Microeconomics 201 Final Exam

1. Unlimited wants
2. Limited resources
-Land, example: "raw stuff", raw materials
-Labor, example: skills + talents of people
-Captial, example: non-human things used to produce outputs.
-entrepreneurial ability, example: managers + inventors, innovators

• Unlimited wants, limited resources → scarcity → choice
Formal definition: economics examines how people choose to use their scarce resources in an attempt to satisfy their unlimited wants.

Scarcity: the shortness of supply, shortage
Choice: 1-what to produce? 2- How to produce? 3- who gets the output?

Definition: a model explains a complex, real world event by focusing on just a few important elements of the event.

A good model strikes a "creative balance" between two competing factors:
1. Realism: contains enough detail to illuminate reality
2. Workability: remains simple enough to work with/understand

A model can be used in two different ways:
1.Helps think through/ conceptualize an issue
2.Makes predictions about actual events.

Definition: of all else equal, the higher the price of a well-defined good or service, the lower the quantity demanded, and vice versa.

1. PC-
2.PS+
3.B+
4.E + or -
5. EXP+
6. PRE+

1. PC-: price, quantity and availability of complement goods (inverse negative relationship).
2. PS+: prices, quality and availability of substitute goods.
3. B+: buyer demographics
4. E + or -: earnings (income) of buyers.
5.EXP+: expectations of future prices for the good.
6. PRE+: preferences for the good.
----
7. P-: price of the good itself- does NOT shift the curve, just slides along

Demand Curve: a price-quantity schedule which shows the quantity demanded of a well defined good or service at each possible price, for a given period of time, all else equal.

Definition: of all else equal, the higher the price of a well-defined good or service, the higher (generally) the quantity supplied, and vise versa.

Supply Curve: a price- quantity schedule which shows the quantity supplied of a well- defined good or service at each possible price, for a given period of time, all else equal.

Supply Shift Factors
1. PAG-
2.PRR-
3.S+
4. EXP + or -
5. T+

1. PAG-: prices of alternative goods
2. PRR-: price, quantity and availability of relevant resources.
3. S+: seller numbers and capacity (including importing firms)
4. EXP + or -: expectations for future prices of the good. "-" is short run expectation, "+" is long run expectation.
5. T+: Technology.
--
6. P-: price of the good itself does NOT shift the curve, just slides along.

Three Pitfalls in Economic Thinking
1. Association is Causation Fallacy
2.Fallacy of Composition
3. Ignoring the Secondary Effects

1. Association is Causation Fallacy:
• Factor A is aossicated (correlated) with factor B → Factor A is causing Factor B.

Alternative possibilities:
1. Factors A and B are associated, but Factor B is causing Factor A.
2. Factors A and B are associated, but only by chance.
3. Factor A may be casually linked to Factor B, but another factor (say Factor C) may have a stronger impact.

Possible example:
Highway speed (Factor A) → Highway safety (Factor B)

2. Fallacy of Composition:
• What is true for part is automatically true for a whole.

Example:
United Airlines cuts their ticket prices alone, and experiences a large increase in sales → if all airlines cut their prices, then all would experience large sales increases.

3.Ignoring the Secondary Effects:
• Those effects which develop slowly over time, but not obvious at first.

Possible example:
Immediate effect of DDT: increased crop yields.
Secondary effect: DDT also damages ecosystems (kills top predators) and insects but also builds a resistance to it.

Normative vs. Positive Economics
Positive Statements: stating "what is" facts.
Normative Statements: stating "what ought to be" opinions.

Basic difficulty: sometimes "facts" and "opinions" get mixed up.

Example that demonstrates this difficulty:
The minimum wage controversy-
Traditional democrats: like minimum wage
Traditional republicans: dislike minimum wage

Issue: does minimum wage generate unemployment?

Rational Self-Interest
Definition: people generally act to further their own well being and they do so in a logical manner.

• Rational does not mean you're perfect; you can still make wrong decisions.
• Self-interest can include the welfare of others.

The Two General Ways of Providing Incentives
1. The "carrot" approach
2. The "stick" approach

1. The "carrot" approach": increase the benefits from doing the activity.
2. The "stick" approach: increase the costs from not doing the activity.

• Incentives do not necessarily have to be in the form of money.

