ADVANCED PLACEMENT MICROECONOMICS HOT SHEET!
Microeconomics is “the study of how households and firms make decisions and how they
interact in markets.”
CHAPTER 1 – TEN PRINCIPLES OF ECONOMICS
1.
The Basic Economic Problem is SCARCITY of Resources. People have unlimited wants
while having limited resources.
2.
A Market Economy is one that allocates resources through the decentralized
decisions of many firms and households as they interact in markets for goods &
services. Price is the rationing device.
3.
A Command Economy is one where supply and price are regulated by the
government rather than market forces. Government planners decide which goods &
services are produced and how they are distributed.
4.
A Mixed Economy is one where there is a mixture of free enterprise and government
control. Also known as Dual Economies.
5.
3 Basic Economic Questions that must be answered by all economies: (1.) What will
be produced? (2.)How much will be produced? and (3.) For whom will it be
produced?
6.
The 3 Macroeconomic Goals of Government: (1.) Steady Growth, (2.) Stable Prices,
and (3.) Low Unemployment.
7.
The Business Cycle is used to illustrate fluctuations in economic activity, such as
employment and inflation.
CHAPTER 2 – THINKING LIKE AN ECONOMIST
1.
In the Circular Flow Model, households supply factors of production (i.e. – land, labor
& capital) through the Factor Market (or Markets for Factors of Production) in return
for wages, rent and profit. Firms then supply goods & services through the Product
Market in return for revenue from households.
2.
Households SUPPLY factors of production and DEMAND goods & services. Firms
SUPPLY goods & services and DEMAND factors of production.
3.
The 4 Factors of Production are (1.) Natural Resources, (2.) Capital, (3.) Labor and (4.)
Entrepreneurship.
4.
The Production Possibilities Frontier shows the combinations of output than an
economy can possibly produce. The curve can be either Bowed Outward or Linear. If
it is bowed outward, that means specialization is required in the production of the 2
products. As a result, capital goods used in the production process cannot be easily
shifted to another industry. As you move down the PPF, to receive an additional unit
on the X Axis, you must give up even more units of the good on the Y Axis (The Law of
5.
6.
Increasing Opportunity Costs is at work). The opportunity cost increases as you move
down the curve. When the curve is linear, the opportunity cost is constant between
the goods. If the opportunity cost is 1:1, then the capital goods are perfectly shiftable
between the 2 industries.
PPF – continued. An economic advancement in good one’s industry will allow the
country to produce more units of good one, all the while maintaining the same
number of goods produced of good two. If there’s a technological advancement in
the production of both products, then the PPF will shift outward for both goods.
“The government should raise the minimum wage” is a Normative Statement (are
prescriptive in nature; they describe the world as it ought to be). “Minimum wage
laws and unemployment compensation benefits cause unemployment” is a Positive
Statement (are descriptive in nature, they describe the world as it is).
CHAPTER 3 – INTERDEPENDENCE AND THE GAINS FROM TRADE
1.
Trade Makes Everyone Better Off. Some industries of the economy will be made
worse off when trade occurs, however, the economy as a whole is better off because
total surplus is increased.
2.
Trade is based on Opportunity Costs. Trading partners should produce the good or
service where they have the lower opportunity cost.
3.
Be leery of College Board trying to trick you. They can structure the international
trade problem in two ways. Either they will give you the quantities that can be
produced by each nation, or they will give you the total time that it takes to make
one unit of a good in each nation. If they give you the latter, you will need to find a
common time period (similar to finding a common multiple in math) so that you can
determine the quantity for each product that can be produced in the common period
that you used. Then, you can determine the opportunity costs in order to see which
country should produce which product.
4.
Absolute Advantage – the scenario where one trading partner can produce more of a
given product using the resources within their country. It is possible for a country to
have an absolute advantage in both products.
5.
Comparative Advantage – trade between countries is based on opportunity costs.
While it’s possible to have an absolute advantage in both products, a country can
only have a comparative advantage in one of the products.
CHAPTER 4 – THE MARKET FORCES OF SUPPLY AND DEMAND
1.
A Market is a group of buyers and sellers of a particular good or service.
2.
A Competitive Market is one in which there are many buyers and sellers so that each
has a negligible impact on the market price.
3.
4.
5.
6.
7.
8.
9.
10.
The Law of Demand – the inverse relationship that exists between price & quantity.
The Demand Curve is downward sloping and depicts the quantity demanded at each
price. As price changes, so too does the quantity demanded, represented as a
Change in Quantity Demanded.
A Demand Schedule is a table that shows a relationship between the price of a good
and the quantity demanded.
The Market Demand Curve is the horizontal summation of all the individual demand
curves for a particular good & service.
Determinants of Demand cause the demand curve to shift. An increase in demand is
represented by an outward shift of the demand curve; a decrease in demand is
illustrated with an inward shift of the demand curve.
Determinants include:
T – Tastes & preferences of buyers
R – Related Goods
Substitutes – an increase in the price of one good leads to an increase in the
demand for the other good.
Complements – an increase in the price of one good leads to a decrease in the
demand for the other good.
I – Income of Buyers
Normal Goods – an increase in income leads to an increase in demand for the
good. A decrease in income leads to a decrease in demand.
Inferior Good – an increase in income leads to a decrease in demand for the
good. A decrease in income leads to an increase in demand.
B - # of Buyers (more buyers = an increase in demand, fewer buyers = a decrease in
demand)
E – Expectations of Buyers – if you expect prices to fall in the future, demand will
decrease in the short term. If prices are expected to be higher in the future,
demand will increase right now.
The Law of Supply – the positive relationship that exists between price & quantity.
The Supply Curve is upward sloping and depicts the quantity supplied at each price.
The Supply Curve depicts the minimum price that the seller is willing to accept for
producing a product. Often, this minimum price is the producer’s cost of
production. As price changes, so too does the quantity supplied, represented as a
Change in Quantity Supplied.
A Supply Schedule is a table that shows the relationship between the price of a good
and the quantity supplied.
The Market Supply Curve is the horizontal summation of all the individual supply
curves for a particular good & service.
11.
12.
13.
14.
15.
16.
Determinants of Supply cause the supply curve to shift. An increase in supply is
represented by an outward shift of the supply; a decrease in supply is illustrated with
an inward shift of the supply curve.
