ECON 202: Principles
of Microeconomics
Review Session for Exam 2
Chapters 5, 6, 9 and 10
Review Session for Exam 1
1.
2.
3.
4.
Externalities, Public Goods and Common Resources.
Elasticities.
Consumer Behavior.
Firm’s Production and Costs.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
2
1. Externalities, Public Goods and
Common Resources

Externality:


An externality causes a difference between:



A benefit or cost that affects someone who is not directly
involved in the production or consumption of a good or service.
the private cost of production and the social cost of production,
or
the private benefit from consumption and the social benefit from
consumption.
Presence of externality creates a situation of market
failure.

When the market fails to produce the efficient level of output.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
3
1. Externalities, Public Goods and
Common Resources

Negative Externality in Production
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
4
1. Externalities, Public Goods and
Common Resources
Private Solution to Externalities
 Markets can cure market failure if property rights are
clearly assigned.
 Coase Theorem


If transaction costs are low, private bargaining will result in an
efficient solution to the problem of externalities.
In practice, we would also need:


All parties have full information about costs and benefits
associated with the externality.
Parties make reasonable demands.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
5
1. Externalities, Public Goods and
Common Resources
Government Solution to Externalities
 In case of negative externalities in production,
government can impose a tax to make producers
internalize the externality.


Amount of tax = Difference between Social Marginal Cost and
Private Marginal Cost.
In case of positive externalities in consumption,
government can impose a subsidy to make consumers
internalize the externality.

Amount of subsidy = Difference between Social Marginal Benefit
and Private Marginal Benefit.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
6
1. Externalities, Public Goods and
Common Resources



Goods can be classified according to
Rivalry: When one person’s consuming a unit of a good
means no one else can consume it.
Excludability: When anyone who does not pay for a
good cannot consume it.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
7




ECON 202: Princ. of Microeconomics
For a public good, the
aggregate demand is
found by adding vertically
the individual demands.
Consumer have
incentives to not reveal
their willingness to pay.
Market do not provide the
economically efficient
quantity of public goods.
Usually governments
provide them.
Review Session for Exam 2
8
1. Externalities, Public Goods and
Common Resources

Free use of common resources can conduce to overexploitation, since users do not bear all the costs.

Tragedy of the commons.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
9
2. Elasticity
Price elasticity of demand
 How much quantity demanded varies when price
changes.
Q2  Q1
 Midpoint formula:
Q Q 
2
 1

Perc. change in quantity demanded  2 
Price elast. dmd. 

P2  P1
Perc. change in price
 P1  P2 


 2 
Unit-elastic
-∞
-1
Elastic
ECON 202: Princ. of Microeconomics
0
+∞
Inelastic
Review Session for Exam 2
10
2. Elasticity


Polar cases:
Perfectly inelastic demand.



Quantity demanded is
completely unresponsive to
price.
Price elasticity of demand is
zero.
Perfectly elastic demand.


Quantity demanded is
infinitely responsive to price
Price elasticity of demand
equals infinity.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
11
2. Elasticity
Determinants of Price Elasticity of Demand
 Availability of close substitutes.


Passage of time.


Demand curve for a luxury is more elastic than the demand
curve for a necessity.
Definition of the market.


As more time passes, more elastic the demand.
Luxuries vs. Necessities.


More substitutes available, more elastic demand.
The more narrowly defined a market, the more elastic the
demand.
Share of a good in a consumer’s budget.

The bigger the share in the consumer’s budget, the more elastic.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
12
2. Elasticity
Elasticity Price of Demand and Total Revenue
 When demand inelastic:



When demand elastic:



A cut in price increases quantity demanded less than
proportionally.
Total revenue decreases.
A cut in price increase quantity demanded more than
proportionally.
Total revenue increases.
When demand unit-elastic:


A cut in price increase quantity demanded proportionally.
Total revenue does not change.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
13
2. Elasticity
Cross-Price Elasticity of Demand
Q2  Q1
 Q1  Q2 


2 

Cross - price elasticity of demand 
P2other  P1other
 P1other  P2other 


2


-∞
+∞
0
Complementary goods
ECON 202: Princ. of Microeconomics
Substitute goods
Review Session for Exam 2
14
2. Elasticity
Income Elasticity of Demand
Q2  Q1
 Q1  Q2 


2

Income elasticity of demand  
I 2  I1
 I1  I 2 


 2 
Necessity
-∞
0
Inferior good
ECON 202: Princ. of Microeconomics
Luxury
1
+∞
Normal good
Review Session for Exam 2
15
2. Elasticity
Price elasticity of supply
 How much quantity supplied varies when price changes.
 Midpoint formula:
Q2S  Q1S
 Q1S  Q2S 


2
Perc. change in quantity supplied 

Price elasticity of supply. 

