INTRODUCTION TO MICROECONOMICS
INTRODUCTION TO MICROECONOMICS ECON 201
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This 12 page Class Notes was uploaded by Verner Kilback on Monday October 19, 2015. The Class Notes belongs to ECON 201 at Oregon State University taught by Staff in Fall. Since its upload, it has received 22 views. For similar materials see /class/224544/econ-201-oregon-state-university in Economcs at Oregon State University.
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Date Created: 10/19/15
Econ 201 Review Notes Part 2 This is intended as a supplement to the lectures and section It is what I would talk about in section if we had more time After the rst three chapters where we talked about rational decision makers what they do and how they should make decisions what happens when one individual interacts with another and nally when many individuals interact together in a market Now we want to look more closely at markets and how economists describe it and what it tells us 4 Demand The 39sz39uuver39s side of the market The rst thing to understand is what we call the law of demand This says simply that people do or buy less of what they like as the price of doing or buying goes up Note that this is the same thing as saying that the demand curve is downward sloping and in fact this is exactly why we draw a downward sloping demand curve A Law of Demand People do or buy less of what they like as the cost of doing it or price of buying it goes up But how do you decide if and how much to buy Well economists need some idea of how much pleasure or enjoyment or use llness you get from doing or consuming something by the way consuming can be thought of as buying or doing something in general not just something you eat economists call this quotutilityquot This is a generic term that we use usually only to compare different individuals but also more generally to measure a persons satisfaction or happiness With the consumption of a good we say you derive utility from it B Total Utility The total amount of utility you get from consuming a certain quantity of a good C Marginal Utility The extra or additional utility you get from consuming one more of a good Law of Diminishing Marginal Utility This is a law that economists assume holds and you should too unless speci cally instructed not to do so that states that as you consume more and more of a good the additional utility you receive from consuming one more goes down Think of this simple relationship More QA Less MUA C Now if you are a rational individual economists believe that you should always try and maximize your total utility after all shouldn t you always try to make yourself as happy as possible To do so it means that you should consume the optimal combination of goods or simply the combination of goods that maximizes your total utility and that you can afford with your income To make it easier for you to do so there is a simple rule to follow E The Rational Spending Rule This rule simply says that the next good you should consume is the one that gives you the highest marginal utility per dollar so that in the end when you have spent all of your money the marginal utility per dollar of each good is equal For two goods this means that MUAPA MUBPB Why Suppose you were in Wegmans and you bought only cookies and apples and you put enough of both in your basket that the cost was exactly equal tot he amount of money you had to spend A cookie costs the same as an apple and it turned out that at the combination of apples and cookies in your basket the marginal utility per dollar of an apple was higher than the MU per dollar of a cookie Then you could put back a cookie and take another apple and your total utility from consuming what is in your basket would go up Finally we introduced the concept of elasticity Elasticity is a way that economists measure the responsiveness of quantity demanded to price F Price Elasticity of Demand The percentage change in quantity demanded that results from a 1 change in price This is important because price and quantity determine total revenue or total expenditure G Total Revenue Total Expenditure PQ or price times quantity demanded For a point on a demand curve if elasticity is greater than 1 in absolute value then we call it elastic and if it is less then one we call it inelastic If the elasticity at the point is equal to one we call it unit elastic The unit elastic point has a special feature it is the point of maximum total revenue 5 Supplv The producer39sseller39s side of the market The supply side of the market is in many ways analogous to the demand side In general we know that if a person values a good at least as much as its price than he she will buy it The same is true on the supply side except in this case we are looking at sellers We know that if the cost of production is less than the price of a good a seller will sell it So where on the demand side we were interested in marginal bene ts on the supply side we are interested in marginal costs If the marginal cost of producing one more of a certain good is less than the price you can sell it for then you should go ahead and produce one more Firms keep doing this until price equals marginal cost or until the last good that is produced costs exactly as much to produce as its price It is this simple idea that induces the supply curve By selling goods for more than they cost to produce rms make pro ts A Pro t Pro t is the difference between the total revenue earned from the sale of a product and total costs both explicit and implicit ie opportunity costs