Determinants include:
R – Resource Costs – if input prices increase, the firm’s supply curve will shift in. If
they fall, the firm’s supply curve will shift out.
O – Other Goods
Substitutes – an increase in the price of one good leads to an increase in the
supply for the other good.
Complements – an increase in the price of one good leads to a decrease in the
supply for the other good.
T – Technology – technological advancements shift the supply curve outward.
T – Taxation – If the firm is taxed at a greater rate, it will decrease supply. If taxes are
lowered, it will increase supply.
E – Expectations of Sellers – if sellers anticipate higher future prices for their product,
they will decrease supply in the short term. If they believe prices will fall in the
future, they’ll increase supply right now.
N - # of Sellers – if the number of sellers increases, supply shifts out; if the number
falls, supply will shift in.
Market Surplus – a situation in which quantity supplied > quantity demanded in the
market. This puts downward pressure on price until it returns to equilibrium.
Market Shortage – a situation in which quantity demanded > quantity supplied in the
market. This puts upward pressure on price until it returns to equilibrium.
When the market experiences either a change in supply or a change in demand (i.e. –
one of the curves shifts in or out), a new equilibrium is created.
When the markets experiences a change in both supply and demand (i.e. – both
curves shift), a new equilibrium is created. When this happens, either Price or
Quantity will be Ambiguous or Indeterminate. REMEMBER TO DRAW THE SHIFTS
THE SAME SO THAT YOU’LL BE ABLE TO DETERMINE THE VARIABLE (P or Q) THAT IS
INDETERMINATE.
CHAPTER 5 – ELASTICITY AND ITS APPLICATION
1.
Price Elasticity of Demand – measures how much the quantity demanded of a good
responds to a change in the price of a good, computed as a %age change in the
Quantity Demanded divided by the %age change in Price.
2.
The price elasticity of demand for any good measures how willing consumers are to
move away from the good as its price rises.
3.
4.
5.
6.
7.
8.
Determinants of Elasticity of Demand – Tina Does Saturday Night Live
T – Time Horizon – goods are more elastic in the long run and more inelastic in the
short run.
D – Definition of the Market
Narrow Market - are more elastic b/c it’s easier to find close substitutes
(i.e. – Coke or Pepsi).
Broad Market – are more inelastic b/c there are not any close substitutes
(i.e. – beverages, food or medicine).
S – Substitute Availability – the greater the # of substitutes, the more elastic demand
will be.
N – Necessities - have more inelastic demand
L – Luxuries - have more elastic demand
The Elasticity of Demand Coefficient is expressed in ABSOLUTE TERMS.
Elasticity Coefficient = 1 Demand is Unit Elastic
Elasticity Coefficient > 1 Demand is Elastic
Elasticity Coefficient < 1 Demand is Inelastic
Remember to use the MIDPOINT METHOD when calculating the Elasticity of
Demand Coefficient.
(Q2 – Q1)/[(Q2 + Q1)/2]
Price Elasticity of Demand = ________________________________
(P2 – P1)/[(P2 + P1)/2]
The Variety of Curves
If the Demand Curve is vertical, Demand is Perfectly Inelastic.
If the Demand Curve is horizontal, Demand is Perfectly Elastic
If the Demand Curve is downward sloping, Demand is Relatively Elastic
*The steeper the curve, the more inelastic it is. The flatter the curve, the more
elastic it is.
Elasticity of Demand and Total Revenue. When demand is elastic, a firm must lower
price to increase revenue. When demand is inelastic, a firm must raise price to
increase revenue.
Elasticity Coefficient Scenarios to Remember:
a. If price rises by 20% and demand falls by 10% - demand is inelastic
b. If price rises by 20% and demand falls by 20% - demand is unit elastic
c. If price rises by 20% and demand falls by 30% - demand is elastic
9.
The Income Elasticity of Demand – a measure of how much the quantity demanded
of a good responds to a change in consumers’ income.
(Q2 – Q1)/[(Q2 + Q1)/2]
Income Elasticity of Demand = ________________________________
(I2 – I1)/[(I2 + I1)/2]
10.
11.
12.
13.
When the Income Elasticity of Demand is Positive, the product is a Normal Good.
When the Income Elasticity of Demand is Negative, the product is an Inferior Good.
Elasticity Coefficient Scenarios to Remember:
a. If income rises by 20% and demand falls by 10% - the product is an Inferior Good.
b. If income rises by 20% and demand increases by 10% - the product is a Normal
Good.
The Cross Price Elasticity of Demand – a measure of how much the quantity
demanded of one good responds to a change in price of another good.
Good X (Q2 – Q1)/[(Q2 + Q1)/2]
Income Elasticity of Demand = ________________________________
Good Y (P2 – P1)/[(P2 + P1)/2]
14.
15.
16.
17.
When the Cross Price Elasticity of Demand is Positive, the goods are SUBSTITUTES.
When the Income Elasticity of Demand is Negative, the goods are COMPLEMENTS.
Elasticity Coefficient Scenarios to Remember:
a. If the price of good Y rises by 25% and demand for good X falls by 15% - the
goods are complements.
b. If the price of good Y rises by 25% and demand increases by 15% - the goods are
substitutes.
The Elasticity of Supply – a measure of how much the quantity supplied of a good
responds to a change in the price of that good.
(Q2 – Q1)/[(Q2 + Q1)/2]
Elasticity of Supply = ________________________________
(P2 – P1)/[(P2 + P1)/2]
18.
The Elasticity of Supply Coefficient is expressed in ABSOLUTE TERMS.
Elasticity Coefficient = 1 Supply is Unit Elastic
Elasticity Coefficient > 1 Supply is Elastic
Elasticity Coefficient < 1 Supply is Inelastic
19.
20.
The Variety of Curves
If the Supply Curve is vertical, Supply is Perfectly Inelastic.
If the Supply Curve is horizontal, Supply is Perfectly Elastic
If the Supply Curve is downward sloping, Supply is Relatively Elastic
*The steeper the curve, the more inelastic it is. The flatter the curve, the more
elastic it is.
THE SLOPE OF THE DEMAND & SUPPLY CURVES
a. When a curve is perfectly elastic, it’s slope is 0.
b. When a curve is perfectly inelastic, it’s slope is UNDEFINED.
