Principles of Economics, Micro – Review Notes
Chapter 2: Thinking Like An Economist
1. The Economist as Scientist
a. The Scientific Method
i
Observation, Theory, More Observation
b. The Role of Assumptions in model building
2. Microeconomics and Macroeconomics
a. Micro: the study of how households and firms make decisions and how they
interact in specific markets.
b. Macro: the study of economy wide phenomena.
3. The Economist as Policy Advisor
a. Positive versus Normative Analysis
i
Normative statements: Opinions on the way things should be (ethical
judgments).
ii
Positive statements: Opinions on the way things are (scientific judgments).
iii Why the distinction is important – Example: Would you rather receive
positive or normative information regarding treatment from your doctor?
b. Economists in Washington
i
Council of Economic Advisors
ii
Department of Treasury
iii Department of Labor
iv
Congressional Budget Office:
v
Federal Reserve
4. Why Economists Disagree
a. Differences in Scientific Judgments
b. Differences in Values
c. Perception versus Reality
5. Economic Models: The Production Possibilities Frontier.
a. The PPF shows the various combinations of output that the economy can possibly
produce given the available factors of production and the available production
technology firms have, and assuming that the economy is operating as efficiently
as possible.
i
Assume the economy can produce some combination of (1) fish and (2)
agricultural products.
ii
Factors of production: things used in the production process.
1. people
2. boats & nets
3. farming tools and plows
4. Note that objects used in the production process, such as boats, farming
tools, and machines, are also referred to as Capital Goods. However,
people are an example of a factor of production that is not a capital good.
iii Production technology: method of fishing or farming.
iv
Think of the PPF as plotting different combinations of fish and agricultural
production as we move people from one sector to the other, and assuming
people are working efficiently.
1
v
Figure 2
b. Points on the PPF (rather than inside) represent efficient levels of production.
i
Efficient: can’t produce more of one good without producing less of another
good.
ii
All points on the curve are efficient. Being higher up the curve does not
imply greater efficiency.
iii All points inside the curve are inefficient.
c. The PPF illustrates tradeoffs and their implied opportunity costs.
i
The opportunity cost of producing more of a good can be seen on the
production possibilities frontier as the amount of the other good which must
be given up.
d. When the PPF is bowed outward it implies that the opportunity cost of a good
rises as more of the good is produced.
e. The PPF can change over time –based, for example, on technological changes or
changes in factors of production.
i
When there are increases in technology or factors of production, the PPF will
bow out in the direction of the good where the increase occurred.
ii
Figure 3
Chapter 3: Interdependence and the Gains From Trade
1. Introduction
a. Today we will discuss the reasons individuals and nations choose to be
interdependent.
b. The bottom line is that people and nations choose to be interdependent (trade)
because they are better off – that is, there are gains from trade.
c. Gains occur if and when a nation specializes in producing the good for which it
has the lowest opportunity cost.
d. Even if a country is superior at producing all goods, it can gain from trade if it
specializes in producing the good for which it has a comparative advantage.
2. Example of the gains from trade (cattle rancher and potato farmer) – setup:
a. The purpose of this two person, two good, example is:
i
To show that gains from trade are possible even if one producer is better at
producing both goods.
b. Assume the following:
i
The economy has only two goods – meat and potatoes.
ii
The economy has only two individuals (you can think of these two individuals
as two countries, say the U.S. and Japan)
iii Each individual can produce both goods.
iv
Each individual likes to consume both goods
v
Each individual works 8 hours a day and can devote this time to growing
potatoes, raising cattle, or both.
vi
Production of meat or potatoes can be done in a single day, and trade occurs at
the end of the day.
3. Example: Constructing the Production possibilities frontier (PPF) for one day’s
work
2
a. The PPF will be for one day’s work for each individual – the rancher and the
farmer.
b. Table at top left of Figure 1: information on each individual’s productivity.
c. Table at top right of Figure 1: can be constructed from table discussed in previous
bullet. This table shows the endpoints of the PPF.
i
Note in this chapter that the PPF is a straight line, so it can be drawn by
simply connecting a line through the endpoints of the PPF.
d. Note: the rancher (R) is better at producing both goods.
e. Figure 1: PPF Farmer
f. Figure 1: PPF Rancher
4. Example: Specialization and gains from trade.
a. Without Trade (and no specialization)
i
Assume that without trade, the farmer and the rancher consume at points
A (4 oz. meat & 16 oz. potatoes) and B (12 oz. meat & 24 oz. potatoes),
respectively.
1. Though the PPF shows the tradeoffs that each faces, it does not tell us
what each will do.
2. Production and Consumption Without Trade
a. Figure 2, Table, first row
b. With Trade (and specialization)
i
Production: Assume the farmer spends all work time producing potatoes
(specializes in potato production) and the rancher spends 6 hours on cattle
production and 2 hours on potato production (specialize in meat
production).
1. Figure 2, Table, row 2: Production with Trade
ii
Now assume that they agree to an exchange: the farmer trades 15 oz. of
potatoes for 5 oz. of the rancher’s meat.
1. Trade
a. Figure 2, Table, row 3
2. Consumption
a. Figure 2, Table, row 4
3. Gains from Trade
a. Figure 2, Table, row 5
iii Each person is better off: now each has more of both goods.
iv
Note that our example showed that there will be gains from trade for both,
even if one producer is better at producing both goods.
5. Principle of Comparative Advantage
a. Absolute Advantage: The producer with the lowest cost in terms of inputs used
(time) is said to have an absolute advantage.
b. Comparative Advantage: The producer with the lowest opportunity cost (what is
given up) is said to have a comparative advantage.
c. Example: Table 1 shows the opportunity costs. It is derived from the table on the
left in Figure 1.
i
The farmer’s opportunity costs of producing 1 oz. of meat is 60 minutes,
which is equivalent to 4 oz. of potatoes (since it takes 15 mins. to make
one oz. of potatoes).
3
The farmer’s opportunity costs of producing 1 oz. of potatoes is 15
minutes, which is equivalent to ¼ oz. of meat (since it takes 60 mins. to
make one oz. of meat).
iii There is an inverse relationship between opportunity costs of different
goods in a two good economy.
d. Differences in opportunity cost create the potential for gains from trade.
e. In a two good world, one person will always have a comparative advantage
unless the two people have the same opportunity cost.
f. For gains from trade to occur, a country must specialize in the production of the
good that it has a comparative advantage.
6. Comparative Advantage and Trade: When Trade Will Occur
a. Even if a country is specializing in the correct good (the one for which it has the
lowest opportunity cost) trade will only be beneficial if the price of the good each
person/country is purchasing is less than the opportunity cost of producing it.
b. Example: farmer
i
The farmer’s opportunity cost of producing 1 oz. meat is 4 oz. of potatoes.
ii
The price of meat in terms of potatoes is given by the exchange rate 15 oz. of
potatoes for 5 oz. of meat.
1. Price of 1 oz. meat = oz. potatoes in trade / oz. of meat in trade = 15/5 = 3.
iii The farmer is willing to engage in trade since the price of meat (3 oz.
potatoes) is lower than the opportunity cost of meat (4 oz. potatoes).
c. Example: rancher
i
The rancher’s opportunity cost of producing potatoes is ½ oz. of meat.
ii
The price of potatoes in terms of meat is given by the exchange rate 15 oz. of
potatoes for 5 oz. of meat.
1. Price of 1 oz. potatoes = oz. meat in trade / oz. potatoes in trade = 5/15 =
1/3.
iii The rancher is willing to engage in trade since the price of potatoes (1/3 oz.
meat) is lower than the opportunity cost of potatoes (1/2 oz. meat).
7. Note, the price of one good is the inverse of the price of the other good.
a. Homework – Calculating Opportunity Costs
i
Opportunity Cost of good on the X axis = Maximum production of good y
/ Maximum production good x (which is just the absolute value of the
slope).
ii
Opportunity Cost of good on the Y axis = Maximum production of good x
/ Maximum production of good y.
b. The crucial question in determining whether trade makes sense it: What would
one have to give up to produce by one’s self versus what one would have to give
up to trade for the good?
