Principles of Microeconomics
Principles of Microeconomics ECON 2010
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Chapter 8 Application The costs of Taxation These days there have been hot debates about whether the government should raise or lower tax is tax good What kind of costs taxation may have 1 The DWL of taxation 1 tax revenue Price Suppw Tax Wedge Price buyers pay Tax Revenue Price sellers receive Demand Quantity qt the size of the tax T times the quantity sold Q thus the tax revenue wquals the area of the rectanle between the supply and demand curves 2An example to show How a tax affects welfare 3 F I G U R E A tax on a good reduces consumer surplus by the area B C and producer surplus by the area D E Because the fall in producer and consumer surplus exceeds tax revenue area B D the tax is said to impose a deadweight loss area C E How a Tax Affects Welfare Without Tax With Tax Change Consumer Surplus A B C A B C F D E Producer Surplus D E F Tax Revenue Total Surplus None BD BD ABCDEF ABDF 7E The area C E shows the fall in total surplus and is the deadweight loss of the tax l Price Price A amply buyers pE Day B Price 7 C without tax P1 E Price D sellers pQ receive F Demand 0 02 01 Quantity 2 The determinants of the deadweight loss For the same supply curve if the demand curve is more inelastic dwl is smaller For the same demand curve if the supply curve is more inelastic dwl is smaller vice vers a 3 Deadweight loss and taX revenue as taxes vary 6 FIGURE How Deadweight Loss and Tax Revenue Vary with the Size of a Tax Price The deadweight loss is the reduction in total surplus due to the tax Tax revenue is the amount of the tax times the amount of the good sold In panel a a small tax has a small deadweight loss and raises a small amount of revenue In panel is a somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue In panel c a very large tax has a very large deadweight loss but because it has reduced the size of the market so much the tax raises only a small amount of revenue Panels d and e summarize these conclusions Panel d shows that as the size of a tax grows larger the deadweight loss grows larger Panel e shows that tax revenue first rises and then falls This relationship is sometimes called the Laffer curve a Small Tax b Medium Tax 2 Large Tax Price Deadweight Deadweight Deadwerght F loss loss loss Supply 3 Supply SUDDIY Tax revenue Tax revenue Demand P5 39 Demand Demand 2 PS s 02 Q1 Quantity 0 02 01 Quantity 0 Q2 01 Quantity The deadweight loss is the area ofa triangle and the area oftriangle depends on the square of tax size Ifwe double the size of tax the base and height ofthe triangle both double so the area ofthe triangle rises by a factor offour d From panel a to panel c e From panel a to panel 0 tax deadweight loss continually increases revenue first increases then decreases Deadweight Loss Revenue Laffer curve 0 Tax Size 0 Tax Size As the tax in creases the level of tax revenue will rise first and fall eventually Price Price Loss Suppw Deadweight Note that the dead weight loss is smaller when supply is inelastic Demand Deadweight Loss Quantity Supply Note that the dead weight loss is smalle Price Price l39 when demand is inelastic Demand Quantity Deadweight Loss Demand Quantity Supply Demand Deadweight Loss Quantity Chapter 10 Application Externalities When you chat loud with your neighbors in class Suppose your noise can be priced Do you ever consider bringing bad effect to your classmates How does the supply curve and demand curve of your noise looks like What kind ofpolicy can your instructor use to decrease your noise 1EXternality DEF An externality arises when a person engages in an activity that in uences the wellbeing of a bystander and neither pays nor receives any compensation for that effect 1 Ifimpact is beneficial then it is a positive externality Examples garden 2 Ifadverse impact then it is negative externality Examples cigarette smoking Under these situations the market does not allocate efficiently Because buyers and sellers only take into account their own personal wellbeing and not that of those who are outside the market and are affected 2 Externalities and Market inefficiency Recall demand curve can represent marginal benefitprivatewillingness to pay for consumers Supply curve can represent private costmarginal cost Figure 1 P205 of the book 1 Negative Externalities quotExample Steel factories which releases pollution S social cost External S private r nc D Q Q mkt optimum iii Cost to society is higher than the cost to steel producers Social cost is equal to the private cost to the firms plus the external costs to those people affected by the pollution eg breathing problems Thus social cost exceeds the private cost paid by producers The optimal amount of production ie steel in the market will occur Where TS is maximized TS maximization occurs Where the social cost curve intersects with the demand curve At this point producing one more unit would lower TS because the value to consumers is less than the cost to produce it quotBecause the supply curve does not reflect the true cost of producing steel the market will produce more steel than is optimal This negative externality could he externalized by a tax on producers for each unit of steel produced DEF lnternalizaing the externality Altering incentives so that people take account of the external effects of their actions e g pollution tax on steel producers 2 Positive Externaliti es quotExample flowers you plan in front of your garden S private r nc D social D private When there is a positive eXternality the social value of the good is greater than the private value and the optimum quantity will be greater than the quantity produced in the market To internalize a positive eXternality the government could use a subsidy That is why education is so heavily subsidized 3 Private solutions to eXternalities We do not always need government to solve Type of private solutions M0ral codes amp social sanctions eg don t litter buy hybrid use fabric bags in grocery store Charities Parties involved with eXternalities can reach an agreement But sometimes private solutions do not always work bargaining not really realistic 3 Public policies toward eXternalities Command amp Control policies that regulate behavior directly eg crime to dump poisonous chemicals into water supply max level of pollution a factory can emit environmental protection agency Marketbased policies provide incentives so that private decision makers choose to solve problem on their own gasoline tax Chapter 15 Monopolrstrc Competrtron Key Questrons normal llfe are somewhere between the two markets 1 Fourtypes ofmarket structures 1 Perfectly competltlon many buyers many sellers allsellers selltne exactsame product free entry and emt z Monopoly Manybuyers one seller only one good entrybarner 3 Monapallstlc competltlon Manybuyers many sellers srmrlar but not ldentlcal goods free entry 43 Ollgapoly Manybuyers a few sellers ldentlcal or srmrlar goods dlfflcult to enter ThanurTypes n1 Market Smlcluxe z Monopollstlccompetltlon rm l ldentlcal 1 characterrstros rrrManysellers A n t w rrrFmduCt dlfferentlatlon rm face a downward sloplng demand curve quotFree entry long run economlc pro t ls 0 Examples books bottled water eldthmg fast food etc 2 The monopollstlcally edmpetrtwe flrm m SR rDDwnwar sldplng ema schoose p o t maxrmlzatmn output level at MRMC VMCF sets prlee by usmg demand cu P T esmmas nrn t PltATC loss PATC zero pro t each a Flrm make39 mm b Flrm make losses Prlce Prlce MC MC AT p ATC ATC n T Prlce re l 7 Pro t Demand Demand MR MR re t Ouantlty Ouantlty mammg mmmg quantlty quantlty 3 The monopollstlc competmon rms m long run Free