ECON 101 KONG
Midterm 2
CMP Review Session
Chapter 5 Efficiency and Equity
Benefit, Cost, Surplus – Consumers (1)
A consumer benefits from the consumption of a product
• this benefit determines Willingness to Pay
• graphically represented by the Demand Curve
Demand Curve:
• x-axis shows units of the product, i.e. quantity
• y-axis shows the Marginal Willingness to Pay, in $
• marginal -> for 1 MORE unit, what is the max the
consumer is willing to pay
The more you have, the less you value a thing
• demand curve slops DOWN
Benefit, Cost, Surplus – Consumers (2)
Market Demand Curve:
• adding up all consumers’ demand curve HORIZONTALLY
Consumer Surplus:
• big idea: area under the demand curve = the total $ that
consumers are Willing to pay for a given number of units
• CS = the area under the demand curve and above the price line
Benefit, Cost, Surplus – Producers
Producer must sell to cover the cost of making a product
Marginal Willingness to Sell:
• to deliver 1 more unit, the price producers must charge
• equals the cost to produce that unit = Marginal Cost
• graphically represented by the supply curve
Market Supply Curve:
• adding up all suppliers’ supply curve HORIZONTALLY
• big idea: area underneath the supply curve = total cost of
producing a given number of units
Producer Surplus:
• area below the price line and above the supply curve
Efficient Market – p* & q*
Equilibrium price (p*) and quantity (q*) is where market
supply curve and demand curve crosses.
Reasons:
• price > p*: producers want to sell more than consumers
are willing to buy
• producers will drop price due to competition for
customers until price = p*
• price < q*: consumers want to buy more than producers
are willing to sell
• consumers bid up price until p = p*
Efficient Market – Total Surplus
Total surplus = CS + PS
• CS + PS = total area under the demand curve and above
the supply curve
• maximized when market is Efficient
Deadweight Loss
• occurs when price ≠ p*, quantity ≠ q*
• when market isn’t efficient
• lost benefit that should have been available to society if
market was Efficient
• … or harm done to society when more than efficient
quantity is produced (wasteful use of resources)
Chapter 6 Government Actions
KEY: don’t memorize, draw graphs
Ways government can “mess with” a market
• Price ceiling (e.g. rent ceiling)
• Price floor (e.g. minimum wage)
• Taxes
• Subsidy
• Quota
When a policy forces the market equilibrium AWAY from the
efficient price and quantity, it always leads to inefficiency
and DWL
Price Controls
Price ceiling/cap: maximum price producers can charge
• no effect if ceiling ≥ p*, otherwise shortage occurs
• rent ceiling leads to less than efficient quantity of houses,
longer Search Time, black market and DWL
Price floor: minimum price that must be paid to producer
• no effect if floor ≤ p*, otherwise excess of supply
• minimum wage leads to unemployment (i.e. quantity of
labour available in excess of the quantity demanded)
• effects: increased job search, DWL
Taxes
1. Tax on consumers, demand curve shifts down by per unit tax
2. Tax on producers, supply curve shifts up by per unit tax
Big idea: consumers and producers want to be able to recreate
their original condition before taxes
Taxes create a NEW equilibrium that is NOT efficient
Tax Incidence: how much of the tax Ultimately falls on
consumers vs producers; careful! doesn’t matter who is taxed,
results are the same
Effect of taxes given different elasticity? Draw graphs to find
out!
Production Quota
Production quota: the max the producers can make
• no effect if quote ≥ q*, otherwise underproduction
• leads to (don’t memorize!):
• decrease in supply
• higher price
• lower Marginal cost
• company wanting to cheat and produce more than quota
Subsidy
Subsidy: government gives monetary aid to firms to help with
production
• opposite of taxing the producer
• encourages over production and DWL
Chapter 10 Organizing Production
Firms want to maximize Economic Profit
Economic Profit: total revenue minus total cost, this is the
opportunity cost of production
Opportunity Cost: value of the best option NOT chosen
Total cost INCLUDES Normal Profit – the amount the owner
earns on average from starting a business
Constraints that limit a firm’s profitability:
• Technology: a WAY of producing a product
• Information: conformation is costly
• Market: consumers have a limit to their budget!
