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ECO 201 Project Template Memo To: My Business Partner From: Date: October 24, 2021 Re: Microeconomics Simulations Introduction

This memorandum report identifies and explains key microeconomic principles using a set of simulation games. The outcome of these games illustrate how microeconomic principles can be applied within real-life situations to help us make better business decisions. This report is a summary of the simulations I played and their results, which include the key takeaways and their significance, for your review and reference. It is divided into the following sections: 1. Comparative Advantage 2. Competitive Markets and Externalities 3. Production, Entry, and Exit 4. Market Structures (including the Price Discrimination and Cournot simulations) 5. Conclusions 6. References

Comparative Advantage

Figure 1.1

Figure 1.2 Our book defines opportunity cost as "whatever must be given up to obtain some item;" therefore, to determine my opportunity cost, an individual would decide what they are giving up to produce each item. (Mankiw, 2021) In the simulation, the opportunity cost of one burger was two fries, while the cost of one fry was half a burger. By deciding which item was produced with the lowest opportunity cost, in this case, fries, and trading that for the product that had a higher opportunity cost, the burger, I increased my output by fourteen combos. An efficient way to determine opportunity cost is by using a production possibility frontier (PPF). A (PPF) graph shows what can be produced with the given supplies. It divulges which combinations are efficient and which are inefficient. According to the Khan Academy's article, "the slope of the PPF indicates the opportunity cost of producing one good versus the other good." (Khan Academy, n.d.) The PPF is beneficial because it gives the business an overall picture of productivity, advising on which product to make more or less of to reach optimal efficiency.

Comparative advantage is described in our book as "the ability to produce a good at a lower opportunity cost than another producer." (Mankiw, 2021) This type of advantage impacts the decision to engage in trade by revealing that the business can specialize in one item, producing it at a lower cost and possibly higher quality due to the increased focus. With trade, the company can offer both products at a lower cost by specializing in one production while another business specializes in the other. Since the PPF slope displays the opportunity costs, companies can quickly acknowledge comparative advantage. Engaging in trade will have an impact on the firm's PPF. Without trade, the combinations will only fall on or within the PPF, displaying efficiency or inefficiency. Once a trade is introduced, the company can now show points outside of its original PPF because the production is reaching limits that were not previously possible. Use the burger and fries’ simulation as an example. Without trade, the most efficient production possible was four burgers per minute and eight fries per minute. With trade, it was possible to contribute six burgers per minute and six fries per minute. This combination was previously beyond the scope of the PPF. By trading fries for burgers, ninety-four combos were produced, while without trade, the maximum possibility was eighty combos.

Competitive Markets and Externalities

Figure 2.1

\ Figure 2.2

Figure 2.3 Supply and demand equilibrium for a product is when the price and quantity of a good align. Ideally, there is no surplus nor shortage of the good. The equilibrium price is when the price equals the cost of the good. If the producer set the price below the cost of the good, they suffer a loss. However, if the producer sets the price above cost and consumers feel they are paying an unfair price for a good, they may petition the government for policy intervention. These interventions include price ceilings, price floors, and taxes. Policy interventions can have many impacts on this equilibrium, depending on the scenario. The price ceiling intervention would create "a legal maximum on the price at which a good can be sold." (Mankiw, 2021) When the equilibrium is below the price ceiling, it would be considered a non-binding and would not affect the market's ability to reach equilibrium. The impact is positive and prevents price gouging. However, if the price ceiling were to fall below equilibrium, it would now be

