Wrap-up of Econ 1
Today: A summary of marginal
analysis and equilibrium; a review
of the 16 chapters
Wrapping up this class

Today’s lecture is meant to do two
things


Highlight some material you will need to
know for the final exam
Help put all of the ideas together so that
you can use the ideas in this class in future
classes and the real world
Marginal analysis



Marginal analysis is almost always
important
Average analysis is important
sometimes
Recall the following slide from the first
lecture…
What will we do in Econ 1?

Think like an
economist does



(Almost) always
think in terms of
marginal
Opportunity costs
typically matter
Sunk costs typically
do not matter

Marginal  “one
additional unit”

For example, FB
describe marginal
benefit as “the
increase in total
benefit that results
from carrying out
one additional unit of
an activity” (p. 11)
Marginal analysis


Marginal analysis will continue to be
important if you plan on majoring in
anything with economics as a tool
When faced with problems in the real
world, try to think marginally with the
tools we have learned
Marginal analysis



In most markets, a firm or consumer will
continue an activity as long as its MB ≥ MC
Without market failure, equilibrium is efficient
Market failures with market power and/or
externalities

Situations exist where government intervention
improves efficiency
Marginal analysis

Finally, marginal analysis applies to
various topics we have discussed in
recent weeks





Information
Labor markets
Quality of life issues
Public Goods
Tax Policy
What have we covered the
past 9+ weeks?


16 chapters that give you a foundation
of microeconomics
Let’s highlight each chapter
Chapter 1: Think like an
economist





Usually avoid averages in analysis
Don’t ignore opportunity cost
Don’t ignore sunk costs
Think marginally
Try to find Pareto improvements when
possible
Chapter 1: What should we
do with energy drinks?

# of drinks
Total benefit ($)
0
0
MB ($)
Avg. benefit
N/A
5
1
5
5

3
2
8
4
2.5
3
10.5
3.5
1.5
4
12
3
-1
5
11
2.2

We should buy the third
energy drink since
MB > MC
(2.5 > 2)
We should not buy the
fourth energy drink
since MB < MC
(1.5 < 2)
Note that we are NOT
maximizing average
benefit or total benefit
Chapter 3: Supply and
Demand (introduction)
Chapter 3: Equilibrium
In equilibrium,
there is no
incentive to
deviate
Chapter 3: What causes
shifts in supply or demand?
Recall difference
between a shift
in a curve vs. a
movement along
a curve
Chapter 5: Marginal utility of
bananas
Banana quantity
(bananas/hour)
Total utility
(utils/hour)
0
0
Marginal utility
(utils/banana)
70
1
70
50
2
120
30
3
150
10
4
160
-10
5
150
Note
diminishing
marginal
utility
Chapter 5: The rational
spending rule and demand

MU per dollar for the last dollar spent of each
good is the same




Suppose the MU per dollar (for the last dollar
spent) was higher for good A than for good B
I can spend one more dollar on good A and one
less dollar on good B
Since MU per dollar spent is higher for good A
than for good B, total utility must increase
Thus, with diminishing MU, any total purchases
that are not consistent with the rational spending
rule cannot maximize utility
Chapter 5: Ind. demand (left &
middle); aggregate (right)
Chapter 5: CS from demand
curves




Height of triangle is
($6 – $3), or $3.
Length of triangle is
(6 – 0), or 6
Area of triangle is
one-half times
length times height
CS = $9
The area of this
triangle is a good
approximation of
CS
Chapter 6: How many
widgets should I build?





MB of 1st hour of work: $15
MB of 2nd hour of work: $13
MB of 3rd hour of work: $11
MB of 4th hour of work: $9
MC of each hour of widget building is
the $10 lost in wages from working at
the coffee shop
Chapter 6: How many
widgets should I build?

Is MB ≥ MC?