Pro t maximizing rms are those rms who try and maximize this difference Firms can compete in different types of markets For this class the main distinction is between perfectly competitive markets where each rm is a price taker or has no in uence on market price for their good and imperfectly competitive markets where rms have some control over the price of the market usually because they supply a large percentage of the total amount of one good to the market When producing goods rms need inputs materials labor factories machines etc We split these inputs up into two categories xed factors of production and variable factors of production B Fixed Factor of Production An input whose quantity cannot be changed in the shortrun C Variable Factor of Production An input whose quantity can be changed in the shortrun Why the shortrun for both Well we de ne the long run as a time period long enough that all factors of production are variable Now just like the law of diminishing marginal utility on the demand side we have a relation about the quantity of goods produced and their bene t it is called the law of diminishing returns D The Law of Diminishing Returns This law states that after some point as you make more and more of a good the variable inputs needed to make one more of the good get bigger and bigger This says that the marginal costs increase similar to the way the marginal bene ts decrease in the demand side We can also talk about the price elasticity of supply in the same way we talked about elasticity in the demand side namely that it is the percentage change in quantity supplied given a 1 change in price What affects the elasticity of supply Well if inputs are exible or especially mobile then it is easy for a producer to change production quantities when prices change so elasticity will increase The same is true if it is easy to produce substitutes or if the product is narrowly de ned doritos corn chips rather than corn chips in general etc 6 The Market Revisited Ef ciency and Exchange Before we looked at how the market works mechanically through the supply and demand diagram but now we want to think about aspects of this mechanism that we nd particularly good or useful The first thing that we know and one of the most powerful ideas in all of economics is that market outcomes are ef cient A word of caution this is also one of the most abused ideas in economics before spouting off about the wonders of the market just be aware that there are a huge amount of conditions for this to be true people must be well informed there must be perfect competition etc This rarely happens in the real world BUT the market often still does better than anything else in these situations A Ef cient A situation is efficient if it is not possible to rearrange things so that some people are better off and no one is worse off Why is the market outcome efficient Try and find an exchange that has not already happened that will make someone better off and no one worse off it is not possible because if it were the market would have brought about that exchange Why This is the idea of the invisible hand self interested people will look for just those trades and do them if they can Economists measure how much people benefit from market exchanges by looking at total economic surplus or just total surplus This is the sum of consumer and producer surplus B Consumer Surplus This is the difference between the value a consumer places on a product the maximum they are willing to pay and the price they do pay for it If we add these up for all consumers in a market that purchase a good then we find total consumer surplus This is the area beneath the demand curve and above the equilibrium price 0 Producer Surplus This is the difference in what a producer would be willing to sell a good at and what heshe actually does sell it at Total PS is the area above the supply curve and beneath the equilibrium price U Total Economic Surplus This is the sum of total consumer surplus and total producer surplus So another way of seeing efficiency is that it is the outcome that maximizes total surplus When the government alters the market with price controls or price supports or per unit taxes on buyers or sellers then efficiency breaks down The moral of the story in the simple world is that the market should maximize the total surplus on its own and the government should pursue its goals by adjusting outside of the market Econ 201 Review Notes Part 3 This is intended as a supplement to the lectures and section It is what I would talk about in section if we had more time After the first three chapters where we talked about rational decision makers what they do and how they should make decisions what happens when one individual interacts with another and nally when many individuals interact together in a market Next we looked more closely at markets and how economists describe them and what they tells us We looked at the demand side of the market consumers the supply side of them market producerssellers and then talked about how the market induces outcomes that are ef cient Now we want to talk mostly about what happens when things aren t as perfect as in the simple model of perfect competition But before that we want to talk about what competition does and the concept of the invisible hand Then we will talk about markets where there does not exist perfect competition but rather imperfect competition Finally we will talk about extemalities labor markets information and governments 7 The Invisible Hand The central concept that that when in a perfect world people act