P2  P1
Perc. change in price
 P1  P2 


2


Unit-elastic
-∞
0
Inelastic
ECON 202: Princ. of Microeconomics
+∞
1
Review Session for Exam 2
Elastic
16
2. Elasticity

Price elasticity of supply depends on the availability of
inputs and capital to increase production.


Inelastic in a short period of time.
After some time has passed, supply will become more elastic.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
17
3. Consumer Behavior
Utility and Consumer Decision Making
 Basic idea of the model:


In economic terms:


Consumers buy the affordable combination of goods that makes
them as well of as possible.
Given the income and prices, consumers will choose a bundle of
goods that maximizes their utility.
Law of diminishing marginal utility.

The more you consume of a good, the less utility you receive
from the last unit consumed.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
18
3. Consumer Behavior

How consumers make decisions


Consumers spend progressively their money available in the
goods which give the highest utility per dollar spent.
Suppose slice of pizza cost $2, cup of coke cost $1 and
total income is $10.
(1)
Slices
of Pizza
(2)
Marginal Utility
( MUPIZZA )
1
20
2
(3)
Marginal Utility
per Dollar
(6)
Marginal Utility
per Dollar
(4)
Cups
of Coke
(5)
Marginal Utility
( MUCOKE )
10
1
20
20
16
8
2
15
15
3
10
5
3
10
10
4
6
3
4
5
5
5
2
1
5
3
3
6
3
--
6
1
--
ECON 202: Princ. of Microeconomics
 MU Pizza 


 PPizza 
Review Session for Exam 2
 MU Coke

 P
Coke





19
3. Consumer Behavior

Optimal consumption satisfy two conditions:



When second condition is not satisfied, we can increase
utility by:



All money is spent.
Marginal utility per dollar is equal across goods.
Consuming less of the good with lower utility per dollar, and
Consuming more of the good with higher utility per dollar.
Sometimes, marginal utility per dollar is never equal
across goods.

Choose the combination with the smallest difference between
MU per dollar across goods.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
20
3. Consumer Behavior


What happens when the price of one of the good changes?
Substitution effect:


Change in quantity demanded keeping constant the consumer
purchasing power.
Income effect:

Change in quantity demanded that results from the change
consumer purchasing power.
D
Giffen good
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
D
21
3. Consumer Behavior
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
22
3. Consumer Behavior
Other factors affecting consumer’s decision
 Social recognition



Consumer can receive utility from consume goods that them
appear knowledgeable and fashionable.
Buying decision depends partially in good’s characteristics and
partially in how many other people are buying the product.
Celebrity Endorsement


Consumers can believe that public figures are particularly
knowledgeable about products.
Consumers feel more fashionable and closer to famous people if
the use the same product they do.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
23
3. Consumer Behavior
Other factors affecting consumer’s decision (cont.)
 Network Externalities



For some products, its usefulness increases with the number of
consumers that use it. (network externality)
Network externalities can create considerable switching costs.
Fairness

Evidence that people like to be treated fairly and usually try to
treat others fairly.


Ultimatum and dictator game.
Businesses consider this concern and keep prices low in some
demand spikes.


Consumers will avoid a firm if they believe firm acts unfairly.
By clearing excess of demand, firms can also make disappear the
popularity of their products.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
24
3. Consumer Behavior
Behavioral Economics


The study of situations in which people make choices that do not
appear to be economically rational.
Ignoring Nonmonetary Opportunity Costs


If you own something you could sell, using it involves an
opportunity cost. (ticket example)
Behavioral economist believe that inconsistency is caused by
endowment effect.


Tendency of people to value more something when they own it than
when they don’t.
Failing to Ignore Sunk Costs

A sunk cost is a cost that has already been paid and cannot be
recovered, and it should be ignored in any later decision.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
25
3. Consumer Behavior
Behavioral Economics (cont.)
 Being Unrealistic About Future



People over-value current consumption and under-value future
consumption.
People have long-run goals, but day to day decisions are not
consistent with those goals.
Some economist argue that these are cases of inconsistent
preferences over time.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
26
4. Firm’s Production and Costs



Technology are the processes a firm uses to turn input
into output of goods and services.
Technological change is a change in the ability of a firm
to produce a given level of output with a given quantity of
inputs.
Short-run is the period of time when at least one input is
fixed.


Usually, the capital is the fixed input.
Long-run is the period of time when a firm can vary all
its inputs.

Size of physical plants or technology used can be changed.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
27
4. Firm’s Production and Costs




In the short run, having at least an input fixed imposes to
the firm costs that can not avoid: fixed cost.
Also, the inputs that the firm can vary impose a cost that
depends on their use: variable cost.
Variable Cost + Fixed Cost = Total Cost
Relevant measure of costs is the Economic Cost, which
include:


Explicit costs (Accounting costs): Costs paid in money.
Implicit costs: Opportunity costs
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
28
4. Firm’s Production and Costs


Production function is the relationship between the
inputs used and the output produced.
Marginal Product of Labor is the increase in production
by hiring one additional worker.


