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Fundamentals of Economics

by: Grayce Heidenreich

Fundamentals of Economics EC 205

Marketplace > North Carolina State University > Economcs > EC 205 > Fundamentals of Economics
Grayce Heidenreich
GPA 3.84

A. Marten

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This 65 page Class Notes was uploaded by Grayce Heidenreich on Thursday October 15, 2015. The Class Notes belongs to EC 205 at North Carolina State University taught by A. Marten in Fall. Since its upload, it has received 13 views. For similar materials see /class/223920/ec-205-north-carolina-state-university in Economcs at North Carolina State University.

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Date Created: 10/15/15
Chapter 12 Lecture Notes November 5 2006 I Monopoly A Single seller in the market B Charges higher prices and produces less output than a competitive firm C Singleprice monopolist charges the same price to all customers 1 Just like all firms a monopoly acts to maXimize its profits a Instead of finding the optimal quantity the monopoly must determine the optimal price 2 A competitive firms faces a horizontal demand curve a They are price takers their output level cannot influence the market price b It can sell the neXt unit for the same price it sold the previous unit i Therefore if it doubles its output it will double its revenue P laE A COMPETITIVE FIRM mg B MONOPOLY Marginal revenue curve Demand curve QUANTITY 0 QUANTITY 0 3 A monopoly faces the entire market demand curve since they are the only seller in the market a The market demand curve is downward sloping so in order to increase the quantity sold the firm must lower its price b For linear demand curves the monopolist39s marginal revenue curve is twice as steep as the demand curve with the same vertical intercept PRICE p PWCEW P1 Demand curve MR1 Marginal revenue curve O1 QUANTITY 0 c Like all profit maximizing firms the monopoly will produce an extra unit of output if marginal revenue is greater than marginal cost MR gt MC i It stops producing when MR MC d Monopoly profits total revenue total costs TR TC i As discussed in chapter 7 the distance between TR and TC is maximized at the point where their slopes are equal marginal revenue MR and marginal cost MC respectively REVENUES COSTS 30000 28000 24000 20000 QUANTITY ii At this point the curves are not moving farther apart or closer together iii Output decision of competitive firm vs monopoly A Competitive firm Marginal cost curve Competitive price p Average cost curve Marginal revenue curve 0 QUANTITY Q B Monopoly Monggiog pm Marginal cost curve Lu 0 E D Average cost curve Demand curve Qm QUANTITY Q 4 Inefficiency of monopolies a As has been discussed price is greater than MR for monopolies b The price is what consumers are willing to pay for an additional unit it measures the marginal benefit of the additional unit to the consumer c For a competitive market the price or marginal benefit to the consumer is equal to marginal cost of producing that additional unit i Which from our marginal analysis discussions is optimal d For a monopoly the price or marginal benefit to the consumer is greater than the marginal cost of producing that additional unit i This is the fundamental reason for why monopolies reduce economic efficiency ii The extent of this inefficiency depends on the magnitude of the difference between MR and price which depends on the shape of the demand curve e Elasticity and price markup i Remember the price elasticity of demand describes the shape of the demand curve ii The more elastic the demand curve the lower the markup A Very elastic demand Less elastic demand Market demand JE ETSL pm curve Marginal A A cost curve 3 Pm E a p 239 a p I D D c Demand curve Marginal revenue curve Marginal revenue curve Qm QC Qm QC QUANTIW Q QUANTITY Q iii Remember a firm in a competitive market faces an infinitely elastic demand curve horizontal so there is no markup f The higher prices result in a reduction of consumer surplus the lower quantity exchanged results in deadweight loss g The market power held by the monopolies allows them to earn higher profits since they can increase the price by reducing the quantity produced i These extra profits are known as monopoly rents D Price discrimination 1 Price discrimination exists when a monopoly charges different consumers different prices 2 For this technique to work there must exist no trade opportunities between the different groups of consumers 3 Monopolies will engage in such techniques in order to exploit the fact that different groups may have different demand curves Ex Consider a monopoly who operates in both the United States and Japan If the demand for the good is higher in Japan and there are no trade opportunities the price charged in Japan will be higher mg UNITED STATES Marginal cost curve p Demand curve Marginal revenue curve 01 QUANTITY 0 PRICE P JAPAN Marginal COSt curve Demand curve Marginal revenue curve 02 QUANTITY 0 4 The firms marginal costs are the same for both groups of consumers but since their demand differs so do the MR curves the firms faces in both groups leading to different prices E Barriers to entry 1 If monopolies are earning such large profits why do other firms not enter the market a Barriers to entry must exist 2 Governments sometime grant a monopoly to a firm a This can happen outright Ex Post office b Or through patents copyrights licenses etc Ex Pharmaceutical companies when they create a new drug i In these cases firms devote resources to obtain a monopoly from the government this behavior is know as rent seeking 3 Single ownership of an essential input a This is rare Ex Panama canal eminent domain powers might be necessary 4 Market strategies Use of monopoly power to break competitors a Potential entrants will estimate their profits if they did enter the market i The incumbent monopoly may reduce its price of threaten to do so in order to make the investment seem less profitable to potential entrants b Predatory pricing i The monopoly drops the price every time another firm enters the market and returns the prices to their former levels once the other firm is driven out of the market ii This is generally illegal c Excess capacity i The monopoly may build capacity in excess of expected demand ii This will intimidate potential rivals d Limit pricing i The incumbent may charge a price below the profit maximizing price ii This may trick potential entrants into thinking the monopolies costs are below what they really are 11 Assessing the degree of competition A In the real world few industries match the extreme cases of monopolies or perfect competition 1 In most industries there exists some level of competition but how do we measure it 2 Another way of asking the question is if a firm raises its price how much will the quantity it sells fall a The lower the decrease in quantity the greater the firm39s market power b This is a question about the elasticity of demand for the firm39s output i Two factors effect this elasticity of demand 1 The number of firms in the industry how concentrated is production within a few firms 2 How different the goods produced by the various firms are B Number of firms in the industry 1 Typically the greater the number of firms in the market the greater the competition in the market Ex Soft drink market vs market for corn 2 Four firm concentration ratio a The percentage of industry output produced by the top four firms b The higher the ratio the greater the market power of the firms Concentration Ratio Publishers Stores Stores C Product differentiation 1 Competitiveness depends on how similar the products are 2 Competitive markets will have goods that are virtually identical EX Wheat and copper industries 3 Imperfect competition arises when the goods are imperfect substitutes a The goods are similar enough that they may be used for the same purpose but different enough to represent consumer39s preferences EX Coke vs Pepsi Kellogg39s Cornflakes vs the store brand b Sources of product differentiation i Intrinsic difference in products ii Geographical availability iii Brand reputation iv Imperfect information 4 Product differentiation implies imperfect competition a If goods are not perfect substitutes firms face downward sloping demand curves b There may be no real difference in the products but consumers may believe there are EX Store brand cereals that are produced at the same factory with the same ingredients as brand name varieties 5 Firms will spend considerable effort to obtain product differentiation in order to obtain market power a When goods are perfect substitutes consumers will choose which ever is cheapest III Oligopolies A There are only a few firms in the market they are generally large compared to the market B The existence of oligopolies depends on how one defines the market 1 The oil industry is an oligopoly 2 Gas stations in a large city may not be an oligopoly but if you consider gas stations within a single neighborhood this market may be an oligopoly a The few firms will be concerned with the actions of the other firms C A firm in an oligopoly must decide whether to compete or cooperate with its rivals 1 There is no set rule on how a firm maximizes its profits in an oligopoly D Collusion 1 A group of firms act jointly as a monopoly in order to obtain monopoly rents and then split up the profits 2 The group attempts to act as one firm a If the collusion is explicit it is called a cartel 3 The