entry zero pro t Price Demand MR Profits maximizing Quantity quantity quotdemand and ATC curves are tangent to each other because we need to havePATC to make sure there is zero proiit PrickATC free entry 3 Monopolistic versus perfect competition 1 Excess capaci Review E idem scale the quantity that minimizes average total cost is alled the 39 39 In I R 39 L r phenornenon excess capacity 2 Markup over marginal cost For aPC rm PMC rUl 39 39 39 39 pgtmc 3 Graph Price Price MC MC ATC m ATE M k F39MR at up MC demand curve Demand MR Quantity Efficient Quantity Quantity pruduEEd Qua my pruduEEd staie Efficient staie R Excess capacity 4 Monopolistic competition and the welfare ofsociety 1 One source ofinefficiency is the markup over marginal cost This implies a deadweight loss 2 Another be ideal consurrfer surplus from the introduction ofanew product Th h 39 other lms lose customers and profit r 39 b 39 have either too few or too many products 3 conclusion quot L hut yum y i l rri in 1 The debate over advertising 2 Adverti ing as a singlal ofquality 3 Brand names 6 A summarization Monopolistic competition between perfect competitionamp monopoly Features that all Lhree market stiu tuies share 6 Rule for maxim ing Con am economic profits in the sliorl run Features that monopolistic competirion shares with nmnopuly Price takerquot Prlce Produces welfarerlnaximizing level of I 7 Features diatmnnopulistic competition shares with competition Number of firms hay in long run Can earn economic profits in long run Perfect competition Maximize profits MR MC M any V Market struttine Monopolistit tompetition Maximize prufits MR MC Monopolv Maximize profits MR M Chapter 11 Public goods amp Common Resources 1 Different kinds of goods Classify goods according to excludability and rivalry in cunsumption divide goods into 4 classes DEF Excludability The property ofa good whereby a person can be prevented from using it DEF Rivalry in consumption The property ofa good whereby one person s use diminishes other people s use 2 four categories of goods private public common resources natural monopoly 1 a figure Fig 1 pg 226 ofbook 2Examples Private goods excludable and rival good clothing most storebought items public goods nonexcludable and nonrival national defense general knowledge highway snow removal food control mosquito control Common resources rival and nonexcludable grazing land ocrea fish note we make these private goods through fish farms Natural monopoly nonrival and excludable Cable TV The boundary between the categories is often fuzzy Whether goods are excludable or rival in consumption is often a matter of degree Public goods and common resources each create externalities because they have value yet have no price because they are not sold in the marketplace These external effects imply that market outcomes will be inefficient in the absence of government involvement or private resolutions to correct the externality 3 The free rider problem DEF A person who receives the benefit ofa good but avoids paying for it 1 Example Suppose there is a street on which 25 people live and which suffers from a litteer problem A weekly streetcleaning service would cost 2500 annually Suppose that each person is prepared ale and willing to pay 100 or more for the benefit of a cleaner street If the service is engaged everyone will benefit however it is possible that some people on the street will refuse to pay anticipating that the service will be undertaken in any event If others in the street will pay for the system anyway the people who did not pay will receive the benefit for no personal expense These people are called free riders This problem is free rider problem 2 Possible result If everybody is trying to free ride the result is that it is possible no system will be installed this is an example of market failure 3 Solution One common solution to the problem is to gather the 25 participants and make them behave like one customer so the decision is reduced from 25 independent decisions to one A vote can be taken but if the answer is yes everyone will be forced to pay regardless of their individual support This is why services such as military defense and police service are almost exclusively provided by governments 4 Tragedy of the commons Example small farm town in Wyoming where cows graze on common land in the middle of town 1 At first everything is fine However as each rancher expands his number of cows the grass will begin to disappear because its being overgrazed fixed amount ofland 2 The ranchers will no longer be able to raise cattle because the private incentives using the land for free outweigh the social incentives using the land carefully 3 This problem could have been prevented if the town had regulated the number of cattle each rancher could have or auctioned off the right to use the common land for grazing 4 Alternatively the town could have divided the common property between its ranchers thus turning the land into an excludable commodity A more modern example is the overfishing of oceans bays and rivers leading to dangerously low seafood populations in some areas 5The importance of property rights With both public goods and common resources the market outcome will be inefficient because of the lack ofwelldefined property rights This absence of property rights can lead to a market failure which implies that in these situations governments can improve the allocation of resources and increase economic wellbeing Chapter 5 Elasticity and Its Applications If the technology of farming increases do you think farmers should be happy Answer not really Drug dealing has been big problem in Mexico what kind of policy do you think can be used to ban this All about elasticity We know the law of demand says that if price decreases people demand more of a good but buy how much 1 ELASTICITY DEF A measure of the responsiveness of quantity demanded or quantity supplied to one ofits determinants price income price of the other goods etc Elastic if changes a lot inelastic if doesn t change a lot Elasticity measures how sensitive people are to prices 2 PRICE ELASTICITY OF DEMAND DEF A measure of how much the Qd of a good responds to a change in the price of that good computed as the percentage change in quantity demanded divided by the percentage change in price 1 Determinants of Price Elasticity of Demand Availability of close substitutes easy to move from one good to the other more subs more elastic Breakfast cereals Necessity or luxury Prescription drugs necessary inelastic or diamonds luxury elastic De nition of the market All Beverages broad inelastic versus soda versus Coke narrow elastic Time horizon With time more substitutes become available more elastic 2 Computing the price elasticity of Demand Price elasticity of demand Percent change in Qd change in Price Example Example Price ofbagels falls 20 amp causes an increase in Qd of 25 s AQd23 125 quot AP 20 4 39 3 Elasticity Unit Elasticity Inelasticity ELASTC if 5gt1 vacations luxuries UNTARY ELASTIC if 51 lNELASTlC if lt1 d PERFECTLY INELASTIC if 50 vertical The flatter a demand curve the more elastic it is 4 The Midpoint Method of Calculating the Elasticity of Demand Note Percent change is New OldOld100 Elasticity is ratio of percent changes therefore going from point A to B will have different elasticity than going from B to A Get around this problem with the midpoint method change of going from 100 to 120 is 20 120 to 100 is 167 Qz Qi QzQl AQd 2 quotquot AP 39 Pz Pl P2P1 2 Example Price of a good increases from 09 to 11 The Qd decreases from 1100 to 900 why bcoz of law of demand 92 Ql 900 1 100 Q2 91 9001100 AQd f f 1000 02 1 AP39 M w 39 02 o2 M w 1 2 2 So in