PRINCIPLES OF ECONOMICS
PRINCIPLES OF ECONOMICS ECON 211
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This 14 page Class Notes was uploaded by Destany Daniel on Monday October 19, 2015. The Class Notes belongs to ECON 211 at Rice University taught by Staff in Fall. Since its upload, it has received 7 views. For similar materials see /class/225022/econ-211-rice-university in Economcs at Rice University.
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Date Created: 10/19/15
A ECONOMICS 2n mumm WDEL 01 man Assnm ans mm mm 1 ThznmWmpmdvcexsafmmnlwutzxeachpmducmgmtnat mxgmd cast kmwsthz Is q q2axmnmgemn1yPArEQ wmA EIEIElandQ whzxeq andqzaxethzampmsaf nnslandZns IcnvelyWe kmwmamwxnmmxmmnnwmmm thgma n 15 m change aftntnhwemlz pxnmtclunge afmltpm 2 Each rm 1nd kydzmndcurve m average xmmlz curve mn71 an AE FaxaLmzarDemdenrveP 7 A r a men 7 Q AQ smung Lhasa wluzsmequtmn we get MRA 7 mt Hanna rm hmudzmmdcnrve m slap afthz mum curve muss large as slap afthz average 11 curve my m vemcalmmxcept 15 m same Price Mu AR unlIlY 3 4 P Each decision maker is doing the best she can given the decision of the other rm Each rm recognizes that varying its own output will affect price but does not take into account any interdependence between its output decision and the other rm39s output decision That is each rm assumes that regardless of what output decision it takes the other rm will not change its output level whatever it is producing Each rm maximizes its pro ts given its forecast on what the other rms will produce If it assumes that q2 qZE Firm l s average revenue curve is P 100 qZE ql and its marginal revenue curve is 100 qZE 2q1 Since MC 0 the rm will produce where MR is equal to zero That is A pro t maximizing ll 100 92E 2 2 By exactly the same logic we calculate the pro t maximizing level of output for rm 2 given its expectations what rm 1 will produce Marginal revenue for rm 2 MR2 100 qlE 2q2 By setting MR2 to 0 the rm nds its pro t maximizing level of output qu 6100 1E 2 3 In the rst two columns of Table l we calculate qlA as a function of qZE In columns 3 and 4 rm 239s pro t maximizing output is calculated as a function of its expectations about what rm 1 will produce The numbers in columns 1 and 2 represent a reaction curve for rm 1 This curve shows how much rm 1 will produce given different expectations about what rm 2 will produce Similarly columns 3 and 4 represent a reaction curve for rms 2 Table l l 2 i i qu in qiE qu 0 50 0 50 10 45 10 45 20 40 30 35 33 13 33 U3 40 0 50 25 60 20 70 15 80 10 90 5 100 0 B Equilibrium Conditions 40 33 U3 25 20 10 The two rms will be in equilibrium when rm 2 actually produces what rm 1 expects it to produce q2E qZA and rm 1 actually produces what rm 2 expects it to produce qlE qlA Substituting these expressions into equations 3 and 2 and setting MR equal to zero we get 100 qu 2q1A 0 2 100 qlA 2qu 0 12 ll 1003 30 100 3 Solving for qlA and qZA we obtain qlA qZA 33 13 That is the two rms are in equilibrium when each produces 33 13 units of output Since together they will produce 66 23 units the price ofthe good will be 33 U3 Since P 100 l qlA qugt I Comparison with and omnetitive Outcome Table 2 compares the results of a duopoly with those of collusive joint pro t maximizing behaVior monopoly and a quotcompetitivequot outcome where price is set equal to marginal cost Table 2 Duopoly Solutions with Industry Demand Curve P 100 qlA qZA Pro ts Pro ts Firm 1 Firm 2 I d q1 q2 Q Collusive 25 25 50 50 1250 1250 Cournot 33 13 33 13 66 23 33 13 1111 19 1111 19 Competitive 50 50 100 0 0 0 A short introduction on the Productlon P0551b111ty Frontler I Resources and Wants ll Scarcity that the resources available are insuf cient to satisfy people s wants is universal 2 Economics can be de ned as the study of the choices people make to cope with scarcityi 3 Resources can be divided into four categories a Labor the time and effort devoted to producing goods and services b Land the gifts of nature used to produce goods and services c Capital goods we have produced that are now used to produce other goods and services Human capital is the knowledge and skill people possess from on the job training and education d Entrepreneurship the resource that organizes labor land and capitali 4i Wants are unlimited II Resources Production Possibilities and Opportunity Cost 1 The production possibility frontier PPF marks the boundary between combinations of goods and ser vices that can be produced and combinations that cannot E0 A production possibility diagram that holds constant the production of all goods save for discs and cases is illustrated in the following gure The production possibility frontier curve separates attainable combinations of production all points inside and on the line from unattainable combinations all points beyond the curve cases lOOOweek discs lOOOweek a Production ef ciency means that more of one good cannot be produced without decreasing produc tion of another good 9 Production ef ciency occurs only when production