firms collude to increase their profits and to not compete with on another Ex OPEC Organization of the Petroleum Exporting Countries a Cartels are illegal in the United States that is firms may not openly collude 4 The problem with cartels is that they are self enforced a A cartel gains monopoly profits by each firm restricting output below the competitive level in order to raise the price to the monopoly price b Problem for an individual firm in the cartel P gt MC i This means any one of the firms can increase its profits by increasing its output PRICE p pm Marginal cost curve Po Demand curve Marginal revenue curve am 06 QUANTITY 0 ii But increasing supply is cheating on the cartel and decreases the price for all firms in the cartel iii A cheater free rides on the cartel it exploits the restraint of the other firms iv If too many firms cheat the price falls dramatically and all firms lose the market become competitive Ex OPEC in the 19805 c The incentives to cheat are due to the difference between the marginal revenue of a member and the marginal revenue of the cartel as a whole d Another reason to cheat is the belief that one is being treated unfairly in the cartel i This makes it harder to allocate output among the members ii If a cartel is illegal members cannot write a legally binding contracts e It is the extra profits from collusion that encourage a firm to violate the law 5 Coordination may also be a problem with collusion a A cartel may not be able to agree on how to restrict output or set price b Firms may tacitly collude i That is they adopt rules without explicit agreements c Price leadership one firm changes its price and others follow its lead Ex American Airlines is alleged to have been a price leader d Firms also cooperate by sharing information 6 The problem of entry a Entry of non cartel firms may lower the cartels profits Ex OPEC has been hurt by Mexican Canadian and Russian oil production b As discussed before monopolies may keep the price low to deter entrance a cartel may do the same i The entry cost must be small for the threat to work Ex Prices in the US airline industry in the late 19805 were not dampened by potential competitors due to the high entry costs c Though many oligopolies exist in industries were entry is limited Ex US automobile industry oil industry etc Chapter 07 Lecture Notes October 9 2006 I Competition A In most industries there are many firms operating in a competitive environment Ex Farmer selling corn at the farmers market cell phone providers even a giant like Microsoft faces competitive pressures B Firms are competing to maximize their profits II Review of revenue A Total revenue is the firm39s version of income 1TRpQ B Marginal revenue is extra revenue a firm receives for selling one more unit 1 MR ATRAQ slope of the total revenue curve 2 Competitive firms are price takers meaning that their choice of output does not affect the market price a Therefore the price is constant so MRp implying that the revenue curve is linear Revenue curve 3 400000 3 360000 Lu 5 I 0 9 10 OUTPUT NUMBER OF VIOLINS III Review of costs A Total costs 1 Total cost is the sum of total variable costs those that vary with output and total fixed costs those that do not vary with output 2 TC TVC TFC total cost total variable cost total fixed cost B Marginal cosfs 1 Marginal cost is the cost of producing one additional unit of output 2 MC ATCAQ slope of the tofal cost cume C Average cosfs 1 The cost per unit of output 2 AC TCQ VCQ FCQ AVC AFC IV Basic conditions of competitive supply A Firms make production decisions at the margin B Afirm39s goal is to maximize profifs 1 Profit TR TC pQ TC pQ TVC TFC erefore to maximize profifs firms want to maximize the distance between total revenue 2 Th and total cosfs a This distance is greate t where the lope of TRand the slope of TC are the remembering that H15 producing at the output level that sefs MR M sa me s s e SIDPE are MR and MC rspectively profifs are maximized by C At this point the revenue earned on the last unit produced equals the cost of b producing the un it i Since the total cost curve is upward sloping at this point the next unit would ma e than the firm could sell it for so no rational firm would cost more to produce beyond this poInt C Competitive markets Total cosi curve 55 5529 2 lt59 D Slope of the total revenue curve price Profits l l Slope of the 1 total cost curve l T marginal cost QT OUAN11TY a 1 Competitive markets consist of many buyers and sellers of a homogeneous product 2 Information is good if not perfect 3 Firms are able to enter and exit the market freely 4 The above three conditions imply that the firm is small relative to the size of the market and is therefore a price taker a Being a price taker means that MR p or that the firm can always sell the next unit of output at the market price 5 Competitive firms maximize profits at the output level where MR MC or p MC a This implies that the marginal cost curve for a firm is also the supply curve for the firm since the marginal cost curve gives the profit maximizing output level given the market price Ex Consider a widget producing firm that has fixed costs of 2 and faces a market price of 10 furthermore total variable cost schedule is described in the table below 1 First compute TC and TR and plot the graph containing the two curves Maximum Profits 4 Q 2 To verify that the distance is between cost and revenue is maximized when p MC compute the marginal cost a At an output level of 4 p MC 10 and the firm sees profits of 15 No other output level will make the firm a larger profit V Entry exit and market supply A Entry 1 A firm that is not currently operating in a market should enter that market whenever it is possible to make a profit 2 Dividing profit by quantity produced to obtain the per unit profit gives profitQ TR TCQ p AC a It may then be seen that it will be profitable for a firm to enter the market if p gt the minimum AC COST on PRICE 5 PER Marginal UNIT cost curve Average cost curve Q QUANTITY 0 3 Different firms face different average cost cumes due to differencE in factors such as scale management locations etc and therefore different firms will enter the market at different prics a The most efficient firms those with the lowest minimum average cost will enter first COST on PRICE inf Average cost A03 curves A6 A02 OUTPUT B Exit 1 A firm will exita market when leaving is if best option most times this is not simply when they stop earning a profit a That is a firm exits when it loses less when shut down than when producing 2 When a firms shuts down it loses it sunk costs and will therefore only shut down if the loses while producing are more than its sunk costs a Shut down if Loss gt FC orTC TR gt FC iTCTRgtFC gt TCgtFCTR gt VCFCgtFCTR gt VCgtpQ gt Avcgtp ii Therefore a firm will operate as long as p gt AVC 3 The result that a firm will operate if p gt AVC makes sense since if a firm shuts down it will lose it fixed costs anyway and therefore only needs to cover the average variable costs a In other words a firm only needs to cover it operating or variable costs if it cannot cover is variable costs it exits the market 4 If a rm operates where the p lt AVC then it not only loses its fixed costs but some of its variable costs as well leading the rational firm to exit where it will only lose its fixed costs C The firm39s supply curve 1 The firm39s supply curve is the marginal cost curve above the shutdown point a The shutdown point is the minimum AVC as it will never operate at a price below this pOInt COST on PRICE PER UNIT Firm SU I Marginal Average pp y cost curve COSt curve curve Average variable cost curve OUTPUT D The market supply curve 1 Th mark e market supply curve is the horizontal sum of the supply curves for all firms in the et Ex Consider the case with only two firms PRICE Firm 1 8 Firm 2 s Market supply supply supply CU rVe CU rve CU rve l I l l l l Q1 02 01 02 QUANTITY 0 2 The market supply curve is upward sloping for two reasons a Each firm will produce more output at higher prices since the higher price covers a higher MC b More firms will enter the market at higher prices VI Looking beyond the basic competitive model A Even without a large number of firms competitive pressures may still exist 1 In certain cases simply the threat of other firms entering the market may be enough to keep prices at competitive levels 2 If sunk costs are low any significant price increase over the minimum average cost will induce entry and lower prices VII Longrun vs shortrun supply A The long run supply curve is flatter than the short run supply curve for two reasons 1 It is more difficult to change output in the short run than in the long run 2 Entry and exit are more of a factor in the long run than in the short run PHCE Shortrun supply curve Longrun supply curve OUTPUT B The long run supply curve may be horizontal PRICE A Shomrun PRICE B 0 market P supply curve Longrun supply curve p0 Longrun D1 supply D1 Do curve DD 00 Q1 02 QUANTITY a 00 02 GUANTITY0 VIII Accounting profits vs economic profits A The income an owner of a firm gets for his investment is the return on her investment 1 If that return is greater than a bank would pay in interest people will invest in firms 2 As more firms that enter the market eventually the excess market supply will the lower the market price 3 This lower market price will reduce the owner39s income 4 This cycle will continue until the return on owner39s investments equal the return paid by banks B In