in a purely self interested way an efficient outcome arises But first what is selfinterested Well for rms it is pro t maximization To study this it is necessary to understand what economists call profit and how that differs to the way you are probably used to thinking about it A Accounting Pro t This is what you are probably used to this is simply the revenue taken in by the rm minus all of its explicit costs This is what an accountant would report or what is recorded in the rm s books Economic Pro t This is different This is the revenue minus all explicit costs and all implicit costs opportunity costs Normal Pro t Is simply the amount of accounting profit which exactly covers opportunity costs it is the same amount as the opportunity cost 55 0 Why this difference in de nition Because economists are concerned with the decision to begin or remain in business and we figure that in order to do so a businessperson must be doing at least as well in their business as they would doing the next best job available to them If not they should go out of business and take that job When there is perfect information in an economy prices play a vital role and more than you might think on first glance D Rationing Function of Price Prices serve as a method of screening out potential buyers who do not value an item as much as others E Allocative Function of Price Prices lead businesspeople to search for underserved markets high prices and avoid overserved markets low prices For these wonderful things to happen information must be free and available to all and competition must be perfect When is competition not perfect When there are barriers to entry F Barriers to Entry Something like a patent or copyright that prevents new firms from entering a market 8 Imperfect Competition So what if there are barriers to entry what then We call this imperfect competition and talk generally about three broad categories r 39 quot 39 competition These are all types of price setters I r s 139 hand A Price Setter a firm who faces a downward sloping individual demand curve B Pure Monopoly A firm that is the only supplier of a unique product C Oligopolist A firm that produces in a market with only a few competing firms D Monopolistically Competitive Firm A firm that produces in a market with many competitors but who is able to differentiate its product from the others All of these types have market power or the ability to raise prices without loosing all of their sales because of the downward sloping demand curve In all cases the firms try to maximize profits and in order to do so follow a simple rule set output such that marginal revenue marginal cost Note that this is the same rule as perfectly competitive firms follow except that for competitive firms MRPrice Because of the downward sloping demand curve when imperfect competitors follow this rule the outcome will no longer be socially efficient In fact they will produce too little than is socially optimal Imperfectly competitive firms can do better if they price discriminate E Price Discrimination Different prices are charges to different consumers based on the consumers reservation prices If a firm can perfectly price discriminate or charge each individual consumer their reservation price then the efficient outcome is restored but with all of the surplus accruing to the firm 9 Games Economists use the theory of games to best describe the interaction among a few rms The idea is that a rm makes its decision both with its demand curve in mind and knowing that its competitor will like respond with some sort of reaction There is really not a lot that I need to say about games except what we mean when we say the quotsolutionquot to the game is But rst a little set up When we describe simultaneous move games were each player moves without knowing what the other players do we use a payoff matrix and when we describe sequential move games when players move in order one after the other we use a game tree A A Payoff Matrix Describes all of the possible payoffs based on the combination of strategies chosen when players move at the same time B A Game Tree Describes all of the possible payoffs based on the combination of strategies chosen when players move one after the other Next we talk about solutions C A Dominant Strategy Is a strategy for one player that yields higher payoffs no matter what the opponent chooses D A Nash Equilibrium Is a combination of strategies that is the best choice for each player based on the action of the opponent Finally a special kind of game E A Prisoner39s Dilemma Is a game where each player has dominant strategies and when they play these strategies they both get payoffs that are smaller than if they had played dominated strategies 10 Externalities Economists believe that markets are ef cient Implicit inthis statement are the assumptions of perfect information zero transactions costs rational consumers etc In fact there are so many assumptions that there are often cases where these assumptions do not hold and the ef cient outcome is not realized by the market The classic example of this is extemalities An extemality is a cost or a bene t that people have to pay or enjoy who are not undertaking the activity that produce these costs and bene ts Another way of expressing this is that these costs and bene ts are not included in the prices of the activities and therefore there is no way for the market to act ef ciently in the allocation of these resources A Negative Externality Is a cost that must be bom by people other than those undertaking the activity B Positive Externality Is