CHAPTER 6 – SUPPLY, DEMAND AND GOVERNMETN POLICIES
1.
A Price Ceiling is the legal maximum on the price at which a good can be sold. It is set
below the market equilibrium and creates a shortage of the good.
2.
A Price Floor is the legal minimum on the price at which a good can be sold. It is set
above the market equilibrium and creates a surplus of the good.
3.
If a price ceiling is set above the equilibrium, it would be non-binding and the market
would settle at the equilibrium on its own.
4.
If a price floor is set below the equilibrium, it would be non-binding and the market
would settle at the equilibrium on its own.
5.
Free markets ration goods with prices.
6.
Price Ceilings lead to:
a.
long lines & waiting
b.
discrimination
c.
under-the-table arrangements
d.
a loss of incentives on the part of the participants impacted by the
governmental policy.
e.
lower prices, lower quantity & lower quality (in other words, they create
inefficiency & reduce surplus in the economy).
7.
Tax Incidence
a.
Based on elasticity – the more inelastic party will shoulder more of the tax no
matter whether that tax is placed on the buyer or the seller. If one party’s
demand or supply curve is Perfectly Inelastic, they’ll have to pay all of the tax,
not matter who the tax is assigned to.
b.
Drawing Your Graphs – Remember to always label your graphs involving tax
with:
* Price Buyers Pay
* Price Without Tax
* Price Sellers Receive
* The Deadweight Loss that results from the tax.
CHAPTER 7 – CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
1.
Welfare Economics - the study of how the allocation of resources affects economic
well-being.
2.
Consumer Surplus – is determined by analyzing the maximum willingness to pay on
the part of consumers with the actual price in the marketplace. This can be graphed
by analyzing the area below the demand curve and above price. If price falls,
consumer surplus increases. If price rises, consumer surplus falls.
3.
Producer Surplus – is determined by analyzing the minimum price that a firm is
willing to accept to supply the product (i.e. – its cost) in comparison to the price that
it receives in the marketplace. Cost includes the value of everything a seller
must give up to produce a good. It includes the expenses required in the
production process as well as the value that the producer places on their own time.
4.
Producer surplus is graphed by analyzing the area above the supply curve and below
price.
5.
Market Efficiency – the goal of the socially benevolent planner is to maximize total
surplus. If an allocation of resources maximizes total surplus, allocative efficiency is
achieved. Allocative efficiency occurs when resources are channeled to their most
productive & desired uses. Any market outcome that reduces total surplus leads to
an inefficient economy.
6.
Free markets produce the quantity of goods & services that maximize total surplus.
CHAPTER 8 – APPLICATION: THE COSTS OF TAXATION
1.
Taxes create a Deadweight Loss; taxes on goods cause the size of the market for the
good to shrink, reducing total surplus.
2.
When determining the revenue associated with a tax, you must multiply the quantity
sold by the size of the tax. It will appear as either a square or rectangle on your graph.
3.
The Deadweight Loss always appears as a triangle. The easiest way to see it or draw
it is to find the Allocatively Efficient quantity and then find the quantity at the new
equilibrium involving the tax.
4.
You should be able to either draw and label a graph, illustrating consumer surplus,
producer surplus, tax revenue and total surplus for a market without a tax and a
market with a tax. You should also be able to illustrate the change between the 2
markets.
5.
The Size of the Tax Determines the Size of the Deadweight Loss – a small tax leads to
a small deadweight loss. A somewhat larger tax increases the deadweight loss but
also increases tax revenue. A large tax leads to a large deadweight loss and raises only
a small amount of tax revenue.
6.
The Laffer Curve – the shape of the curve looks like the Arch in St. Louis and reflects
the fact that as the size of any tax increases, at first tax revenue will increase as
well. However, when the size of the tax hits a certain point, tax revenue received
from the tax in the economy will begin to fall. Consequently, as the size of the tax
increases, the size of the deadweight loss increases.
CHAPTER 9 – APPLICATION: INTERNATIONAL TRADE
1.
When the world price is above the domestic price, the country has a comparative
advantage in the production of the good. Domestic producers will charge the higher
world price, increasing domestic producer surplus.
2.
When the world price is below the domestic price, another country has a comparative
advantage in the production of the good. Domestic producers will now charge the
lower world price, increasing domestic consumer surplus and reducing domestic
producer surplus. In either situation, Total Surplus is increased through trade. The
gains to the winners exceed the losses of the losers.
3.
Tariffs are put in place to protect domestic producers when the world price is lower
than the domestic price. The tariff raises the world price, reduces the number of
imports, and increases the quantity produced domestically, thereby increasing
domestic producer surplus. Consumer and Total Surplus is reduced by the tariff as a
deadweight loss is created. Additionally, some of the original surplus at the world
price is lost to the government in the form of tax revenue.
4.
Import Quotas place a limit on the quantity for foreign products that are allowed to
enter into the domestic country. Quotas work in a similar fashion to tariffs.
However, instead of the government keeping some of the surplus in the form of tax
revenue, license holders receive the area between the deadweight loss triangles.
This surplus is steered out of the country to the producing nation.
5.
Arguments for Restricting Trade:
a.
The Jobs Argument – the domestic country protects jobs at home when it
restricts trade.
b.
The National Security Argument – in some industries, it is in the best interest
of protecting the country by not trading with other nations which may have a
competitive advantage in the production of a good. In other words, a country would
not want to be dependent on another nation for resources needed for the production
of military goods, especially if there is a chance that the 2 countries could be at war
w/ each other.
c.
The Infant Industry Argument – sometimes a government must shield its
industries from foreign competition when the industry is just starting out. Once the
industry is competitive, then its government would lower the trade restrictions so
that the industry could compete on its own.
6.
7.
d.
The Unfair Competition Argument – it’s often the case where other countries’
companies will receive subsidies from their government to give them an advantage in
the global marketplace. Restricting trade from these countries protects domestic
companies.
e.
The Protection as a Bargaining Chip Argument – when governments negotiate
foreign trade, they’ll often threaten trade restrictions in one industry as a way of
getting what they want in another industry.
The World Trade Organization, created in 1995, administers trade agreements,
provides a forum for negotiations, and handles disputes that arise among the 144
countries who are members of the WTO.
