ECON 102 Tutorial: Week 2
Shane Murphy
www.lancaster.ac.uk/postgrad/murphys4/
s.murphy5@lancaster.ac.uk
Additional Resources
 Videos that explain the basics of many of the
ideas, terminology, and theories that we will learn
in both micro and macro economics:
https://www.khanacademy.org/economics-financedomain/microeconomics
 It’s not compulsory to review them. They are just
an additional resource that explain the same
concepts in a slightly different way and use slightly
different examples. Note that the ordering of
topics is not the same as what we are following,
so you’ll have to look around to find the topic that
you’d like more help with.
Four important mistakes in decision-making
We learned that people are rational decision makers. But
sometimes people make mistakes or don’t follow the rules of
rational behavior. There are four important mistakes (pitfalls) that
people often make when making decisions. What are they?
Four important mistakes in decision-making
 Measuring costs and benefits as proportions rather than
absolute money amounts
 Would you walk 30 minutes to save £10 on a £1000 laptop?
Would you walk 30 minutes to save £10 on a £40 videogame?
 The absolute value is important here -- £10 is £10 either way.
 Ignoring Opportunity Costs
 Many people fail to consider what they give up by taking a
particular action
 Failure to ignore sunk costs
 A sunk cost is a cost that is non recoverable at the moment a
decision is made – it doesn’t matter what you chose, you lose
the sunk cost either way.
 Failure to understand the average vs. marginal distinction
 When deciding how much of an activity to undertake, the focus
should always be on the cost and benefit of one additional unit
of an activity.
Question 1(a)
Mike is currently a taxi driver in Manchester. Each hour Mike operates his taxi costs
him £5 in petrol. The total revenue that Mike expects to bring in from operating his
cab for h hours is given in the following table:
If Mike is trying to maximize his profit (i.e.
total revenue minus total costs), how many
hours a day should Mike spend operating his
cab?
What information do we need to know if
we want to find out how to maximize profit?
What is the Cost-Benefit Principle?
Number of Hours
Operating Cab
0
1
2
3
4
5
6
7
8
Total Revenue
0
£25
£45
£60
£70
£75
£79
£83
£85
Cost-Benefit Principle: The level of an activity should be increased if, and only if, the
marginal benefit exceeds the marginal cost. So, in our case as long as MR>MC.
Later on in the course, we’ll actually learn that profit is maximized where MR = MC.
Question 1(a)
Each hour Mike operates his taxi costs him £5 in petrol. So, his MC = £5.
How can we find Mike’s MR?
Marginal Revenue is the change in Total Revenue that results when we change the
number of hours worked.
Number
of HoursTotal TotalMarginal
Revenue
Number of
So, using that definition, we can fill in the
Marginal Revenue column in the table.
If Mike is trying to maximize his profit
(i.e. total revenue minus total costs),
how many hours a day should Mike spend
operating his cab?
Hours
Operating
CabRevenue
Operating
0
Cab
1
0
0
2
1
£25
2 3
£45
3 4
£60
4 5
£70
5
£75
6
6
£79
7
7
£83
8 8
£85
Revenue
0
£25
£45
£60
£70
£75
£79
£83
£85
Using the Cost-Benefit Principle, we will keep on increasing the number of hours
until MR becomes less than MC.
So, MC becomes > MR if Mike chooses to go from 5 to 6 hours. So, Mike would
choose to drive his taxi for 5 hours.
Question 1(b)
Now suppose that Mike rents his taxi from Dave. Mike has agreed to
pay Dave £5 per day for the next 5 years.
Does your answer from part a change? Explain
This does not change the answer from part a. The £5 rental fee is
unavoidable by Mike (hence that cost is sunk) and should not affect
Mike’s decision making.
Question 1(c)
Instead of the agreement described in part b, now assume that Mike
has agreed to pay Dave £5 for each hour he operates his cab, for the
next year. Does your answer from part a change? Explain.
Essentially, the marginal cost of operating the cab has increased by £5
per hour. We can use the same methods as we did in part (a) to find
that Mike should now operate his cab for only 4 hours.
In contrast to part b, the rental fee is now not a sunk cost; here Mike
can reduce the rental fee by driving less.
So, a sunk cost, is a cost that you incur regardless of the choice that
you make. It is a cost that will not change depending on what choice
you make.
Question 1(d)
Now assume that Mike owns his own car. It turns out that there is a local florist
looking for someone to deliver flowers. There is also a local bakery looking for
someone to deliver bread. Mike estimates that if he takes the job delivering
flowers, he’ll earn £40 per day in profit. If he takes the job delivering bread,
he’ll earn £45 in profit. Assume Mike can only have one job.
i) What is the opportunity cost to Mike of continuing to work as a taxi driver?