8. Summary
a. Gains from trade are possible even if one is better at producing both goods.
b. Differences in opportunity cost, and hence comparative advantage, create the
potential for gains from trade.
c. When gains from trade are possible, producers (countries) can benefit by
specializing in the good in which they have a comparative advantage.
d. However, trade only make sense if the price is below the opportunity cost.
ii
4
Chapter 4: The Market Forces of Supply & Demand
1. Markets: the interaction between buyers and sellers in a particular location.
a. “Price and quantity are determined by all buyers and sellers as they interact in the
marketplace.”
b. Examples: the market for soybeans, the market for mid-sized sedans, the market
for oil, the market telephone service.
2. Competitiveness of Markets
 Definition: The less impact each seller (and buyer) has on the price of a good in a
particular market, the more competitive is the market.
 Below are examples of different types of markets. Each market in the below list
is less competitive than the prior one.
a. Perfectly Competitive Market: A market where (1) all goods being sold are
virtually identical and (2) the number of buyers and sellers is large.
i
Price Takers: buyers and sellers in a perfectly competitive market are called
price takers because they have no choice but to take the price the market
offers.
b. Monopolistically Competitive: many different sellers of similar goods where each
seller may offer a slightly different price.
c. Oligopoly: a few sellers selling similar or identical goods. Often there will be
tacit or explicit collusion to keep prices high.
d. Monopoly: one seller that sets the price to maximize its profits.
3. Modeling Perfectly Competitive Markets
a. Assumptions:
i
All goods being sold are virtually identical.
ii
The number of buyers and sellers is large.
b. Although the assumptions are not true in the majority of markets, the model gives
insight into what will occur in a large number of markets.
4. Modeling Perfect Competition: Demand
a. Demand represents buyers and refers to how much a person wants (or people
want) to buy.
b. Demand Schedule (Figure 1): a table “that shows the relationship between price
of a good and the quantity demanded, holding” constant all other factors that
influence demand.
i
Example: your demand for CDs.
ii
Table with P (price) in left column and Q demand (quantity demanded)
1. Write down your demand for CDs (the amount you want to purchase) in a
year at a price of $20, $15, $10, $5, and $1.
c. The Demand Curve (Figure 1): a graph “that shows the relationship …”
i
Plot your own demand curve for CDs using the information from your
Demand Schedule.
a. Put P on the Y axis and Q (representing your supply) on the X axis.
b. The demand curve represents buyers.
c. The demand curve tells us how demand changes as we vary P and
other factors are held constant.
5
ii
Law of Demand: Demand is negatively related to price (Demand curve slopes
downward)
d. Market Demand versus Individual Demand (Figure 2)
i
The market demand is the sum all of individual demand curves.
1. Sum the schedules and then plot. OR
2. Sum the individual demand curves horizontally.
ii
If each individual has a negatively sloped demand curve, then the market
demand curve will be negatively sloped.
e. Variables that influence Demand / Buyers (Table 1)
i
Price
1. When price changes, we move along a demand curve.
ii
Variables that can shift the demand curve include the following:
 There are many factors that influence demand besides price. As these
other factors change, the demand curve will shift.
1. Income
a. Normal goods: When income increases, demand shifts right
(increases), and vica versa.
b. Inferior goods: When income increases, demand shifts left (decreases),
and vica versa.
2. Prices of related goods
a. Substitutes: A related good is a substitute for the good in question, if
consumption of the good in question goes down (up) when the price of
the related good goes down (up).
i.
P other good increases  Demand for this good shifts right
(increases), and vica versa.
ii.
Example: ipod, mp3 downloads
b. Complements: A related good is a complement for the good in
question, if consumption of the good in question goes up (down) when
the price of the related good goes down (up).
i.
P other good increases  Demand for this good shifts left
(decreases), and vica versa.
ii.
Example: 400 CD changer
3. Tastes
a. For example, as fads change, your tastes change.
4. Expectations
a. Expected income changes
b. Expected price changes
5. Number of buyers
a. Immigration
iii Shifts in demand occur when at a given P, demand increases or decreases.
This corresponds with a horizontal shift of the demand curve.
1. Figure 3
iv
Movements along a demand curve occur when the price changes.
1. Figure 4
5. Modeling Perfect Competition: Supply
a. Supply represents sellers.
6
b. Supply Schedule: a table “that shows the relationship between price of a good and
the quantity supplied,” holding constant all other factors that influence supply.
i
Figure 5
ii
Example: your supply of labor.
iii Table with P (price – in this case the wage) in left column and Q Supplied
(quantity supplied – in this case the amount of hours worked per week)
1. Write down the amount of hours per week you would work at a wage of
$100/hr, $75, $50, $25, $1
c. The Supply Curve: A graph “that shows the relationship …”
i
Figure 5
ii
Plot your own supply curve for hours worked.
a. Put P on the Y axis and Q (representing your supply) on the X axis.
b. The supply curve represents sellers.
c. The supply curve tells us how supply changes as we vary P and other
factors are held constant.
iii The firms supply curve is its cost curve (marginal cost curve).
iv
Law of Supply: Supply is positively related to price.
d. Market Supply versus individual supply
i
The market (or aggregate) supply is the sum of all firm supply curves.
1. Figure 6
2. Sum the schedules and then plot OR
3. Sum the individual supply (MC) curves horizontally.
e. Variables that influence Supply / Sellers (Table 2)
i
Price
1. When price changes, we move along a supply curve.
ii
Variables that can shift the supply curve
1. Input prices
2. Technology
a. Technological advancements can cause firms costs to go down.
3. Expectations
a. If a firm expects prices will rise, it may restrict current supply and hold
onto it for later.
4. Number of sellers
a. New firms may come into the market, increasing the aggregate Q sold
at each P.
iii There are two ways to think of a shifts in supply
1. Figure 7: When at each P, there is a change in the Q supplied (a horizontal
shift of the supply curve).
2. When at each Q, there is a change in costs (a vertical shift in the supply
curve).
6. Supply & Demand Together
a. Plotting both Qd and Qs on the x axis.
b. Equilibrium (Figure 8): the point at which the demand and supply curves
intersect.
i
Equilibrium Price
1. P* in the graph.
7
2. It is also called Market Clearing Price.
ii
Equilibrium Quantity
1. Q* in the graph
iii Law of Supply & Demand: the market’s ability to push the price and quantity
towards equilibrium.
1. P* and Q* in the graph
2. Surplus (excess supply: Figure 9): When prices are above equilibrium. In
this instance, some firms have an incentive to lower their price because
they are not selling their output.
3. Shortage (excess demand: Figure 9): When prices are below equilibrium.
In this instance, some consumers have an incentive to pay a higher price
because they want the good and cannot get it at the prevailing price.
4. Prices: the mechanism for rationing scarce resources.
a. There are only so many goods, and prices determine who gets them.
5. The invisible hand
c. Semantics / Definitions
i
There are two ways to get a change in the equilibrium level of supply
(demand).
1. Change in supply (demand): Shift in the supply (demand) curve.
2. Change in the quantity supplied (demanded): Movement along a supply
(demand) curve.
ii
Graph 1 (both Qd and Qs rise, due to a rightward D curve shift). Here we
would say that there was an …
1. Increase in demand
2. Increase in quantity supplied
iii Graph 2 (again both Qd and Qs rise, this time due to a rightward S curve
shift). Here we would say that there was an …
1. Increase in quantity demanded
2. Increase in supply
d. Three Steps to Analyzing Changes in Equilibrium (Table 3)
i
Comparative statics: the analysis of the change which occurs when an event or
events shift the demand, the supply curve, or both.