1st hour?  Yes, since $15 > $10
2nd hour?  Yes, since $13 > $10
3rd hour?  Yes, since $11 > $10
4th hour?  No, since $9 < $10
Chapter 6: Supply using
graphs


We make this graph
make intuitive sense
We will see that:



Profits are positive at
price P1
Profits are negative
at prices P2 and P3
Firms will shut down
when price is P3
Chapter 6: Marginal analysis
 Hire 4 employees/day
Note that
you have to
check the
shutdown
condition
after
solving this
problem
# of empl./day
Phones per
day
0
0
1
2
3
4
5
MB ($/phone)
MC ($/phone)
18.00
5.00
18.00
4.00
18.00
10.00
18.00
12.50
18.00
25.00
20
45
55
63
67
Chapter 6: Example of
producer surplus


When P = 25 per
unit, shaded area is
approximate
producer surplus
Area is a triangle,
one-half times
length times height:
0.5  10  25 =
125
Chapter 4: Elasticity

Elasticity


%Q
Elasticity 
%P
Calculated by the
percentage change in
quantity divided by the
OR
percentage change in
Q / Q P Q P
1
price

 
 
P / P Q P Q slope
Denominator could be
something else, but for
now think price
Chapter 7: Long-run
consequences of rent control


Suppose that the
long-run equilibrium
of apartments in I.V.
is $2,400 per month
rent, and 2,000
units rented
With rent control of
$1,200/month, we
see excess demand
($100s)
24
excess
demand
12
(100s units)
Chapter 7: Price ceiling at G


Total surplus is
trapezoid ADFE (at
most)
ΔCEF is potential
surplus that is never
gained
Chapter 7: What happens
with a subsidy?




Before the subsidy, price
is P2; quantity is Q1
With subsidy, quantity
demanded at price P2 is
Q2
In short-run, notice new
price for apartments is P1
This price is $500 higher
than before

All of the subsidy goes to
the apartment owners
Chapter 7: Max, Jill, United
Airlines, and efficiency

Recall that
United is
better off
with this
policy too
Going from a first-come, first-served policy to a
voluntary incentive system has improved the
outcomes of both Max and Jill


Max has improved by $120 and is traveling in style, just the
way he wants
Jill is able to make her meeting and save the contract
Chapter 7: Surplus and
deadweight loss with taxes




Consumer surplus
(top Δ)
Producer surplus
(bottom Δ)
Tax revenue
generated
(rectangle)
Deadweight loss
(right Δ)
Chapter 7: Marginal cost
pricing

Supply of electricity




8 Mwh (coal) @ 3¢/Kwh
20 Mwh (natural gas) @
5¢/Kwh
10 Mwh (wind power) @
9¢/Kwh
6 Mwh (solar power) @
15¢/Kwh



Suppose that at a price
of 9¢/Kwh, 30 Mwh
were demanded
All coal capacity and
natural gas capacity can
be used, and 2 Mwh
provided by wind
MC pricing tells us to
charge 9 ¢/Kwh in order
to maximize surplus
Chapter 8: What should Jill
do?



Jill should run a home business if
her economic profit is positive
Economic profit is total revenue
minus all costs (including
opportunity cost of not working)
Economic profit if she opens
business =
$200,000 – ($160,000 + $60,000) =
– $20,000  Do not open business
Chapter 8: Long run equilibrium
 economic profits are 0
Chapter 8: Present value


We can calculate how much a future payment
is by discounting it by interest rate r
We calculate the present value of a future
payment as follows


Payment of M is received T years from now
PV represents present value:
M
PV 
T
(1  r )
Chapter 8: Present value of
a permanent annual payment

Present value of an
annual payment of
M every year
forever, when the
interest rate is r :
M
PV 
r
Chapter 2: Absolute advantage
and comparative advantage

Absolute advantage


“One person has an absolute advantage over
another if he or she takes fewer hours to perform
a task than the other person” (F/B p. 36)
Comparative advantage

“One person has a comparative advantage over
another if his or her opportunity cost of
performing a task is lower than the other person’s
opportunity cost” (F/B p. 37)
Chapter 2: Comparative
advantage
Greg
David

Opportunity cost Opportunity cost of
of cooking a pizza
making a salad
½ salad
2 pizzas
¼ salad
4 pizzas
To find comparative advantage for each
person, find the lowest number in each
column
Chapter 9: What happens
when trade is possible?


Recall that all of the
points along PGQ are
the efficient points of
the production
possibilities curve
Recall that this shape
occurs due to
increasing
opportunity costs as
more is produced
Chapter 9: CS and PS w/o
imports (left); w/imports (right)
Imports
Chapter 9: Total surplus and
tariff money collected




CS
PS
Tariffs
What is
missing?