takes place on the frontier Because another good must be given up there is a tradeo F The opportunity cost of an action is the highest valued alternative forgone a On the production possibility frontier the opportunity cost of producing more of one product for example one more case is the output of the other good that must be foregone for example discsi b The opportunity cost of a case is the number of discs that must be foregone per case hence opportunity cost is a ratio c The opportunity cost of a case is the inverse of the opportunity cost of a disc 5 Different resources are not equally effective in producing different goodsi Thus along the production possibility frontier producing more of a good has increasing opportunity costs a The convex bowedout shape of the production possibility frontier re ects increasing opportunity costs b Most activities in the real world are subject to increasing opportunity costs III Economic Growth H Economic growth is the expansion in production to Factors that cause economic growth technological progress and increases in the resource endowment such as capital accumulation or increases in population a Technological progress is the development of new goods and better ways to produce goods and services b Capital accumulation refers to the growth in a society7s capital resources 9 The greater the rate of capital accumulation andor technological progress the more rapidly the pro duction possibility frontier expands that is the more rapid is economic growt F Economic growth is costly The opportunity cost is incurred because resources are devoted to man ufacturing capital goods and developing new technologies rather than to producing goods for current consumption 5 Nations that incur the cost of devoting more of their resources to capital accumulation or technological change Hong Kong grow more rapidly than nations that choose not to pay the cost and thus devote fewer resources the United States to such purposes The following picture shows an expanding PPF as a result of technological progress cases 1000week discs 1000week IV Gains From Trade 1 People7s abilities differ as a result different people have different opportunity costs of producing a particular goo to 9 1 A person has a comparative advantage in producing something if that individual can produce it at a lower opportunity cost than anyone else In terms of a production possibility diagram the opportunity cost of producing a good is related to the slope of the production possibility frontier at the point of production a The gure on the left below shows Tom s production possibility frontier His opportunity cost of 1 disc is 13 of a case and the opportunity cost of of 1 case is 3 discs The equation of his PPF is c d 3 or c 1 7 3 The gure on the right shows Nancy7s PPFi Her opportunity cost of 1 disc is 3 cases and the opportunity cost of a case is 13 of a disc The equation of her PPF is 03d3 or 0373di Tom can produce another disc at a lower cost in foregone cases 0333 cases per disc than can Nancy 3 cases per case Nancyls production possibility frontier is steeper than Tomlsi Thus to produce an additional case Nancy sacri ces fewer discs than Tom does 033 discs per case for Nancy versus 3 discs per case for Tom so Nancyls opportunity cost of producing one more case is less than Tom s opportunity cost Nancyls opportunity cost of an additional case is relatively lower so she has a comparative advantage in cases Tom s opportunity cost of an additional disc is relatively smaller so he has a comparative advantage in producing discsi 1f Tom and Nancy specialize in the good for which they have a comparative advantage and exchange what they produce each can have more tape and more cases g g g Tom s PPF g Nancyls PPF o o o o 3 3 3 3 3 g Q O O 1 3 1 Discs lOOOWeek Discs lOOOWeek 4 Suppose Tom and Nancy want to produce CDs Since each CD requires one disc and one case Tom and Nancy want to produce discs and cases in equal number a case is useless Without a disc and Vice versa be on their 131317 since any point inside their PPF is inef cient and a point to the right of it is unattainable To be able to nd the point on their PPF Which has equal coordinates we look at the intersection of their PPF With the diagonal line d c in this case Tomls PPF Nancyls PPF 3 1 075 075 l 075 3 075 1 Discs lOOOWeek Discs lOOOWeek Cases lOOOWeek Cases lOOOWeek Both Tom and Nancy can produce 750 discs and 750 cases hence 750 CDs 5 The following picture shows Tom and Nancyls joint PPFi It shows how much they can produce if they combine their resources Note that the upper left hand side of the joint PPF has the same slope as Tom s In that region Tom should produce cases since he can do so at lower cost than Nancyi However once 3000 discs are being produced Tom cannot produce more so Nancy must shift resources from cases to discsi At that point the joint PPF curve has the slope of Nancyls PPF re ecting her higher opportunity cost of discs Cases 1000week Discs 1000week Note that if they specialize