1. Step 1: determine whether the event shifted the supply or demand curve.
a. In order to do this, one must determine which of the demand factors or
supply factors was changed by the event.
2. Step 2: determine which way the curve shifted.
3. Step 3: use the D and S diagram to determine how shift affects equilibrium
price (P) and quantity (Q).
ii
Example 1 (Figure 10): Imagine a heat wave hits. What happens in the
market for soft serve ice cream.
1. Note: There is no shift in the supply curve in response to the demand
curve shift.
iii Example 2 (Figure 11): Imagine a hurricane destroys part of the expected
sugar crop in a given year. What happens in the market for soft serve ice
cream.
8
1. Note: There is no shift in the demand curve in response to the supply
curve shift.
e. Simultaneous Shift in Supply & Demand (Figure 12)
i
Ice cream example: simultaneous heat wave and hurricane.
1. The change in Q is ambiguous. It is determined by the relative magnitude
of the supply and demand shifts.
2. In a different example, it could be the change in P that was ambiguous.
Chapter 5: Elasticity and its Application
1. Introduction
a. This chapter presents a quantitative way of measuring how the quantity of a good
demanded (purchased) or supplied (sold) can change in response to certain
factors.
b. Definition of Elasticity (Sensitivity): The change of one variable in response to
the change in another variable.
i
For example: the change in the quantity demanded (or supplied) in response to
a change in the price (or income)
c. Bottom line: elasticity essentially is reflected by the steepness of the curve.
i
Steeper curves are less elastic or more inelastic.
2. Computing the Price Elasticity of Demand / Supply
a. Normal Method
i
Price Elasticity of Demand / Supply =
|(% change in quantity) / (% change in price)| =
|[100 x (Q2 – Q1)/Q1] / [100 x (P2 – P1)/P1]| =
|[(Q2 – Q1)/Q1] / [(P2 – P1)/P1]| =
ii
Note that the elasticity changes depending on which point we label as 1 and
which point we label as 2.
1. Example: with point (P=4, Q=120) and point (P=6, Q=80) we see that
elasticity is either .66 or 1.5 depending on which point you label point one
in the elasticity equation above.
a. This is one property that economists don’t like about our definition of
elasticity.
b. The Midpoint Method:
i
It solves our problem of getting a different elasticity depending on which
point we label as point 1 versus 2.
ii
Price Elasticity of Demand =
|(% change in quantity) / (% change in price)| =
|(%∆Q/Q) / (%∆P/P)|
[(Q2 – Q1)/((Q2+Q1)/2)] / [(P2 – P1)/((P2+P1)/2)]
c. Elasticity changes as we move along a linear demand curve.
i
Elasticity equals infinity at P axis, 0 at Q axis, and 1 somewhere in between.
ii
This is a property that many economists don’t like about our definitions of
elasticity.
3. The Variety of Demand and Supply Curves
a. Elastic: Elasticity > 1.
b. Inelastic: Elasticity < 1.
9
c. Unit Elasticity: Elasticity = 1.
d. Perfectly Inelastic: elasticity = 0.
i
A vertical demand curve.
e. Perfectly Elastic: elasticity is infinite.
i
A horizontal demand curve.
4. The Price Elasticity of Supply and its Determinants
a. The “flexibility of sellers to change the amount of the good they produce.”
i
Beachfront land versus manufactured goods.
b. Time Horizon: supply is usually more elastic in the long run.
i
Changes at existing firms: In the short run existing firms cannot easily adjust
their output levels to changing market conditions due to capacity constraints.
1. Workers: Can hire more workers in the LR.
a. Overtime workers in SR versus new staff in LR.
2. Production Facilities: Can purchase more machines in the LR.
ii
Entry/exit: In the long run new firms can enter the market and old firms can
close down.
5. Determinants of Price Elasticity of Demand
a. Availability of Close Substitutes
b. Necessity versus Luxury
c. Definition of the Market
i
For example, food versus specific types of food.
d. Time Horizon: demand is usually more elastic in the long run.
i
Consumption habits
1. It takes time for consumers to change their consumption habits
ii
The demand for some goods are tied to the stock of another good.
1. Since the stocks of goods change slowly the demand for a certain good
related to that stock will change slowly.
2. Example: price of gasoline and shift towards more fuel efficient cars.
6. Other Demand Elasticities
a. The Income Elasticity of Demand
i
(Percentage change in quantity demanded) / (Percentage change in income)
1. (Q2 – Q1)/Q1 / (I2 – I1)/I1
2. (Q2 – Q1)/[(Q1 + Q2)/2] / (I2 – I1)/[(I1 + I2)/2]
ii
Normal Goods: positive income elasticity of demand
1. Necessities (like drugs): small
2. Luxuries (like jewelry): large
iii Inferior Goods (like Top Raman): negative income elasticity of demand
b. The Cross-Price Elasticity of Demand
i
(Percentage change in quantity demanded of good A) / (Percentage change in
the price of good B)
A
A
B
B
B
1. (Q 2 – Q 1)/Q1 / (P 2 – P 1)/P 1
2. (QA2 – QA1)/ [(QA1+ QA2)/2] / (PB2 – PB1)/[(PB1 + PB2)/2]
ii
Substitutes: Cross-price elasticity is positive.
1. Goods consumed in place of one another. That is, alternatives, such as
beef and chicken.
iii Complements: Cross-price elasticity is negative.
10
1. Goods consumed together such as peanut butter and jelly.
7. Application of Supply, Demand, and Elasticity: the market for drugs
Chapter 6: Supply, Demand, and Government Policies
1. Introduction:
a. The two policies we will discuss today are (1) controls on prices (either price
ceilings or price floors) and (2) taxes.
2. Controls on Prices
a. Price Ceiling: When the price is not allowed to rise above a legislated maximum
level.
i
Often imposed to help buyers purchase the good/service at a lower price.
ii
Example: rent control.
b. Price Floor: When the price is not allowed to fall below a legislated minimum
level.
i
Often imposed to help sellers sell the good/service at a higher price.
ii
Example: price supports for farmers and the minimum wage.
3. How Price Ceilings Affect Market Outcomes
a. Non Binding Constraint: Price ceilings above the market price will have no effect.
i
See Figure 1
b. Binding Constraint: Price ceilings below the market price will result in shortages.
i
See Figure 1
ii
Qd is how much people want to buy.
iii Qs is how much people can buy.
iv
Q, the amount purchased and sold, is the minimum of the two.
c. What are the effects of a binding price ceiling.
i
Buyers
1. Some pay less, but
2. Less get good than did before.
3. Other (amount determined by size of shortage)
a. Depreciation in quality of good or service sold.
b. Rationing  Potentially, time wasted in lines.
c. Rationing Potential discrimination.
ii
Sellers
1. Less sold and at a lower price.
d. Binding price ceilings produce winners (some buyers) and losers (sellers, and
some buyers).
i
They don’t unambiguously help buyers, the group they are intended to help.
ii
The elasticity of supply is an important determinant of how many buyers don’t
get the good after the price ceiling is imposed.
e. Case Study: Rent Control In The Short And Long Run
i
Figure 3
ii
The more inelastic the supply curve, the fewer buyers that lose their apartment
in response to the rent control.
iii In the short run a shortage will develop but it will be relatively small due to
the inelasticity of demand and supply in the short run. (See Figure 3.)
iv
In the long run, the shortage will increase.