this case the good is unit elastic Note Because of the law of demand quantity demanded will always move in the opposite direction to that of price change so the price elasticity of demand will always be negative It is common to ignore the negative sign and report only the absolute number 4 Total Revenue amp the Price Elasticity of Demand DEF TOTAL REVENUE The amount paid by buyers and received by sellers of a good computed as the price of the good times the quantity sold TR PQ Example P Iamba uice Market 35 TRPQ P 350150 525 D Q W 150 Q Relationship between TR amp Elasticity Demand inelasticHAPgtAQd Price effect greater than quantity effect For increase in price Qd falls only a little and TR rises So Price and TR move in same direction Demand elasticHAQdgtAP Quantity effect greater than price effectFor increase in price Qd falls a lot and TR falls Price amp TR move in opposite directions Demand unit elastic Price increase leads to decrease in Qd such that TR same unit means the changes are the samePrice decrease leads to increase in Qd such that TR same again changes are the same Back to example price increases from 350 to 4 00 P Iamba Iuice Market Old TR was 5 25 400 Increase P amp decrease in Qd lowered TR 350 Elastic since TR went down with increased P PLoss of125 Elasticity along a Linear Demand Curve Even though the slope change in ychange in X is constant the elasticity ratio of changes is not Low price amp high Qd inelastic demand High price amp 10w Qd elastic Elasticity gt1 Elastic Unit Elastic Elasticity lt1 Inelastic Between 9 and 10 01012 1091092112119219 Between 1 and 2 8989221122317 Total revenue curve inverted U shaped Total revenue for a unit elastic demand curve is a horizontal straight line 3 Income Elasticity of Demand INCOME ELASTICITY OF DEMAND A measure of how much the quantity demanded of a good responds to a change in consumers income computed as the percentage change in quantity demanded divided by the percentage change in income Formula Income elasticity of demand Percent change in Qd change in Income AQd AY Normal goods have positive income elasticities both changes in same direction Inferior goods have negative income elasticities changes in opposite directions Necessities tend to have small income elasticities while luxuries tend to have large income elasticities 39 4 Cross Price Elasticity ofDemand m CROSS PRICE ELASTICITY OF DEMAND A measure of how much the quantity demanded ofa good responds to a change in price of another good computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good CrossPrice elasticity of demand Percent change in Qd good 1 change in P good 2 mg 5quot AP Substitutes have positive crossprice elasticities pepsi and coca cola Complements have negative crossprice elasticities ipod and ipod accesories Zero implies no relation 5 Elasticity of Supply We know that higher prices raise the quantity supplied The elasticity of supply measures just how much and how big this effect is 1DEF PRICE ELASTICITY OF SUPPLY A measure of how much the quantity supplied of a good responds to a change in the price of that good computed as the percentage change in quantity supplied divided by the percentage change in price 2 Formula Price elasticity of supply Percent change in Qs change in Price 8 AQS AP 3 Determinants of Elasticity of Supply 1 Time longer the time horizon the more elastic 2 Availability of Inputs elastic when inputs are easily available eg land on the beachfront are inelastic in supply whereas pizza cars are more elastic Chanter nnmaud and n l nan mkmg over Chrlstam Romer Berkeley job Why olo we neeol economlc advlsers7 Economlc pollcles balance between efflclency and equlty etc USA new7 2010 u llal y l ll Lu Isltgood7 Bad7 De ols 1 Controls on Frlce There are legal restrlctlons on how hlgh or low a market prlee may go regulate prlces There are two mam types of prlee controls prlce eelllngs ampprlce floors purl r rlm l l h M eg rent control malnohng prlce eelllng always less than eoulllbrlum prlee malnohng prlce eelllng results In shortage QdgtQsJ quotGraph analysls Check my notes In class Price Supply Prlce Ceilng Shortage Demand Quantlly 8 Def Deaolwelght loss loss surplus usually from mterventlon ml thls pollcy good7 llp l Dlsaolxantage some people can not even buy house anymore black market dlscrlmmatlon there IS oleaolwelght loss ZJFrICe Floor a legal mlnlmum on the prlce at whlch a goool can be sold eg mlnlmum wage agneultural products mnmng pnse u nr always greater than ethhnum pnce u lus y e e E 3 E 5 Pnce nnms nntbmdmg anymnre when ms helnwethhnum pnce Graph Analysis Checkmynntes In class the hne 1s pnce annrnntsnhng Price SL1 Surplus pp y Pnce Ceihng Demand Quantity Quantity Quantity Dmanded Supphea Withabmmngpnce nnr thems asuxplus Irmemarketwasunregulam CSAED vs CE TS AECDE Ifthemarkethasapnce nnrlmpnsedmenc QTSAEC Net change m tntal surplusde7deadwexgltlnss ZTaxes Def Tax mndence The manner In whmh the hunden nr a tax 1s shared amnng pantinme m Ecnnnmy Measure nrwhn actuallypays rnrthe tax 1 Taxes nn buyers quotBuyers have tn pay certain amnunt nn a gnnd eg 31 per umtbnuglt causes a den ease m demand exnse tax nn gas alcnhnl mbaccn mm example Pvlce Supply Pbuvzvs Pmmm ax TEX Pseuers l Di Dz Quantity Demand Cuxve mu shm downward 19M bythe amount ofthetax Quantity sold mu decrease quotwho pays7 Buyers pay more for Tax s discourage market activity Buyersamp sellers sharethe memenee ofthetax 2Texes an seHers ers Have m pay eenern amount an aguud causes a dech39ne m supp y amp e Price 52 5l Phllyers I Pwmlulll lax Tax Psellers Demand Quanmy Supply eurye wlll shlft le Quauucy soldwlll deerease Buyers amp Sellers share burden buers pay more and buy less sellers ell less and reeerye less 3 Elasticity and Luelelerree at a tax Large share ofthe burden falls on me more ruelasue eurye lnelastlchr Demand elasue supply educers pay more emand ruelasue supply elastlciBuyers pay more Prlce wants Pwm nm m sews Elastic uDW PW Pllce Phuvms mm ax Pseugrs nelastic Elastic eman Quantity Quantlty Chapter 15 Monopoly Key Questions Why do monopolies arise How do monopolies choose their P and Q How do monopolies affect society s wellbeing What can the government do about monopolies What is price discrimination 1 Monopoly DEF A firm that is the sole seller ofa product without close substitutes They have market power they are price makers there are barriers to entry 2 Why monopolies arise The main cause is barriers to entry Three resources of barriers 1 Monopoly resources A key resource is owned by a single firm Eg DeBeers owns most of the diamond mines Ownership of the only well in the town 2 Government Created Monopolies Government gives a single firm the exclusive right by patents copyright laws Eg Microsoft and windows medical devices 3 Natural Monopolies a single firm can make the entire market Q at lower cost than could several firms Economies of scale exist Eg water supply 3 How monopolies make production and pricing decisions 1 Monopoly vs PC For a PC curve perfectly elastic demand curve MRP For a monopoly a monopolist is the only seller so it faces the market demand curve To sell a larger Q the firm must reduce p thus MR is not equal to P Price Demand Ouanmy Price Demana Ouunllly between p and MR formonopoly PC market MRP we a The output effect more output is sold so Q is higher The price effect to sell more output p must fall so p is lower The price effect results in declining marginal rev Graph Price Demand Quaniily Marginal Revenue 3 Pro t maximization Pro t maximization quantity always happens when MRMC An example So monopoly will produce at 23 P12 Graph Price Marginal Cos Demand 0 Quantity Marginal Revenue PC PMRMC at maximization M pgtMRMC