accounting terms the return received by the owner on his investment would be considered the profit C In economic terms we say that there is zero economic profit 1 Remember economists include opportunity costs in their calculations as well and therefore if we subtract off the opportunity cost of the owner39s investment the money she would recipe by investing with a bank the economic profit is zero D Economic rent 1 Another key concept in understanding economic profit is the concept of economic rent 2 If all firms in the market had identical technology management input prices etc then they would all have zero economic profits however this is not the case in the real world and those firms that make an economic profit due to an advantage are said to be paid economic rents Chapter 03 Lecture Notes September 8 2006 I The role of prices A Prices are the method economic agents use to communicate B Prices provide both incentives and information 1 They provide information about the relative scarcity of goods and provide incentives to use scarce goods most efficiently 2 When the price of a good is high economic agents will buy less and substitute other goods EX If the price of beer became really high relative to liquor people would start substituting liquor for beer at parties a No public announcement is necessary because the prices provide all the necessary information C Prices are determined by supply and demand 1 Therefore we will use supply and demand based analysis to answer questions about changes in prices II Demand A Demand is the total quantity of a good or service that would be purchased at a given price B The demand curve shows total quantity purchased at each price PRICE 3 500 Quantity Pomt PrIce demanded A 500 O 400 B 300 1 C 200 2 D 150 3 E 125 4 300 F as 100 6 G 75 9 H 50 15 200 C 150 100 50 r I I I I I I I 0 2 4 6 8 10 12 14 16 QUANTITY OF CANDY BARS C An individual39s demand curve show the quantity demanded by a particular consumer at each price D The demand curve has a negative slope meaning that as the price decreases consumers demand more of the good E Market demand curve 1 The market demand curve is horizontal sum of the individual demand curves for every consumer in the market EX Let the market for candy bars only have two consumers Roger and Jane given their individual demand curves we can compute the market demand curve PRICE Roger s Jane s Market 150 demand 150 demand 150 demand curve curve curve 75 75 75 I O l l l l l l l l 2 4 6 8 12 16 20 2 QUANTITYOF CANDYBARS F The intercept of the graph which determines its location depends on socioeconomic factors such as 1 Income 2 Social trends 3 The price of related goods 4 Expectations about the future G Shifts in the demand curves 1 Shifts in the demand curves can take place for many socioeconomic reasons a Tastes change Ex One day everyone in America wakes up and decides they love rap music the demand curve for CDs would shift to the right PRICE OF CDs Do D1 Demand curve after change Initial demand curve QUANTITY OF CD5 b Prices of related goods i The direction of the shift depends on whether the goods are complements or substitutes a Complements are goods that if the price of one increases demand for the other decreases Ex Peanut butter and jelly PRICE OF PRICE PEANUT 0F BUTI39ER D0 JELLY D1 D0 B A GUANTITY OF QUANTITY OF JELLY PEANUT BUTI39EFI b Substitutes are goods that if the price of one increases demand for the other increases Ex Tea and coffee PRICE OF PRICE COFFEE OFTEA Do Do D1 B A QUANTITY OF COFFEE QUANTITY OF TEA c Income i An increase in income will shift the demand curve for most goods to the right PRICE OF CANDY BARS Demand curve after change Initial 1 demand curve QUANTITY OF CANDY BARS d Information Ex We find out that Pontiacs explode after 20000 miles the demand curve for Pontiacs might shift e Availability of credit Ex If the banking industry decides to reduce the number of automobile loans it intends to give the demand for cars will shift to the left PRICE OF AUTOMOBILES D1 Do QUANTITY OF AUTOMOBILES g Changes in expectations i If consumers expect the price of a good to increase in the future they will increase purchases today while the good is cheaper Ex If consumers believe that in the future geopolitical concerns will push up the price of steel and therefore the price of cars one would expect the demand curve to shift to the right in the current period PRICE OF AUTOMOBILES Do D1 QUANTITY OF AUTOMOBILES ii A change in expectations may be selffulfilling more on this later III Supply A Supply is the quantity of goods or services a firm or household wants to sell at a given price B The supply curve shows the quantity of the good available at each price PRICE 5 Point Price Su l H 500 ppy H 500 100000 Supply G 300 95000 curve F 200 85000 E 150 70000 D 125 50000 300 C B A 200 i 150 i B 100 C D 50 54 l I I I I I I I O 10 20 30 4O 50 6O 7O 80 90100 QUANTITY OF CANDV BARS THOUSANDS C The supply curve has a positive slope meaning that as the price increases the quantity the producers want to supply increases 1 The curve has this shape because producers find it more profitable to increase production when prices are high 2 A higher price allows firms to cover the higher costs of producing more goods EX overtime pay D Market supply curve 1 The market supply curve is the horizontal sum of the individual supply curves for every firm in the market 2 This causes the market supply curve to also have a positive slope EX Let there only be two candy bar companies in the market PRICE PRICE PRICE 6 Chocolates W Market Melt inthe Mouth s S s Clho fe supply 150 7 supply curve pp y curve 1 25 125 1 25 0 50 40 QUANTITY OF CANDY BARS THOUSANDS E Shifts in the supply curve 1 Note that a change in price results in a move along the supply curve and NOT a shift in the curve 2 Examples of shocks that would cause a shift in the supply curve a A change in the price of inputs Ex An exogenous shock increases the price of coffee beans This increase in the price of inputs to coffee production will cause the supply curve for coffee to shift left PRICE OF COFFEE p lt p 02 Q1 QUANTITY OF COFFEE a b A change in technology Ex Suppose a new invention improves the process of grinding up the beans thus causing the costs of producing coffee to fall This will cause a shift of the supply curve to the right c A change in the natural environment d A change in the availability of credit e A change in expectations IV The law of supply and demand A An equilibrium is a situation in which there are no forces or reasons to change B In a market equilibrium neither those on the demand or supply side have reason to change their actions C Market clearing price 1 The equilibrium price in a market is that which equates the quantity demanded with the quantity supplied 2 Equilibrium occurs where the demand and supply curves intersect PRICE demand curve Q UA NTlTY D Excess supply 1 The law of supply and demand predicts that prices will move to equilibrium values 2 Excess supply causes prices to fall as producers have more than they can sell at the current price so they lower the price which in turn causes consumers to demand more at the new lower price This pattern continues until the equilibrium is reached PRICE Market B supply 5 Market demand curve QUANTITY OF CANDY BARS MILLIONS E Excess demand 1 If excess demand exists there is not as much supplied as demanded This causes consumers to bid up the price and as the price rises suppliers increase production This pattern continues until equilibrium is reached PRICE Market supply curve demand curve QUANTITY OF CANDY BARS MILLIONS F Demand and supply shifts 1 Supply shift a Consider a leftward shift in the supply curve at the original price there is now excess demand so the price rises to the new equilibrium PRICE p Supply curve 51 P1 p E 2 0 Demand curve Q1 02 QUANTITY OF CANDY BARS a 2 Demand shift a Consider a leftward shift in the demand curve at the original price there is now excess supply so the price falls to the new equilibrium PRICEP Supply curve l P1 E0 E1 L P2 Demand curve 02 Q1 QUANTITY OF CANDY BARS a V Price value and cost A Marginal value 1 Price is related to the marginal value and not the total value Ex The price of water can be low even thought the initial value is high 2 DiamondWater paradox a Water is a necessity of life but the price is low while diamonds are a luxury but the price is high b Price does not reflect importance it only reflects supply and demand PRICE OF PRICE OF WATER j DIAMONDS Supply of A diamonds Demand for water V 2 Supply of water i 1 Demand for B i diamonds l N I r Y QUANTITY QUANTITY OF OF WATER D39AMONDS Quantity Quantity Equilibrium E quot 39 qUilibrium needed bet0W uanlil I to live which extra q y quantlty water has little use B Price and Cost 1 Price and cost are not the same thing Price is what an item sells for and cost is the expense of making an item 2 When the costs of producing a good increase the price increases why a This is due to the fact that an increase in costs will cause the supply curve to shift to the left Chapter 11 Lecture Notes November 2 2006 I Extending the basic competitive model A Relaxing our previous assumptions 1 Previously it was assumed that there were many buyers and sellers in the market which made them price takers 2 Though in the real world firms have some market power a Firms are not necessarily price takers but instead have some influence over the price they receive EX Nike is able to charge more for its shoes than Puma 3 