Production Possibilities Frontier
"Be all that you can be curve"
• Below the curve: not producing efficiently
• On the curve: producing efficiently

1. What to produce?
2. How to produce?
3. Who gets the output?

MC= marginal costs
MB= marginal benefits

Shifting the Production Possibilities Frontier
1. Increase/Decrease in Resources
• More land, labor, capital, entrepreneurial ability→ greater production capability → PPF shifts outward

2. Increase/ Decrease in Technology
• More technology → greater production capability→ PPF shifts outward

Technology: our pool of knowledge about the industrial arts

Optimization
Definition: making a well-defined measure the best that it can be, most often this means making something as big as possible.

Social optimization: what would make the world a better place?

Private optimization: where firms maximize profits and consumers maximize satisfaction.

Equilibration: quantity demanded= quantity supplied

Opportunity Cost
Definition: the benefit generated by the best alternative forgone when an action is taken.

The Law of Increasing Opportunity Costs
Definition: in the short run, as more of a good is produced, the marginal opportunity cost rises.

Example: Tongass National Forrest

Specialization
Definition: specialization occurs when a person concentrates on performing a single task (or else a few related tasks)

Advantages:
1. Allows people to perform only those tasks, which they are good at → increases productivity
2. Continuously producing the same good allows people to get better.
3. Less time wasted in switching from one task to another.
4. Allowing people to specialize in turn allows firms to use more sophisticated/ efficient machines.

Disadvantage:
1. Too much specialization can cause worker boredom, frustration → efficiency then declines; don't overdo it.

Economic Systems
Basic Definition: a collection of institutions/ organizational arrangements, which answer the three basic questions for an entire economy: what to produce? How to produce? Who gets the output?

Two Basic Attributes used to define economic systems:
1. Ownership of non-human (land and capital) resources: private vs. government
2. Economic coordinating mechanism: prices vs. government

Market Equilibration with Supply/Demand: Surplus vs. Shortage
Assume: large # of buyers and sellers

Surplus: quantity supplied > quantity demanded
• Pressure is to lower price

Equilibrium: quantity supplied = quantity demanded

Assumptions Underlying Supply/ Demand Analysis
• Large # of sellers (mostly small)
• Large # of buyers (mostly small)
• Good information on prices across both buyers and sellers
• Relatively easy to enter and exit the market
• Relatively homogeneous product in terms of type, size, quality, etc.

When these assumptions are satisfied, we have a "competitive" market: supply/demand analysis is valid.

Attaining Market Equilibrium
Assume: large # of both buyers and sellers

Surplus: quantity supplied exceeds quantity demanded; pressure is to LOWER price.

Shortage: quantity demanded exceeds quantity supplied; pressure is to RAISE price.

Equilibrium: quantity demanded = quantity supplied; the actions of the two groups are "harmonized."

Derived Demand
Definition: the demand for a resource; derived from the demand for product(s) produced by the resource.

Example:
The demand for newsprint- a type of paper use to produce newspapers: it is derived in part from the demand for newspapers; the demand for electricians is derived in part from the demand for housing.

If the demand for newspapers : feeds back and pulls up the demand for all the resources used to produce newspapers such as newsprint, all else equal.

If the demand for newspapers : feeds back and reduces the demand for all the resources used to produce newspapers such as newsprint, all else equal.

Introduction to the Concept of Elasticity
The concept of Elasticity: a quantitative measure of response; a response more detailed version of the law of demand.

Price elasticity of demand tells you: price goes up by xx→ quantity demanded goes down by xx, all else equal.

Mental Images of Elasticity
Think of a rubber band:
• If it stretches easily, it's flexible; responsive to pulling; it's elastic.
• If it is hard to stretch, its inflexible, unresponsive to pulling, its inelastic.

Firm Demand: all else equal, shows the quantity demanded by consumers at various prices for a single firm, which sells well-defined product.

Market Demand: all else equal, shows the quantity demanded by consumers at various prices for all firms, which sell a well-defined product.

Firm demand tells you:
• Firm sales at a given price, and in turn:
• Total revenues at a given price, which in turn:
• Is an important determinant of profit:
• Total revenues- total costs = profit

Firm Demand: all else equal, shows the quantity demanded by consumers at various prices for a single firm, which sells well-defined product.

Market Demand: all else equal, shows the quantity demanded by consumers at various prices for all firms, which sell a well-defined product.

Overall definition: the price elasticity of demand is ratio. The bottom of the ratio is the initial % change in price; the top is the resulting % change in quantity demanded (the response of consumers to the initial price change)

The ratio tells you which % change (price or quantity demanded) is bigger → in turn tells you the extent to which consumers are "price responsive". That is:

R > IC → Ratio > 1 (top of ratio is bigger than the bottom) → consumers are price responsive; their change in quantity demanded exceeds the initial % change in price.