ONE OF THE HARDEST THINGS THAT THEY CAN ASK YOU DO TO IS TO DETERMINE THE
TERMS OF TRADE BETWEEN 2 COUNTRIES WHEN TRADE IS BASED ON OPPORTUNITY
COSTS.
CHAPTER 10 – EXTERNALITIES
1.
An Externality is the uncompensated impact of one person’s actions on the wellbeing of a bystander. This is sometimes called a Spillover because the true costs or
benefits are not fully covered by the producer.
2.
The Government must get involved in the marketplace when there is Market
Failure (i.e. – the market fails to achieve an efficient outcome). Market Failure
occurs when there is/are:
a.
Market Power – the ability of a single entity to have an influence on P & Q
b.
Externalities
3.
When a firm does not cover the true cost or benefit of producing a product, the
government can bring the market back into balance by: Taxing Negative Externalities
or Subsidizing Positive Externalities. While a tax on the producer creates a
deadweight loss in society, the tax is actually has a positive impact on the economy
by reducing the quantity of output produced in the marketplace (SEE #8 BELOW).
The tax forces the producer to internalize the externality.
4.
When drawing an externality graph, remember to always label the initial Demand
Curve as MPB – Marginal Private Benefit and the initial Supply Curve as MPC –
Marginal Private Cost.
5.
With a Negative Externality, you will always shift the Supply curve inward
demonstrating that the current quantity is too high prior to the tax by the
government. In other words, there is overproduction associated with a negative
externality. The new Supply Curve should be labeled MSC – Marginal Social Cost.
6.
7.
8.
9.
With a Positive Externality, you will always shift the Demand curve outward
indicating that society wants increased output. In other words, there is
underproduction based on society’s demand for the product. The individual producer
does not increase production because of the cost associated with the added output.
The government must subsidize the producer to cover the additional costs
associated with the increased production necessary to meet society’s demand.
Make sure that you can draw any deadweight loss associated with both positive
and negative externalities. For a negative externality, the top of the triangle will face
left. For a positive externality, the top of the triangle will face right.
Pigovian Taxes correct the effects of a negative externality because they align
private incentives with market efficiency. Pigovian taxes consider the well-being of
innocent bystanders and move the MPC (Marginal Private Cost) closer to the MSC
(Marginal Social Cost).
Pollution Permits are another way to reduce negative externalities such as pollution
because they limit the quantity produced by firms. If the permits are tradable, then
incentives are created for firms to reduce pollution so that they can profit from the
sale of unused permits in the private marketplace.
CHAPTER 11 – PUBLIC GOODS AND COMMON RESOURCES
1.
The Various Goods in an Economy are identified based on 2 characteristics:
a.
Is the good excludable? – can people be prevented from using the good? A
good is made excludable by having a price attached to it.
b.
Is the good rival? – does one person’s use of the good diminish another
person’s ability to use it?
2.
4 TYPES OF GOODS
a.
Public Goods – goods that are neither rival nor excludable.
Examples: a fireworks display, XL106.7 radio station, national defense, basic
and research.
b.
Common Resources – goods that are rival but not excludable.
Example: the town common, a swing set at Delaney Park, clean air & water,
congested roads, buffalo, fish & whales.
c.
Private Goods – goods that are rival and excludable.
Examples: concert & sporting event tickets, toll roads such as the 408, dinner at
Red Lobster, cows (vs. buffalo) and clothing at Banana Republic.
d.
Natural Monopolies - goods that are excludable but not rival.
Examples: fire protection, cable television, telephone service, and utilities.
3.
The Free Rider Problem – many private firms will not supply goods to society b/c they
cannot prevent the Free Rider Problem (i.e. – a problem that exists due to the fact
that people can benefit from a good while not having to pay for it). Because public
goods are not excludable, the free-rider problem prevents the private market from
supplying them. The government must then provide public goods when it feels that
the total benefit to society exceeds the costs associated with the good. The
government provides the good, using tax revenue to pay for it.
4.
Prior to providing a public good to society, the government will conduct a CostBenefit Analysis to compare the costs of a public good with the benefit derived from
it.
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
1.
The U.S. has a progressive tax structure, using Marginal Tax Brackets (MTB). Each
additional dollar earned is taxed at a higher level. Remember, a person’s salary isn’t
taxed at their MTB, it is taxed at different levels.
2.
The Federal Government raised the majority of their revenues from personal income
taxes.
3.
State & Local Governments derive their primary revenues from Sales & Property
taxes.
4.
Taxes & Equity
a.
The Benefits Principle – the idea that people should pay taxes based on the
benefits they receive from government services. Citizens who live in Bay Hill
have a greater need for police protection than those who live in Dover Shores
due to the fact that their homes and material possessions cost more.
b.
The Ability to Pay Principle – the idea that taxes should be levied on a person
according to how well that person can shoulder the burden.
Horizontal Equity – the idea that taxpayers with similar abilities to pay
taxes should pay the same amount.
Vertical Equity – the idea that if taxes are based on ability to pay, then
richer taxpayers should pay more than poorer taxpayers.
6.
3 TAX SYSTEMS
a.
Proportional Tax System – all taxpayers pay the same fraction of income. For
example, everyone pays 10% of their earnings in taxes.
b.
Regressive Tax System – a tax for which high income earners pay a smaller
fraction of their income in taxes than do low income earners.
c.
Progressive Tax System – a tax for which high income earners pay a larger
fraction of their income in taxes than do low income earners.
7.
Because Equity & Efficiency are the 2 most important goals of the tax system, the
goals often come in conflict with each other. Proposed changes in tax laws could
increase efficiency while reducing equity, or increase equity while reducing efficiency.
CHAPTER 13 – THE COSTS OF PRODUCTION
1.
Total Revenue = price x quantity
2.
Total Cost = Total Fixed Cost + Total Variable Cost
3.
Total Fixed Cost is not dependent upon output. The costs are the same whether you
produce 0 units or 1,000,000 units.
4.
Total Variable Costs – costs that are dependent on production. As output is increased,
variable costs will also increase.
5.
Accounting Profit – Total Revenue – Total Cost. Accounting profit only takes into
consideration explicit costs (input costs that require an outlay of money by the firm).