at maximization A Monopoly Pro t Pro t TRTC Pro t TRQTCQJ Q Pro t PATC Q Pviu Margm i Cast Average A r 7 Tom P 39 39 Dost Dema ld Prom I e aimcl Maigmal Relemu 4 The welfare cost of monopoly 1 Social ef cient optimum level n A good or service rt i i a good or service 39 39 4 curve and the marginal cost curve intersect TS is maximized 2 Monopoly production level ef cient level a consumers are willing to pay more than MC but don t get because Loss is DWL Monopolist restricts Q so price is high Pilce DWL Marginal Cost Average PL n Toial Cost Demand 0 Quantity Marginal Revenue WL is same idea as when we implemented a tax before Monopolist is like tax D collector WL is same idea as when we implemented a tax before Monopolist is like tax collector DWL because QmltQpc Pro t is not DWL Monopolist is producing less than the Policy makers can respond y 39 make monopolized industries more competitive Try n Regulating the behavior of the monopo is s Turning ome private monopolies into public enterprises Doing nothing 1 Increasing Competition with AntitrustLaws i u t i prevents collusion Coke and Pepsi Ford and GM ATampT in 1984 into 8 smaller companies Example Whole Foods and Wild Oats Microsoft 1998 file because operating system bundled with internet browser Prevented other software Netscape from being as competitive 80 pcs Microsoft Software changes Competition with Apple and Linux operating system 2000 Microsoft has to break up Costs of antitrust laws Some mergers to lower costs not to gain power 2 Regulations Government may regulate the prices that the monopoly charges Normally for natural monopolies The regulator may force the monopolist to implement the efficient outcome Example water supply Possible that there will be loss of profit if subsidize by tax dwl 3 Public ownership Government may run the monopoly itself Example Common in Europe water electric telephone USA Postal Service Disadvantage private owners have incentive to minimize costs to get higher profits If costs are not kept down people are fired Government may not 4 Doing nothing Each of the policies has some drawbacks So economists argue that it is often best for the govt not to try and remedy problems associated with monopoly pricing 6 Price discrimination m PRICE DISCRIMINATION The business practice of selling the same good at different prices to different customers Can t price discriminate in competitive market because many firms selling identical goods Firm needs market power to discriminate Need to be able to separate customers to discriminate age income student etc Market segregation Arbitrage prevents price discrimination Buy cheap sell expensive somewhere else means will just sell at one price Must be able to prevent resale Helps to offset some of the DWL from monopoly Increases the monopolist s profits Reduces the consumer surplusetc Example Movie market air plane ticket discount couponsfinancial aid CHAPTER 4 THE MARKET FORCES 0F SUPPLY AND DEMAND Burker king or MCD A latest News From Economist Burger King Whopper to go Same Fast food Different MCD old people salads coffee Burger King young people Stockmarket investors prefer Big mac Recession had favored big MCD over BK why Competitive market how demand can change why stock market prefers Big mac Those are all related with what we are going to learn 1 Markets amp Competition DEF Market A group of buyers amp sellers ofa particular good or service Buys demand sellers supply DEF Competitive Market A market in which there are so many buyers and so many sellers that each has a negligible impact on the market price We ll assume for this chapter that markets are perfectly competitive Goods are identical Buyers and sellers are so numerous that no single buyerseller has in uence over market price Buyers and sellers are price takers example wheat lots of buyers and sellers 2 Demand 1Key terms DEF Quantity Demanded The amount of a good that buyers are willing amp able to purchase at some specific price DEF Demand Schedule A table that shows the relationship between the price of a good and the quantity demanded DEF Demand Curve Graphical representation of the demand schedule Relationship between the price and quantity demanded Price Since two points decide a line plot two points individually link them together we get demand curve Note that price is on Y axis q on X axis 1 A decrease in price gt 2 increases quantity of coffee Demanded DEF Law OfDemand Other things equal the quantity demanded ofa good falls when the price of the good rises Market Demand VS Individual Demand Market demand is sum ofindividual demand curves given same price sum all the quantity demanded in the market for each individual we will have market demand Example Now let s look at market demand Price Steve s Quantity Phil s Quantity Market Quantity Demanded Demanded Demanded 5 5 5 10 4 1 0 6 16 3 1 5 7 2 2 2 2 0 8 2 8 1 2 5 9 34 Now the individual demand curve and market demand curve Steve Phil Market 2 Change in quantity demanded vs change in demand Change in a quantity demanded other things equal a change in goods own price leads to a change in quantity demanded a move along a given demand curve Example For steve price changes from 5 to 4 quantity demanded changes from 5 to 10 graph it and show Change in demand Factors other than good s own price pynte can change the demand for a good that is a change in one of these factors shifts the entire demand curve Increase in demand means that at any given price the quantity demanded has increased The Price of related goods Substitutes Two goods for which an increase in the price of one leads to an increase in the demand for the other pepsi and cocacola pairs of goods that are used in place of each other Here use the example to analyze and ask them Complements Two goods for which an increase in the price of one leads to an decrease in the demand for the other gas and cars pairs of goods that are used together Again use the example to analyze and ask them Income Normal good a good for which other things equal an increase in income leads to an increase in demand luxuries are considered one kind ofnormal good clothes etc Inferior good a good for which other things equal an increase in income leads to a decrease in demand second hand clothing fast food Number of buyers market demand is drived from individual demands As N increases D increasesBigger cohort size bigger demand Tastes preferences like it or not how much you like it Suddenly these two years maxi dresses are popular demand for this dress is increasing Expectations Your expectation for the future may affect your demand for a good or service now expect your future income to increase your demand increase Note increase ofdemand shifts demand curve to right decrease ofdemand shifts demand curve to left 3 Supply 1Key terms DEF Quantity Supplied The amount of a good that sellers are willing amp able to sell at some specific price DEF Supply Schedule A table that shows the relationship between the price ofa good and quantity supplied DEF Supply Curve A graphical representation of the supply schedule The relationship between price and quantity supplied 1 An increase in price gt 2 increases quantity of coffee SUPPLIED DEF Law of Supply Other things equal the quantity supplied ofa good rises when the price of the good rises Market Supply VS Individual Supply Market supply is sum ofindividual supply curves Given same price sum all the quantity supplied in the market for each individual we will have market supply Price John s Quantity Other producer Market Quantity Supplied Supplied Quantity Supplied 5 80 7920 000 4 70 6930 7000 3 60 5940 6000 2 50 4950 5000 1 40 3960 4000 2Change in quantity supplied VS change in supply