Previously it was assumed that products were homogeneous though in the real world nonhomogeneous products and brands do exist EX Not all shoes are the same and different brands of shoes have differences in design quality etc B Imperfect information 1 Consumers and firms rarely have perfect information remember this was an assumption of the basic competitive model 2 Consumers do note have perfect information about the quality of goods EX Buying a used car is it a lemon or not 3 Firms do not have perfect information on the productivity of workers EX Will he work as hard as he can or just enough so that he doesn39t get fired C Private cost assumption 1 In the basic competitive model it was assumed firms and consumers bare all the consequences of their actions a There are no spillover effects on other 2 Externalities a An action by a consumer or firm that has an effect on others for which it neither pays nor is paid compensation EX A hiker litters in the woods EX A messy roommate EX A firm producing electricity from coal releases sulfur into the air D Rivalrous goods 1 In the basic competitive model we assumed all goods were rivalrous Ex When one consumer purchases a gallon of gasoline the gallon is unavailable to other consumers 2 Public goods exist in the real world a Public goods are examples of extreme positive externalities b Nonrivalrous and Nonexcludable i Nonrivalrous one39s use of the good does not limit others39 use ii Nonexcludable There are very high costs to prevent other consumers use of the good Ex National defense bridges fireworks II Imperfect competition and market structure A Monopoly 1 A monopoly is firm who is the only seller in the market Ex The post office has a monopoly on delivering letters to your mailbox Ex Panama is a monopoly in the South American isthmus canal industry 2 Most times monopolies arise due to barriers to entry Ex In the United States it is against the law for anyone other then the postal service to deliver mail to consumer39s mailboxes this prevents others from entering the market B Oligopoly 1 An oligopoly exists when there are a few sellers in the market the firms are usually large compared to the market Ex Domestic package shipping FedEx UPS and USPS Ex Long distance phone providers 2 There is some degree of competition in the market Ex If UPS lowers its prices FedEx does not have to charge the exact price UPS does but they can not ignore the price drop completely 3 Since there are a relatively small number of firms in the market they will take into account the other firms39 actions and reactions when making decisions C Monopolistic Competition 1 There are many firms in the market but each has some monopoly power due to brand loyalty Ex Soft drinks Coke Pepsi RC Cola etc Ex Computers Dell Apple Gateway etc 2 The products are different enough that competition is limited Ex The price of Pepsi may fall but that does not mean that everyone who drinks Coke will switch some will stay with Coke because there is enough of a difference that a preference exists 3 A firm is able to raise its price and not lose all of its customers due to brand loyalty D Price and quantity under imperfect competition 1 Under perfect competition there were many firms in competition and therefore they were price takers a Prices were constant and firms could sell all they wanted at that price i MR P b The profit maximizing firm will produce the quantity that will set marginal cost equal to marginal revenue MC P 2 Under imperfect competition firms are able to influence the price and do not simply except a market price a To sell one more unit the firm must lower its price Ex Consider a monopoly who is supplying all of the demand for the good at the current price Since the demand curve for the good is downward sloping the firm knows the in order to sell more output increase demand it must lower the price b Remember marginal revenue is the amount the firm can sell its next unit of output for i Under imperfect competition the firm must lower its price to sell the next unit ii Therefore MR lt P c A profit maximizing firm sets MC MR so in the case of imperfect competition MC MR lt P i This is considered inefficient since the price is greater than the cost of producing the last unit ii In perfect competition there are incentives for the firm to increase production if P gt MC but with imperfect competition these incentives do not exist and this is inefficient d If the price is too high then too little is produced E Government policies 1 The government may act to prevent monopolies from forming or break up ones that exist in order to obtain more efficient outcomes Ex The break up of Ma Bell 2 The government may also help to create or keep monopolies Ex Post office III Imperfect information A The information problem Ex In high school did you know exactly how much you would enjoy or benefit from college Ex Do firms know how hard employees will work Ex Is the potential hire smart or did they cheat their way through college B Will including the concept of imperfect information in our economic models help us better analyze the decisions of economic agents 1 More on this in future chapters you will have to wait to see VI Externalities A Economic agents do not necessarily bear all the consequences of their actions nor do they reap all of the rewards B Pollution is a negative externality 1 Production reflects only private costs and not social costs 2 Since firms do not pay all of the costs they produce too much pollution Ex If a steel mill had to pay the social costs there would be less steel produced and also less pollution C Government policies towards externalities 1 Tax negative externalities this forces firms to pay the social costs associated with the negative externalities 2 Positive externalities too few are produced so the government may wish to enlarge supply via subsidies Ex Nuclear energy V Public goods A Public goods are ones that are nonrivalrous and nonexcludable B Pure public good 1 The marginal cost of supplying a pure public good to an additional consumer is zero 2 The marginal cost of excluding an additional consumer is very high Ex Streetlight once installed and running the cost of lighting the sidewalk for one extra consumer is zero while the marginal cost of excluding an extra consumer from the benefits of the light is very high C The consumer who pays for the good does not receive all of the benefits from the good Ex A nice flower garden your neighbors property value will increase a benefit they did not pay for D Public goods are under supplied 1 Free rider problem Ex A neighborhood wants to build a park so it takes donations from all of the residents to pay for the park i An individual resident thinks they will not donate and save their money since the after the other neighbors will donate and the park will get built anyway ii If everyone in the neighborhood thinks this way the park may not get built there will be an under supply of the public good a The free rider problem helps to explain the under supply of public goods b Government has a role in supplying these types of goods Chapter 25 Lecture Notes January 06 2007 I Government spending and tax revenues A In 2005 US federal government spending gt 2 trillion 1 National defense Social Security parks etc B State and local government spending gt 15 trillion 1 Schools police fire etc C In the 19805 and 19905 government spending gt tax revenues 1 The government must borrow money to finance this excess spending 2 Government deficit G T a Where G is government spending and T is tax revenue 3 Government debt accumulated amount owed from previous deficits and accumulated interest D In 1998 the federal government turned around the budget situation to a surplus E Since 2002 the federal government budget has returned to a deficit due to tax cuts recession and war time spending II Composition of government spending and tax revenues A Discretionary spending 1 Decided on a yearly basis EX Defense government operations most education and training B Nondiscretionary spending 1 Interest payments on government debt 2 Entitlements a The law mandates specific benefits to individuals and families if they meet certain criteria EX Social Security Medicare Medicaid food stamps 3 Spending on Social Security health care and interest total 70 of federal government spending C Defense spending has fallen from 6 percent of GDP at the end of the cold war to just over 3 percent now D Interest payments have fallen due to the surplus in the late 19905 and low interest rates E Government spending on health care has doubled as a percentage of GDP International affairs 1 International affairs 1 National defense National 17 defense 23 Health Net interest 15 10 Medicare Medicare 11 8 Social Security 20 Outlays 2002 Outlays 1990 F Individual federal income taxes 46 percent of total federal government revenues corporate federal income taxes 9 percent Receipts 2002 Receipts 1990 Individual Social Security Social Security Individual and income and income retirement Jig5 retirement taxes receipts recelopts 450 38 370 Corporate Corporate Income tax income tax 8 9 II Adding the government to the full employment model A Government spending and taxes affect the product and capital markets 1 Product market a Increases in G increase spending on goods and services from firms b Increases in T reduces demand by reducing disposable income 2 Capital market a If the government is running a deficit GgtT then the government must borrow money in the capital market