to the right This results in the price of B being higher and a greater quantity demanded In order for the producer to meet the higher demand he must produce more of good A at every price Thus the supply curve for good A shifts to the right To be sure that you A J 11b titnte in r J quot work the example for a decrease in the price of good B Other events that were said to shift the supply curve for some goods were weather and the number of firms Weather was pointed out for its critical role in the production of agricultural products Since weather affects the final amount agricultural products that can be grown it affects supply We think of good weather as shifting the supply curve to the right and bad weather as shifting the supply curve to the left The number of firms in a given industry was also noted for shifting the aggregate supply curve If we think of all rms wanting to supply the same amount of goods at each price it is easy to see that more rms will result in more being supplied at every price This is the result of the ability to do a horizontal summation of rms supply curves More rms indicate more supplied at every price and thus a rightward shift in the supply curve E uilibrium Equilibrium 7 where the price equates the quantity supplied and the quantity demanded At the equilibrium price the amount producers want to supply is just equal to the amount the consumers want to purchase There are three methods for nding the equilibrium If presented with a chart the equilibrium is the price at which the supply quantity equals the demand quantity If a graph is given equilibrium occurs at the intersection of the supply and demand curves If equations for supply and demand are given the equilibrium price can be found by setting QD Qs and solving for P The equilibrium quantity is then found by substituting the equilibrium price into the demand or supply equation Consumer Surplus 7 the difference between the value of the good and its price Graphically consumer surplus corresponds to the area between the demand curve and the equilibrium price Producer Surplus 7 the difference between producer revenue and the opportunity cost of production Generally this corresponds to the area that is above the supply curve and below the equilibrium price Intervention in Markets The government may choose to intervene in markets in order to produce some desired outcome The government often institutes programs to keep prices arti cially above or below what they would be in equilibrium These programs often result in outcomes other than that which was intended Below is a brief description of some of the ways the government might intervene in markets The majority of these programs are applied to agricultural markets Price ceiling 7 a price set by the government that cannot be exceeded If the price ceiling is set above the equilibrium price then the program has no effect on the market If the price ceiling is set below the equilibrium price then there will be excess demand Consumers will demand more of the good at the price ceiling price than producers want to supply Price oor 7 a price set by the government that cannot be undercut If the price oor is set below the equilibrium price then it has no effect on the market If the price oor is set above the equilibrium price then there will be excess supply Producers will want to supply more to the market than consumers want to purchase at the price oor price Price supp011 7 a price set by that government that it guarantees by offering to purchase an unlimited quantity of the good at the speci ed price If the price support is set below the equilibrium price the market is unaffected If the price support is set above the market price then producers supply more to the market than consumers want to purchase The government purchases all of the excess supply at the specified price Price guarantee program or subsidy program 7 the government guarantees a price producers will receive for each unit sold in the market The government enforces this price by paying the difference between the market price and the guaranteed price to producers for each unit they sell Excise Taxes Excise tax 7 a per unit tax paid by the producer of the good An excise tax shifts the supply curve up by the amount of the tax Legal incidence of a tax 7those having legal responsibility for paying a tax The legal incident of an excise tax falls on the producer of the good The producer is responsible for making sure that the tax is paid Net price 7 the per unit revenue the firm receives once the tax has been paid Net price is the equilibrium price with the tax minus the amount of the tax Net Price PET Tax Tax Revenue 7 the total amount of tax collected in dollars The amount of tax collected is equal to the amount of the tax multiplied by the after tax equilibrium quantity Tax Revenue Tax QET Economic Incidence refers to those having the economic burden of the tax The economic incidence may fall on consumers r J or both and J r Consumer tax incidence 7 the portion of the tax that the consumer is forced to pay through higher prices and lower quantities This is the