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
Implicit Costs do not require an outlay of money by the firm. Implicit costs take into
consideration the opportunity costs associated with one’s decision. The opportunity
costs factor in the lost opportunities associated with the next best alternative that a
person could have experienced.
Economic Profit = Total Revenue – Explicit Costs – Implicit Costs
If Economic Profit is Zero, you have Zero Economic Profit or Normal Profit.
Economic Profit can be either normal, positive or negative.
The Production Function illustrates the relationship between the quantity of inputs
used to make a good and the quantity of output of that good. The shape of the
Production Function is upward sloping and curved. As the # of inputs is increased,
the production function gets flatter (i.e. – the increase in output increases at a
decreasing rate), demonstrating Diminishing Marginal Product.
Marginal Product of Labor (MPL) = the output that an additional worker adds to Total
Product.
Marginal Revenue Product of Labor (or Value of the Marginal Product of Labor) =
MPL x price .
Fixed Cost – remains constant and is not dependent on production output. The FC
curve is horizontal.
Variable Cost – costs that do vary with the quantity of output produced. The VC
curve begins at 0 and parallels the TC curve.
Average Total Cost (ATC) = TC divided by output. ATC is U-Shaped. The Marginal Cost
Curve ALWAYS crosses ATC at its minimum; the quantity where this occurs is called
the EFFICIENT SCALE.
Average Fixed Cost (AFC) = FC divided by output. AFC is downward sloping; as
output is increased, FC is spread across more units, thereby decreasing AFC.
Average Variable Cost (AVC) = VC divided by output. AVC is U-Shaped. The Marginal
Cost Curve ALWAYS crosses AVC at its minimum. The vertical distance between ATC
and AVC represents AFC; AVC gets closer to ATC as output increases due to the fact
that AFC is declining.
18.
19.
20.
21.
22.
Marginal Cost – the change in Total Cost that arises from an extra unit of production.
When MC is below ATC, ATC is falling. When MC is above ATC, ATC is rising. This
reflects the property of diminishing marginal product. At lower levels of output,
specialization allows the firm to increase output and lower costs (i.e. – increasing
returns). At some point, however, diminishing returns will be experienced and costs
will begin to rise.
The Relationship Between Short-Run and Long-Run ATC – the cost of a factory is
fixed in the Short Run, but variable in the Long Run. In the Short Run, if a firm wants
to increase output, all it can do is increase variable inputs (i.e. – add more workers,
acquire more resources, go to additional work shifts/increase the # of hours in a work
day). Firms cannot increase the size of their facility or build additional locations in the
Short Run. In the Long Run, firms can expand their facilities, allowing the firm to
lower costs at increased output levels.
The Long Run ATC Curve Demonstrates:
a.
Economies of Scale – Long Run ATC falls as quantity of output is increased.
Specialization allows this to happen.
b.
Constant Returns to Scale – Long Run ATC stays the same as the quantity of
output is increased.
c.
Diseconomies of Scale – Long Run ATC increases as quantity of output is
increased. This occurs due to coordination problems associated with managing
a large organization.
IF LONG RUN ATC IS DOWNWARD SLOPING, YOU HAVE A SCENARIO WHERE IT IS
MORE EFFICIENT TO HAVE ONLY ONE SUPPLIER PROVIDE THE ENTIRE MARKET WITH
THE GOOD B/C A NATURAL MONOPOLY HAS A DOWNWARD SLOPING ATC CURVE.
CHAPTER 14 – FIRMS IN COMPETITIVE MARKETS
1.
A Competitive Market, sometime called a Perfectly Competitive Market, has 2
characteristics:
a.
There are many sellers and many buyers in the market.
b.
The goods are offered by the various sellers are largely the same (the goods are
said to be Homogenous).
2.
Price Taker - No single buyer or seller can impact the market price.
3.
Firms are free to enter & exit as they please. There are no barriers to entry or exit.
4.
PC Firms have No Market Power; thus they have Normal LR Profit.
5.
A PC Firm’s Total Revenue = Average Revenue = Marginal Revenue.
6.
A PC Firm’s Demand Curve is Horizontal and is labeled D = TR = AR = MR.
7.
Marginal Revenue = the change in Total Revenue when an additional unit of output is
produced & sold.
8.
For a PC Firm, MR = Price.
9.
10.
11.
12.
13.
14.
15.
16.
16.
17.
18.
19.
20.
21.
For a PC Firm, Price = MC. Thus the firm has no market power, or ability to set P >
MC.
A PC Firm produces at the maximizing output level where MR = MC.
Because the firm’s MC Curve determines the quantity of the good the firm is willing
to supply at any price, it is the PC Firm’s Supply Curve.
A PC Firm’s SR Production Decision – a competitive firm will continue to produce in
the short run as long as its price covers its AVC. If price is < AVC, the firm will SHUT
DOWN.
A PC Firm’s LR Production Decision – a competitive firm will EXIT in the long run if its
price cannot cover its ATC.
Sunk Costs – a cost that has already been committed and cannot be covered. Sunk
Costs should not factor into a firm’s decision to either continue or cease with its
operations.
A PC FIRM CAN HAVE A SHORT RUN POSITIVE ECONOMIC PROFIT. In this instance,
the firm’s price at the profit maximizing quantity is above ATC. Due to the Curse of
Competitive Markets, SR Positive Economic Profit will lead to an increase in
competitors (i.e. – the market supply curve will shift out). This will lead to a lower
price in the market. Price will be driven downward until each firm receives Normal
Profit and the market is back in LR equilibrium.
A PC FIRM CAN HAVE A SHORT RUN NEGATIVE ECONOMIC PROFIT. In this instance,
the firm’s price at the profit maximizing quantity is below ATC. SR Negative Economic
Profit will lead to an decrease in competition (i.e. – the market supply curve will shift
in). This will lead to a higher price in the market. Price will be driven upward until
each firm receives Normal Profit and the market is back in LR equilibrium.
IN LR EQUILIBRIUM, A PC FIRM WILL RECEIVE NORMAL PROFIT. Normal Profit means
that the firm is producing at the Allocatively Efficient Level of Output. Everything that
society wants, it gets. Total Surplus is maximized on in the PC Market, but is not in
the markets of Monopoly, Oligopoly or Monopolistic Competition. In each of these
market structures, because P > MC, firms restrict output and create market
inefficiency.