considered binding and legally prevent the market from reaching equilibrium. This impact would be harmful, resulting in a shortage of goods and forcing suppliers to ration. The government may also issue a price floor which sets “a legal minimum on the price at which a good can be sold.” [ CITATION Man21 \l 1033 ] This intervention has a positive impact as long as equilibrium remains above the price floor. If the price floor were set above equilibrium, the result would be a surplus since the supply would far outweigh the demand. Policy interventions can also be used to offset society’s cost rather than producer cost or consumer price. This is displayed in the simulation as the permit buyers must obtain before purchasing a robot dog. The purpose is to allow people to purchase the dogs for their benefit, the security, while of also trying to balance society’s cost, the public nuisance of the dogs barking. The positive side of this intervention is it decreased the total nuisance per person. However, the negative side is it increased the buyers overall cost paid to own a robot dog, ultimately decreasing the demand for robot dogs. The determinants of price elasticity of demand are the availability of close substitutes, if the product is a necessity or luxury, how the market is defined, and the duration of the time horizon. (Mankiw, 2021) Items with close substitutes have a more elasticity because consumers can easily pick another item if their preferred item is priced too high, such as milk, almond milk, low fat, and full fat. Whereas items with an inelasticity, such as eggs, consumers will pay whatever price demanded because there are no close substitutes. In the instance of necessity or luxury, the book makes an important note that "whether a good is a necessity or a luxury depends not on the good's intrinsic properties but on the buyer's preferences." (Mankiw, 2021) Necessities have an inelastic demand, because regardless of price, consumers will pay for it, such as lifesaving medications. Luxuries, such as swimming pools, have an elastic demand where the price will affect the demand, because if the item is too expensive, consumers simply won’t purchase it, dropping the demand. Another factor is how the market is defined. If the market is a broad category, such as fruit, the demand is considered inelastic because there are no comparable substitutes for fruit, so price changes will not affect the demand. However, if the market is more specific, such as tropical fruit, the demand is more elastic because there are other types to consider. Based on the determinants, we can see if an item

has an elastic demand the price effects the demand; however, if the item has an inelastic demand, the price does not have a significant effect on the demand. It is also important to note that with an elastic demand, while an increase in price may drop the demand, the revenue made from the price increase can exceed the revenue lost from the decrease in demand. In some cases, the product can have perfect elasticity, as seen on the oranges from the simulation. Because the oranges were perfectly elastic, even the slightest increase in price led to a significant drop in demand therefore, a decrease or even loss in revenue for the firm. When policy market interventions, such as a price ceiling, price floor or a tax, are utilized properly, the result can be consumer and producer surplus. When placed appropriately, the price ceiling is above equilibrium, the result can be consumer surplus because they are paying less than what they’re willing to pay. In the price floor, if the equilibrium remains above the floor, the result can be producer surplus because they are able to charge over their cost to produce the item. Consumer and producer surplus with taxes depends on who the responsibility to pay the tax falls on. If producers are meant to pay the tax, the result could be consumer surplus, however, if producers raise their prices to make up for the tax, consumers may not be willing to pay the price. If the consumer is meant to pay the tax, they may not be willing to pay the price, resulting in no producer or consumer surplus. Overall, with taxes, one party is paying more than they are receiving, discouraging market activity.

Production, Entry, and Exit

Figure 3.1

When entering the market, a firm’s goal is to maximize profit. A business owner would need to determine what quantity to produce that would result in the highest profit possible to accomplish this goal. The owner should enter the market when the firm will be profitable, which is when the “price of the good exceeds the average total cost of production.” [ CITATION Man21 \l 1033 ] In the simulation, the driver needed to pay a fee whenever they decide to drive. This fee is the drivers average total cost to drive. They also needed to estimate how many other drivers would be driving at the same time. When more drivers are involved, the revenue per hour decreases, because there are more drivers to accept jobs. If there are

several drivers, the driver should exit the market (not drive) because the profit would be less than the average total cost of driving. When there are not as many drivers, the revenue per hour goes up, the driver should enter the market because the profit will be more than their average total cost to drive. Marginal cost (MC) is “the increase in total cost that arises from an extra unit of production.” [ CITATION Man21 \l 1033 ] When an owner uses this concept to decide how much to produce, they need to determine how much it will cost them to produce one more unit. They also need to determine how much they will make from producing one more unit, or their marginal revenue (MR). When the companies MR equals their MC, they will have reached a profit-maximizing level. If the MR is less than their MC, they need to decrease the unit produced and if their MR is greater than their MC, they need to increase the number of units produced. In the simulation, the driver considered how much they could make in each hour. Once the cost of driving an extra hour equaled how much more they could make; they realized their maximum driving hours. If they were to drive one more hour over that, the cost of that hour would outweigh what they could make. Fixed costs are the costs a company incurs regardless of its production. (Mankiw, 2021) While fixed costs are constant, the items listed as fixed costs can change. Businesses typically have less to work within the short run, so more items are listed as fixed costs. The average total cost (ATC) is affected more drastically, as well. However, as a company grows, it can expand and grow, changing some fixed costs into variable costs. Meanwhile, the ATC is stretched out over a more extended period, so small changes do not affect the ATC as dramatically. (Mankiw, 2021)

Market Structures Market Structure Perfect Competition Monopolistic Competition

Number of Firms

Type of Product Sold

Price Taker?