b If the government is running a surplus GltT then the government is saving in the capital market 3 New circular flow of income Households Goods purchased VVage Payment income for oods g s Profits Taxes awng Interest and vaend Transfers 39quotcume fpaymegt Borrowing Product Market w Capital Market Labor Market Goods Government Profits purchased Inte39eSt interest and payments payments ReVenues lnveshnent Taxes funds wage Goods produced Labor hired Firms B Private savings 1 Supply equals demand means that at full employment a Yf C I G 2 Households spend their income on consumption and taxes with the remainder going to savings a Yf C T 8p i Where Sp is private savings 3 The two equations above lead to a I G T 8p 4 Rewriting the above relationship leads to a Sp I GT b In other words private savings must cover investment and the government deficit 5 Let 89 be the net savings by the government b It may then be seen that 5p 59 I i That is national savings must equal investment in equilibrium ii Yf C T T GI 6 An increase in taxes reduces the government deficit a The tax hike reduces disposable income so consumption falls which increases both private and national savings b Interest rates fall and investment increases i Higher investment today means the capital stock will be larger in the future and future potential GDP will be larger C The government and the capital market 1 National savings is independent of the interest rate a 5g depends on political factors not the interest rate b Sp depends on income not the interest rate c 50 national savings 5 is a vertical line i Infinitely inelastic 2 Investment is a negative function of the real interest rate 5 Consider an increase in government spending 61 a The government deficit increases I 59 falls b This causes national savings to fall shifting the savings curve to the left c The real interest rate rises which reduces investment d The is denoted as the crowding out effect i Extra government spending crowds out investment spending Increase INTEREST RATE r In deflClt National gt saving 1 curves r0 investment schedule 51 so SAVING S INVESTMENT I D Tax cuts and crowding out 1 It would appear that since tax cuts increase decrease Sg they would crowd out investment Ex A tax cut of 100 billion increases the government deficit by 100 billion at full employment i Households receive 100 billion extra disposable income ii Suppose Or by 90 billion then S p r by 10 billion iii But 89 by 100 billion iv S Sp Sg falls by 90 billion v The national saving curve shifts to the left by 90 billion vi So the interest rate rises which again chokes off investment 2 The theory of Ricardian equivalence predicts that this may not be the case a When T decreases the government will increase its borrowing b The government must eventually pay this back so T r will increase in the future i Households know this and save today39s tax cut to pay the increased future tax bill ii Sp r with the tax cut iii When T S g but S p r so national savings S is constant c Without a change in S there is not crowding out of investment 3 Does Ricardian equivalence actually hold a Do private savings actually increase when taxes decrease i Yes but the increase in SD is small ii Some of the tax cut is consumed iii So investment is partially crowded out IV Government deficits and surpluses A The government deficit is the difference between government spending and tax collections in a year 1 The government cannot borrow the way households or firms can 2 The government borrows by issuing government bonds T bills to finance the deficit 3 Government debt is the accumulated amount the government owes from previous 4 Should a government run a deficit EX US example largest deficits as a of GDP during WWII i This debt was paid off by taxes paid by workers many years after the war ended ii Since later generations benefited from the Allied victory in WWII sharing the financial burden of the war across generations makes sense a Government borrowing shifts some of the burden of expenditures to future generations i Does this inter generational shift make sense for spending on roads Social Security Government operations B Recent government deficit activity 1 Currently the deficit is at its highest level ever 400 The Federal Deficit BILLIONS SS lOO 7200 300iliilllllliiiiliiiililllliiiiliiiillilllliii 1960 1965 1970 1975 1980 1985 1990 1995 2000 2 Though the economy has been growing as well therefore in order to appropriately analyze the deficit it should be observed as a percentage of GDP a As a percentage of GDP the deficit was its largest after WWII The Federal Deficit as a Percentage of GDP 6 5 4 3 a2 0 E o 1 0 v 1 27 3 llllllllllllll llllllllllllll llllllllllllll 1960 1965 1970 1975 1980 1985 1990 1995 2000 3 The US has a larger debt to GDP ratio than other industrialized nations a Though most other industrialized nations do have a national debt and are running deficit V Factors affecting government budget A Defense spending was 6 at the end of the cold war is just over 3 today and depends on the future global political situation B Increased social spending on the elderly as the population grows older spending on Social Security and Medicare will increase C Health spending Medicare and Medicaid health care spending on the poor may increase due to increases in health care costs prescription drug entitlements Chapter 05 Lecture Notes July 05 2007 I The basic problem of consumer choice A Assumption of rationality 1 In order to analyze the behavior of consumers we will make the assumption that consumers behave rationally a This assumption is reasonable as rationality simply means not wasting resources and pursuing what one believes is in their self interst B The budget constraint 1 Review of the budget constraint from chapter 02 a Oonsu mers have a limited amount of income to spend and the budget constraint shows all the combinations of two goods that a consumer can buy if they spend all of their income In other words the budget constraint shows the opportunity set for the consumer 39 39 come b given prices and the consumers In Clothes Budget Constraint Opportunity Set 0 Pizza 2 Intercepts and SIOPE a Intercepis i xintercept MPx the most X a consumer can buy with income M the consumer only buys X ii yintercept MPy the most Ya consumer can buy with income M the consumer only buys Y b Slope i Slope of the budget constraint relative price PxPy ii The slope of Ex If PX shown in Jul lt 3 Individual preferences a We know the rational question is which one b This depends on i Few people the budget constraint shows the tradeoff a consumer faces 2 and Py 1 then you c the slope PxPy 21 an trade 1 X for 2 Ys which is 2 M x E choosing a point on the budget constraint consumer will consume a set on the budget constraint but the the consumer39s preferences for the goods choose extreme points Ex Consider the choice between pizza and shoes Few will choose only pizza or only shoes as most people get bored with too much of one thing Clothes Only clothes no pizza Budget Constraint Only Fina no clothes Pizza ii We like diversity and variety iii Most consumers choose a point on the budget constraint between the two intercepts c The consumer39s choice depends on how they value the two goods i Consumers make decisions based on the marginal value of goods Ex Consider the pizza and shoes example from before The consumer will weigh the extra value she gets from an extra pizza against the cost of the extra pizza Where this cost is in ter s of the number of shoes she has to forgo in order to obtain the extra pizza that is the opportunity cos 4 Effects on consumption of income changes a An increase in income will cause a parallel shift in the budget constraint away from the origin i The slope does not change as prices have not changed Ii Consumers are better off as the opportunity set is larger meaning they can buy more goods b A decrease in income will cause a parallel shift in the budget constraint towards the origin 39ncome changes consumers choose a point on the new budget constraint and like before this new point depends on their preferences d Normal vs inferior goods i Normal goods If income increases consumption of these goods increases ii Inferior goods If income increases consumption of these goods decreases Ex Ramen noodles e Income elasticity of demand i Income elasticity of demand is the sensitivity of demand to changes in income ii Income elasticity of demand DluAQdDluAM iii Income elasticity for normal goods gt 0 iv Income elasticity for inferior goods lt 0 v The income elasticity of luxury goods is high Ex movies vi The income elasticity of necessities is low Ex car repairs II A closer look at the demand curve A Deriving demand curves 1 Suppose the price PX of good X increases 2 Geometrically there are two effects from this increase 0 lt a The slope of the budget constraint is steeper remember the slope is PxPy and PX got bigger b The xintercept moves towards the origin as the consumers real income or purchasing power decreases c As may be seen the consumer is worse off as the opportunity set is now smaller 3 The income effect a PX increases the consumer is now poorer since the opportunity set is smaller and will therefore change their consumption of X i If X is a normal good she buys less of X ii I X is an inferior good she buys more of X since she her income in real terms has decreased decreased purchasing power 4 The substitution effect a When the price of X increases good X becomes relatively more expensive compared