Each firm’s MC Curve is its Supply Curve.
The SR Market Supply Curve is Upward Sloping.
The LR Market Supply Curve is Horizontal.
There are 2 reasons why the LR Market Supply Curve is Upward Sloping. They are:
(1.) a resource used in production may only be available in limited quantities and (2.)
firms within the industry have different cost structures.
Can Firm’s Enter or Exit in the Short Run? NO, entry & exit can only take place in the
Long Run.
22.
23.
Because firms can enter & exit in the LR, as compared to the SR, the LR Supply Curve
is more elastic than the SR Supply Curve.
CONSTANT, INCREASING & DECREASING COST INDUSTRIES
a.
Constant Cost Industry – the LR Supply Curve is horizontal for a PC Firm. New
market entrants have no affect on the cost curves; they don’t move.
b.
Increasing Cost Industry – new entrants bid up the prices of inputs, so each
firm’s cost curves rise. The market price will adjust upward compared to what it
was before. The LR Supply Curve will be upward sloping. The cost curves rise.
c.
Decreasing Cost Industry – new entrants create greater demand for inputs that
allow those inputs to be produced through mass production techniques. This
allows the industry to benefit from lower costs of production. The cost curves
fall.
CHAPTER 15 – MONOPOLY
1.
Price Maker – a monopoly charges a P > MC.
2.
Monopolies have Excess Capacity – they do not produce at the Allocatively Efficient
Level (i.e. – it’s not in the best interest of society). They can do this b/c they do not
have any competition. Thus, there are no close substitutes.
3.
Why Monopolies Arise – 3 Reasons:
a.
A key resource is owned by a single firm.
b.
The government gives a single firm the exclusive right to serve the market.
c.
Natural Monopoly is in the best interest of the economy. This is true because
the costs of production make a single producer more efficient than a large
number of competitors.
4.
Natural Monopolies Have a Downward Sloping ATC Curve. As the quantity of output
is increased, ATC per unit falls.
5.
A Monopoly has a Downward Sloping Demand Curve; A PC Firm has a Horizontal
Demand Curve.
6.
A Monopolist’s MR is ALWAYS less than the price of its good. The reason for this is
due to the fact that if the monopolist wants to sell an additional unit of output, it
must lower the price on all previous units sold.
7.
A monopolist’s Demand Curve & MR Curve always start at the same point.
8.
The monopolist’s MR Curve can go negative, crossing the X axis. Any quantity to the
right of this point will actually cause TR to decline. If you are asked the quantity that
maximizes TR, you want to select the quantity where the MR Curve crosses the X
axis.
9.
When MC < MR, the monopolist can increase profit by producing more.
10. When MC > MR, the monopolist can increase profit by cutting production.
11. For a Monopolist – P > MR = MC
12
13.
14.
15.
16.
17.
18.
19.
20.
For a PC Firm – P = MR = MC
A Monopoly’s Profit is determined by (Price – ATC) * Quantity
A Monopolist doesn’t have a Supply Curve.
The MC Curve reflects the costs of the monopolist.
Because the Monopolist charges a P > MC, it produces a less than optimal level of
output. Thus, there is a deadweight loss associated w/ a monopoly. To find the
socially optimal level of production for a monopolist, you need to find the quantity
where the MC Curve crosses the Demand Curve.
PUBLIC POLICY TOWARD MONOPOLIES
a.
Increasing competition through anti-trust legislation – The Sherman Antitrust
Act & Clayton Act strive to curb monopoly power. The govt. can use these laws
to prevent mergers that reduce competition in the marketplace. They also
enable the govt. to breakup companies.
b.
Regulation – the govt. regulates the prices that monopolies are allowed to
charge. Some people might wonder why the govt. doesn’t require a monopoly
to charge a price = MC. There are 2 reasons why this is not an effective policy:
(1.) Natural Monopolies have a declining ATC curve so the MC curve will always
lie below ATC. This would cause the Natural Monopoly to lose money and have
to be subsidized by the govt., which creates a deadweight loss in another area.
(2.) if monopolies are regulated, with price being set at a specific level, there is
no incentive to reduce costs. If the monopolist lowered its costs, it would
reason that the govt. would then lower their allowed price.
c.
Public Ownership – the govt. may elect to own the monopoly itself (i.e. – the
U.S. postal service)
d.
Do Nothing – many economists believe that it actually better for the govt. to
not get involved in the marketplace, allowing the inefficiency of the monopoly
to remain.
Price Discrimination – the practice of selling the same good to different customers at
different prices. To be able to price discriminate, a firm must have market power; a
PC Firm cannot price discriminate b/c they are a price taker.
Price Discrimination (a.) Increases Profits, (b.) Can be implemented when you are
able to segment customers into different groups based upon their willingness to
pay, and (c.) increases the output of a monopolist (i.e. – the output gets closer to
the socially optimal level).
PERFECT PRICE DISCRIMINATION describes a situation where the monopolist is able
to charge every customer their maximum willingness to pay. The outcome is one in
which producer surplus is maximized, there is no deadweight loss, and there is no
consumer surplus.
21.
22.
23.
24.
25.
A LUMP SUM TAX ON A MONOPOLY DOESN’T ALTER THE PROFIT MAXIMIZING PRICE
& QUANTITY.
A PER UNIT TAX ON A MONOPOLY DOES ALTER THE PROFIT MAXIMIZING PRICE &
QUANTITY.
A lump sum tax will decrease profit b/c FC increase.
A per unit tax on a monopolist will raise the firm’s MC Curve upward. Why? B/c ATC
& AVC will increase.
For both a Monopolist and a Monopolistically Competitive Firm, when MR is
negative, Elasticity of Demand is INELASTIC.
CHAPTER 16 – OLIGOPOLY
1.
Firms face competition, but, at the same time, do not face so much competition that
they are price takers. Economists call this situation Imperfect Competition.
2.
Few Sellers
3.
Interdependence among sellers; sellers are better off cooperating instead of
competing.
4.
Oligopolies do not want to compete based on price; instead they’d prefer to compete
on service.
5.
The actions of any one seller in the market can have a huge impact on the profits of
all the other sellers. Firms will match prices reductions on the part of competitors but
will never increase price in response to other firms increasing price.
6.
Firms sell similar products.
7.
P > MR = MC
8.