a bene t that is enjoyed by people other than those undertaking the activity But what if there were prices for the eXtemalities would the ef cient market outcome be restored The answer is yes as long as there can be costless negotiation between all of the affected parties We call this result the Coase theorem C The Coase Theorem If people can costlessly negotiate the purchase and sale of the right to perform activities that cause eXtemalities they can always arrive at ef cient solutions to the problems caused by the extemalities One interesting outcome of this is that if negotiation is costless it does not matter who has the right to do what either way the ef cient outcome will emerge 11 Labor Markets Now we take a step back for a moment and consider how labor markets work Not surprisingly they work in the very same way that goods markets work A laborer s worth is determined by what they produce and their salary re ects this Firms measure the worth to them of a worker by assessing their marginal product A The Marginal Product of Labor MP Is the additional output a rm would gain by hiring that worker The Value of Marginal Product of Labor V MP Is the MP times the price of the product the firm produces or the dollar value of MP 55 So rms will hire workers until the VMP is equal to wages This statement is equivalent to saying until the marginal bene t of doing so equals the marginal cost How is MP determined By two things how many workers are already employed and by the worker s human capital C Human Capital Is the total education training reliability work ethic health intelligence etc that determine how productive a worker is Finally the concept of winner take all markets is one coined by Prof Frank and describes the case where very small differences in human capital translate into huge differences in compensation 12 The Economics of Information The ef cient market idea rests on the assumption of perfect information but this is obviously not true in general In fact information is often scarce and as consumers we are constantly trying to nd out more about products option and prices But there is a cost associated with doing so so we again can think of the search for information along traditional costbene t lines One question is why is information seemingly so scarce Well it is usually costly to provide and there is the free rider problem A The Free Rider Problem When it is difficult to exclude nonpayers from utilizing a certain good it will be underprovided This is one reason why it is hard to nd knowledgeable salespeople when shopping and with more and more intemetbased shopping it is sure to get worse Another problem arises when one party in a transaction has more information than the other This can lead to exploitation of the uninformed but can also hurt the informed in some cases We callthis asymmetric information B Asymmetric Information The situation when buyers and sellers are not equally well informed about the goods in the market The result of this is often that the level of the quality of goods in the marketplace falls This is known as the lemons model In this case if the seller of the high quality item can credibly signal its quality then the problem is solved and there is no more asymmetric information but often times this is very difficult 13 Government Since there are all of these cases where the efficient market assumptions fail what should be done For example if all of the residents of Ithaca value having the snow cleared from the streets how do we overcome the extemality problem Usually it is through government intervention Governments are charged with the provision of public goods A A Public Good Is a good or service that is nondiminishable and nonexcludable in general B Nondiminishable If the consumption of the good or service by one person does not affect the quantity available to other consumers C Nonexcludable If it is difficult or costly to prevent people who do not pay to consume the good or service So clean roads in winter are public goods How does government pay for the provision of these goods well in a democracy this is a very difficult question and one that occupies a whole field of economics but in general through taxes donations private contracting etc Econ 201 Review Notes This is intended to help you follow the course of the course a course quotroadmapquot if you will and is not intended as an exam review sheet it is neither complete nor comprehensive I have tried to cover some key concepts using different terminology than the text The text however is the last word on all matters Remember doing problems is always the best review for the exams 1 The Individual This course started by focusing on human beings acting as individuals and making decisions in an economic environment We began by assuming that individuals are Rational A Rational A rational individual makes decisions based on the appropriate costs and bene ts associated with each decision The rational individual decides based on the action that provides himher with the largest economic surplus We then discussed what exactly are the appropriate costs and bene ts to include in a cost bene t analysis B Cost Bene t Analysis This is simply the comparing of all the bene ts associated with a certain action with the costs of the same action But what are the appropriate costs and bene ts to compare We discussed two main problem areas C Ignore Sunk Costs This is a common pitfall If at the time of the decision certain costs associated with the action you are considering are non recoverable than you should not include them in your costbene