Change in quantity supplied a change in good s own price leads to a change in quantity supplied a movement along a given supply curve Change in Supply factors other than good s own price PENTO can change the supply for a good that is a change in one of these factors shifts the entire supply curve Price of input Suppliers are strongly in uenced by the costs of inputs used in the production process Eg steel for automobiles microchips for computers labor materials energy Expectation expect prices ofwheat to go up will make the farmers decrease their supply now and increase their supply later Number of suppliers Technology and Taxes tech improvement leads to cost reduction and so increase in supply Tax increases cost and subsidy reduces cost Others Regulations weather prices of substitutes in production Regulations Cigarettes as example Weather Florida orange juice Prices of substitutes in production Wheat and Corn 4 Supply and Demand Together 1Equilibrium DEF Equilibrium A situation in which the market price has reached the level at which the QsQd graphically it is the intersection of supply curve and demand curve give the graph DEF Equilibrium Price The price level at which QsQd DEF Equilibrium Quantity The quantity demanded and the quantity supplied at the equilibrium pricegive the graph Surplus QsgtQd and Shortage QsltQd DEF Surplus A situation in which quantity supplied is greater than quantity demanded and sellers will be frustrated DEF Shortage A situation in which quantity demanded is greater than quantity supplied and buyers will be frustrated Price Suppw Surplus 250 J 5o Demand I I 4 10 Ice Cream Cones DEF LAW OF supply and demand the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance 2Exercise change in the equilibrium price and quantity A change in demand pynte coffee market a income increases b price of tea decreses A change in supply coffee market c technology improvement make farmers produce more coffee beans d less farmers grow coffee beans Change in both supply and demand combination of a and b Combination of a and d Combination of b and c Combination of b and d Table four cases Chapter 14 Application Firms in Competitive Markets What kind of goods has a competitive market Gas Maybe some agriculture goods such as wheat corn beans etc 1Comp etitive market Def A market with many buyers amp sellers trading identical products so each buyer amp seller is a price taker Features Many buyers and sellers Actions ofbuyers amp sellers don t affect market price therefore all are price takers Homogeneous product Goods offered by the sellers are same Free entry and exit no barriers 2 Revenue of competitive firms 1 Want to max profit 139ITRTC Price does not depend on the quantity one person decides to produce and sell So TR is proportional to output TRPQ Average revenue TRQ so for all firms average revenue is just the price Marginal revenue ATRAQ so for the perfectly competitive firmsp is fixed the marginal revenue is also just the price 2 An example Let s consider Craig s Corn Farm in Ohio Qty of Corn 1 4 5 3 Profit maximization 1 A Simple Example of Profit Maximization Craig s Corn Farm Change Qty of in Profit 2 Goal is to max profit How much corn should they produce 34 4 really 3 How else to see this Compare MR amp MC Produce if MRgtMC what you re getting for next bushel is greater than what is costing you do increase production Don t produce if MRltMC So the optimal production point is when MRMC 4 Graph The marginalcost curve and the firm s supply decision MC upward sloping PMRAR for the PC firms so price line is horizontal Let us draw some curves and show the optimal decision graphically MC R1 MR2 AVC MR Q1 Qma Q2 MC1 Ignore the ATC and AMC curve when drawing the curve to students prroducing at Q1 MRgtMC so profit will increase increase the level of output prroducing at Q2 MRltMC so profit will decrease decrease the level of output Optimal decision is to produce where MRMC pr increases then maybe it will be optimal to increase production to Q2 Note since firm s MC curve determines the quantity of the good the firm is willing to supply at any price the mc curve is also the competitive firm s supply curve 4 Firm s short run decision to shut down and long run decision to exit or enter a market 1 Shut down refers a SR decision not to produce anything because of current market conditions Still have to pay your fixed costs but save on your variable costs Exit refers to a LR decision to leave the market 2 Shortrun decision to shut down lfa rm shuts down then it loses all revenuefrom selling its product but at the same time is also saving on the variable costs of production At least it only loses xed costcon tin uing production my incur more loss Shut down if TRltTVC Shut down if TR QltTVC Q recall TRPQ Shut down if PltAVC Thus the MC curve above AVC is the firm s short run supply curve Graph Look at pg 297 in book Fig 3 3 Longrun decision to exit or enter a market Firm exits if the revenue it gets from production is ess than total cost Exit if TFltTC Exit if TR QltTC Q recall TRPQ Exit if PltATC Enter if PgtATC Competitive firm s LR Supply curve is portion of MC above ATC curve Graph Pg 299 Fig 4 5 Measuring profit and loss in competitive markets 1 Profit TRTC Multiply amp divide by Q Profit TRQ TCQQ Profit PATCQ 2 Graph Pg 300 Fig 5 Look for the production quantityq my MRMC From q look for the ATC Check profit gt0 or lt0 6 The supply curve in a competitive market 1 The short run Market Supply with a Fixed Number of firms Each firms SR supply curve is its MC curve above AVC Firms are identical so just multiply by number of firms Graph P Individual Firm P Market 1000 firms Supply MC 200 100 Q firm Q market 300 500 30000 50000 2 The long run Market Supply with Entry amp Exit Suppose that all firms have same technology thus same cost curve Free entry and exit firms remaining in the market in long run must be making zero economic profit but positive acc profit Profit PATCQ so long run PATC also MRMC at profit maximization point We get PATCMC whenever ATCMC ATC hits its bottom which is efficient scale In long run MCP mc is the supply curve so long run supply curve is a horizontal line Graph p303 figure 7 3 A shift in demand in the short run and long run A graph p305 figure 8 initial condition Market begins in longrun equilibrium with the firm earning zero profit Shortrun response But then an increase in demand raises the price leading to shortrun profits for a firm Longrun response When profits induce entry supply increases and the price falls restoring longrun equilibrium Assume start in LR equilib Now there is some exogenous shock such that demand increases say suddenly eating corn means you only need 3 hours of sleep to be fully rested and function and you get tons more energy Demand shifts up which drives up P SR profits Pgtmin ATC so new firms will enter free entry S will shift out in LR Drives price back down to LR equilib CHAPTER 2 THINKING LIKE AN ECONOMIST 1Microeconomics vs Macroeconomics DEF Microeconomics The study ofhow HH amp firms make decisions and how they interact in markets DEF Macroeconomics The study ofhow economy works as a whole entity also study economywide phenomena such as in ation unemployment and economic growth Closely intertwined but attempt to study different questionsmodels 2 Positive amp Normative Statements DEF Positive statements Claims that attempt to describe the world as it is descriptive based on fact Key word Was is will DEF Normative statements Claims that attempt to prescribe how the world should be value judgment prescriptive Key word Should ought Positive statements can be verifiedstated using economic data normative involve personal viewpoints