Price Formula

Freedom of Entry?

Short-run Profit?

Longrun Profit?

Industry Examples

Agriculture, Beef, Fish , Movies, Restaurants

Market Structure

Number of Firms

Type of Product Sold

Price Taker?

Price Formula

Freedom of Entry?

Short-run Profit?

Longrun Profit?

Industry Examples

oft, Tap water companies, Cable TV s, Cigarettes, Cars,

Monopolies Oligopolies Table 4.1

One reason for market inefficiency in a monopoly is "because a monopoly is the sole producer in its market, its demand curve is simply the market demand curve." (Mankiw, 2021) If a monopolist wants to raise the price of their product, consumers will purchase less, which restricts the monopoly's profitability. Another inefficiency is "in monopolized markets, price exceeds marginal cost." (Mankiw, 2021) This is inefficient for the market because for the profit to be pleasing to the supplier, the price of the good is unfavorable to the consumer and vice versa. Therefore, the market is not favorable as a whole. These inefficiencies of a monopoly are measured with a deadweight loss triangle. The area of the deadweight loss triangle is equivalent to the total surplus lost because of monopoly pricing. (Mankiw, 2021) In monopolistic competition, several businesses offer comparable goods. Inefficiency in this market lies in the long run because, ultimately, the profit is propelled to zero. This is caused by companies' ability to freely enter and exit the market depending on current profit levels, often resulting in an imperfect number of firms in the market. Another inefficiency is the "markup of price over marginal cost." (Mankiw, 2021) This generates inefficiency because it results in the deadweight loss seen in a monopoly. When the government allows, firms in an oligopolistic market choose their pricing by colluding with other firms in cartels. Often the outcome is inefficient for society and prohibited by law, or one firm becomes greedy and produces more than agreed upon, hoping to gain a more significant profit. When prices are chosen individually, “the oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost)” (Mankiw, 2021)

Firms in perfectly competitive and monopolistic market structures determine their profitability by determining where their total revenue from sales exceeds their total cost of production because their pricing has an insignificant amount of market power as seen in perfectly competitive market power, or their market power is restricted by the lack of competing firms as seen in monopolistic markets. Meanwhile, because firms in monopolistic competition market structures have some market power, their price exceeds marginal costs, so they determine their profitability when their marginal revenue exceeds their marginal cost. [ CITATION Man21 \l 1033 ] Oligopolistic firms expect to determine their profitability the same as monopolistic competitive firms, however, “each oligopolist is tempted to raise production and capture a larger share of the market. As each of them tries to do this, total production rises, and the price falls.” [ CITATION Man21 \l 1033 ]

Conclusions Overall, microeconomics provides insights that are often overlooked by the accounting side of a business. As future business owners, we should not only take into consideration if sales can overcome the cost of production, but also how it compares to other firms on that market, the elasticity of the product, any opportunity costs, society’s costs, as well as the long and short run projection for the company. My recommendation for the business would be to go for the perfect competition market structure. This market structure has free entry and is easy to exit. We will need to do some research to determine how elastic the product is, decide what the demand for the product is and supply the product accordingly. We will also need to determine our price point by calculating what the cost to produce this item is, how similar products are priced and what the consumer base is willing to pay. We should consider if we can offer any incentives for purchasing our products or if we have any allies to trade with to reduce costs or increase our consumer base. The ten principles of economics are an excellent guideline for us to consider when making these decisions.

References Khan Academy. (n.d.). The Production Possibilities Frontier. Retrieved September 09, 2021, from https://www.khanacademy.org/economics-financedomain/microeconomics/basic-economic-concepts-gen-micro/production-possibilities/a/the-production-possibilities-frontier-and-socialchoices-cnx-2 Mankiw, N. G. (2021). Principles of Economics. Boston: Cengage Learning, Inc....