11
4. How Price Floors Affect Market Outcomes
a. Non Binding Constraint: Price floors below the market price will have no effect.
i
See Figure 4
b. Binding Constraint: Price floors above the market price will result in surpluses.
i
See Figure 4
ii
Qd is how much people want to buy.
iii Qs is how much people can buy.
iv
Q, the amount purchased and sold, is the minimum of the two.
c. What are the effects of a binding price floor.
i
Buyers
1. Pay more.
2. Purchase Less.
ii
Sellers
1. Some sell at a higher price, but
2. Less sell the good/service then before.
3. Other (amount determined by size of shortage)
a. Rationing Potential discrimination.
d. Binding price floors produce winners (some sellers) and losers (buyers, and some
sellers).
i
They don’t unambiguously help sellers, the group they are intended to help.
ii
The elasticity of demand is an important determinant of how many sellers
don’t sell the good after the price floor is imposed.
e. Case Study: Minimum Wage
i
Figure 5
ii
In the labor market, the price is the wage (W) and the quantity is the number
of workers (L).
iii The minimum wage is a price floor.
iv
The more inelastic the demand for labor, the smaller the number of workers
that lose their jobs in response to the minimum wage.
5. Evaluating Price Controls
a. “Price controls often hurt those they are trying to help.”
b. Sometimes “Helping those in need can be accomplished in ways other than
controlling prices.”
i
Examples:
1. Rent subsidies as an alternative to rent control.
2. An earned income tax credit as an alternative to a minimum wage.
ii
Though these policies are often better than price controls, they are not perfect
as they cost the government money and hence require higher taxes.
6. Taxes on Buyers
a. Figure 7
b. In response to a tax, the demand curve shifts down by the amount of the tax.
i
“To induce buyers to demand any given quantity, the market price must now
be … lower to make up for the effect of the tax.”
c. Analyzing the effects of a tax on buyers:
i
The intersection of the new (after tax) demand curve and supply curve yield
the “price sellers receive” and the quantity when there is a tax (Qt).
12
The “price buyers pay” is greater than the “price sellers receive” by the
amount of the tax since buyers must pay both the “price sellers receive” to the
sellers and the tax to the government.
d. The Effects of a Tax:
i
A tax reduces the size of the market.
ii
Both buyers and sellers share the burden of a tax (measured in how much the
price increased and decreased, respectively), though their shares of the burden
are not equivalent.
7. Taxes on Sellers
a. Figure 6
b. In response to a tax, the supply curve shifts up by the amount of the tax.
i
“To induce sellers to supply any given quantity, the market price must now be
… higher to compensate for the effect of the tax.”
c. Analyzing the effects of a tax on sellers:
i
The intersection of the new (after tax) supply curve and demand curve yield
the “price buyers pay” and the quantity when there is a tax (Qt).
ii
The “price sellers receive” is lower than the “price buyers pay” by the amount
of the tax since the sellers have to give the amount of the tax to the
government after receiving the “price buyer pay” from the buyers.
d. The Effects of a Tax:
i
Again, a tax reduces the size of the market.
ii
Again, both buyers and sellers share the burden (measured in how much the
price increased and decreased, respectively) of a tax, though their shares of the
burden are not equivalent.
8. Taxes on buyers and sellers are equivalent in terms of their effect on price and
quantity (with linear demand and supply curves).
a. The tax trick.
i
Figure 8
ii
Wedge a vertical line the size of the tax between the demand and supply
curve.
iii Note the price at which the vertical line meets the demand and the supply
curve.
1. The upper price is the price buyers pay
2. The lower price is the price sellers receive.
iv
Note the quantity at which the vertical line meets the demand and supply
curves. This is the quantity with a tax.
b. Implications of the fact that taxes on buyers and sellers are equivalent
i
The government cannot pick who receives the burden of a tax by choosing
who to tax.
c. Case Study: Can Congress Distribute The Burden Of A Payroll Tax?
i
A payroll tax is a tax on buyers in the labor market. Remember, in the labor
market buyers are firms that are buying worker time and sellers are
individuals selling their work time. Therefore, a payroll tax is a tax on firms.
ii
No, Congress cannot distribute the burden of a payroll tax. Regardless of the
fact firms are paying the tax, workers still bear some of the burden of the tax.
9. Elasticity and its effect on the relative burdens (incidence) of a tax.
ii
13
a. Incidence of a tax: “How the burden of a tax is distributed among the various
people who make up the economy.”
b. The greatest burden (biggest price change) falls on the group with the most
inelastic curve (i.e., the least elastic curve).
i
Figure 9
c. Case Study: Who Pays The Luxury Tax?
i
Since the demand curve for luxury goods tends to be elastic (and is likely
more elastic than the supply curve for luxury goods), sellers bear a greater
burden of the tax. Therefore, the relatively lower income workers at the yacht
factory are hurt more (pay more of the tax) than the yacht buyers, despite the
fact that the yacht buyers are the ones being taxed.
Chapter 7: Consumers, Producers, and the Efficiency of Markets
1. Introduction
a. This chapter gives us the tools that we will use in future chapter to measure the
impacts of government intervention into markets.
2. Consumer Surplus (CS)
a. Definition: “The [net gain] that buyers receive from participating in a market.”
b. The total area below the demand curve and above the price (up to the
quantity)
c. Consumer Surplus (Net Gain) = Benefit/value - Cost
i
Benefit = Willingness to Pay
1. The maximum price that someone will pay for a good.
a. It is the value a consumer places on a good.
b. Table 1
2. Each point on the demand curve represents an individual’s willingness to
pay.
a. Figure 1
ii
Cost = Price of the good
d. Consumer Surplus = benefit/value (willingness to pay) – price
i
This is the sum of all vertical lines (or areas) below the demand curve and
above the price (up to the quantity)
1. Figure 2
e. Using the Demand Curve to Measure CS in a market.
i
A higher P decreases CS.
ii
A lower P increases CS.
iii Figure 3
3. Producer Surplus (PS)
a. Definition: “The [net gain] to sellers of participating in a market.”
b. The total area above the supply curve and below the price (up to the
quantity)
c. Producer Surplus (Net Gain) =Benefit – Cost
i
Benefit/value = Price of the good
ii
Cost = Willingness to Sell
1. The lowest price a seller will accept for a good.
a. It is the cost of producing.
14
b. Table 2
2. Each point on the supply curve represents an individual firm’s willingness
to sell, or cost.
a. Figure 4
d. Producer Surplus = price –cost
i
This is the sum of all vertical lines (or areas) below the price and above the
supply curve (up to the quantity)
1. Figure 5
e. Using the Supply Curve to Measure PS in a Market
i
A higher P increases PS.
ii
A lower P decreases PS.
iii Figure 6
4. Market Efficiency
a. Efficiency versus Equity
i
Efficiency: when an allocation of resources maximizes total surplus.
ii
Equity: “the fairness of the distribution of well-being among the various
buyers and sellers.”
iii In this chapter we focus on efficiency.
b. Total surplus
i
Definition: the sum of consumer and producer surplus.
ii
How it’s measured.
1. “The total area between supply and demand curves up to the point of
equilibrium represents the total surplus in this market.”
a. Figure 7
2. Alternatively
a. Total S
= consume surplus + producer surplus
b. Consumer S = benefit/value to buyers – price
c. Producer S
= price – cost to sellers
d. Total S
= Benefit/value to buyers – Cost to sellers
e. Figure 8
c. Evaluating the Market Equilibrium
i
Total surplus is maximized.
1. Total surplus is lower to the left and to the right of the equilibrium
quantity, compared to at the equilibrium quantity.
a. Figure 8
ii
Those who buy the good value the good the most.
iii Those who sell the good have the lowest costs.
iv
Given 1, 2, and 3: “The equilibrium outcome is an efficient allocation of
resources.”
5. Qualifications on Conclusions
a. The results only hold under the following conditions.
i
There are no externalities.
ii
Markets are perfectly competitive.
Chapter 8: Application – The Costs of Taxation
1. Introduction
15
a. We revisit taxation, and use our tools from last chapter to put a numerical value
on the costs (in terms of lost consumer and producer surplus – that is lost welfare)
of a tax.
b. Our first example of how government intervention into the market can reduce
welfare (i.e., can reduce total surplus).