Example a Prices rise when the government increases the quantity ofmoney positive It describes a relationship could use data to confirm or refute b The government should print less money normative A value judgment cannot be confirmed or refuted 3 Models and Two Examples Economists use models and simplifying assumptions to try to understand the world around them Economic models are composed of diagrams and equations DEF Model is a simplified representation of reality 1 Mode 1 Circular Flow Diagram DEF Circular Flow Diagram A visual model of the economy that shows how dollars ow through markets among hh and firms lnpuls Houstholds Goods amp Services Two Players rms formcome mm Two Markets The market for goods and semces rms sell goods and semces to HH get rents capital get Interests 2 Model 2 Produmon Fossxbllmes Fronner FFFJ mu um Beer 1000 kegg oC 900 kegs 800 kegs Pizza 2700 3000 5000 pizzas Some points F if only produce beer 1000 kegs 0 pizza E if only produce pizza 5000 pizzas 0 keg Most likely some combo like point A and B PPF depends onAvailability of resources and level of technology Points ABEF On PPF feasible and efficient Efficient using resources fully can s produce more of one good without producing less of another Point d Feasible but inefficient lazy workers food going bad etc Point c Infeasible PPF illustrates Principle 1 Tradeoffs prroducing 2700 pizzas want to increase pizza production to 3000 must give up how much beer 100 PPF illustrates Principle 2 Opportunity cost The OC ofincreasing pizza from 2700 to 3000 is 100 kegs ofbeer Thus the OC of 1 pizza is 13 keg ofbeer Law ofincreasing opportunity cost DEF the opportunity cost ofproducing additional unites ofa good rises as society produces more of that goods Example From B to Athe DC of 1 beer is 3 pizzas and from Ato F the DC of 1 beer is 27 pizzas BA 300pizzalttigt100beer AF 2700pizzalttigt100 beer PPF bowed our due to law ofincreasing 0C Straight line PPF implies constant 0C PPF MoveShift Change in technology and resources increase in technology and resources can push out PPF Decrease in technology and resources can contract PPF Example What if change in tech allows for faster brewing PPF moves out for production give a picture here What if increase in labor force Entire PPF moves out give a picture here What if mad caw attacks half of cow production What if wars kill half of the labor force Entire PPF contracts CH21 The theory of consumer surplus 1 Budget constraint the possible combinations of different goods that he can buy given his income and price of the goods slope of the budget constraint relative price of the good 2 Indifferent Curves consumers preferences slope of an indifference curve marginal rate of substitution 3 consumers optimum choice tangent point between consumer budget constraint and the highest indifference curves at this tangent point slope of IC marginal rate of substitution slope of BCthe relative price of the goods 1 Budget Constraint DEF the limit on the consumption bundles that a consumer can afford I Slope of the budget constraint the rate at which the consumer can trade one good for another I Slope of budget constraintrelative price of the two goods 2 Preferences what the consumer wants DEF indifference curve a curve that shows consumption bundles that give the consumer the same level of satisfaction A consumers set of IC gives a complete ranking of the consumers preferences DEF marginal rate of substitution a curve that shows consumption bundles that give the consumer the same level of satisfaction Marginal rate of substitution slope of the IC Properties of IC 1 Higher ICs are preferred to lower ones 2 ICs are downward sloping 3 ICs do not cross 4 ICs are bowed inward 1 E l lIl When does a country expon or import Why does people use tariff Is tariff good 1 Autarky demand Price Supply Consumer Surplus Price Wlthout trade Producer Surplus Demand Quantity 2 Import or expon Depends onworld prlce World Price 39 39 eh IwagtPdexpon If PsltPd impon Nnm Peru 39 39 39 n ide Im 3 Two cases not affect the world price 1 Case 1 PwgtPd Expon Qs equals world Qd but Qsgt domestic Qd Prlce Su l Exports W Y Price after trade World Price Price before trade Demand Q uantity Welfare without trade Consumer surplus AB Consumer sur lus A Producer surplus BCD Total surplus ABCD Changes in welfare Consumer surplus B Producer surplus BD Total surplus D Producers gain consumer lose overall welfare increases so economy as awhole is better off this is the gains from trade 2 Case 2 PwltPd Import When trade is allowed Pd will decrease to Pw Price Supply Price before trade Price after trade World Price Imports Demand Quantity Welfare without trade Consumer surplus A Producer Surplus BC Total Surplus ABC Welfare with trade Consumer surplus ABD Producer surplus C Total surplus ABCD Changes in welfare Consumer Surplus BD Producer surplus B Total surplus D When a country imports a good domestic consumers of the good are better off domestic producers of the good are worse off but total surplus is increases and the economic wellbeing of the whole country rises 3 Effects ofa Tariff Tariff a taX on imported good A tariff raises the price above the world price thus the domestic price will rise to the world price plus the tariff As the domestic price rises the domestic quantity demanded will fall but the domestic quantity supplied will rise The quantity imported will decrease 1 Example Just look at the graph 5 De nition of tar domestically a tax on goods produced abroad and sold A tariff raises the price above the World price Thus the domestic price of Will rise to the world price plus the tariff As the domestic price rises the domestic quantity of steel demanded Will i the domestic quantity of steel supplied will rise The quantity of imports w an he market will move closer to the domestic market equilibrium that occurred before trade Welfare before the Tariff with trade a Consumer surplus is equal to A B C D E F in Producer surplus is equal to G c Government revenue is equal to zero d Total surplus is equal to A B C D E F G Price Supply A I World Price tariff I c D E F Pnce after trade World Price G Deman Quantity Imports after tariff Welfare after the Tariff a Consumer surplus is equal to A B b Producer surplus is equal to C G c Government revenue is equal to E 2 Welfare before the tariff with trade C0nsumer surplus ABCDEF Pr0ducer surplus G Government revenue 0 T0tal surplus ABCDEFG 3 Welfare after the tariff C0nsumer surplus AB Pr0ducer surplus CG Government revenue E T0tal surplus ABCEG 4 Changes in welfare C0nsumer surplus CEEF Pr0ducer surplus C Government revenue E T0tal surplus DF Chapter 7 Consumers Producers amp Efficiency of Market Even though we know equilibrium prices occur when SD everybody has different value thus different willingness to pay for a good Bidding 1 Welfare Economics The study of how the allocation of resources affects economic wellbeing We examine benefits that buyers and sellers receive from participating in the market Recall from principles Markets are usually a good way to organize economic activity 2 Consumer Surplus 1Willingness to pay Def is the maximum price at which a consumer is willing to buy a good Value to buyers each consumer would then want to buy at a price less than the WTP and is indifferent ifprices equals WTP Example Market for used Mankiw Textbook Potential WTP Graph At any given quantity the price given by the demand curve re ects the willingness to pay of the marginal buyer the buyer who would leave the market first if the price were any higher 21ndividual consumer surplus Def The amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it wtpprice a net gain to an individual