portion of the tax revenue that before the tax was consumer surplus The consumer tax incidence can be calculated as the difference between the equilibrium price with tax and the equilibrium price before the tax multiplied by the equilibrium quantity after the tax Consumer tax incidence PET PE QET Producer tax incidence 7 the portion of the taX that the producer pays as the result of reduced quantities sold It is the p01tion of the taX revenue that was producer surplus prior to the taX The producer taX incidence can be calculated as the difference between the equilibrium price before the taX and the net price multiplied by the equilibrium quantity after the taX Producer taX incidence PE NetPrice QET It should be noted that the consumer and producer taX incidence sum to equal the taX revenue Dead Weight Loss 7 a measure of the allocative inefficiency caused by a taX It is the surplus that is lost due to the implementation of the taX Although the consumer and producer taX incidence is taken from their surpluses it is not lost as the government receives it The dead weight loss can be calculated as one half of the difference between the before and after tax equilibrium prices multiplied by the size of the taX Dead Weight Loss 12 TaXQE QET Elasticity Elasticity 7 measures the responsiveness of one variable to changes in another related variable using percentage changes Price elasticity of demand 7 measures the percentage change in the quantity demanded for a percentage change in price It is a negative demand since as price increases quantity decreases Arc elasticity of demand indicates the percentage change in demand for a 1 percent change in the price between two points on the demand curve An expression for the elasticity of demand is 8D 7 A 9 AP inl where AQD the percentage change in demand Q 1 2L 2 MJ and AP the percentage change in price Pz P L 2 for two points Q1 P1 and Q2 P2 on the demand curve Through some simple algebraic manipulation the formula reduces to 8D QQn Elf Pf Q2Q1P2 P1 This formula is for the arc elasticity of demand For linear demand curves we can also calculate the elasticity of demand for a single point or the point elasticity of demand using the formula 8D 7 lSlope P Q We de ne three special cases of elasticity We say demand as elastic inelastic or describe it as having unit elasticity depending on the size of 8D Elastic 7 when in absolute value terms the percentage change in quantity demanded is greater than the percentage change in the price The value of the elasticity of demand in this case is less than 71 SD lt l A horizontal demand curve is perfectly elastic Inelastic 7 when in absolute value terms the percentage change in quantity demanded is smaller than the percentage change in the price The value of the elasticity of demand in this case is between 0 and 7l 0 gt SD gt 1 A vertical demand curve is perfectly inelastic Unit Elastic 7 when in absolute value terms the percentage change in quantity demanded is equal to the percentage change in the price SD l Determinants of the elasticity of demand 1 Substitutability of other goods a Narrowness of the definition of the good b Availability of substitutes depends on tastes c Time horizon 2 Importance of the item in the budget Cross Price Elasticity this is the percentage change in the quantity demanded of good A divided by the percentage change in the price of good B When this measure is positive this indicates that goods A and B are substitutes When this measure is negative this indicates that goods A and B are complements Income Elasticity this is the percentage change in the quantity demanded of good A divided by the percentage change in income When this measure is negative this indicates that good A is an inferior good When this measure is positive this indicates that good A is a normal good Supply Elasticity this is the percentage change in the quantity supplied divided by the percentage change in the price of the good lThe Classical Model I Model of out ut determination and econom The ClassIcal Model wideequmbr lm y I Can be used to study economic growth and business cycles I Considered a more complete description of the Chapter 7 longrun than the shortrun Lecture notes posted online l Key Building Blocks l Key Building Blocks I Closed economy no exports and imports I Populated by two types of agents in Households I Agents interact in three markets in Goods Market GM u Loanable Funds Market LFM u Firms in Labor Market LM I Later will also add government I Markets are competitive in Like in Econ 101 demand and supply determine the equilibrium outcome lAgents and Markets in Classical Model Markets Gm warm I Goods market is where firms sell their output to EDD grinds households consumption goods and other firms investment goods mm L m d Wigwam F I Loa nable funds market is where household save a Fu lm vs Hmmlds WEN n 5 funds for Interest and fIrms seek funds to finance investment projects I Labor market is where households offer labor labur labur and firms hire them to produce goods Labur Market l Households I Recipients of all factor payments by firms income I Make two