IC > R → Ratio < 1 (top of ratio is smaller than the bottom) → consumers are price unresponsive; their change in quantity demanded is smaller than the initial % change in price.

IC = R → Ratio = 1 (top of ratio is equivalent to the bottom) → unitary elasticity

The bigger the ratio → consumers are more price responsive.

The smaller the ratio → consumers are less price responsive.

Factors Affecting Consumer Responsiveness to Price Changes
1. Price, quality and availability of substitutes:
• Lower price/ higher quality/ greater availability → more likely price elastic
• Higher price/ lower quality/ lesser availability → more likely price inelastic

2. Proportion of consumer's budget spend on the good:
• Higher the proportion→ elastic
• Lower the proportion → inelastic

3. The time consumers have to respond to a price change:
• More time to respond → elastic
• Less time to respond → inelastic

4. Whether the good is a luxury or a necessity:
• Luxury → elastic
• Necessity → inelastic

Total Utility: the subjective satisfaction derived from consuming a particular good or service. It cannot be rated numerically and hence cannot be compared across individuals.

Marginal Utility: the change in the total utility derived from consuming one more unit of a particular good or service.

Law of Diminishing Marginal Utility: the more you consume of a good or service per time period, the smaller the marginal utility or the last unit consumed, all else equal.

Marginal Physical Product (MPP) of an Input: the amount of additional output generated by adding one or more unit of a particular input, holding constant the use levels of the other inputs.

Law of Diminishing Marginal Returns: as more and more of a variable input is added to a given amount of a fixed input, the resulting MPP eventually begins to decline.

Explicit Costs: actual cash payments for equipment, wages, rent, insurance, etc.
• "paper trail" - paying out cash, writing a check, etc.

Implicit Costs: no cash transaction, but you are using resources anyway.
• There is no obvious transaction with these costs, and so they are hard to see, but they are costs nevertheless, such as income forgone when you decide not to take a job, interest forgone when a person invests their own money in a business instead of putting it in a bank.

Example: time business owners spend on businesses. Sometimes invested funds.

Basic Cost, Revenue and Profit Terminology
Firms attempt to maximize profits: total revenues (TR)- total costs (TC)
TR= total revenues
TC= total costs
TEC= total explicit costs
TIC= total implicit costs

Accounting Profit: TR- explicit costs; implicit costs ignored

Economic Profit: TR-TC (explicit + implicit)

"Normal" Profit: the accounting profit which exists when the firm just breaks even, e.g., when economic profits are zero.

Economic (True) Profit = TR- TEC -TIC = TR - TC

Accounting Profit = TR- TEC; accounting sometimes have a hard time recording TIC, because there is no obvious transaction.

Hence accounting profit overstates economic (true) profit by TIC; it misses the implicit costs.

So, "Normal" profit is a particular kind of accounting profit; it's the accounting profit that, when adjusted for TIC, equals zero. When accounting profits = normal, economic (true) profits are simultaneously zero.
That is: normal profit- TIC = 0.
It follows that: normal profit = TIC.

Inputs: resources you use to produce output

Variable Input: relatively easy to increase/decrease amount used.

Variable Cost: increases as output increases.

Fixed inputs: difficult to adjust amount used.

Fixed costs: costs which are independent of output; which still exist even when output falls to zero.
Total cost = total fixed cost + total variable cost.

Short Run vs. Long Run

Short Run: at least one important variable is fixed.

Long Run: all resources are variable.

Short run in housing market: 12- 18 months.

Long run in housing market: greater than 12-18 months; enough to build new units.

An Overview of Firm- Decision- Making: The Three Basic Questions Asked by Business Firms

Assume: goal of the firm is to maximize profits, "price taker"

3 Questions:
1. How much output (signified by Q*) should the firm produce to maximize profits?
Answer: produce up to where, for the last unit, MR ≥ MC → Q* (play marginalism)

2. At optimal output (Q*), what are firm profits?
Answer: TR (AR x Q) - TC (ATC x Q) = Profits (+, 0 or -)

3. If profits are negative at Q*, should the firm shut down?
Answer: losses > fixed (shutdown) costs → shutdown; set Q = 0.
Losses < fixed (shutdown) costs → stay at Q*
^ this is known as the shutdown rule

Basic Cost/ Revenue Definitions

Marginal Cost (MC)= the change in total costs due to producing one more unit of output.
Marginal Revenue (MR): the change in total revenues due to selling one more unit of output.
Average Total Cost (ATC): total costs ÷ quantity
Average Revenue (AR): total revenue ÷ quantity = price (= firm demand curve)
Total Cost (TC): ATC x Q (= total fixed cost + total variable cost)
Total Revenue (TR): AR x Q
Total Fixed Cost (TFC): or shutdown cost, what the firm still has to pay out if Q=0.