2. The Deadweight Loss of Taxation
a. Figure 3
b. Modeling a Tax: Figure 1
c. Consumer Surplus (CS)
i
CS without a tax: A + B + C
ii
CS with a tax: A
d. Producer Surplus (PS)
i
PS without a tax: D + E + F
ii
PS with a tax: F
e. Government Revenue from the tax (GR)
i
Government receives T x QT
ii
Figure 2
iii GR without a tax: 0
iv
GR with a tax: B + D
f. Deadweight Loss (DWL)
i
Deadweight Loss is just the decline in total surplus brought about by the tax.
ii
TS (without tax) = CS + PS + GR = A + B + C + D + E + F
iii TS (with tax) =
CS + PS + GR = A + B + D + F
iv
Difference = deadweight loss = C + E
v
Understanding deadweight loss: Figure 4
3. The Determinants of Deadweight Loss (DWL)
a. Price elasticities of supply and demand
i
Figure 5
ii
The more elastic is the supply curve, the greater is DWL.
iii The more elastic is the demand curve, the greater is DWL.
iv
What types of goods would the government want to tax?
1. Goods with an inelastic D curve, S curve, or preferably with both curves
inelastic.
4. Deadweight Loss And Tax Revenue As Taxes Vary
a. Tax Graphs (See Figure 6, top 3 graphs)
i
small tax
ii
medium tax
iii large tax
b. Deadweight loss versus size of tax (See Figure 6, lower left graph)
i
In a graph with the size of the tax on the x axis, and the amount of the
deadweight loss on the y axis, we see that deadweight loss rises rapidly with
the size of the tax.
c. Tax Revenue versus size of tax (See Figure 6, lower right graph)
i
In a graph with the size of the tax on the x axis, and the amount of tax revenue
on the y axis, we see that starting from a level of zero taxes, if we increase the
16
tax rate there is initially a rise in tax revenue. However, as tax rates continue
to rise eventually tax revenue will fall and they will ultimately become zero.
5. Case Study: The Laffer Curve and Supply-Side Economics (Reaganomics)
a. The Laffer Curve is the tax revenue graph we just studied, where the tax is an
income tax.
b. Laffer hypothesized that a decrease in the income tax rate (the tax on labor) would
increase the amount of tax revenue for the government.
i
This belief was known as Supply Side Economics
c. “Economists continue to debate Laffer’s argument. Many believe that subsequent
history refuted Laffer’s conjecture that lower tax rates would raise tax revenue.”
i
Government debt ballooned from just over 30% of GDP to approximately
50% of GDP during the Reagan administration.
d. Is Laffer’s argument without merit?
i
It depends on what side of the Laffer curve you are on.
ii
It may be correct for those taxpayers facing the highest tax rates.
1. As it was for the highest income Americans in the 1980’s.
iii It may be more plausible when applied to other countries, where tax rates are
much higher than in the U.S.
1. As it was for Sweden in the early 1980’s.
6. Conclusion
a. “When the government imposes taxes on buyers or sellers of a good … society
loses some of the benefits of market efficiency.”
b. While the costs of taxation (DWL) cannot be avoided, it can be minimized by
taxing inelastically supplied and or demanded goods.
c. “How much revenue the government gains or loses from a tax change cannot be
computed just by looking at tax rates.”
Chapter 9: Application – International Trade
1. Introduction
a. We will utilize our welfare tools to show the gains from trade
b. Another example of how government policies can reduce total welfare.
i
We will utilize our welfare tools to show the negative effects of government
trade policies that restrict trade – tariffs and quotas.
2. The Equilibrium without trade
a. Figure 1
b. Imagine a country which produces steel domestically and doesn’t allow trade with
other countries. Consumer and producer surplus is visible from our normal graph
of supply and demand.
3. Assessing The Impact of Trade
a. Assume that a country is small and can thus purchase or sell all it wants at the
prevailing world price.
b. With this assumption, the domestic price becomes the prevailing price in the
economy for either an exporting or importing country.
4. The direction of trade and the relationship between the world price and the
domestic price.
17
5.
6.
7.
8.
9.
a. If the world price of steel is above the domestic price, then the country will
become an exporter of steel once trade is permitted.
b. If the world price of steel is below the domestic price, then the country will
become an importer of steel once trade is permitted.
The Effects on Trade for an Exporting Country (world P > domestic P)
a. Figure 2
b. The world price becomes the prevailing price in the economy.
c. Welfare effects of free trade versus no trade.
i
See table in Figure 2
d. Bottom Line
i
The economic well-being of the nation rises in the sense that the gains of the
winners exceed the losses of the losers.
ii
Domestic producers of the good are better off.
iii Domestic consumers of the good are worse off.
The Effects of Trade on an Importing Country (world P < domestic P)
a. Figure 3
b. The world price becomes the prevailing price in the economy.
c. Welfare effects of free trade versus no trade.
i
See table in Figure 3.
d. Bottom Line
i
The economic well-being of the nation rises in the sense that the gains of the
winners exceed the losses of the losers.
ii
Domestic producers of the good are worse off.
iii Domestic consumers of the good are better off.
Conclusions on Free Trade
a. Trade raises the overall welfare of a nation.
b. Trade helps some, but hurts others.
The Effects of Trade Restricting Policies – A Tariff
a. A tariff is a tax on imported goods.
b. Figure 4
i
A tariff pushes up the prevailing price by the size of the tariff.
c. Welfare effects of a tariff.
i
In this analysis, the benchmark from which all comparisons are made is free
trade.
ii
See table in Figure 4.
d. Bottom Line
i
The economic well-being of the nation falls (deadweight loss) in the sense that
the losses of the losers exceed the gains of the winners.
ii
Domestic producers of the good are better off.
iii Domestic consumers of the good are worse off.
Arguments For Restricting Trade
a. The Jobs Argument
i
But free trade creates as well as destroys jobs.
b. The National Security Argument
i
Yes, but that argument may be used too quickly.
c. The Infant-Industry Argument
18
i
But picking the winning industries is difficult.
b. The Unfair-Competition Argument
i
But the benefits of consumers would exceed loss to producers.
c. The Protection-as-a-Bargaining-Chip Argument
ii
The threat may not work – the country might be forced to carry out its threat
and lose welfare or back down and lose credibility.
Chapter 10: Externalities
1. Introduction
a. “An externality arises when a person engages in an activity [or two parties engage
in a transaction] that influences the well-being of a bystander and yet neither pays
nor receives any compensation for that effect.”
i
Negative externalities: Smoking, aluminum production, automobile exhaust,
barking dogs
ii
Positive externalities: Schooling in a high crime area, renovation of a
dilapidated home, restored historic buildings, research into new technologies
b. Our first example of when markets fail to allocate resources efficiently.
c. An example of how government intervention into the market can actually help
bring about a more efficient solution.
2. Graphing Markets with Externalities
a. Review
1. Total S = Value (Benefit) to Buyers – Cost to Sellers
2. “Value to Buyers” is the demand curve
3. “Cost to Sellers” is the Supply curve.
b. Our total surplus equation now must be modified to take into account any possible
externality.
i
Total surplus = social value (value to society) – social cost (cost to society)
1. Social value (value to society) = private value + positive externality
a. D = private value
b. Social value is the value to all of society, not just buyers. It includes
both the value to buyers and the value to positive externality receivers.
2. Social cost (cost to society) = private cost + negative externality
a. S = private cost
b. Social cost is the cost to all of society, not just sellers. It includes the
costs to sellers as well as the “cost” to negative externality sufferers.
c. Now, total surplus is maximized at the point where the social value curve
intersects the social cost curve.
d. Note that before, when there were no externalities, social value = private value
and social cost = private cost. Therefore, total surplus was maximized at the
intersection of the D and S curves. This is no longer the case with externalities.
3. Externalities and Market Inefficiency
a. Negative Externalities
i
Assume for every ton of steel produced, the inhabitants of the town are
negatively impacted by $100 due to the health effects of the pollution.
ii
Figure 2
19
1. The social cost curve is $100 higher than the private cost curve (Supply
curve) due to the externality.
iii With a negative externality there is over production.