important decisions in Given income decide how much to save S and consume C u Given time endowment decide how much labor to supply to the market and how much leisure to consume l Firms I Produce output using capital machines and labor people I Make two important decisions in How much labor to employ in How much to invest in new machines that will result in more capital in the future l SavingsConsumption Decision of HH I Will assume households decide to save a constant fraction oftheir income SsY u Implies consumption is also a constant fraction of income CYS1sY in Example s13 if income is 150 S50 consumption is CYS113150100 l Implied Supply of Savings I Supply of savings by households as function of interest rate return on savings lnte rest rate sY Savings lLaborLeisure Choice of HH I Assume households supply 1 unit of labor each and so supply of labor simply equals population size L Supply of Labor I Supply of labor by households as a function of real wage real compensation of labor Real Wage L Labur l Production in Firms I Produce output using capital machines K and labor people L in Production summarized is by a production function in Example Y IE Assumed properties ofthe production function u Output increasing in labor and capital in Diminishing returns from labor and capital El Returns to scale are constant Properties of Production Function I Increasing in labor and capital in Add labor or capital 9 output will increase I Diminishing returns from labor and capital in Add labor while keeping capital fixed 9 output increases but increments smaller and smaller as you keep adding more and more labor I Returns to scale are constant 9 production process is replicable double labor and capital and output will exactly double Diminishing Returns From Labor Fix capital K10 for example Output Tl my Labur L Same change if labur Diminishing Returns From Capital Fix labor L1o for example Output Tiny Capital k Same change if capital Demand for Labor I Diminishing returns from labor 9 demand for labor decreasing function of real wage in Given a fixed level of capital K each incremental worker adds less and less to production I Cost of hiring a worker increases 9 firms are willing to hire fewer workers Demand for Labor I Demand for labor fora fixed level of capital K Realvvage WF bur demand Labur panda l Demand for Labor I Increase in capital K shifts labor demand Real Wage WF39 Labur penple l Demand for Investment Funds I Diminishing returns from capital 9 demand for investment decreasing function of interest rate I Given a fixed level of labor L each incremental unit of capital adds less and less to production I Cost of funds increases 9 firms want to invest less l Demand for Investment Funds I Demand for funds for a fixed level of labor Interest Rate Demand fur mere machines Number er Machines l Demand for Investment Funds I Increase in labor force herepopulation shifts demand for investment Interest Rate Demand fur mere maemnes Number er machines Recap I So far determined demand and supply in u Labor market I Loanable funds market I Now need to answer what will be the outcome in the entire economy What is Going to Happen I Equilibrium ofa system is a state ofthe system in which there are no internal forces in the system to produce a change We Is not an equilibrium ans Is an equilibrium MW l What is Going to Happen I Equilibrium in this model is when all markets clear ll Demand for labor supply of labor ll Demand for investment supply of funds ll All output gets sold ie planned consumption and planned investment equals output CIY l Equilibrium Employment L I Labor market equilibrium determines L Realwage Labursupply L WF Laburdemand L Labor peuple Equilibrium Output Y I Y determined by L capital K predetermined OW Pmductlunfunctlun atflxed level at k l Labur l people Rea wage Labursupply L WF39 Laburdemand Labor peuple Equilibrium Planned Investmentl I Loanable funds market determines investment I interest Rate emarld fur lrlvestrnerltl investment Say s Law Spending Purchases Output I In the classical model all output gets sold automatically and so CIY I We do not need to worry about the goods market ll Follows from a simple accounting identity implied by the circular flows l Circular Flows in the Classical Model a Goods market 927 l 39 3 Ems w eh quotc WI 7 NW 0 was m we a mamI lme em s1m Households 5 Luanable Funds Pluecls Fm y eman l Mama lulFurlds ppv ulFunds h bm w 9 6 Labor M arke t l Say s Law Outflows Inflows l Say s Law Outflows Inflows I I Y flows from firms to households by definition ava wvw ngmt M I On the expenditure side 5 9w ii S flows out r 6 If Hug ehuy ds Savi EESHVdS Luaaa ELZiEynus Filmsr u ows in w 6 ii Since In equilibrium in the loanable funds 5 market S outflows inflows and so C Y we LabDrM39ark t What Happens to Capital K What Happens to Capital K I Today s K predetermined but future K evolves I Our equilibrium is a static equilibrium with investment ii Given capital we pin down investment ii Capital tomorrow capital today employment and output dePI39EClatlon 0f capital anEStment I It raises questions wherethe economy is