Principles of Microeconomics
Review for the Final Exam
Akos Lada
August 11th, 2014
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint
Contents
1. Review of Homework Assignment 10
2. Introduction to Economics – The Big Picture
3. A collection of “punch-lines”
4. Additional Q&A
1. Review of Homework
Assignment 10
The information
Alfaguara Publishing Co. faces the following demand schedule for
the next novel of Mario Vargas Llosa, the prestigious novelist
recipient of the 2010 Nobel Prize in Literature:
Price
Quantity
(1,000s) novels
$100
90
80
70
60
50
40
30
20
10
0
0
100
200
300
400
500
600
700
800
900
1,000
The units is in thousand books,
so at a price 0, the quantity
demanded is 1 million books
The author is paid $ 2 million to write the book, and the marginal cost
of publishing the book is a constant $10 per book.
Compute the total revenue, total cost, and profit at each
quantity. What quantity would a profit-maximizing
publisher choose? What price would it charge?
Price
$100
90
80
70
60
50
40
30
20
10
0
Quantity
(1,000s)
0
100
200
300
400
500
600
700
800
900
1,000
Total
Revenue
(millions)
$0
9
16
21
24
25
24
21
16
9
0
Total Cost
(millions)
Profit
(millions)
$2
3
4
5
6
7
8
9
10
11
12
$-2
6
12
16
18
18
16
12
6
-2
-12
A profitmaximizing
publisher would
choose a
quantity of
400,000 at a
price of $60
or a quantity of
500,000 at a
price of $50;
Both
combinations
would lead to
profits of $18
million.
Compute marginal revenue. (Recall that
MR = ∆TR/∆Q). How does marginal
revenue compare to the price? Explain.
Price
Quantity
(1,000s)
$100
90
80
70
60
50
40
30
20
10
0
0
100
200
300
400
500
600
700
800
900
1,000
Total
Revenue
(millions)
$0
9
16
21
24
25
24
21
16
9
0
Marginal
Revenue
(millions)
---$9
7
5
3
1
-1
-3
-5
-7
-9
Marginal revenue is
always less than price.
Price falls when
quantity rises because
the demand curve
slopes downward, but
marginal revenue falls
even more than price
because the firm loses
revenue on all the
units of the good sold
when it lowers the
price.
Graph the marginal-revenue, marginal-cost, and demand
curves. At what quantity do the marginal-revenue and
marginal-cost curves cross? What does it signify?
The marginal-revenue
and marginal-cost
curves cross between
quantities of 400,000
and 500,000.
This signifies that the
firm maximizes profits
in that region.
In your graph, shade in the deadweight
loss. Explain in words what this means
The area of deadweight loss
is marked “DWL” in the
figure.
Deadweight loss means that
the total surplus in the
economy is less than it
would be if the market were
competitive, because the
monopolist produces less
than the socially efficient
level of output.
If the author were paid $3 million instead of $2 million
to write the book, how would this affect the publisher’s
decision regarding the price to change? Explain
• If the author were paid $3 million
instead of $2 million, the publisher
would not change the price,
because there would be no change
in marginal cost or marginal
revenue.
• The only thing that would be
affected would be the firm’s profit,
which would fall.
Suppose the publisher was not profit-maximizing but
was concerned with maximizing economic efficiency.
What price would it charge for the book? How much
profit would it make at this price?
• To maximize economic efficiency,
the publisher would set the price at
$10 per book, because that is the
marginal cost of the book.
• At that price, the publisher would
have negative profits equal to the
amount paid to the author.
2. The Big Picture
8
9 10
Welfare Analysis
(CS, PS, DWL) and
Efficiency
1
0
How
Economists
think
(principles)
Why Trade?
(PPF and
Comp
Advantage)
2
PERFECT MARKETS
Price
controls
(floors,
ceilings)
4 5 6
Supply and
Demand
Comparative
Statics
Elasticity
(price,
income,
cross-price)
3 4
MOTIVATION
8
7
11
Taxes
(on consumer
producer; on
elastic /
inelastic
agent)
MARKET FAILURES
TOOLS
12
13 14
14 15
Externalities
(positive,
negative)
Public goods
& Common
Pool
Resources
Competition
vs.