After certain number of workers, increments in production will be
every time smaller. (law of diminishing returns)
Average Product of Labor is the quantity produced
divided by the amount of workers hired.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
29
4. Firm’s Production and Costs
QUANTITY
OF WORKERS
QUANTITY
OF
PIZZA OVENS
QUANTITY OF
PIZZAS
PER WEEK
MARGINAL
PRODUCT OF
LABOR
AVERAGE
PRODUCT OF
LABOR
0
2
0
—
—
1
2
200
200
200
2
2
450
250
225
3
2
550
100
183.3
4
2
600
50
150
5
2
625
25
125
6
2
640
15
106.7
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
30
4. Firm’s Production and Costs

With information from production function, we can also
obtain the costs the firm faces.
QUANTITY
QUANTITY
OF
OF WORKERS PIZZA OVENS
QUANTITY OF
PIZZAS
PER WEEK
COST OF
PIZZA OVENS
(FIXED COST)
COST OF
WORKERS
(VARIABLE COST)
TOTAL
COST OF
PIZZAS
0
2
0
$800
$0
$800
1
2
200
800
650
1,450
2
2
450
800
1,300
2,100
3
2
550
800
1,950
2,750
4
2
600
800
2,600
3,400
5
2
625
800
3,250
4,050
6
2
640
800
3,900
4,700
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
31
4. Firm’s Production and Costs



Marginal Cost is the change in a firm’s total cost from
producing one more unit of a good or service.
When production changes by many units after increasing
an input, marginal cost can be estimated as:
Change in Total Cost
Marginal Cost 
Change in Quantity Produced
In the short-run:


If marginal product of labor increase, marginal cost decreases.
If marginal product of labor decreases, marginal cost increases.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
32
4. Firm’s Production and Costs





Average Total Cost = Total Cost / Quantity
Total Cost
=
Fixed Cost + Variable Cost
Average Total Cost = Average Fixed Cost +
Average Variable Cost
Average Fixed Cost = Fixed Cost / Quantity
Average Variable Cost = Variable Cost / Quantity
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
33
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
34
4. Firm’s Production and Costs


Marginal Cost (MC), Average Total Cost (ATC) and
Average Variable Cost (AVC) are U-shaped
Marginal Cost (MC) intercepts ATC and AVC at minimum
point.






When MC is higher than ATC, ATC increases.
When MC is lower than ATC, ATC decreases.
When MC is higher than AVC, AVC increases.
When MC is lower than AVC, AVC decreases.
As output increases, Average Fixed Cost turns smaller.
As output increases, difference between Average Total
Cost (ATC) and Average Variable Cost (AVC) shrinks.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
35
4. Firm’s Production and Costs
Cost in the long-run
 When in the long-run a firm can decrease average cost
by increasing production, this firm experiences
economies of scale.
 Level of output where economies of scale are
exhausted: minimum efficient scale.
 If long-run average cost remain unchanged as
production increases, the firm experiences constant
returns to scale.
 If long-run average cost increases as production
increases, the firm experiences diseconomies of scale.
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
36
Problems
According to some recent reports, the
livestock sector generates more
greenhouse gas emissions than
transport, which contributes to global
warming. As a consequence, the
agricultural sector has been affected
by a substantial reduction in crop
yields.
Suppose the effect of the externality
from the livestock to the agricultural
sector can be measured as $120 per
head of cattle.
Find the DWL and the efficient
number of heads. How would the
government intervene this market to
reach the efficient level of production?
ECON 202: Princ. of Microeconomics
Marginal
Cost and
Marginal
Benefit
Livestock market
Private
Marginal
Cost
$1,120
$1,060
$1,000
$940
$880
Marginal
Benefit
80
Review Session for Exam 2
90
100 110 120
Millions of
Heads
37
Problems
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
38
Problems
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
39
Problems
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
40
Problems
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
41
Problems
Ernest can spend all his money in buying fish and coconuts. The store charges
one dollar for a coconut and 2 dollars for a fish. After spending all his money,
with his current consumption, Ernest is obtaining 60 units of marginal utility per
dollar from fish and 80 units of marginal utility per dollar from coconuts.
Is he optimizing his utility? If not, which good should he increase consumption?
Now the price of fish goes down to $1.5 and Ernest has his income reduced.
Suppose that Ernest is again spending all his money and consuming the
original combination of goods.
Is he optimizing his utility? If not, which good should he increase consumption?
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
42
Problems
ECON 202: Princ. of Microeconomics
Review Session for Exam 2
43
ECON 202: Principles
of Microeconomics
Review Session for Exam 2
Chapters 5, 6, 9 and 10