• MC, ATC are derived from TC
• MR, AR (price) are derived from TR

MC, MR → helps answer: what to produce, e.g., what is Q*?
ATC, AR → helps answer: what are profits at Q*?

TFC → helps answer: if profits < 0 should the firm shut down?

Scale Economies: examine changes in long run average total costs (LRAC) as plant size (output) increases.

Two Forces of Production Determine Scale Economies:
1.Specialization: bigger size (output) means greater specialization among inputs (workers, machines) → specialization increases input productivity, lowers costs → LRAC falls as output increases.

2. Coordination and Control: bigger size (output) means greater difficulties in managing the plant → proper management reduces input productivity, raises costs, LRAC rises as output increases.

1.Economies of Scale
2.Constant Returns to Scale
3.Diseconomies of Scale.

Economies of Scale: gains from specialization, dominates coordination and control difficulties → on balance, LRAC falls as output increases.

Constant Returns to Scale: specialization gains and coordination and control difficulties exactly offset one another → on balance, LRAC remains unchanged as output increases.

Diseconomies of Scale: coordination and control difficulties dominate specialization gains → on balance, LRAC rises as output increases.

Market Power: the ability of a single firm, or a group of firms acting together, to influence price.

Monopoly: a great deal of market power (no close substitutes)

Oligopoly: some market power (some close substitutes)

Perfect Competition: no market power (a large number of substitutes, all exactly the same)

Perfect Competition: no market power (a large number of substitutes, all exactly the same)

Definition of Short Run: time period when # of firms is fixed.
• Too short of a time period for significant entry and exit to occur.

Short Run Equilibrium Conditions:
• Market Level: S= D
• Firm Level: MR=MC
• Firm Profits: Non-zero (+ or -)

Definition of Long Run: time period when # of firms is variable due to entry/exit dynamics.

Long Run Equilibrium Conditions:
• Market Level: S= D
• Firm Level: MR= MC
• Firm Profits: ZERO (system is at rest; no incentives for entry or exit) → key difference between short run and long run

• Price is as low as possible (consistent with firms breaking even) → benefits society at large.
• Costs are as low as possible (inefficient firms forced to exit) → benefits society at large.
• This is accomplished in the absence of the use of force (no government regulation) → enhances individual freedom → again benefits society at large (or so it is alleged).

Definition: when entire industry output is produced at lowest cost by a single firm.

Underlying Cause: economies of scale over relevant range of output.

Examples: local telephone service, water provision, cable TV.

1. A monopolist can change any price it wants to.
2. Monopolists always make positive profits.

Oligopoly: Firm Interdependence Plus Uncertainty
Interdependence: with so few firms, what one firm does affects the others.

Uncertainty: not sure what the other firm is going to do.

Factors That facilitate Collusion:
1. A Few, Large Firms: easier to make collusive agreements when number of participants is few.
2. High Entry Barriers: less competition from entrants, which keeps colluded price high.
3. Inelastic Market Demand: fewer sales lost due to price increase → probably higher profits from collusion.
4. Similar Product/Cost Structure Across Firms: easier to agree when firms are similar.
5. Low Rate of Technological Change: easier to agree product/production processes are stable.
6. Simple, Standard Product: easy to make agreements about simple, straightforward products.
7. Small, Inexperienced Buyers: easier to take advantage of.
8. Stable Demand: easier to agree with stable market.

Factors That Discourage Collusion
1. A Large Number of Small Firms: harder to agree
2. Low Entry Barriers: more competition from entrants, which pushes down price. The barriers facilitate more competitive pressures.
3. Elastic Market Demand: higher price greatly reduces sales → gains from collusion probably not as great.
4. Dissimilar (Heterogeneous) Product/Cost Structures Across Firms: harder to make collusive agreement when firms differ.
5. High Rate of Technological Change: harder to make collusive agreements when market constantly in flux.
6. Complex, Differentiated Product: harder to agree on complex products.
7. Large, Smart Buyers: harder to take advantage of.
8. Unstable Demand: harder to agree with market in flux.

1. Be better than all the other firms in the market→ expand market share (through external growth) dominate the market.
legal standing: generally okay.

2. Fixing prices with other firms.
Legal standing: illegal if done via phone calls, memos, meetings, etc.

3. Mergers, so as to expand market share and dominate the industry (external growth).
Legal standing: if market share expansion sufficiently large, then may be illegal.