Monopoly
APPLICATION
3. A collection of
“punch-lines”
0) How economists think…
• Economics as the study of how society manages scarce resources
• 4 principles of how people make decisions
1.
2.
3.
4.
People face trade-offs
The cost of something is what you give up to get it (opportunity cost)
Rational people think at the margin
People respond to incentives
• 3 additional principles we saw in the course
5. Trade can make everyone better off
6. Markets are usually a good way to organize economic activity
7. Governments can sometimes improve market outcomes
1) Production Possibilities Frontier
• PPF (the
production
possibilities given
the current
technology and
resources)
• Efficient, inefficient
and unfeasible
points
• PPF’s slope and
opportunity cost
Wheat
(tons)
6,000
5,000
E
D
4,000
3,000
F
G
C
2,000
B
1,000
A
0
0
100 200 300 400 500 600
Computers
1) Gains from trade
• Absolute
advantage vs.
comparative
advantage
Comparative advantage is the ability to
produce a good at a lower opportunity cost
than another producer
• Comparative
advantage allows
for:
• Specialization
• Increase in the
size of the
economic pie
• Gains from trade
Opportunity Cost of:
Computer
Wheat (ton)
United States
10
1/10
Japan
5
1/5
The graph below shows what Canada and Mexico can
produce in a 40-hr workweek. What is the opportunity cost
of computers in terms of printers in Canada and Mexico,
respectively?
computers
computers
Canada
Mexico
10
4
4
1.
2.
3.
4.
printers
10 printers in Canada, 2 printers in
Mexico
1 printer in Canada, ½ printer in
Mexico
1 printer in Canada, 2 printers in
Mexico
10 printers in Canada, ½ printer in
Mexico
5
printers
When one speaks of “demand” in a particular market, this
refers to:
1.
2.
3.
4.
The quantity demanded at a certain
price
Only one price-quantity combination
on the demand schedule
The slope of the demand curve at one
point
The whole demand curve
2) Demand
•
Demand ≠ Quantity
Demanded
•
Shifts vs. movements along the
curve
•
Demand Shifters
1. Number of Buyers
2. Income
•
•
Law of demand
•
Demand Schedule
•
Individual demand vs. Market
demand
Normal vs. Inferior goods
3. Prices of related goods
•
Substitutes vs. Complements
4. Tastes
5. Expectations
2) Supply
•
Supply≠ Quantity Supplied
•
Law of supply
•
Supply Schedule
•
Individual supply vs. Market
supply
•
Shifts vs. movements along the
curve
•
Supply Shifters
1. Number of Sellers
2. Input prices
3. Technology
4. Expectations
2) Equilibrium
P
$6.00
D
Surplus
S
$5.00
$4.00
P* $3.00
$2.00
$1.00
Shortage
$0.00
0
5
10 15 20 25 30 35
Q*
Q
3) Comparative statics
To determine the effects of any event,
1. Decide whether event shifts S curve,
D curve, or both.
2. Decide in which direction curve shifts.
3. Use supply-demand diagram to see
how the shift changes equilibrium P and Q.
No change in
Supply
Increase in
Supply
Decrease in
Supply
No Change in
Demand
P same
Q same
P down
Q up
P up
Q down
Increase in
Demand
P up
Q up
P ambiguous
Q up
P up
Q ambiguous
Decrease in
Demand
P down
Q down
P down
Q ambiguous
P ambiguous
Q down
The number of suppliers of Good D has increased. What
will be the effect on the market price and quantity for Good
E if it is a complement of Good D?
1.
2.
3.
4.
5.
Price
Increase
Increase
Decrease
Decrease
No change
Quantity
Decrease
Increase
Decrease
Increase
Increase
There has been a technological advancement in the
production of good B. Good B is a substitute for Good C.
Knowing this, the most likely scenario is that:
1.
2.
3.
4.