to Y b Therefore the consumer substitutes away from good X toward good Y c This effect is represented by the steeper slope of the new budget constraint 5 Putting the income and substitution effect together for a normal good a If X is a normal good total demand for X fails when the price of X increases i From the substitution effect the consumer substitutes away from the relatively more expensive X ii From the income effect the consumer demands fewer units of X since the price increase reduced her real income 6 Putting the income and substitution effect together for an inferior good a If X is an inferior good total demand for X fails when the price of X increases i From the substitution effect the consumer substitutes away from the relatively more expensive X ii From the income effect the consumer demands more of X since there is a reduction of real income and X is an inferior good iii Even though the income and substitution effects push the demand for X in different directions the income effect is usually small and the substitution effect dominates pushing the the total demand for X down b Goods for which the income effect dominates the substitution effect and the total demand for X increases when there is a price increase are known as Giffen goods i Though Giffen goods are theoretically possible they are not observed in the real world 111 Utility and the description of preferences A The benefits derived from consuming goods and services is denoted as utility B It is not possible to compare one person39s utility to that of another person 1 We cannot say one person is happier than another but we can determine if the one person is willing to pay more for a good or service than another person C Economists use a quotwillingness to payquot criteria to measure utility since we cannot say how quothappyquot some level of consumption makes them 1 The utility curve then represents the consumer39s willing ness to pay at each quantity of the good Ex 250 for 5 sweaters 450 for 10 etc a Note willingness to pay is not the same as the market price 2 The extra utility a consumer receives from one additional unit of the good or service is known as the marginal utility a This may viewed as how much the consumer is willing to pay for an additional unit this view puts marginal utility in a dollar measure b Successive increments of a good become less desirable this is the law of diminishing marginal utility Ex If you have one sweater one more might make you a lot happier but if you have 50 sweaters how much happier would one more make you c Therefore the consumers willingness to pay for additional units diminishes Willingness Marginal to pay Utility 5 UtIlIy Curve 250 400 200 300 1 50 200 1 00 1 00 50 0 1 2 3 4 5 Sweaters 0 1 2 3 4 5 Sweaters Ex Consider the following utility function for pizza and it39s corresponding marginal u iity 3 A consumer will buy every unit of a good for which her willingness to pay gt price a The consumer stops buying when her willingness to pay price b The consumer will not buy if her willingness to pay lt price 4 Maximizing utility a A consumer will maximize their utility when their willingness to pay marginal utility MU price i Since we know that the marginal utility curve is diminishing with respect to quantity we know that at this point the utility received from an additional unit will be lower and therefore be below the price and a ra onal individual would not purchase the additional unit b Since Mup for all goods it must be the case that MUxPx MUyPy MUZPZ i This says that if the consumer is maximizing her utility then the extra utility per dollar must be equal for all goods Ex Consider the case in which MUxPx gt MUyPy 1 This says that the consumer receives more utility per dollar from consuming good x than good Y 2 The consumer should then buy more x and less Y as she buys more x MUx falls due to diminishing marginal utility and as she buys less Y MUy increases D Consumer surplus 1 Consumer surplus measures consumers39 gain from exchange in dollar terms 2 Consumer surplus is the difference between the willingns to pay and the price actually paid a This difference represents the quotsavingsquot consumers receive because the market price is lower than what they are willing to pay Ex Consider the situation where you go into a smre planing to purchase a pair of sneakers at you are quotwilling to payquot 90 for but the smre is only charging 50 This difference of 40 is your oonsumer surplus from the exchange 3 Consumer 39 39 h under quot and above the pride oonsumers actually pay Marginal Price of Demand Sweaters 0 Sweaters 4 when the price rises oonsumer surplus decrea5 for two reasons a Fewer goods are bought and there is no consumer surplus for the goods not purchased anymore b Those who still buy the product quotsavequot less sinoe the price is higher remember oonsumer surpl s is the If ence between willingns no pay and the price so this area would shrink if the price increased c The lost oonsumer surplus is the mtal harm to consumers due m the price increase Marginal Lost Consumer Surplus 0 sweaters 5 Consumer surplus and taxes a Taxes tend m raise the price of the good being taxed b The loss of consumer surplus measures the total harm of the tax m consumers IV The basic model of consumer choice A Criticisms of the basic model 1 Few consumers make economic decisions by consciously examining budget constraints and computing marginal utility curves a True but irrelevant b It is like saying the a physicists explanation of how billiard balls travel cannot be oorrect because the players do not work out the equations ahead of time 2 Consumers do not really know what they want a True b Judging by their purchases many consumers seem b have illrformed and unstable preferences 3 Consumers lack complete information about prices and hence cannot know their budget constraints 4 The interaction of preferences and prices may make a person39s decision process very complex EX The price of a good may influence a consumer39s attitude towards it B While there are valid critiques of the basic consumption model they only show that the model is incomplete 1 The model is still useful 2 By being explicit about our assumptions we can know which ones if any are not valid in a particular instance Graphing Review Lecture Notes August 28 2006 I Linear functions A Functional form 1 y mx b Ex Consider the budget constraint with the functional form y 2x 12 14 12 Slope 2 m 10 D O 8 6 Michelle s budget 4 constraint 2 I I I I I o 1 2 3 4 5 6 7 B Slope 1 Given a unit change in the horizontal axis the slope is the value by which the vertical axis will change while moving along the curve 2 In the functional form above m is the slope of the line 3 Given two points on a curve one may compute the slope using the quotrise over runquot technique a Slope riserun y2 y1 x2 x1 Ex Given points A and E one may compute the slope riserun 6 8 3 2 2 4 Extreme cases a The slope of a vertical line is infinite A The slope of a vertical line is infinite VARIABLE y VARIABLE x b The slope of a horizontal line is zero The slope of a flat horizontal line is zero VARIABLE y VARIABLE x C Intercepts 1 Vertical or y intercept a When x is equal to zero at what value does the line cross the vertical axis b In the functional form above it may be seen that if x 0 then y b therefore b is the yintercept Ex In the example the yintercept is b 12 2 Horizontal or x intercept a When y is equal to zero at what value does the line cross the horizontal axis b In the functional form above it may be seen that if y 0 then x bm therefore bm is the xintercept Ex In the example the xintercept is bm 12 2 6 II Interpreting curves A We are able to call a linear function a curve as it a specific case of a curve one in which the slope is constant B In most curves the slope will change as one moves along the curve 1 At a point along the curve we may compute the slope by using the quotrise over runquot method by choosing a second point very close the the original Ex Consider the following production possibilities curve Production possibilities 100 curve 9 g 80 l l E m 60 Z 3 D 40 2O O l l l 20 4O 6O 80 100 BUTTER TONS 1 At point E 70 70 we may compute the slope by choosing a second point 71 69 that is very close to the original and calculate riserun 69 70 71 70 1 Riie 69 70 3 Run 71 7o 72 E 70 68 66 l l o 68 7o 72 2 At point A 90 40 we may compute the slope by choosing a second point 91 38 that is very close to the original and calculate riserun 38 40 91 90 2 Rise38 40 Run 91 90 c 46 44 42 A 40 38 36 I l A 0 86 88 90 92 3 Notice that the slope has changed from point E to point A C Beware of a graph39s scale EX The curves presented below are identical A B 12 Michelle39s 24 budget 10 constraint 20 Michelle s budget constraint NUMBER OF CDS PURCHASED NUMBER OF CDS PURCHASED l o NUMBER OF DVDS PURCHASED NUMBER OF DVDS PURCHASED Chapter 06 Lecture Notes October 6 2006 I Profits costs and factors of production A Maximizing profits 1 The firms goal is to maximize profits 2 This goal is what determines what how and how much a firm will produce 3 Profits total revenue costs a Total revenue pQ this is the firms income 4 Firms may have objectives other than just profits but if a firms neglects profits too much they will go bankrupt B Costs 1 Costs are what a firm must pay in order to produce its product 2 Given a chosen quality level firms will attempt to lower costs while maintaining this level of quality 3 Firms will vary the inputs of production until they