heading in the future K 1767K I WWW may ii Will make capital part of our analysis soon I Where 5 is depreciation rate of capital fraction of capital worn out in production Adding Government to the Model Adding Government to the Model I Key assumptions ii Government takes away net taxes Tfrom households factor income Yand spends G in the goods market on goods and services l Key Modifications l Budget Deficit and Surplus I Government savings TG or deficit if negative I Budget deficit is a situation when government affects the loanable funds mar et spending exceeds net tax receipts GTgt0 in When TGgt0 governments saves and supplies in Government borrows in the loanable funds funds to the LF market market in When TGlt0 government borrows from the I Budget surplus is a situation when government private sector and takes away funds from LF net tax receipts exceeds spending TGgt0 markEt in Government saves in the loanable funds I Households after tax income is Y T market l Modified Loanable Funds Market Say s Law Holds with Government STVG merest Rate private savings gsuavve gngrsnfnt I Again think in terms of inflows and outflows E i Y flows from firms to households u S and Tflows out n and G flows in TuftEaIrlEuenmdasnd u STG in equilibrium in loanable funds market Wfs frgg by I So again what flows out ST flows in as G and pnva mw so CIGY l 5 T S D a 5 u Algebraically CIGCSTGGCSTY ST GI Say s Law Holds Red Green Numerical Example I Suppose G0 T0 s2 L10 K10 and YK1ZL1Z calculate output and investment in the equilibrium of the classical mo el I Assume depreciation rate of capital 10 10 of capital stock wears out each period due to aging What will bethe level of capital next period Households PW I Is it more or less than today lSqution I YK1ZL1Z10 SsYT2x102 d In equilibrium STG and so 2 I K tomorrow 9K today 2 9x10211 I 11gt10 K is growing in K today 10 d K tomorrow 11 Dynamic Long run Equilibrium Dynamic Equilibrium I So far silent about K d Given predetermined capital K determined output investment and employment d In other words determined static equilibrium within a periodbut not dynamic across periods I Our goal Find out where the economy is heading in the future l Basic Idea I Future output investment and employment depends on today s investment I Evolution of capital from one period to the next critical to determine where the economy is heading Evolution of Capital I Recall our assumption Kmmmy l1 5lK I taday I IMPLIES Future capital depends how investment I compares to depreciation 6K K 1 K IK tomorrow today today 7 5Ktoday l I 7 K I 7 5 K and 50 K today today tom arrow Evolution of Capital Ktomorrow Ktoday I I The above equation implies in Igt 6Knmy 9 capital K grows d K 6Knmy 9 capital Kfulls u I 6Knmy 9 capital K remains unchanged Finding Out Where Economy Is Heading L fixed pppuiatipn SiZE aivvays true in statie Equiiibrium Output determined untiuri tunetipn arid eapitai K Capitai K Finding Out Where Economy Is Heading Output v investment sY Cunstant traetiun pt uutput Capitai K Finding Out Where Economy Is Heading OutputY investment sY Cunstant traetiun pt uutput Capitai K Finding Out Where Economy Is Heading Capitai Depreciatiun eK A straignt iine Output Y investment SY Capitai K Finding Out Where Economy Is Heading Capitai Depreciatiun eK OutputY investment sY inveetmemmepregiatipn investmentltDepreeiatipn Capitai K Capitaiincreases Capitaitaiis Over time Him Finding Out Where Economy Is Heading Capitai Depreciatiun eK Output Y investment sY investmeneoepreciatipri iWESWEnkDEWSEig qn A E Capitai K Capitai increases Capitai taiis Over time r iim Finding Out Where Economy ls Heading Capital Debreeiatibn 6K OutputY investment sY lnvestmentiDepreciatlun lnvestmenkDepreciatiun39 A E Capital K Capital inereases Dvnarnie Capital falls aver tirne n PrlimP Pmiilihrium i What Is Dynamic Equilibrium I Recall Given predetermined level of capital K static equilibrium is employment output and investment such that all three market are in equilibrium I Dynamic equilibrium isthe level of capital K such that in the underlying static equilibrium investment I depreciation of capital 6K Key Properties of Dynamic Equilibrium I Dynamic equilibrium is an equilibrium as there are no internal forces to produce a change in You start there you stay there forever I But it is also a stable equilibrium in No matterwhere you start internal forces bring you back to this this point Stable Equilibrium I Stable equilibrium ofa system is an equilibrium such that the system automatically returns to it if disturbed This is not a stable equilibrium the ball falls it disturbed This is a stable equilibrium the ball autumatically returns it disturbed M Numerical Example Continued I Suppose G0 T0 s2 L10 K10 and YzKlZLlZ u Assuming depreciation rate of capital 10 find the dynamic equilibrium Solution I Need to find K such that in the underlying static equilibrium 5K I In any static equilibrium L10 sYTTG 2K12L122K121012 n Thus need K such that 2K12101Z5K I Calculating we obtain K40 u HINT Divide both sides af by the square root afK and then raise both sides to the square Compute