1. Efficiency is achieved at the intersection of the social value curve and the
social cost curve.
iv
A tax will enable the market to reach the efficient level of production.
1. When an externality exists but somehow the efficient point is reached (for
example through taxes), we say that the externality is internalized.
v
Note that some pollution is efficient.
b. Case Study – Why Is Gasoline Taxed So Heavily
i
Gasoline taxes can be rationalized by a desire of the government to internalize
the externalities produced by drivers: Congestion, accidents, pollution.
c. Positive Extenalities
i
Assume for every person college educated in the town, the inhabitants of the
town are positively impacted by $100.
ii
Figure 3
1. The social value curve is $100 higher than the private value curve
(demand curve).
iii With a positive externality there is under production.
1. Efficiency is achieved at the intersection of the social value curve and the
social cost curve.
iv
A negative tax (subsidy) will enable the market to reach the efficient level of
production.
1. Subsidy: When the government pays you to consume something. For
example a scholarship for getting educated.
2. With a subsidy the externality is internalized.
4. Public Policies Toward Externalities: There is a role for government to help bring
about an efficient level of externalities when, for example, the assumptions of the
Coase Theorem do not hold.
a. Command-and-Control Policies
i
Banning all output.
ii
Regulating the level of output.
b. Corrective Taxes (a.k.a. Pigouvian Taxes)
i
Here we will model a tax on the amount of pollution, or “glop.”
ii
Figure 4, Panel a.
1. Downward sloping demand for pollution.
2. The government sets the price of pollution (the tax)
3. The government can achieve any level of pollution by adjusting the tax.
c. Tradable Pollution Permits
i
With tradable pollution permits, the government auctions off permits that
allow firms to pollute a certain amount in each year. A firm can sell its
permits to another firm whenever it wants.
ii
Figure 4, Panel b.
1. The government sets supply of pollution (by setting the supply of permits)
rather than price.
20
iii
The same outcome can be achieved with either a tax or a tradable pollution
permit.
d. The ranking of preference of these policies: tradable pollution permits, corrective
taxes, command-and-control policies.
i
Corrective taxes and tradable pollution permits are more efficient in that they
induce the greatest reductions in pollution from the companies that can do so
the most cheaply.
ii
Corrective taxes and tradable pollution permits also create greater incentives
to develop clean technologies.
iii Tradable pollution permits, compared to corrective taxes, allows the
government to more accurately choose the level of polution.
5. Objections to the Economic Analysis of Pollution
a. Some think that we should not allow any pollution. It would not be optimal to
ban all pollution if consumer and producer surplus are decreased by more than the
decline in the negative externality.
6. Private Solutions To Externalities
a. Moral codes and social sanctions
i
“Do unto others as you would have them do unto you.”
b. Charities
i
Example: Education Scholarships are essentially a subsidy.
c. Mergers
i
Example: the bee keeper and the apple farmer.
d. Contractual agreements
i
Under certain circumstances market participants can negotiate with one
another to bring about an efficient solution.
7. The Coase Theorem – When Contractual Agreements Work
a. Definition: “According to the Coase theorem, if private parties can bargain
without cost … then the private market will always solve the problem of
externalities and allocate resources efficiently… [regardless of the] distribution of
rights.”
b. Why Private Solutions Do Not Always Work
i
Transaction costs: The costs that parties incur in the process of agreeing to
and following through on a bargain.
1. The cost of lawyers to draft contracts.
ii
The high cost of getting together a large number of affected individuals.
iii Bargaining simply breaks down between the party/parties receiving the
externality and the party causing the externality.
Chapter 11: Public Goods and Common Resources
1. Introduction
a. Another example of where:
i
Markets can produce inefficient results.
ii
Government intervention can increase efficiency.
2. Non-Excludable (NE) vs. excludable goods
a. Goods are NE if people cannot be, or are not, excluded from using the good.
b. NE good examples
21
3.
4.
5.
6.
i
Fireworks
ii
Lighthouses
iii Commons
iv
Fisheries
Rival vs. non rival goods:
a. Non-Excludable goods (and excludable goods) can be broken down into two
categories, those that are rival and those that are not (non rival).
b. Rival Goods: goods where one person’s use diminishes another’s ability to use it.
Box Diagram: Four different categories of goods based on the above two
characteristics.
a. Public Goods – Non Excludable & Non Rival.
b. Common Resources – Non Excludable & Rival.
c. Private Goods – Excludable & Rival.
d. Club Good – Excludable & Non Rival
So what’s so bad about NE goods?
a. When goods are NE, the result is that there is no consumption of the good – and
this is often inefficient.
Public Goods and the free rider problem.
a. Example: Fireworks Display
b. The Problem (called the Free Rider problem) – people don’t pay for the good
thinking they will rather “free ride”:
i
Remember, the good is non-excludable, so if a firework company puts on a
firework show, consumers can watch it even if they do not pay.
c. The Result – no firm produces the good:
i
If everyone “free rides,” then no one ends up paying for the good. Thus no
firm has an incentive to produce the good as there will be no buyers.
d. Solutions:
i
Make the good excludable (if this is possible).
ii
The government imposes a tax which it uses to pay for good.
e. An alternative view of the problem – an Externality:
i
“One way to view this market failure is that it arises because of an externality.
If [a company] puts on the fireworks display, [it] confers an external a benefit
on those who see the display without paying for it.”
f. Example
i
Assume you’re in a town with 100 families. Each family values a fireworks
display at $10. It would cost $500 (or $5 per family) to pay for a fireworks
display.
ii
Is it efficient to have the fireworks display? That is, would the total surplus of
the town members rise if there was a fireworks display?
iii Under these assumptions above, would you vote for a mayor who ran on a
platform of raising taxes by $5 per family to pay for a fireworks display?
Essentially, you would be voting to compel yourself (and everyone else) to
pay for the fireworks display.
g. Important Public Goods:
i
National Defense
ii
Basic Research
22
iii Fighting Poverty
7. Cost-Benefit Analysis
a. In deciding whether to implement a certain policy or project, policy makers often
must undertake cost-benefit analysis to determine whether the benefits of the
proposed policy exceed the costs.
b. Sometimes the benefit of a project is the reduced probability of the death of a
citizen. For example, building a stop light at a busy intersection would reduce the
probability that a pedestrian was killed by a car while trying to cross the street.
c. In determining whether or not to build the stoplight, a policymaker would want to
compare the benefit of the reduced probability of death with the cost of the
stoplight.
i
Assume a stop light would reduce the probability of that someone loses a life
at the intersection by 0.5% (from 1.6% to 1.1%), and
ii
Assume that the value of a life is $10 million.
iii To determine the benefit of the stoplight, we want to multiply the reduced
probability of death by the value of a life.
1. The benefit of the stoplight is $10 million x 0.005 = $50,000
iv
If the cost of the stop light were less than $50,000, it would make sense to
build the stoplight since NG = B – C would be greater than zero.
1. Remember, when NG > 0 it implies “do it,” i.e., undertake the action
being considered. In this case, “do it” means “buy the stop light.”
8. Common Resources and the externality problem.
a. Example: “Tragedy of the Commons”.
b. The Problem (called the Externality problem) – over use and under care of
the good:
i
People see little personal benefit to saving some grass for next year because
they only get a small portion of their “savings” as most of it is consumed by
others. Thus there is a positive externality to saving (i.e., to not using).
ii
With care, again people see little personal benefit because they only realize a
small portion the grass their care creates as most of it is consumed by others.
Thus there is a positive externality to care.
c. The Result – depletion of the good:
i
If everyone makes this same analysis, everyone ends up over using the good
and under caring for the good. The result is that the good gets depleted over
time and is then unavailable.
d. The Solution – Make the good excludable:
i
Regulate use of the good.
ii
Tax people who want to use the good.
iii Privatize the good.
e. Important common resources:
i
Clean air and water.
ii
Fish & Wildlife
iii Congested roads.