t analysis D Remember Opportunity Costs Associated with almost any action are opportunity costs which are the net value of the next best action foregone There are typically many things you might do if you were not going to do a certain action choose the best one consider its bene t minus any costs associated with it and this is the opportunity cost associated with doing the action you are considering Next when asking questions in the nature of how much or how many you need to think about the marginal value of each one and compare that to its cost E Marginal Bene t The Marginal Bene t of a certain action is the additional bene t you receive from doing one more of the action eg consuming one more of a good doing one more of an activity You have to think of doing one more after you have already done the ones before so if you are considering buying three or four pieces of pizza you need to think about the extra bene t from the fourth piece of pizza after you have already consumed the other three Finally for the rational decision maker to make the correct decision we require that heshe compare the economic surplus associated with each action and choose the action that nets himher with the most surplus F Economic Surplus Simply the bene t minus the cost associated with the action in consideration 2 More than one Individual Now we move on to worlds where there is more than one person present What we want to know first is if there is any reason for them to interact economically The answer is almost always quotyesquot This is because most people are comparatively better at something than are others We call this Comparative Advantage A Comparative Advantage We say that a person has a Comparative Advantage in the production of a good if their opportunity cost of the production in terms of some other good is lower than someone else s Note that this is different from having an Absolute Advantage B Absolute Advantage We say that a person has an Absolute Advantage in the production of a good if that person can produce it more ef ciently than someone else By e cient we mean that they use fewer resources time materials effort etc If two people have comparative advantages than they can both be made better off through specialization and trade We strive to achieve the largest possible economic surplus and thereby make the situation ef cient because by doing so we can make everyone better off 3 The Market Now we want to focus on a certain good or service We say that for each good or service there exists a Market A The Market This is a description of all the people who might potentially buy or sell a particular good or service So perhaps normally you would not consider buying a quotHansonquot CD but if the price were low enough say 10 cents you might just go ahead and buy it than you are part of the market for Hanson CD s In fact in the example above you are part of the Demand Curve for Hanson CD s B The Demand Curve This is the description of how many of the good buyers will want to buy at each price This is all of the people who wish to buy at a certain price and how many they wish to buy at that price But suppose that at a price of 10 cents very few stores are willing to sell Hanson CD s because they feel that they will loose money Well all of the stores individuals record clubs etc make up the Supply Curve for Hanson CD s C The Supply Curve This is the description of how many sellers wish to sell a particular good at each price We can put these two things together in the market for a certain good and then look for the particular price of a good at which the number of the good that sellers want to sell is exactly equal to the number of the good that buyers want to buy This is Market Equilibrium D Market Equilibrium The price at which the quantity demanded of a good is exactly equal to the quantity supplied We call this price and quantity equilibrium price and equilibrium quantity If the price in the market is too high or is too low than we can have shortages or surpluses E Shortage When the market price for a good is such that the quantity demanded is larger than the quantity supplied F Surplus When the market price for a good is such that the quantity demanded is smaller than the quantity supplied You must be very careful about changes in supply and demand and changes in quantity supplied or quantity demanded G Change in Supply 0r Demand This is a shift in the supply or demand curves and is due to changes in factors other than the price of the good in question H Change in the Quantity Supplied 0r Demanded This is a movement along the supply or demand curve and happens only with a change in the price of the good in question Finally we have to keep in track of what happens in the case of when two goods are used together or when two goods are used in place of each other We call these Complements and Substitutes respectively I Complements Two goods are said to be complements in consumption when an increase in the price of one causes a leftward shift in the demand curve of the other This means that as coffee becomes more expensive less will be consumed by the law of demand that as price rises quantity demanded falls and therefore there will be less demand for cream Substitutes Two goods are said to be substitutes in consumption when an increase in the price of one causes a rightward shift in the demand curve of the other This means that when the price of apples increases people will eat less of them by the law of demand so the demand for other fruit for example oranges goes up 9
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