Two triangles
are lost with
the imposition
of tariffs
Chapter 10: Marginal
revenue

Marginal revenue



How much additional
is received by selling
one more unit of the
good?
We must first
calculate TR
Notice that for
Q > 1, MR < P
P
4
Q
0
TR
0
MR
3
3
1
3
1
2
2
4
-1
1
3
3
-3
0
4
0
Chapter 10: Market power

How Do Firms Gain Market Power?





Exclusive control over important inputs
Patents and copyrights
Government licenses or franchises
Economies of scale  Natural monopoly
Networks
Chapter 10: Simple
monopoly example

What is lost?


Triangle EIK is
lost, since the
monopolist stops
producing once
quantity reaches
A
This triangle is
deadweight loss
(DWL)
Chapter 10: Price
discrimination

Price discrimination can take many forms



Discounts of goods and services that have little or
no value if transferred to another person
Perfect price discrimination, where a different
price can be charged to each person
Rebates, which require effort to get a discount
Chapter 11: How do we find
Nash equilibrium (NE)?



Step 1: Pretend you are one of the players
Step 2: Assume that your “opponent” picks a
particular action
Step 3: Determine your best strategy (strategies),
given your opponent’s action




Underline any best choice in the payoff matrix
Step 4: Repeat Steps 2 & 3 for any other opponent
strategies
Step 5: Repeat Steps 1 through 4 for the other
player
Step 6: Any entry with all numbers underlined is NE
Chapter 11: Nash
Equilibrium
Person 2
Action C
Person
1

Action D
Action A 10, 2
8, 3
Action B 12, 4
10, 1
Which
box(es) have
underlines
under both
numbers?


Person 1
chooses B
and Person
2 chooses C
This is the
only NE
Chapter 11: Dominant
strategy
Person 2
Action C
Person
1
Action A 10, 2

Action D
8, 3
A strategy is
dominant if that
choice is
definitely made
no matter what
the other
person chooses

Action B 12, 4
10, 1
Example:
Person 1 has a
dominant
strategy of
choosing B
Chapter 11: Sequential
game
Person 1
chooses
yes
B
A
Person 1
chooses
no
C
Person 2
chooses
yes
20, 20

5, 10
Person 2
chooses no
Person 2
chooses
yes

10, 5
Person 2
chooses no
10, 10

If Person 1 knows
that Person 2 is
rational, then she
will choose yes,
since 20 > 10
Person 2 makes a
decision from point
B, and he will
choose yes also
Payout: (20, 20)
Chapter 11: Some classic
game theory games

Games with inefficient equilibria



Coordination games



Battle of the Sexes
Chicken
Zero-sum game


Prisoner’s Dilemma
Public Goods game
Matching pennies
Animal behavior

Subordinate pig/Dominant pig
Other games also
played as part of
activity
Chapter 12: An unregulated
market with externalities
external
cost per
unit
(= Social MB)

Deadweight loss shaded

These units produced have Social MC greater
than Social MB
Chapter 12: A market with
externalities and a tax
With tax equal
to distance of
vertical arrow:
The efficient
solution is
achieved
external
cost per
unit
(= Social MB)

The government can set a tax equal
to the external cost per unit
Chapter 12: A market with
externalities and permits
external
cost per
unit
(= Social MB)

Market price for the good will be B,
since E units are being produced
Chapter 12: An algebraic
example
MCSocial = Q + 10
MC = Q
Price B = 55
Price C = 50
Recall E = 45
and F = 50


external
cost per
unit of $10
P = 100 – Q
Inefficient equilibrium, P = Q  P = 50
Socially optimal equilibrium, P = Q + 10  P = 55
Chapter 12: Highway/bridge
problem, what is efficient?
Example
with 20
people
that must
travel from
point A to
point B
# on bridge
Travel time on
bridge
Total minutes
for bridge
travelers
Total minutes
for highway
travelers
Total minutes
for all drivers
1
10
10
380
390
2
11
22
360
382
3
12
36
340
376
4
13
52
320
372
5
6
14
15
70
90
300
280
370
370
7
16
112
260
372
8
17
136
240
376
9
18
162
220
382
10
19
190
200
390
11
20
220
180
400
Chapter 12: Income from
calves with property rights
# of calves
on the
commons
1
2
Price per 2year-old cow
sold ($)
130
120
Income per
cow ($ per
year)
30
20
Total calf
income ($
per year)
Marginal
income ($
per year)
30
>$5 
INVEST
10
>$5 
INVEST
30
40
2
3
114
14
42
2
4
111
11
44
Invest as long as marginal income is at least $5
<$5 
STOP!
Chapter 13: Optimal amount
of information