Output is less than the socially optimal level b/c firms have price making ability.
9.
When firms cooperate, they act like a monopoly.
10. B/c each firm cares only about its own profit, there are powerful incentives at work
that hinder a group of firms from maintaining the monopoly outcome.
11. Collusion – an agreement among firms in a market about quantities to produce or
prices to charge.
12. Cartel – a group of firms acting in unison.
13. Oligopolies produce a quantity that is > than that of a Monopoly but < than that of a
PC Firm.
14. The price for an Oligopoly is < than a Monopoly’s price but is > than the price found in
a PC Market.
15. Game Theory - the study of how people behave in strategic situations.
16.
Prisoners’ Dilemma – a particular “game” between 2 captured prisoners that
illustrates why cooperation is difficult to maintain even when it is mutually beneficial.
17. Dominant Strategy – a strategy that is best for a player in a game regardless of the
strategies chosen by the other players.
18.
NASH EQUILIBRIUM – a situation in which economic actors interacting w/ one
another each choose their best strategy given the strategies that all the other
actors have chosen.
SUPPLEMENTARY MATERIAL - THE PRICE EFFECT & THE OUTPUT EFFECT
1.
Firms such as monopolies and oligopolies have price making capability. As such, they
often are confronted by the question “Should we increase output to raise profit?”
2.
To answer this question, economists focus in on:
a. The Output Effect – B/c P > MC, producing one more unit will at the current price
will raise profit.
b. The Price Effect – Raising production will increase the total amount sold, which
will lower the price and profit on all gallons sold.
3.
What should the firm do? If the OUTPUT EFFECT > PRICE EFFECT, the firm should
increase production b/c profits are increasing.
4.
If the PRICE EFFECT > OUTPUT EFFECT, the firm will not increase production.
5.
Firms will increase production until the 2 effects balance.
6.
If the # of Oligopolists increases, the market looks more like a competitive market
and the Price Effect falls and will ultimately disappear altogether. Price approaches
MC, and the quantity produced approaches the socially optimal level.
7.
Competition keeps price closer to MC.
CHAPTER 17 – MONOPOLISTIC COMPETITION
1.
An Imperfectly Competitive Market.
2.
Characterized by Many Firms and Differentiated Products.
3.
Each firm faces a downward sloping demand curve since they are a price maker.
4.
Since products are not identical, firms will use marketing to develop brand loyalty.
5.
B/c of Free Entry & Exit, there will be NORMAL PROFIT IN THE LONG RUN.
6.
SR Profit & Loss is possible. If P > ATC in the SR, the firm will have Positive Economic
Profit. New firms will enter in the Long Run (Entry & Exit can only take place in the
LR – NOT the SR), driving price down until there is Normal Profit (the point on the
demand curve where P = ATC). Remember the “KISS.”
7.
When new firms enter the market due to SR Positive Econ. Profits, each firm’s
individual quantity demanded decreases.
8.
IT IS CRITICAL THAT YOU UNDERSTAND THAT THE ENTRANTS WILL CAUSE THE
INDIVIDUAL FIRM’S DEMAND & MR CURVES TO SHIFT DOWNWARD. THIS
OCCURRENCE WILL ELIMINATE THE SR POSITIVE ECONOMIC PROFIT.
9.
If there is SR Negative Economic Profit, firms will exit in the LR, putting upward
pressure price until it reaches the point of tangency on the ATC Curve.
10.
11.
12.
13.
14.
15.
16.
IT IS CRITICAL THAT YOU UNDERSTAND THAT THE ENTRANTS WILL CAUSE THE
INDIVIDUAL FIRM’S DEMAND & MR CURVES TO SHIFT OUTWARD. THIS
OCCURRENCE WILL ELIMINATE THE SR ECONOMIC LOSS.
If there is negative economic profit, firms will leave the market. The remaining firms
will experience an increase in their quantity demanded.
The # of firms in the market adjusts until economic profits are zero or normal.
P>MR = MC
Just like a Monopoly, a Monopolistically Competitive Firm has excess capacity &
markup; there is no excess capacity in a PC Market b/c they produce the socially
optimal output where MC = D.
Since there is a markup of P over MC, there is a deadweight loss.
The government’s administrative burden to eliminate the deadweight loss would be
overwhelming, so the govt. allows the Monopolistically Competitive Market to
operate freely.
CHAPTER 18 – THE MARKETS FOR THE FACTORS OF PRODUCTION
1.
This chapter deals with the inputs that are used to produce goods & services.
2.
The demand for the factors of production is a Derived Demand. It is based on the
demand or supply of a different good in another market.
3.
Labor markets are governed by the forces of supply & demand.
4.
The Production Function illustrates the relationship between the quantity of inputs
used and the quantity of output of a good. As each additional input is added, the
corresponding output increases at a diminishing rate. At some point, it could
decrease. This property is called DIMINISHING MARGINAL PRODUCE.
5.
MPL – Marginal Product of Labor – is the increase in the amount of output from an
additional unit of labor. It can be calculated by finding the Change in Quantity of
Output divided by the Change in Labor.
6.
MRPL (or VALUE OF THE MARGINAL PRODUCT OF LABOR) = MPL x PRICE
7.
To maximize profit, a competitive firm will hire workers up until the point where
MRPL = Wage. If MRPL > Wage, the firm will hire additional workers to increase
profit. If MRPL < Wage, the firm will layoff workers in order to increase profit.
8.
The supply curve of labor for a firm is a horizontal line labeled S = WAGE.
9.
The demand curve of labor for a firm is a downward sloping line labeled D = MRPL.
10. When a firm hires labor up to the point where MRPL = Wage, it produces up to the
point at which P = MC.
11. WHAT CAUSES THE LABOR DEMAND CURVE TO SHIFT?
a.
Output price
b.
Technological Change
c.
Supply of other factors
12.
13.
14.
15.
16.
17.
The Supply of Labor reflects how workers’ decisions about the LABOR-LEISURE
TRADEOFF respond to changes in opportunity cost.
The Market Labor Supply Curve is upward sloping, meaning that an increase in the
wage induces workers to increase the quantity of labor they supply.
WHAT CAUSES THE LABOR SUPPLY CURVE TO SHIFT?
a.
Changes in Tastes
b.
Changes in Alternative Opportunities
c.