K Market for Refurbished Washing Machines Each person demands a washing machine at the price next to their name Jose 700 Richard 600 Amy 500 Anthony 400 Nathan 300 Darrell 200 Geoffrey 100 Each person is willing to supply a washing machine at the price next to their name Susan 100 Betty 200 Cathy 300 Darva 400 Emily 500 Francis 600 Germaine 700 The market equilibrium is shown in the following gure P 700 400 100 At the equilibrium 0 Consumer Surplus CS is 600 0 Jose s CS is 300 0 Richards CS is 200 0 Amy s CS iS 100 0 Producer Surplus PS is 600 0 Susan s PS is 300 0 Betty s PS is 200 0 Cathy s PS is 100 0 Total Welfare TWCSPS1200 Example 1 Consider a price ceiling of 200 At this price producers will only be willing to supply 2 washing machines but consumers will demand 5 700 400 200 100 Assuming that only the consumers with the highest valuations get to buy refurbished wash machines 0 CS is 900 0 Jose s CS is 500 0 Richards CS is 400 0 PS is 100 All ofthe PS is Susan s o TW is 1000 Comparing the TW at the equilibrium and at the price ceiling we see that the deadweight loss resulting form the price ceiling is 200 This deadweight loss results from the fact the quantity is too low under the price ceiling The point I was trying to make in lecture is that this sort of deadweight loss understates the efficiency loss due the price ceiling for several reasons 1 N E 4 Under the price ceiling there is a potential for an inefficient allocation of buyers When we calculated a deadweight loss of 200 we assumed that both Jose and Richard were allowed to purchase washing machines Assuming that Jose and Richard purchase washing machines under the price oor is assuming an efficient allocation of buyers as they are the two people with who most want to washing machines Alternatively we could allow Nathan and Darrel to purchase washing machines If Nathan and Darrel purchased the washing machines that come to market under the price ceiling consumer surplus will only be 100 all from Nathan rather than the 900 calculated above and deadweight loss will be 1000 The consumers might have to get up early and spend some time waiting in line for the right to buy a refurbished washing machine at the price of 200 Susan and Betty the two people willing to supply washing machines at a price of 200 might start doing a crummy job with their refurbishing because they get the same price for a good refurbished washing machine as they do for a crummy one We could have unregulated black markets develop as consumers who were not able to buy washing machines at the ceiling price of 200 try to get washing machines at high prices Example 2 Consider a price oor of 600 At this price producers will be willing to supply 5 washing machines but consumers will only demand 2 700 600 400 100 Assuming that only the producers with the lowest opportunity cost get to sell refurbished wash machines 0 CS is 100 All from Jose 0 PS is 900 0 Susan s PS is 500 0 Betty s PS is 400 0 TW is 1000 Comparing the TW at the equilibrium and at the price oor we see that the deadweight loss resulting form the price oor is 200 This deadweight loss results from the fact the quantity is too low under the price oor This deadweight loss calculation understates the efficiency loss due the price oor for several reasons 1 N E 4 Under the price ceiling there is a potential for an inefficient allocation of sellers When we calculated a deadweight loss of 200 we assumed that both Susan and Betty were allowed to sell washing machines Assuming that Susan and Betty sell washing machines under the price oor is assuming an ef cient allocation of sellers as they are the two people with the lowest opportunity cost of refurbishing washing machines Alternatively we could allow Francis and Emily to sell washing machines If Francis and Emily sold the washing machines that come to market under the price oor producer surplus will only be 100 all from Emily rather than the 900 calculated above and deadweight loss will be 1000 Wasted resources resulting form the surplus a One approach to dealing with the problem of surplus is for the government to purchase the surplus and dispose of it To do this the government would have to buy 3 washing machines at a price of 600 each for a total of 1800 but only 600 of the 1800 will go toward higher producer surplus ie the government buys washing machines from Cathy Darva and Emily but it only increases PS by 600 If the government doesn t buy the surplus then there is wasted time and effort as Cathy Darva and Emily seek buyers for their washing machines Under this sort of policy and assuming that the sellers with the lowest opportunity cost get to sell in the market or get their surplus purchased by the government 39 CS is 100 All from Jose i PS is 1500 from all sellers but Francis and Germaine iii Government Expenditures are 1800 iv Total welfare is 200 The sellers might start offering quality to that consumers don t value highly because they cannot compete on price Corruption and illegal activity as the sellers via for the right to sell at the price oor price or sell at lower prices in a black market