The opportunity cost is the value of the next best alternative available.
In this case, it’s the £45 per day Mike gives up from delivering bread.
ii) Should Mike continue to work as a taxi driver or take one of these other two
jobs?
Compare his profit in part (a) to his opportunity cost to make this decision.
From part a, we know that Mike will operate his cab for 5 hours. He’ll earn
total revenue of £75 and his total cost is 5*5 = £25. Thus, mike earns £50 in
profit per day operating the taxi.
Since the benefit of operating the cab, £50, is greater than the opportunity
cost, £45, Mike should continue to operate as a taxi driver.
Questions 2-5 deal with shifts in supply and
demand, which are covered in Chapter 3 of your
book. Let’s quickly review:
- The difference between an increase in supply and
quantity supplied (demand and quantity
demanded)
- The four rules governing the effects of supply and
demand shifts
- What are the factors that shift supply and
demand.
Supply vs. Quantity Supplied
What is a change in quantity supplied? How can we graph it?
What is a change in supply? How can we graph it?
The same is true for demand vs. quantity demanded.
Supply vs. Quantity Supplied
What is a change in quantity supplied? How can we graph it?
It is a movement along a supply curve, in
response to a change in price of a good or s
service.
What is a change in supply? How can we graph it?
It is a shift of the entire supply curve.
The same is true for demand vs. quantity demanded.
Let’s Graph Supply & Demand Shifts
Increase in Demand
Decrease in Demand
Increase in Supply
Decrease in Supply
Four Rules for Supply & Demand Shifts
Increase in Demand
Demand increases, causing an
increase in equilibrium price and in
equilibrium quantity.
Increase in Supply
An increase in supply will cause the
equilibrium price to decline and the
equilibrium quantity to rise.
Decrease in Demand
A decrease in demand will cause the
equilibrium price and the equilibrium
quantity to decline.
Decrease in Supply
Supply decreases, causing an
increase in equilibrium price and a
decrease in equilibrium quantity.
Factors that shift Supply & Demand
Factors that cause an increase in demand:
 A decrease in the price of compliments
 An increase in the price of substitutes
 An increase in income (for a normal good)
 An increased preference by demanders for the
good/service.
 An increase I the population of potential buyers
 An expectation of higher prices in the future
All of these cause demand to shift to the right.
The opposite of these factors will cause demand to shift left.
Factors that shift Supply & Demand
Factors that cause an increase in supply:
 A decrease in the cost of materials, labour, or other
inputs used in production of the good/service
 An improvement in technology that reduces the cost
of production of the good/service
 A improvement in the weather (for agricultural
products)
 An increase in the number of suppliers
 An expectation of lower prices in the future
All of these cause supply to shift to the right.
The opposite of these factors will cause supply to shift left.
Question 2
Dimethylpolysiloxane is a chemical used in the U.S. to produce various items
sold by fast food restaurants, like McDonald’s.
Graphically illustrate and explain what would happen in the market for fast
food in the U.S. if the price of Dimethylpolysiloxane decreased dramatically.
This chemical is an input to production in the U.S. fast food industry.
Thus, a decrease in its price leads to an increase in the supply of fast food in
the U.S.
The supply curve shifts right, price of fast food falls, and the quantity of fast
food consumed increases.
Question 3
Graphically illustrate and explain what would happen in the market
for tea if instability in Columbia limited the supply of coffee beans.
A decrease in supply of coffee beans leads to an increase in the price
of coffee.
Since coffee and tea are substitutes, this leads to an increase in
demand for tea.
Price of tea rises, and quantity of tea increases.
Question 4
You own a cookie production plant. Recently the spread of mad cow
disease has left the cattle industry devastated. Your economic advisor
does not believe this will impact your sales. I think your advisor is
mistaken. Who do you think is correct, and why? Provide a graphical
milk
illustration.
Milk and cookies are complements.
If the supply of cattle falls => the supply of milk decreases => price of
milk increases.
If the price of milk increases => demand for cookies decreases =>
price and quantity of cookies decreases.
cookies
Question 5
Graphically illustrate and explain the following newspaper headline:
“Price of ACE inhibitors increase dramatically as baby boomers reach
retirement age”. (Note: ACE inhibitors are a type of medication used
to treat heart disease.)
As the baby boomers reach retirement age, there is essentially an
increase in the population of elderly people. Since elderly people
would be more likely to have need for heart disease medication, the
demand for ACE inhibitors increases, which leads to the rise in the
price.
Next Week
 Please check Moodle for next week’s worksheet
from Prof. Rietzke (on Wednesdays), and for
maths questions from Prof. Peel (on Thursdays).