find the most cost effective method of production C Production with one variable input Note this does not exclude additional fixed inputs 1 The production function relates the single variable input to the output Ex Consider a wheat farm with a fixed amount of land machinery and fertilizer Labor is the only variable input OUTPUT OF HHHHHHHHHHHHHHHH W WHEAT IN 170 I THOUSANDS l OF BUSHELS 15 I I Production l I I function I I I 140 I I I I I I I Slope in this region 15 bushels per hour of labor 120 margInal product of an hour of labor increasing labor input by 1000 hours increases output by 15000 bushels 95 T l I I I l A l l l l 1 1 l l l l 1 0 5 6 7 8 9 1o 11 THOUSANDS OF HOURS WORKED i Note that the amount of labor used increases the output increases but at a diminishing rate 2 Marginal product MP is the extra output produced from one additional unit of the input holding all other inputs fixed a MP is the slope of the production function b Diminishing returns or diminishing marginal product i Holding all other inputs fixed as more labor is used the marginal product of labor diminishes ii Additional workers are not as productive as previous workers due to crowding of fixed inputs Ex Consider farm equipment operated by one person adding another worker may allow the machine to be operated while the first worker is on his breaks but the second worker will not be as productive as the first because there is only one piece of equipment c The diminishing marginal product implies that even if wages are constant across workers additional units of output cost more than previous units 3 Other shapes of production functions a Constant marginal product doubling inputs doubles output OUTPUT Production function INPUT b Increasing marginal product doubling inputs more than doubles output i A garbage collection firm in Raleigh increases its customers from 1000 to 2000 They do not need to double their labor force since the average distance between houses is now less OUTPUT Production function LABOR D Fixed vs variable inputs 1 Fixed inputs a Firms need some input just to get started Ex Firms may need space furniture machines before any output is produced b These are fixed inputs since they do not depend on the level of output c Fixed costs are the money spent on fixed inputs these are constant across all levels of output 2 Variable inputs a Inputs that depend on the output level are denoted as variable inputs b Labor and materials are usually variable inputs c Variable inputs generate variable costs II Types of costs and cost curves A Total costs are the sum of total fixed costs and total variable costs TC TFC TVC Ex A farmer pays fixed costs for land and equipment and variable costs for labor fertilizer a nd seed s COST COST COST THOU A THOU B THOU c SANDS SANDS SANDS 1 75 150 165 135 Variable 1 cost curve 145 120 135 130 118 Fixed cost 90 105 curve 100 25 75 IV l l l l l l 0 OUTPUT 0 95 120140155170 0 95 120140155170 OF WHEAT OUTPUT OF WHEAT OUTPUT 0F WHEAT THOUSANDS OF THOUSANDS OF BUSHELS BUSHELS B Marginal cost and marginal product 1 Marginal cost is the extra cost of producing one additional unit of output COST PER A UNIT Total cost curve Marginal cost AC I I W QUANTITY 0 Oneunit increase in output AQ 1 2 Marginal cost is the slope of the total cost curve MC ATCAQ COST s PER UNIT COST 3 3 PER UNIT Total cost slope Of lg tota costmarm I curve at cos 0 I 01 01 l l 01 QUANTITY 0 150 105 93 75 60 4 0 C Marginal cost curve 95 120 140 155165170 OUTPUT OF WHEAT THOUSANDS OF BUSHELS Ex Suppose a farmer increases labor from 7000 hours to 8000 hours and output increases by 10000 bushels 3 If w is the wage then marginal cost MC wMP a One additional hour of labor produces 10 additional bushels b 10 bushels per hour or 1 bushel every 110 of an hour is the marginal product of c If the wage is 10 per hour each additional bushel costs 1 to produce a The more productive labor is the lower the cost of producing the next unit 4 With diminishing marginal product eventually labor will be less productive causing marginal costs to rise a This leads most marginal cost curves to be upward sloping which is reallyjust a reflection of diminishing marginal returns C Average costs and average variable costs 1 Average costs are the total costs divided by output AC TCQ a Average cost is the slope of the line between a point on the total cost curve and the origin 2 Average variable costs are the total variable costs divided by output AVC TVCQ 3 AC AVC AFC TCQ VCQ FCQ D U Shaped cost curves with fixed costs 1 As covered previously inputs have diminishing marginal returns so marginal cost is increasing 2 Initially average costs fall as the fixed costs are being spread over a larger number of output units a Average costs are lowest at some point Q b Average costs decline to Q and rise thereafter 3 Average costs start to rise as diminishing marginal returns starts to set in and dominate COST 1 0 5 PE 5 Marginal UNIT cost curve Average cost curve 105 93 m 75 H 60 l l I o V95 120 140 155 165 170 OUTPUT OFWHEAT THOUSANDS OF BUSHELS E The relationship between average costs and marginal costs 1 When the cost of the next unit marginal cost exceeds the average then the average costs rises 2 When the cost of the next unit marginal cost is less than the average then the average costs falls 3 When the cost of the next unit marginal cost equals the average then the average costs neither rise nor fall Ex Consider a course that has three exams where your average is 80 on the first two exams The third exam is then the marginal exam a If you get a 90 gt80 on the marginal exam the average rises b If you get a 50 lt80 on the marginal exam the average falls c If you get a 80 80 on the marginal exam the average stays the same 4 In general the position of the margin relative to the average determines what happens to the average 5 Therefore marginal cost will intersect average cost from below at the minimum average cost Q COST MC AC Min AC 0 OUTPUT F If the price of a variable input rises the marginal cost and average cost curves shift up 1 The marginal cost curve shifts up due to this style MC wMP of relationship between MC and variable input prices COST A COST 3 PER T02 PER M02 M 0 UN Total cost UNIT 1 A02 curves T01 Variable input T AC1 prices increase T Average cost curves Marginal cost curves OUTPUT OUTPUT G If the price of a fixed input increased the total cost and average cost curves would shift up but the marginal cost curve would remain unchanged 1 Fixed inputs are needed to produce any amount of output and therefore do not change how much the next unit costs to produce they only determine how much it would cost to get up and running III Shortrun and longrun curves A The difference between short run and long run 1 The short run is a time period in which some inputs are fixed 2 The long run is a time period in which no inputs are fixed all factors of production may vary B Short run cost curves 1 Those inputs that are fixed in the short run generate fixed costs for the short run a Labor and raw materials are the principal variable inputs in the short run b This generates U shaped average cost curves for the short run 2 Short run marginal cost curves are relatively flat or constant over a wide range a In many firms output may be increased by 10 by increasing the inputs to production by 10 b As the output level increases eventually less efficient maybe older machines may need to be brought on line and workers start getting paid over time c Therefore the short run marginal cost curve is typically almost flat at low levels of output and very steep at higher levels of output C Long run cost curves 1 In the long run none of the inputs to production are fixed a That is in the long run a firm can change everything about itself including its size and its production facilities 2 The shape of the long run cost curves depend on returns to scale 3 Returns to scale RTS if all inputs change by the same proportion Ex double all inputs does output change by more less or an equal proportion a Constant returns to scale if all inputs double then output doubles i The long run average cost curve is flat ii If all inputs double TC doubles If output doubles Q doubles Therefore AC stays constant AC TCQ 2TC2Q iii The constant average cost in the long run means that long run marginal cost must be constant and equal to long run average cost 1 If marginal cost was not constant average cost would be changing iv Constant returns to scale are prevalent in manufacturing b Increasing returns to scale if all inputs double then output more than doubles i Average costs falls as output increases they are slightly downward sloping but will level off ii Therefore bigger is better for firms facing increasing returns to scale Ex Consider large retail outlets such as Walmart they only need one headquarters only a few store designs and so forth so that when they want to add additional store they are not as expensive as the previous ones c Decreasing returns to scale if all inputs double then output increases by less than double i Average costs increase as output increases in other words the long run average cost curve is upward sloping ii Firms with decreasing returns to scale are more efficient at low levels of output and typically stay small Ex Krispy Kreme in 19905 attempted to rapidly expand its operations and ran into problems due to decreasing returns to scale iii In this case the long run marginal cost curve is upward sloping and sits above the long run average cost curve 