Production Efficiency
Technologically efficient: when firm can’t produce the
quality with less inputs
Economically efficient: when firm can’t produce the quality
at a lower cost
An economically efficient method has to be technologically
efficient.
The relative price of inputs determines the economically
efficient method
Businesses & Markets (1)
Types of business: choices of funding
1. Sole Proprietorship: funded by ONE owner
2. Partnership: funded by TWO or MORE owners
3. Corporation: funded by a large number of owners who
will not be liable to pay debt if company goes bankrupt
Types of market: level of competition
1. Perfect competition: large number of firms producing
identical products
2. Monopolistic competition: large number of firms
producing somewhat different products
3. Oligopoly: few firms in the market
4. Monopoly: only one firm
Low barrier to entry can work to keep price down!
Businesses & Markets (2)
Types of market: level of competition
1. Four-Firm Concentration Ratio: percentage of sales
accounted for by the largest 4 firms (0-100)
2. Herfindahl-Hirschman Index: sum of the percentage of
sales accounted for by the largest 50 firms
Careful about limitations of indexes specific to A industry
Production activity of coordinated by
1. firm: lower transaction cost and economies of team
production
2. market: sellers and buyers of resources uses price to
coordinate production
Usually a mix of the two!
Chapter 11 Output and Costs
1. Short-Run: period of time before the firm can alter ALL
factors of production
2. Long-Run: period of time after the firm CAN alter all
factor of production
Plant (capital) is the building / machines / big investments usually the hardest to alter.
For simplicity: long-run = after a firm can change its plant
An existing plant is considered a sunk cost
Sunk Cost: cost that has already been incurred and can’t be
alter anymore (reduced, reclaimed, etc)
Short-Run Production Behaviour
Product schedule
• Remember short run = plant doesn’t change
• Schedule relates total product to marginal product to
average product
• Total Product: total output given an amount of labour
• Marginal Product: amount of extra output that can be
achieved by using one more worker
• Average Product: total output divided by total labour
Laws:
1. Increasing Marginal Return at the beginning due to
specialization (division of labour)
2. Decreasing Marginal Return due to crowding and plant
limitations
Costs
Total Cost: cost of all factors: TC = TFC + TVC
Total Fixed Cost: doesn’t vary by level of production
Total Variable Cost: costs that increases or decreases as
output increases or decreases – costs of labour and capital
Marginal Cost: cost needed to produce 1 MORE unit
Relationships between average and marginal
Marginal > Average: average increase
Marginal < Average: average deceases
Graph tips:
1. vertical distance between ATC and AVC = the height of AFC
2. MC cuts AVC and ATC at their minimum
Cost curves VS Product curves
Costs curves align with product curves
• MP going up -> MC going down
• AP going up -> AVC going down
• AP cuts MP at the output where MC cuts AVC (or the
quantity where AVC is lowest)
Don’t memorize! Think it through, graph on P.260
Long-Run Production Behaviour (1)
Long-run = plant (amount of capital) can change
Long-Run Production Function: shows how output varies with
both labour AND capital
KEY: capital also has increasing and diminishing marginal
returns
Long-Run Average Cost Curve:
• draw all the Short-Run Average Cost Curves, one for each
possible plant, on the same graph
• trace out the lowest segments of the curves to get LRAC
• LRAC curve is the LOWEST average cost to produce a given
a quantity when firm can alter both labour AND capital
Long-Run Production Behaviour (2)
As output increases, firms can decrease ATC by switching to
larger plants – Economies of Sale
There comes a point when more output requires large plants
that raises ATC due to diminishing returns from capital –
Diseconomies of Scale
THE output quantity in the long run when firm achieves the
lowest ATC is called Minimum Efficient Scale