from the purchase of a good Example prrice is 30 what is the consumer surplus for A 30 3 Total Consumer surplus Def The sum ofindividual consumer surpluses of all buyers ofa good Total consumer surplus in market3015550 Graph 4 Total CS in a market with continues demand curve The area below the demand curve and above the price is consumer surplus Graph Lower price increased consumer surplus People already buying get more surplus More people can buy leading to new CS Graph 3 Producer Surplus 1 Cost amp Willingness to sell DEF Cost The value of everything a seller must give up to produce a good the cost is the lowest price at which the sellers is willing to sell a good Example Supply of used Mankiw books Graph 2 Individual producer surplus DefThe amount a seller is paid for a good minus the seller s cost of providing it p cost net gain to an individual from selling a good Example ifprice is 30 what is the PS for A 25 3 Total producer surplus Def The sum ofindividual producer surplus of all the sellers ofa good Example Using supply curve to measure producer surplus Graph 4 Producer surplus with a continuous linear supply curve the area above the supply curve and below the price Graph Higher priceHigher ps Graph Any any given quantity the price given by the supply curve represents the cost of the marginal seller 4 Market efficiency 1The Benevolent social planner allknowing allpowerful wellintentioned dictator maximizes economic wellbeing of society 2 Economic well being is measured by total surplys Consumer surplus Value to buyersamt paid by buyers Producer surplus Amt received by sellers cost to sellers Total surplus CS PS Total surplus Value to buyers cost to sellers If total surplus maxed then outcomeallocation is efficient 3 EFFICIENCY The property of a resource allocation of maximizing the total surplus received by all members of society Chapter 17 Oligopoly Key Questions What kind of market structure does airplane market have Why do we need to learn game theory 1 Oligopoly market 1 DEF Only a few sellers each offering a similar or identical product to the others Example airplane markets oil markets 2 Characteristics of an Oligopoly market Few sellers offering similar or identical products Interdependent lms each lm s action in uences the pro t of the other rms Best off cooperating and acting like a monopolist To maximize pro t rms in an oligopoly might choose to form a cartel A cartel is a group of rms acting together to limit output raise price and increase pro t cartels are illegal in the US There is a tension between coopreration and selfinterest 2 A duopoly an oligopoly with only two members A duopoly Example Demand Schedule for water AampB supply water P TR 11 12 0 0 l Ifwe are in perfect competition what would the equilibrium price and quantity Pmrmco so q12 2 In monopoly what would be the equilibrium price and quantity MRMC q6 p6 3 In duopoly two get together and act like a monopoly this is called collusion DEF collusion an agreement among firms in a market about quantities to produce or prices to charge DEF cartel a group of firms acting in unison Each supply 3 gallous and each gets profit of 18 But A may want to produce 4 gallons price 5 he will get 20 better than with the cartel Same for B then total supply will be 8 price 4 each will get 16 Worse than when they collude So if duopolists pursue their own selfinterest they may end up being worse than before 4 Nash equilibrium A situation in which economic participants interacting with one another each choose their best strategy given the strategies that all the other have chosen In this example NE occurs when both supply 4 Note that the oligopolists could earn a higher total profit of they cooperated with each other The oligopoly price is less than the monopoly price but greater than the perfectly competitive market price 3 Game theory and the economics of cooperation DEF Game theory the study of how people behave in strategic situations Dominant strategy a strategy that is best for a player in a game regardless of the strategy chosen by the other players Def Prisoners Dilemma a particular game between 2 captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial Example Prisoner s dilemma Oligopoly as a Prisoner s dilemma Boeing and airbus Here is their payoff matrix s Decision Decision Low Production Airbus Airbus The dominant strategy for Boeing is to produce at a high rate For the same reasons the dominant strategy for Airbus is to produce at a high rate Even though total profit would be highest if both firms produced at a low rate self interest will encourage them to produce at a high rate Example of US and Soviet Union CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE Questions How many of you are driving American cars Japanese cars European cars Look at the tag of your clothes Where was it made Why does people trade Remember Trade can make everybody better off Why trade is interesting On March 5th 2003President George W Bush placed tax on imported steel which contradicts with bush s normal free trade policy Why Political issues this taX will protect Pennsylvania and West Virgiia two swing but key states for Bush s election This tax policy hurt Europe they decided to start a trade war by imposing taX on orange juice So Florida got hurt where Ieb Bush Bush s brother was actually the governor for Florida 1Key questions Why do people and nations choose to be economically interdependent How can trade make everyone better off What are absolute advantagescomparative advantages 2 PPF and Trade Example The farmer and rancher both work 8 hours oflabor per day and use this time to produce potatoes raise cattle or both Pay attention to the table especially first line Hours needed to Amount produced in 8 produce one ounce of hours Meat Potatoes Meat Potat Farmer 1hour 14 hour 8 32 Rancher 13hour 1 6 hour 24 48 Step 1 Draw PPF Linear Slope ofPPF Assume that the farmer s and rancher s technology for producing meat and potatoes allows them to switch between producing one good and the other at a constant rate a a The Farmer39s Production Possibilities Frontier b The Rancher s Production Possibilities Frontier Meat ounces Meat ounces 24 If there is no trade the rancher chooses this production and consumption If there is no trade the farmer chooses this production and 12 consumption O 16 3392 Potatoes ounces 0 24 48 Potatoes ounces Step 2 Without Trade Farmer s and Rancher s consumption possibilities their production possibilities Step 3 Specialization and Trade Farmer specialize in the production of potatoes Rancher specialize in the production of meat Farmer trade with the rancher for meat Suppose the rancher will spend 6 hours per day producing meat and 2 hours per day producing potatoes The farmer will spend 8 hours per day growing potatoes a How many meat and potatoes does the rancher produce Can use two ways to calculate For the rancher if we use the left hand information 13 hour to produce one meat 1 hour can produce 3 meat now he uses 6 hours to produce meat he can produce 18 meant Right hand information 8 hours can produce 24 meat 1 hour can produce 3 248 meant 6 hours can produce 18 By the same method rancher can produce 12 potatoes b How many meat and potatoes does the farmer produce 0 32 c The rancher will trade 5 meats for 15 potatoes is it accepted For the rancher if he trades 5 meantltgt 15potatoes if he produces it himself 5 meat cause him 53 hour which he can only produce 5361O potatoes so trade makes him feel better by the same method we can also prove that trade also make farmer better off do it yourself Trade is accepted if and only if the trade price is between two opportunity costs 0C for farmer 8 meatltgt32 