The quantity demanded for Good C
will increase
The quantity demanded for Good C
will decrease
The demand for Good C will increase
The demand for Good C will decrease
4) Calculating Elasticity
• Three steps:
1. Calculate the percentage changes in quantity and the percentage
change in price
end value – start value
midpoint
x 100%
2. Calculate the elasticity using these two numbers as inputs
Price
elasticity of
demand
Percentage change in Qd
=
Percentage change in P
3. Interpret the result (inelastic, elastic, unit elastic)
5) Different elasticities
Price elasticity of
demand
=-
Income elasticity of
=
demand
Cross-price elast.
of demand
=
Percentage change in Qd
Percentage change in P
Percent change in Qd
Percent change in income
% change in Qd for good 1
% change in price of good 2
5) Elasticity (of Demand)
P
P
Q
Perfectly inelastic
P
Q
Perfectly elastic
P
P
1%
Inelastic
Q
Elastic
Q
1%
Unit-elastic
Q
6) Determinants of Elasticity
Supply
Demand
1.
The extent to which close
substitutes are available
2.
Whether the good is a necessity
or a luxury
3.
How broadly or narrowly the
good is defined
4.
The time horizon – elasticity is
higher in the long run than the
short run
1.
How easily sellers can change
the quantity they produce
E.g: Supply of beachfront
property vs. new cars
2.
For many goods, price
elasticity of supply is greater in
the long run than in the short
run
Firms can build new
factories,
or new firms may be able to
enter the market
7) Price controls
• Binding vs. non-binding
• Binding price ceilings (e.g. rent control)
• Leads to shortage
• Effect is more severe in the long run
• Rationing, informal market, decrease in quality
• Binding price floors (e.g. minimum wage)
• Leads to surplus
• Size of shortage / surplus depends on elasticity of Supply and
Demand
• Generally, effect larger in the long run when S&D become more
elastic
Refer to the labor market graph below. The
imposition of an $8 minimum wage would cause
Wage
SL
W = $8
We = $6
DL
65
1.
2.
3.
4.
80
100
Labor hours
additional unemployment of 20
labor hours
unemployment of 35 labor hours
a labor shortage of 35 labor hours
no change in the equilibrium wage
and employment because the
minimum wage is not binding.
8) Taxes
1.
•
•
2.
•
3.
•
•
What shifts?
If imposed on buyers, it is equivalent to a decrease in
income, shifts the demand curve left
If imposed on sellers, it is equivalent to an increase
in input costs, shifts the supply curve left
What is the size of the shift?
The amount of the tax
Tax incidence (who pays for the tax burden)
Whether the tax is charged to the producers or to the
sellers is irrelevant – the tax incidence is the same in both
cases
What matters is the elasticity of Supply and Demand
•
If Supply is more inelastic, the larger share of the burden
falls on the sellers.
•
If Demand is more inelastic, the larger share of the burden
falls on the buyers
Why would the removal of the $0.18 cents gasoline
tax not help consumers much?
U.S. Market for Gasoline
ST
Price
($/gallon)
$0.18
tax
S0
PT = P C
P0
PP
D0
QT Q0
1.
2.
3.
4.
Qty. (gallons)
because gasoline is a necessity and
demand is inelastic
because suppliers were paying the large
part of the tax burden
because the supplier will not pass on the
tax reduction to the consumers
because the tax reduction is shot-term and
taxes will go up again
8) Welfare Analysis
P
$5
Supply curve shows private cost, the
costs directly incurred by sellers.
4
Demand curve shows private value,
the value to buyers (the prices they are
willing to pay).
The Consumer Surplus (CS) is the
area between the equilibrium price
and the Demand curve
3
$2.50
2
The Producer Surplus (PS) is the area
between the equilibrium price and the
Supply curve
Total Surplus (TS) = CS + PS + GR
1
0
0
10
20 25 30
Q
We think of it as an (imperfect)
measure of aggregate welfare in
society
9) Calculating changes in welfare
(example – changes in CS)
P
To calculate the area
of the triangles:
½ (base x height)
60
1.
50
Fall in CS
due to buyers
leaving market
40
To calculate the area
of the rectangles:
30
base x height
10
20
2.