Private vs. Public Interest Theory of Regulation
Public Interest: regulations designed to help society as a whole.

Private Interest: Government regulations designed to help a special interest group: may hurt society as a whole.

The Role of Government From a "Public Interest Theory" Perspective
1. Assistance in enforcing contracts (court system) and protecting private property (police protection) - establishing and enforcing the "rules of the game."
2. Combating Market Power:
• Antitrust Law: preventing price fixing or mergers which may reduce competitive pressures.
• Regulating "natural monopolies": public utility regulation of local phone companies, electric power.

See p. 327

3. Dealing with Externalities
Definition: an unpriced byproduct of producing a good that harms or benefits individuals who are not involved in buying/ selling the good.

Examples of negative externalities: water and air pollution, traffic congestion, and urban noise.

Examples of positive externalities: primary and secondary education, green space.
See p. 328

4. Providing for "Public Goods"
Definition: a good which is available to all (regardless of who pays for it or not) and which can be jointly consumed by a large group of people.

Examples of Public Goods: national defense, police and fire protection.
Why the market can't provide public goods: free rider problem. You can consume the good whether or not you pay for it.

Solution: via taxes, make everybody pay → no more free riders.

5. Providing the "proper" distribution of income. Too many poor people?
• Tax the rich and give to the poor. This function of government is highly controversial.
6.Promote full employment and price stability. Private markets may not generate these outcomes.
• Government, either through fiscal policy (taxing and spending) or monetary policy (regulation of the money supply), may be able to attain these goals.

Resource Markets: An Introduction

Optimal resource usage for the firm (marginalism once more):
MRP= MRC

Marginal Revenue Product (MRP): the marginal benefits from using the resource.
Marginal Resource Cost (MRC): the marginal costs of using the resource.

Where:
MRP= Poutput- marginal physical product
MRC= wage or salary

Output Market Factors (Demand "derived" from output market):
P, Pc, Ps, B, E, E, P
Resource Market Factors:

MPP increases⇒MRP increases⇒demand for resource increases ; opposite if MPP decreases

Price of substitute input increases⇒demand for resource increases; opposite if substitute price decreases

Price of complementary input increases⇒demand for resource decreases opposite if complementary price decreases.

Examples of substitute resources:
• Oil and coal (both can be used to produce electricity)
• Typesetters and computers (both can set type for newspapers)

Examples of Complementary Resources:
• Iron Ore and Coke (a type of coal used to produce steel)
• Lumber and Carpenters

P+, PAG-, PRR-, S+, E +or-, T+
P+= Price of Resource (wage or salary in labor markets)
PAG-= Earnings in Alternative Use (alternative occupation for labor)
PRR-= Price of Inputs Used to Produce Resource (tuition/ training cost)
S+=Number of Firms Providing Resource (number of possible workers in labor markets)
E +or-= Expectations of the Future Price (wage/salary; usually increases supply but not always)
T+= Technological Change Enhancing Availability of Resource (improved training facilities)

Non- Pecuniary Aspects of Labor Supply
Better working conditions → S increases
Poor working conditions → S decreases

Overall Importance:
• Approximately 10% of the US output is exported
• Many key products imported from abroad
- Approximately 30% of all cars sold
- Most titanium
- Diamonds
- Food stuff such as cocoa, bananas, coffee
- Large amounts of crude oil

Why Trade?
Basic Reason: international trade facilities specialization → increases world output

-Countries differ in their resource endowments; trade allows countries to specialize in producing those goods, which most readily match their resource endowment.

-US: lots of good agricultural land→ specializes in food production; lots of high skilled workers, technology → specializes in high technology goods (aircraft, computers)

-Countries differ in their preferences for goods; trade allows countries to trade goods they prefer less to obtain goods they prefer more.

Law of Comparative Advantage: countries specialize in producing goods in which they have either the greatest advantage or else the least disadvantage compared to other countries.

B- 80%
Midpoint Formula
10 + 15 = 25
25/2= 12.5
$5 decrease/ 12.5 = .40
.40 x 100 = 40%

2.0 = R/40%
R= 80%

quantity demanded will increase by 80%.

B- Inelastic Market Demand

A-when gains from specialization exceed coordination and control losses over the entire range of industry output.

C-Actual and perceived interdependence among firms.

C-$4.00
when output is 9, price is $5.00
9 x $5.00 = $45.00

when output is 10, price is $4.90
10 x $4.90 = $49.00

$49.00- $45.00 = $4.00

Marginal Revenue = $4.00

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