Find the point
where MB = MC
Example: Use
MC1 and MB1
curves

Optimal amount of
information is 7
units, at a cost of
$15 per unit
Chapter 13: The internet
and information

Assumption



Any product that is not good is worthless
If you trust Bloomingdale’s  pay $89; know with
certainty you get a good product
If you believe that the $50 jacket is good with 50%
probability, you would expect to buy 2 (on average)
before buying a good jacket

Expected spending: $100
Yugo car
Chapter 13: Lemons

A used car dealer has the following
information about used Yugo limos:

Plums are worth



Lemons are worth



$3,000 to the dealer
$1,200 to the owner
$250 to the dealer
$100 to the owner
100 Yugo limos owned privately


Example 1: Half of the limos are plums, half are lemons
Example 2: One-quarter of the limos are plums, threequarters are lemons
Chapter 14: MP and VMP to
analyze profit maximization
Cost to
hire an
additional
worker is
$100 per
day
# of
empl./day
Phones per
day
0
0
1
2
3
4
5
MP (extra
phones per day)
VMP ($ per
day)
20
360
Yes
25
450
Yes
10
180
Yes
8
144
Yes
4
72
No
Hire?
20
45
55
63
67
Chapter 14: Some human
capital qualities

Education





Direct knowledge
Intelligence
Signaling
Training
Work and life
experiences




Energy level
Work habits
Trustworthiness
Initiative
Chapter 14: When are
unions effective?

Finding qualified workers outside of a
union is difficult or impossible

Example: Writers’ strike



See “Additional reading” on class website for
more on this topic
When a firm is making economic profits
When a unionized firm can hire better
workers than nonunionized firms
Chapter 14: Discrimination

A wage gap between men and women’s
pay has existed for decades


Some of this can be explained by
controlling for education, experience, and
other factors
Some discrimination may be occurring

Firms that do discriminate based on factors
such as gender and race are less likely to
be competitive in the long run
Chapter 14: Income
distribution
Quintile
1980
1990
2000
Bottom 20 percent
$12,756
$12,625
$14,232
Second 20 percent
$27,769
$29,448
$32,268
Middle 20 percent
$41,950
$45,352
$50,925
Fourth 20 percent
$58,200
$65,222
$74,918
Top 20 percent
$97,991
$121,212
$155,527
Top 5 percent
$139,302
$190,187
$272,349

Also note the following ideas

John Rawls’ “veil of ignorance”


Shrinking economic pie
Income redistribution, including EITC
Chapter 15: Inefficient
levels of health care



Inefficient
equilibrium with
complete insurance:
Red circle
Efficient amount of
health care: Green
circle
Equilibrium with
20% co-payment:
Yellow circle
0.2 MC
Chapter 15: Smoke
abatement costs
Tons of smoke emitted per day
4
3
2
1
0
Total abatement cost, firm A
$0
$14
$30
$50
$75
Total abatement cost, firm B
$0
$20
$45
$80
$120
Total abatement cost, firm C
$0
$25
$60
$100
$150

Let’s try $30 abatement MC or less


7 green arrows
We now have reached the efficient level of 5 tons
of emissions
Chapter 15: Ways to
improve safety



Safety laws
Formation of unions
Offer financial incentives



Increased training
Shorter work days


Higher safety  Bonuses (money, gift certificates, tickets for
prize giveaways)
Tired people are more likely to be clumsy and inattentive
Workers’ compensation

Insurance system for those injured while working
Chapter 16: Public goods

To find
efficient level
of fireworks,
set PUBLIC
MB = MC


PUBLIC
MB
50 – 2Q = 10
Q = 20
MC
PRIVATE MB
Chapter 16: Government
failure

Pork barrel legislation


Price supports


Passes MB/MC test in home district, but
not when people outside the district are
factored in
A few win big; many lose a small amount
Rent-seeking

Inefficient amount of lobbying
Chapter 16: Taxation


Laffer curve (at
right) shows that
t* is not 100%
Goods with
inelastic demand
and markets with
negative
externalities are
good markets to
tax