9. Conclusion: The Importance of Property Rights
23
a. The real underlying problem with public goods and common resources are that
property rights do not exist. Non-excludability implies that property rights do not
exist.
b. “Property rights of individuals over assets consist of the rights, or the powers, to
consume, obtain income from, and alienate these assets.” [Barzel, 1989, p. 2]
Chapter 13: The Costs of Production
1. Introduction
a. This chapter we will present the theory of the firm
b. We will use the following two chapters to explain what happens in competitive
and monopolistic markets.
2. Opportunity Costs vs. Accounting Costs (Understanding Costs)
a. In this class, costs will refer to opportunity costs, not accounting costs.
b. Opportunity Costs (what is given up) = Explicit Costs + Implicit Costs
i
Implicit costs do not involve a cash outlay.
ii
Examples of implicit costs:
1. The foregone interest from owned machinery (see Cost of Capital, below).
2. The foregone wage of the firm’s owner.
c. The Cost of Capital as an Opportunity Cost
1. Opportunity cost of owned capital = r, where r is the foregone interest in
the period the capital is used. That is, it is the interest that could have
been earned if the capital (machine/tool) was sold off and the money
deposited into a savings account.
a. Note that we assume the firm can sell the machine at the end of period.
d. Accounting Costs
i
Accounting costs are exclusively explicit costs.
3. Economic Profit vs. Accounting Profit
a. In this class, profits will refer to economic profits, not accounting profits.
b. Profit = Total Revenue – Total Cost
c. Accounting Profit = Total Revenue – Accounting Costs
i
= Total Revenue – Explicit Costs
d. Economic Profit = Total Revenue – Opportunity Costs
i
= Total Revenue – Explicit Costs – Implicit Costs
e. Implications & Advantages of using Economic Profit
i
Economic profit is the amount an owner of a firm is making compared to the
next best alternative.
ii
Assume the following: total revenue is 70,000, material costs are 20,000,
foregone earnings are 40,000, value of an owned machine is $100,000, saving
account interest is 10%.
1. Econ Profit = 70,000 – 20,000 – (40,000 – 10,000)
iii If economic profit > 0, then stay in (or go into) the business.
iv
If economic profit < 0, then get out of (or don’t go into) the business.
v
If economic profit = 0, then the firm owner is indifferent between staying in
business and doing the next best alternative.
4. The Production Function
a. Assumptions of the model
24
Firms use only capital (“the factory”) and workers as inputs to produce goods.
In the short run, we assume that capital (the size of the factory) is fixed and
output can only be adjusted by varying the number of workers.
b. Definition
i
The production function describes the “relationship between the quantity of
inputs (workers) and the quantity of output.”
ii
See Table 1 and Figure 2.
c. Marginal Product (of labor)
i
Marginal (additional) product (output of) labor (another worker)
ii
The change in output when a firm adds one more worker.
iii The slope of the production function.
d. Diminishing Marginal Product (MP)
i
When MP decreases as more workers are hired.
ii
Equivalently, when the production function gets flatter.
iii Diminishing marginal product is caused by, among other things, workers
running out of things to do. (Remember, this is the short run when capital is
fixed.)
5. The Total Cost curve
a. Assumptions of the model
i
Same as for the production function.
b. Definition
i
The total cost curve describes the relationship between the quantity of output
and the total cost.
ii
See Table 1 and Figure 2.
6. The relationship between the Total Cost curve and the Production Function.
a. The production function implies the TC Curve
i
See Table 1: the TC curve can be calculated from the production function.
ii
See Figure 2: If the TP curve is getting steeper, the TC curve is getting flatter,
and vica versa.
1. Intuition: If workers are getting less productive (diminishing MP), you
have to hire more workers to get the same increase in output, so marginal
costs are increasing.
7. The Various Measures Of Cost
a. See Table 2.
b. Fixed Costs (FC)
i
Definition: costs of inputs that “do not vary with the quantity of output
produced. [Fixed costs] are incurred even if the firm produces nothing at all.”
ii
In our simplified model, fixed costs are capital costs, i.e., the cost of “the
factory.”
c. Variable Costs (VC)
i
Definition: costs of inputs that “change as the firm alters the quantity of
output produced.”
ii
In our simplified model, variable costs are worker costs.
d. Total Costs (TC)
i
Total Cost = Fixed Cost + Variable Cost
1. TC(Q) = FC(Q) + VC(Q)
i
ii
25
e. Average Fixed Cost (AFC)
i
AFC = FC / Q
f. Average Variable Cost
i
AVC = VC / Q
g. Average Total Cost
i
ATC= TC / Q
ii
ATC = AFC + AVC
h. Marginal Cost
i
MC = ΔTC / ΔQ
ii
“Marginal cost tells us the increase in total cost that arises from producing an
additional unit of output.”
8. Typical Cost Curves
a. See Figure 5.
9. The Shapes of Cost curves
a. Falling Average Fixed Cost
i
The numerator is fixed and the denominator is increasing.
b. Rising Marginal Cost
i
The marginal cost is the cost of making a particular unit of production, not
counting the fixed costs. For example, the cost of making the first shirt (at a
shirt factory), the second shirt, etc.
ii
This reflects diminishing marginal product.
c. Relationship between Average Variable Cost and Marginal Cost.
i
Whenever MC is less than AVC, AVC is falling. Whenever MC is greater
than AVC, AVC is rising.
ii
The MC curve crosses the AVC curve at its minimum.
iii Remember, the MC is the cost of making a particular unit of production. It
turns out that the VC is the sum of the MC. Therefore, the AVC is just the
average of the MC.
iv
Analogy: AVC “is like your cumulative GPA. MC is like the grade in the
next course you will take.”
1. Falling portion of curve: MC (new course grade) dragging ATC
(cumulative GPA) down.
2. Rising portion of curve: MC (new course grade) pulling ATC (cumulative
GPA) up.
d. U –Shaped Average Total Cost
i
Implied by the relationship between the AVC and MC.
ii
Efficient scale: the bottom of the ATC curve. It is the quantity that
minimizes average total cost.
10. Long Run Costs
a. Assumptions
i
Again, firms use only capital (“the factory”) and workers
ii
In the long run, we no longer assume that capital is fixed. Instead we assume
output can be adjusted by varying either capital or the number of workers.
b. Definition: The long run cost curves display the minimum cost combination of
capital and workers necessary to produce each level of output when both capital
and labor can be adjusted.
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c. See Figure 6.
d. Economies of Scale: when ATC declines as output expands. Alternatively, when
TC less than doubles as output doubles.
i
Potential Cause: specialization
e. Diseconomies of Scale: when ATC increases as output expands. Alternatively,
when TC more than doubles as output doubles.
i
Potential Cause: coordination problems
f. Constant Returns to Scale: when ATC remains constant as output expands.
Alternatively, when TC doubles as output doubles.
g. The Relationship between Short-Run and Long-Run Average Total Cost.
i
Each different level of capital has a different short-run cost curve.
ii
The lower bound of the collective SR ATC curves traces out the LR ATC
curve.
Chapter 14: Firms in Competitive Markets
1. Introduction
a. We will utilize our theory of the firm presented in Chapter 13 to reveal the
following:
i
How a firm in a competitive market will determine how much to produce.
ii
The effects of changes in market demand in both the short run and the long
run in a competitive market.
2. What is a Competitive Market
a. A competitive market typically has three characteristics.
i
“There are many buyers and many sellers in the market.”
1. Implies that no entity in the market has any “market power.”
ii
“The goods offered by the various sellers are largely the same.”
1. Implies that a firm cannot raise its price above that of its competitors
without losing all its sales.
iii
“Firms can freely enter or exit the market.”