Fall in CS due
to remaining
buyers
paying higher P
D
0
0
5 10 15 20 25 30
Q
10) Market equilibrium and
efficiency
Total = CS + PS
surplus
Total
= (value to buyers) – (cost to sellers)
surplus
• Definition: An allocation of resources is
efficient if it maximizes total surplus.
• We say that the market equilibrium quantity is
efficient because it maximizes total surplus.
This means:
• At any other quantity it is possible to increase TS
by moving towards the equilibrium quantity.
• The goods are consumed by the buyers who value
them most highly.
• The goods are produced by the producers with the
lowest costs.
11) The welfare effect of a Tax
P
CS = A
PS = F
Tax revenue
=B+D
Total surplus
=A+B
+D+F
Deadweight loss
C+E
A
PB
S
B
D
C
E
PS
D
F
QT
QE
Q
11) Elasticities and Deadweight loss
• The size of the deadweight loss is
determined by the elasticity of
supply and demand of a good.
• The more elastic the Supply or the
Demand of a good is, the larger the
deadweight loss.
• The less elastic the Supply or the
Demand of a good is, the smaller
the deadweight loss.
• This is very informative for the
decision of “What products to
tax?”.
12) Externalities
• The uncompensated impact of one
person’s actions on the well-being of a
bystander.
• Can be negative
• Making social costs higher than private
costs
• Leads to an over-production of the good
(with respect to the optimal quantity)
• … or positive
• Making social value greater than private
value
• Leads to an under-production of the good
(with respect to the optimal quantity)
12) Policy responses to externalities
• Command-and-control policies (regulation)
• Market-based policies
• Corrective taxes (pigouvian taxes) or subsidies
• Taxes that induce private decision makers to take into
account the social costs generated by a negative
externality
• Subsidies that induce private decision makers to take
into account the social benefits generated by a positive
externality
• Tradable pollution permits
• Firms with lower costs of reducing pollution can sell
their permits to firms with higher costs of reducing
pollution.
• Market-based policies (theoretically) can achieve
the same goals as regulations, but more efficiently
13) Public Goods
• Are goods that are nonexcludable and non-rival
• If the benefit of a public
good exceeds the cost of
providing it, government
• Some important public goods
should provide the good and
are:
pay for it with a tax.
• National defense
• Economists use cost-benefit
• Knowledge created through
basic research
analysis to determine how
• Fighting poverty
much to provide of a public
good.
• Public goods are difficult for
private markets to provide
• Cost-benefit analysis is
because of the free-rider
imprecise because benefits
problem.
are hard to measure.
14) Common Pool Resources
• Are goods that are at the same time not
excludable but rival.
• Some important Common Resources are:
• Clean air and water
• Congested roads
• Fish, whales, and other wildlife
• Leads to the overconsumption of the
resource (e.g. the tragedy of the commons).
• Possible policies available to the
government to address this issue include:
•
•
•
•
Regulate use of the resource
Impose a corrective tax
Auction off permits allowing use of the resource
If the resource is land, convert to a private good
by dividing and selling parcels to individuals
14) Competition
• Competitive firms
maximize profits
at the Q where
MR=MC
• (Any) firm’s profit is
the difference
between the Price
and their per-unit
cost (ATC).
• In a perfectly
competitive market
in the long run, all
firms make zero
economic profit.
Costs, P
MC
P
MR
ATC
profit
ATC
at Q optimal
Qoptimal
Q
15) Monopoly
•
•
Monopolies, just like competitive
firms, maximize profits at the Q
where MR=MC
However, unlike competitive firms
their MR is lower than their P
•
•
•
Because, since monopolies are
the only seller, face the market
demand curve – in order to sell
additional units they need to P
lower the price
They set the optimal Q at the place
where MR=MC, and then charge
the maximum price that they can
charge at that quantity.
Because they produce less than the
competitive market equilibrium at
a higher price, monopolies generate
a deadweight loss
Price
Deadweight
MC
loss
P
= MC
MC
D
MR
QM QC
Quantity
4. Additional Q&A