in producing discs and cases they can produce a total of 3000 cases and 3000 discs which make a total of 3000 CDs whereas if they do not they can produce only 1500 both Tom and Nancy can produce 750 CDs 6 An individual has an absolute advantage if he or she can produce more of all goods per unit of input than anyone else a An individual who has an absolute advantage does not have a comparative advantage in producing a b Even an individual with an absolute advantage can gain by specializing in the good for which he or she has a comparative advantage and exchanging it for other products 7 Markets arise because different individuals have comparative advantages in different activities Each can bene t from specializing in production and trading with others to acquire the range of goods and services they wish to consumer ECON 21 1 Supplement on Elasticity 1 What is elasticity Elasticity is a measure of how quantity Q demanded or supplied responds to change in the determining factors F such as own price income or price of other goods We can calculate the elasticity of almost any economic relationship curve but the most common are those discussed here The general formula for the elasticity of some curve with respect to factor F is 8 AQQ AFF Which can be interpreted as follows Elasticity percentage change in Q percentage change in F Elasticity tells you how sensitive the quantity is to changes in the factor F IMPORTANT REMARK When you calculate elasticity you must be sure that ONLY factor F is changing while all other remain the same ceteris paribus rule Let s use the following notation XA the quantity of good X at point A PXA the price of good X at point A PYA the price of good y at point A M income AZ the change in variable Z bA the slope ofthe curve at point A 2 Two ways of calculating elasticity 21 Point elasticity The way quantity reacts to change in F depends on the point or region in which you are on the curve Suppose that you want to find out the elasticity at point A and you know the slope at point A Then you can use the following formula 8 AQQA LALE AFFA AF QA bA QA Which can be interpreted as follows Elasticity inverse of the slope at point AFQ ratio at point A This is called POINT ELASTICITY as we calculate it at a certain point Example Suppose that the demand curve is described by the following equation P l bQ What is the elasticity of demand at point QA q The price at QA q is PA l bq Let us now use the formula to nd the elasticity 8 LEl 1i 1 Q b 617 be be 22 Arc elasticity Sometimes you don t know the slope of the curve but you observe two points on the curve point A and point B Then you can use the following formula AQQ QAQBFAFB2QAQBFAFB AFF FA FE QAQB2 FA FE QAQB Which can be interpreted as follows Elasticity change in Qchange in Faverage Faverage Q This is called ARC ELASTICITY as we calculate it across the arc between A and B 3 Specific elasticities and how to interpret them We will now present some of the more common elasticity measures 31 Demand elasticity ownprice elasticity Shows how quantity demanded reacts to the change in price of the good ie as we move along the demand curve AXX XA XB PPf APXPX P P XA XB Due to the Law of Demand this elasticity is always a negative number except in the rare case of Giffen goods That s why demand elasticity is usually reported as an absolute value of the above as a positive number D s sl iAXX APXPX XAXB P PXB PEP5 XAXB We distinguish 3 cases 8 D gt 1 demand is elastic The revenue from the sales of X consumer s expenditures on X decreases when PX is increased in the AB range 8 D l demand is unit elastic The revenue from the sales of X consumer s expenditures on X is maximized in the AB range 3 D lt l demand is inelastic The revenue from the sales of X consumer s expenditures on X increases when PX is increased in the AB range 32 Crossprice demand elasticity Shows how quantity demanded reacts to the change in price of another good The formula below shows how demand for X reacts to the change in price of good Y AXX XA XBPYAPYB 3 7 W APYPY Pf Pf XAXB We distinguish 3 cases 8 XY lt 0 when X and Y are complements 8 W gt 0 when X and Y are substitutes 8 XY 0 when X and Y are unrelated 33 Income elasticity Shows how quantity demanded reacts to the change in income AXX XA XB MA MB AMMMA MB XAXB We distinguish 3 cases 8M lt 0 when X is an inferior good 8M gt 0 when X is a normal good 8 M 0 when demand for X is independent of income For the case ofa normal good we have 2 subcases 0 lt 8M lt l when X is a necessity ie as income goes up the share of expenditure on X in indiVidual s budget decreases 8M gt 1 when X is a luxury good ie as income goes up the share of expenditure on X in indiVidual s budget increases 34 Elasticity of supply Shows how quantity supplied reacts to the change in price of the good ie as we move along the supply curve AXX XA XBPP MaiPX Psi ng XAXB S Notice that this is the exact same formula as for the elasticity of demand except here X is quantity supplied not quantity demanded