1. Implies that long run economic profits are zero in the industry.
iv
Price takers: “… sellers in competitive markets must accept the price the
market determines and, therefore, are said to be price takers.”
b. Marginal Revenue in a Competitive Market
i
Total Revenue (TR)
1. TR = P x Q
ii
Marginal Revenue (MR)
1. Definition: the change in the total revenue of a firm resulting from a one
unit increase in the number of goods sold.
2. MR = P, for a firm in a competitive market.
3. Profit Maximization And The Competitive Firm’s Supply Curve
a. Marginal-Cost Curve and the Firm’s Supply Decision
i
“If marginal revenue is greater than marginal cost, the firm should increase its
output.”
ii
“At the profit-maximizing level of output, marginal revenue and marginal
cost are exactly equal.”
1. The firm supply will be at the point where P = MC.
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2. See Figure 1 and Figure 2
b. Measuring Profit in Our Graph for the Competitive Firm
i
See Figure 5
1. Profit = TR – TC
2. Profit = (TR/Q – TC/Q) x Q
3. Profit = (P – ATC) x Q
c. Why Do Competitive Firms Stay in Business If They Make Zero Profit?
i
Zero profit implies that the firm’s owner is making as much in business as in
the next best alternative.
d. Spilt Milk & Other Sunk Costs
i
Sunk cost: “Economists say that a cost is a sunk cost when it has already been
committed and cannot be recovered.”
ii
The firms fixed costs are sunk: “We assume that the firm cannot recover its
fixed [capital] costs by temporarily stopping production” because it has signed
a contract which obligates it to pay for the capital.
e. The Firm’s Short-Run Decision to Shut Down
i
Shutdown: “a short-run decision not to produce anything during a specific
period of time because of current market conditions.”
ii
Because fixed costs are sunk, a firm does not consider fixed costs in its
decision to continue operating. Thus, “the firm shuts down if the revenue that
it would get from producing is less than its variable costs of production.”
1. Shut down if:
TR < VC
2. Shut down if: TR/Q < VC/Q
3. Shut down if:
P < AVC
iii That is, in the short run, a firm will shut-down (stop producing) if the
price is below the minimum of the AVC curve.
1. When this happens, “the firm will be losing money (since it still has to pay
fixed costs), but it would lose even more money staying open” because it
must pay its fixed costs.
2. When the price is above the minimum of the AVC curve, the loss of the
firm is smaller than the fixed costs it must pay if it shuts down, so the firm
will continue to operate.
3. When the price is below the minimum of the AVC curve, the loss of the
firm is greater than the fixed costs it must pay if it exist the market, so the
firm will shutdown.
iv
“The competitive firm’s short-run supply curve is the portion of its
marginal-cost curve that lies above average variable cost.”
1. Figure 3
f. The Firm’s Long-Run Decision to Exit or Enter a Market
i
Exit: “a long-run decision to leave the market.”
ii
In the long run the firm’s fixed costs are no longer sunk. The reason is that
the contract term on the capital costs has expired. Thus the firm will exit the
market if it making negative profits, as it would rather make zero than make a
negative amount.
iii In the long run, fixed costs are no longer sunk, therefore they are considered
in the decision whether to stay continue operating. Thus, “the firm exits the
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market if the revenue it would get from producing is less than its total costs
[fixed costs plus variable costs].”
1. Exit if:
TR < TC
2. Exit if:
TR/Q < TC/Q
3. Exit if:
P < ATC
4. Enter if:
P > ATC
iv
That is, in the long run, a firm will exit the market (stop producing) if the
price is below the minimum of the ATC curve.
1. When the price is above the minimum of the ATC curve, the firm’s profits
are above zero (its profits if it stops producing), and the firm will continue
to operate.
2. When the price is below the minimum of the ATC curve, the firm’s profits
are below zero (its profits if it stops producing), and the firm will exit the
market.
v
“The competitive firm’s long-run supply curve is the portion of its
marginal-cost curve that lies above average total cost.”
1. Figure 4
4. The Short Run Supply Curve in a Competitive Market
a. The market supply curve is simply the sum of the supply curves of the individual
firms which are in the industry.
b. Why Do Competitive Firms Stay in Business If They Make Zero Profit?
i
Zero profit implies that the firm’s owner is making as much in business as in
the next best alternative.
5. A Shift In Demand in the Short Run and Long Run
a. Assume all firms are identical
b. Figure 8: Consider two graphs
i
Graph 1: Market Demand & Supply
ii
Graph 2: Representative firm cost curves (ATC & MC). The representative
firm is a firm whose cost curves look like all other firms. Its curve shapes
“represent” the cost curves of all other firms in the industry.
c. Figure 8, Panel a: Start at a situation where economic profits are zero, that
is, where the market price is at the minimum point on the ATC curve.
i
You will understand why this is where we start when you see that this is
where we end.
d. Figure 8, panel b: Outline of events in the Short Run:
i
Demand shifts out 
ii
Increase in price 
iii Profits > 0 in short run 
1. When P >= Min ATC, economic profit is above zero.
iv
Summary: In the Short Run, firms in the industry earn above zero economic
profits.
e. Figure 8 panel c: Outline of events in the Long Run
i
Firms enter the industry 
ii
Supply shifts out 
1. Figure 6.
iii Price declines (as firms enter) until price is at Min ATC 
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1. So long as P is above Min ATC, profits will be above zero, and entry will
continue to occur.
iv
Entry stops since economic profit are now zero.
v
Note: This is why we started from at a price that implied zero economic profit.
vi
Summary: New firms enter into the industry economic profit returns to zero.
6. The Long Run Supply Curve in a Competitive Market
a. The long run supply is a horizontal line at the price which is at the minimum of
the ATC curve.
b. Why the Long-Run Supply Curve Might Slope Upward
i
“Some resource used in production may be available on in limited quantities.”
ii
“Firms may have different costs.”
Chapter 15 – Monopoly







Definition of a Monopoly
o A firm can raise its price without losing all its customers (firm is a price maker).
 Implies the firm has a downward sloping demand curve.
Why Monopolies Arise
o A key resource owned by a single firm
 One example is a natural resource
 Another example is a human resource (a person or group of people) that
allows a firm to make a superior product)
o Government
 Patents
 Copyrights
o Natural Monopolies (Figure 1)
 When ATC curve continually declines.
Margin Revenue for a monopolist (Figure 3)
o Intersects the Price axis at the same point as the demand curve.
o Twice as steep as the demand curve.
The optimal P* and Q* for a monopolist (Figure 4)
o Just as for a competitive firm, the profits will be maximized where MR = MC.
 First determine the Q* where MR = MC.
 Then determine the P* which results in a demand of Q*.
 That is, on the graph go straight up from Q* (point where MR = MC) until
you reach the demand curve and stop. Then you are at the monopolist’s
optimal price.
Profit for a monopolist (Figure 5)
o (P – ATC) x Q
 The relevant P is the monopolist’s price (described immediately above).
 The relevant Q is the Q* where MR = MC.
 The relevant ATC is the ATC* at Q*
Deadweight loss of monopoly (Figure 8)
o Very similar to the deadweight loss of a tax – think of the firm’s MC curve as the
supply curve and the distance between the marginal cost and the demand curve at
the optimum Q* as the size of the tax.
Public Policy
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
Price Discrimination (Figure 10)
o Price discrimination occurs when a monopolist knows each customer’s
willingness to pay and can charge each customer a different price.
o Under these conditions a monopolist will charge each customer the customer’s
willingness to pay.
o The optimal quantity for a monopolist is now at the point where the MC curve
and the Demand curve intersect.
o Deadweight loss is eliminated.
o Monopolist captures all consumer surplus.
Note: It has been a pleasure teaching you all this quarter. I look forward to seeing
you on campus and hopefully in some of my classes. Good luck here and in your
careers and don’t hesitate to stop by if you ever want some advice or want to talk
about anything. Enjoy your break.
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