potatoes 1 meatltgt4 potatoes 0C for rancher 24 meat lt1Igt48 potatoes 1 meant ltgt2 potatoes 3 is between 2 and 4 so it is good d Trade Meat Potatoes Trade Meat Potatoes Farmer 0 32 15 potatoes to 505 17 3215 rancher Rancher 18 12 5 meats to 13185 271215 farmer e Grains from trade Compare PPF and consumption possibilities in both cases With trade they are able to consume quantities of potatoes and meat they couldn t reach before a The Farmer s Production and Consumption b The Rancher s Production and Consumption Meat ounces Meat ounces Rancher s production with trade 24 Rancher s consumption 18 39 39 39 39 39 39 39 with trade Farmer39s consumption 13 with trade Rancher s Farmer39s production and consumption 5 n without trade production and consumption without trade Farmer s production with trade O J L 3392 Potatoes ounces 0 12 24 27 4398 16 17 Potatoes ounces 3 Absolute Advantage and Comparative Advantage 1 Absolute Advantage DEF the ability to produce a good using fewer inputs than another producer does or the ability to produce more goods Within given inputs Hours needed to Amount produced in 8 produce one ounce of hours Meat Potatoes Meat Potatlt Farmer 1hour 14 hour 8 32 Rancher 13hour 1 6 hour 24 48 Rancher has absolute advantage in the production of both potatoes and meat 2 Comparative Advantage Opportunity cost DEF Opportunity cost What must be given up to obtain some item Key to do this for each person check how many of each goods they can produce if they use all their time to produce only one good Farmer 8 meat lt2igt 32 potatoes so 1 meatltigt4 potatoes Rancher during same time 24 meat lt2igt 48 potatoes so 1 meat lt2igt 2 potatoes Amount of produced Opportunity cost Meat Potatoes Meat Farmer 8 3 2 4 potatoes Rancher 24 48 2 potatoes Opportunity cost ofproducing one good inverse of the opportunity cost of producing another good So what is the oc of farmer producing potato 1 meat 0c of Racher producing potato 1 meat Comparative Advantage DEF the ability to produce a good at a LOWER opportunity cost than another producer compare 0C ofproducing meat and potato for farmer less opportunity cost represents ca thus the rancher has oc in producing meat rancher has oc in producing potatoes 4 The price of the trade For both parties to gain from trade the price at which they trade must lie between the 0C In the above example the farmer and the rancher must trade at the rate of between 2 and 4 potatoes for each ofmeat 5 A typical Example for exams Chapter 13 Application The costs of production Objective of a firm ifyou own a firm what is your goal It is possible for firm owners to have different goals but the one motive that makes he most accurate prediction about how firms behave is the assumption ofprofit maximization 1Total revenue total cost and profit Total revenue the amount a firm receives for the sale of its output pq Total cost the market value ofinputs a firms uses in production Profit total revenuetotal cost 2 Economic profit vs accounting profit 1 Explicit cost and implicit cost DEF explicit cost input cost that requires an outlay ofmoney by the firm DEF implicit cost input cost that does not require an outlay of money by the firm Economic costs include all the opportunity costs include both implicit and explicit costs when analyzing firm s costs Accountants only include explicit costs and ignore implicit cost 2 An example Mary bought her boutique from Sam She spent 500000 ofher savings to do so If she had instead left the money in an account that earned 5 interest she could have earned 25000 interest This 25000 is implicit Economists count this 25000 as an implicit cost QC Accountants ignore it because it does not show up on the books 3 Economic profit vs Accounting profit DEF economic profit TRTC including both explicit and implicit costs DEF accounting profit TRtotal explicit costs Ifimplicit costsgt0 then accounting profit will always be greater than economic profit Economic profit is what motivates the firm to supply goods and services Firm making economic profit will stay in business Firm who are making economic losses are unable to cover the costs of production and unless conditions change will exit the market 3 Production and total costs 1 A few definitions DEF production function the relationship between quantity of inputs used to make a good and the quantity of output of that good DEF Marginal product the increase in output that arises from an additional unit of inputs DEF Diminishing marginal product The property whereby the marginal product of an input declines as the quantity of the input increases keeping the quantity of other inputs the same 2 An example An example No of Output Marg Cost of Cost of TC cost Workers P ho tos hr Pro duct Boutique Workers factory per Labor cost workers 0 0 100 0 100 1 20 20 100 10 110 2 35 15 100 20 120 3 45 10 100 30 130 4 50 5 100 40 140 3 Graph of total production and total cost Both graphs show the diminishing marginal cost When the studio is too crowded developing an additional set ofphotographs requires a lot of additional input labor time and thus is costly Thus when the quantity produced is large the total cost curve is relatively steep Quantity of Total Cost Output Total Cost Curve Production Function 30 4 The various measures of cost 1Fixed and variable costs Fixed cots must be paid no matter how much goods you want to produce rent a place buying a license for a pizza restaurant Variable cost vary as the quantity produced varies salaries basic inputs such as tomatoes cheese pepperonietc for pizzas 2Average and Marginal costs Average tells you how much it costs on average to produce a good Marginal tells you how much more it will cost to produce an additional good DEF average total cost total cost divided by the quantity of output DEF average fixed cost fixed cots divided by the quantity of output DEF average variable cost variable costs divided by the quantity of output DEF marginal cost the increase in total cost that arises from an extra unit of production ATC AFC AVC ATCTCQ AVCVCQ MCATCAQ 3 An example 9 4 curves Costs MC Quantity of Pizz MC upward sloping re ects diminishing marginal product AFC is average fixed costs so always decreasing AVC is always increasing but less than marginal cost diminishing marginal products ATCAFCAVC so ATC is pulled down by the PC then it hits the MC curve and that39s its min then its pulled up by the marginal curves Bottom ofthe ATC curve is the efficient scale The quantity of ouput that minimizes average total cost cuts MC at that point Why When MCltATC ATC is falling When MCgtATC ATC is rising When MCATC ATC hits the lowest point 5 More typical curves Costs MC Quantity of Out AFC is always decreasing But diminishing MP rising MCJneed not start immediately after the first worker is hired Depending upon the production process MP MC might first rise fall and then fall rise which also makes AVC curve Ushaped 6 Costs in the short run amp in the long run In short run can39t build new factory or add on to store In long run everything can change So in long run ATC looks different than in the short run thus ATC in LR different from ATC in SR Future 6 from book Economies amp Diseconomies of Scale When long run ATC declines as Q increases it is called economies of scale This is the period that firms benefit from specialization and learning When long run ATC is constant as Q increases it is called constant returns to scale When long run ATC is rising as Q increases it is called diseconomies of scale This happens because of coordination problems too much specialization not enough communication left hand doesn39t know What the right hand is doing
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