4 If a firm expects output to grow in the long run then they will buildacquire additional production facilities as to produce the expected long run output at the lowest possible cost per unit Ex Consider the case in which a firms only alternative in the long run is to build more pl a nts A A Longrun total I cost curve 703 z a b E n T01 3 lt j 8 Slope minimum f 7 shortrun average 8 cos O 01 Q2 E Longrun g 3 average n cost curve 3 A01 Ac2 A03 12 II 3 0 Minimum 9 shortrun w average 0 0 cost curve 01 Q2 QUANTITY Q a The firm has a variety of different options for increasing its size Ex renting or building how big this will cause other total cost curves to exist between TCl and TCZ and so forth leading to a smooth version of the long run total cost curve i it will make its decisions so that it may attain the desired level of long run output at the lowest possible long run average cost Chapter 28 Lecture Notes January 05 2007 1 Money prices and inflation A So far we have studied the real side of the economy real wages real interest rates real GDP 1 In the full employment model output Yf was independent of prices and the level of money in the economy 2 How does inflation and the money supply fit into the story B The value of money and prices P are related 1 The relationship is such that the price level is the inverse value of money a When P rises the value of money fails because 1 will buy fewer goods C Supply and demand for money 1 Money demand a Households and firms need money to make transactions b The amount of money they demand depends on the value of the transaction they must make i The higher the value of the transactions the more money households and firms must hold c The total value of transactions is PY i Where P is the price level as measured by the CPI and Y is the output of the economy ii Note that PY nominal GDP d Quantity equation of exchange provides a method of determining money demand i MDV PY 1 Where MD is money demand and V is the velocity of money 2 The velocity of money is the average speed of money and will depend on the technology for making transactions ii MD 1VPYf at full employment 1 If P1 gt M D1 21fo gt MD 2 Money supply a Money supply MS is affected by the Federal Reserve39s monetary policy 3 Equilibrium in the money market r a MS MD gt MS 1VPY b Since Yf and V are constants MS and P must move in order to ensure this relationship holds i MS gt P ii Households want to spend this extra money which increase prices P39r iii Since wage contracts are negotiable w39r as P39r meaning that the real wage wP will remain constant and thus changes in the MS will not have an effect on the labor market and in turn will not have an effect on Yf iv In the full employment model changes in MS will only affect nominal variables such as P and w c Neutrality of money i The fact that changes in the money supply only affect nominal variables and do not change the real variables in the full employment model is known as money neutrality EX If My by 10 percent then P39r by 10 percent and nominal wage39r by 10 percent 1 Since the real wage didn39t change there is no effect on the labor market and therefore no change in Yf ii The following do not change when MS in the full employment model 1 The real wage 2 The real interest rate which is determined by S and I 3 Real GDP which is determined by labor capital and technology 4 It is the growth rate of the money supply that causes inflation INFLATION RATE 80 7o 60 50 4o 307 20 7 39 39 l l l l 0o 10 2o 30 4o 50 60 70 80 MONEY GROWTH RATE II The financial system in modern economics A The financial system is composed of all the institution that help direct savings by households to those firms and other households that wish to borrow 1 The capital market is the financial market B Financial intermediaries are institutions that operate between savers and borrowers 1 Commercial banks 2 Life insurance companies 3 Credit unions 4 Savings and loan associations C Commercial banks play a key role in the creation of money and credit in the economy III Creating money in modern economics A Originally exchange took place in the form of bartering 1 This was difficult as an exchange required a double coincidence of wants a That is both parties had to want something from one another b This led to the creation of money B Properties of money 1 Money is a medium of exchange a Facilitates transactions of goods and services 2 Fiat money declared valuable by the government a This is the case with the US dollar it is just a piece of paper but is declared valuable by the US government and may therefore be used as a medium of exchange 3 Money does not have to be fiat money 1 Societies in the past have used commodities as a medium of exchange Ex Gold salt cigarettes etc 4 Store of value 5 Unit of account C Measuring the money supply 1 M1 transaction money a Most liquid immediately convertible into goods b M1 currency coins checking accounts traveler39s checks 2 M2 M1 savings accounts lt100000 money market mutual funds held by individuals certificates of deposit fixed time deposits eurodollars dollars deposited in European banks 3 M3 M2 large savings accounts over 100000 institutional money market mutual funds M1 BiI39iOHSv U55 M2 Billions uss M3 Billions uss Saving deposits Checking Currency money market accounts 6640 6156 60446 accou nts 31449 deposns 8847 Traveler s Money market Small saving checks mutual funds gen deposits Isl1115 Tuanrggt 75 8068 8058 institutional 11026 4 We said the money supply was important for understanding inflation but the growth of the different types of measurements are quite different RATE OF GROWTH Va 20 l l I l l I l l I l l I l l I l l l l l I l l I l I I l l I l l l l l I 1960 1965 1970 1975 1980 1985 1990 1995 2000 YEAR D The money supply and the bank39s balance sheet 1 A bank39s balance sheet Bank s Balance Sheet Assets Reserves Liabilities Deposits Loans Net Worth Government Bonds Total Total 2 Assets things the bank owns or the claims it has on others a Reserves i Cash within the vault ii Reserves at the Fed 1 Required reserves 2 The required reserve ratio is controlled by the Fed iii Excess reserves bLoans c Government and other bonds 3 Liabilities what the banks owes to others or the claims others have on the bank a Deposits from checking accounts or other demand deposits 4 The net worth of a bank assets liabilities 5 The two sides of the balance sheet are always equal EX AmericaBank AmericaBank Balance Sheet Assets Liabilities Loans outstanding 28 million Deposits 30 million Government Bonds 2 million Reserves 3 million Netwoth 3 million Total 33 million Total 33 million E How banks create money 1 Savings by a household are then used to supply loans EX Suppose a consumer deposits 1000 in currency into a checking account i If the required reserve ratio is 10 that means the bank is able to lend out 900 2 The money multiplier effect is that an increase in the banks reserves of 1 means that deposits will increase by a multiple of one IV The Federal Reserve or Fed A The Fed oversees and monitors the banking system B Conducts monetary policy 1 Controls the nominal interest rate and influences the supply of money C Structure 1 Board of Governors 2 Twelve regional Fed banks 9 Boston 5 San Francisco Federal Reserve bank cities Q Dew Boundaries of Federal Reserve districts 12 Boundaries of Federal Reserve branch territories r7 State borders a Federal Reserve Board Washington Dc D Voting membership on the Federal Open Market Committee FOMC 1 Fed overseen by the seven member Board of Governors in Washington DC a Members are appointed by the president subject to Senate confirmation b Tenure of fourteen years c Chair serves four years staggered off of the presidential election cycle 2 FOMC a Conducts monetary policy b Twelve members i Seven members of the Board of Governors ii The New York region Fed Reserve president iii Four of the remaining eleven regional presidents on a rotating basis E Open market operations OMOs 1 The Fed controls the supply of reserves through open market operations 2 OMOs are the Fed39s most important monetary policy tool 3 The Fed conducts an OMO by buying or selling government bonds on the bond market in New York a The stock of bonds that the Fed sell comes from previous purchases it made from the public b The Fed does not obtain government bonds from the Treasury 4 When the Fed purchases a bond it pays using a check a When this check is deposited in the seller39s bank the Fed credits that bank39s reserves the amount of the check b The bank now has more deposits and excess reserves c This is how the Fed creates new reserves d The money multiplier then goes to work creating more and more deposits that is more money F Other instruments of monetary policy held by the Fed 1 Reserve requirements 2 Discount rate 3 Selecting the appropriate instrument a Reserve requirements and discount rate are blunt instruments b Reserve requirements are rarely used c OMOs are used daily V The stability of the US banking system A Before the creation of the Fed banks runs were frequent B The Fed has been able to reduce the threat of bank runs 1 Reserve requirements and deposit insurance 2 Assure depositors that banks have sufficient funds 3 The Fed acts as a quotlender of last resortquot a Banks can borrow from the Fed if they are in trouble 4 Capital requirements a Fed requires bank owners to meet capital requirements b This ensures that owners of banks run them carefully


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