Immigration
The rental price of capital is what a person pays to use a factor or production (such as
a machine or computer) for a limited period of time.
The profit maximizing # of inputs is determined by finding where the Rental Price
(Wage for Workers) = the MRPK (Marginal Revenue Product of Capital).
To find the combination of labor & capital that maximizes profit, you should use the
formula:
MRPL / Wage = MRPK / Rental Price
Remember, a company wants to “Get the Biggest Bang for their Buck” when
employing labor & machines to produce the product.
CHAPTER 19 – EARNINGS AND DISCRIMINATION
1.
What causes earnings to vary so much?
a.
Compensating Differentials – refers to the difference in wage that arises from
nonmonetary characteristics of different jobs (i.e. – the night shift gets paid
more than the day shift).
b.
Varying Levels of Human Capital – higher education levels lead to higher
incomes.
c.
Ability, Effort & Chance – skilled vs. unskilled workers
d.
Superstar Phenomenon
2.
Labor demand reflects MPL, with each worker being paid the value of his or her
marginal contribution to the economy’s production of goods & services.
3.
ABOVE EQUILIBRIUM WAGES – CAN BE CAUSED BY:
a.
Minimum Wage Laws
b.
Labor Unions
c.
Efficiency Wages - firms elect to pay higher than normal wages to attract top
talent b/c they believe that the higher wage will reduce turnover &
absenteeism and increase worker effort.
CHAPTER 20 – INCOME INEQUALITY AND POVERTY
1.
Income inequality can be analyzed by using QUINTILES (i.e. – breaking the population
down into 1/5ths.
2.
If income were distributed equally across all families, each 1/5th of families would
receive 1/5th of the total income.
3.
The Lorenz Curve analyzes the distribution of income within the economy. The
further the curve is from the 45 degree line, the wider the gap is with regard to the
distribution (i.e. – most of the income will be in the highest 20%’s hands.
4.
The Gini coefficient is a number between 0 and 1, where 0 corresponds with perfect
equality (where everyone has the same income) and 1 corresponds with perfect
inequality (where one person has all the income — and everyone else has zero
income).
5.
Policies to Reduce Poverty:
a.
Minimum Wage Laws
b.
Welfare
c.
In-kind Transfers – transfers to the poor given in the form of goods & services
rather than cash.
d.
Negative Income Tax – collects tax revenue from high income households and
gives transfers to low-income households.
CHAPTER 21 – THE THEORY OF CONSUMER CHOICE
1.
A Budget Constraint – depicts the limit on the consumption “bundles” that a
consumer can afford.
2.
The budget constraint shows the various combinations of goods the consumer can
afford given his or her income and the prices of the 2 goods.
3.
Consumers face opportunity costs when determining how much of each good that
they wish to consume.
4.
An Indifference Curve is a curve that shows consumption bundles that give the
consumer the same level of satisfaction.
5.
The Marginal Rate of Substitution is the rate at which a consumer is willing to trade
one good for another. It is the amount of one good that a consumer requires as
compensation to give up one unit of the other good.
6.
Things to Remember:
a.
Higher Indifference Curves are Preferred to Lower Ones – b/c they represent
more of the product for the consumer as opposed to less of the product.
b.
Indifference Curves are Downward Sloping - the reason for this is due to the
fact that as the quantity of one good is reduced, the quantity of the other good
must increase.
c.
Indifference Curves will NEVER Cross
7.
8.
9.
d.
Indifference Curves are Bowed Inward
The Income Effect – is used to explain the Law of Demand. The Income Effect
indicates that a lower price increases the purchasing power of a buyer’s money
income, enabling the buyer to purchase more of the product than he or she could
buy before. A higher price would have the opposite effect.
The Substitution Effect – suggests that at a lower price, buyers have the incentive to
substitute what is now a less expensive product for similar products that are now
relatively more expensive. The product whose price has fallen is now “a better
deal” relative to the other products.
A CLOSER LOOK: A PRICE CHANGE HAS 2 EFFECTS ON CONSUMPTION:
According to the law of demand, when the price of a good changes, the amount of
that good that consumers are willing and able to buy changes in the opposite
direction. For example, when the price of Coke rises, the quantity demanded of
Coke falls (all else equal).
Why is this so? Economists have identified two important components of a change
in price. First (and the most obvious effect), when the price of a good rises, the
money that a consumer has budgeted for consumption has a lower purchasing
power. So, even though a consumer’s budget hasn’t changed, the price increase
makes it as if her budget has decreased, just like a decrease in the consumer’s
income. The way the consumer responds to this altering of purchasing power is
referred to as the Income Effect. Second (and less obvious), when the price of a Coke
rises, given the purchasing power of the consumer, the amount of other goods that I
must sacrifice to acquire one unit of the good increases. Thus, Coke is relatively lessexpensive compared to other goods. The relative price of a good is the amount of
some other good that must be sacrificed to obtain the good in question. For
example, if Coke costs $0.50 and a Snickers bar costs $1.00, then each Coke “costs” ½
of a Snickers bar. Therefore, the relative price of Coke is ½ Snickers bar. Similarly,
each Snickers bar “costs” 2 cokes. The relative price of a good just expresses its cost
in terms of another good. Now, if the dollar price of Coke rises to $1, the consumer
must now give up 1 Snicker to acquire each Coke (Coke is relatively more expensive),
but the consumer now need only give up 1 Coke to acquire a Snickers bar (Snickers
are relatively less expensive). With the substitution effect, the consumer, taking
into account the new relative prices, switches between goods in order to keep her
overall level of satisfaction unchanged.
10.
11.
GIFFEN GOODS - are goods that violate the Law of Demand. In other words, when
price goes up, people will buy more of a good.
UTILITY - is used to measure the satisfaction that is received by the customer when
they consume a product. As consumers purchase additional units of the same
product, no matter how low the price goes, eventually, their Marginal Utility (i.e. –
the satisfaction associated with consuming one additional unit) is going to decline.
This is attributed to the Law of Diminishing Marginal Utility. This is very similar to
what was discussed earlier with regard to production. However, instead of measuring
the change in production when one additional unit of input (i.e. – labor or machine)
is added, we are now focusing on measuring the change in satisfaction that the
customer receivs when one additional unit of a good or service is consumed.