ECON EXAM 3 Cheat Sheet - This document covers everything learned for exam 3 of Mizzou\'s Microeconomics PDF

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This document covers everything learned for exam 3 of Mizzou's Microeconomics course- 1014 taught by Professor Parsons. Hope this helps on your exam!...

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Chapter 14- Price Discrimination Price discrimination means charging more than one price for the same product. •The practice is common in many markets. –Different prices in different markets. –Perfect price discrimination –Tying –Bundling •Price discrimination can increase surplus as compared to simple (single-price) monopoly. Simple case: 2 markets or groups with different demand curves (3rd degree price discrimination) •Identical MC for both groups •Key assumption – No arbitrage is possible. –Resale from one buyer to another cannot occur. •Monopolist can increase profits by charging different prices in the different markets. The Principles of Price Discrimination: 1a) If the demand curves are different, it is more profitable to set different prices in different markets than a single price that covers all markets. (The firm wants to price discriminate.) 1b) To maximize profits the monopolist should set a higher price in markets with more inelastic demand. 2) Arbitrage may make it difficult for a firm to set different prices in different markets, thereby reducing the profit from price discrimination. (The firm may not be able to price discriminate.) One way to summarize when price discrimination is feasible is given by the following rules: 1. the firm must have market power and face at least two markets with differing demand curves 2. determining which consumers come from which market must be relatively simple (children and senior discounts, different countries, or languages) 3. the ability to resell the good from one market to the next must be limited Preventing Arbitrage: firms develop arbitrage-discouraging techniques: – Coding DVDs so cheaper Indian DVDs won’t play in US players – Vets are not allowed to write prescriptions for humans. – Selling services instead of goods Welfare effects? As compared to a non-price discriminating monopoly,  Profits are higher for the monopolist (otherwise they would not want to price discriminate).  Gains from trade are higher if Q is higher. Limiting case: Perfect price discrimination – Charge each buyer his or her maximum willingness to pay. – Again: Need to prevent arbitrage Is Price Discrimination Bad? • If price discrimination increases output, then total surplus will increase. • This greater output reduces the deadweight loss of monopoly (Q goes up, so lost gains from trade fall). • If the firm practices PPD, then the deadweight loss of monopoly is eliminated (but all the surplus goes to the monopolist). • Price discrimination also makes it easier for firms to cover their fixed costs, increasing their incentives to innovate. • Similarly, this may also be a way for a regulated natural monopoly to maintain profits at an efficient level of output even if AC > MC at that point. Tying- Consumption of one good requires the consumption of a second good produced by same firm. • Tying allows firms to price discriminate. – Firms’ price-discriminate by pricing the base good below cost and the variable good above cost. – Consumers reveal their willingness to pay through the variable good. – Firms basically charge a different price to every consumer based on their usage of the variable good. Bundling: Similar to Tying, requires that a good be bought along with other goods. – Examples: Cable TV (Can’t buy individual channels), Software (Microsoft Office), Newspaper (All sections and advertising) – Most beneficial in high fixed cost, low MC industries where consumers value the bundle similarly but differ in which of the individual components they view as high versus low value – Assume MC=0: Should Microsoft bundle or unbundle? Price? CHAPTER #15: OLIGOPOLY AND GAME THEORY Oligopoly Behavior: Is complicated because it’s not a single firm considering its own costs and pricing independently (like competitive firms and monopolies). The profits of a large firm depend heavily on the actions taken by other large firms. Strategic Decision-Making = Decision-making in situations that are interactive. Mutual Interdependence – A situation where each firm’s profit depends not only on their own prices and strategies but also on those of the other firms in the market. Strategic Behavior – Firms consider the expected reactions of their rivals when making their pricing, output, and other decisions. Cartels: A cartel attempts to move a market from a competitive one to what would occur if the market were controlled by a single monopoly; Cartels work best for commodities with limited geographic options for entry. • Manufacturing cartels tend to break down in the long run because firms can enter. • But the short run can last quite a while. Undifferentiated product (Q) • • Small number of producers o Assume 4 firms in the industry. They want to form a cartel (and act like a monopolist). o Step one – Set the overall production level at the monopolist quantity where industry profits are maximized, i.e. Q = QM. Once the overall production level is set, then set a production quota for each cartel member. Oligopoly: “Competition among the few”; Small number of firms; High barriers to entry Firms may not form cartels but generally prices will be above competitive levels (P > MC). Even in the absence of collusion, the behavior of any one firm will affect price. Pursuit of market power can lead to innovation and product differentiation. One reason firms innovate is to produce a product with fewer substitutes Fewer substitutes mean more inelastic demand, leading to higher prices and profits. Firms also compete by differentiating their products with different styles or features. CHAPTER 16: Competing for Monopoly: Network Goods Network good: A good whose value to one customer increases the more that other customers use the good. EX: Telephones, Facebook, Microsoft Word, Blu-ray discs; Network externality (positive externality) Monopolies and Oligopolies Sell Network Goods:  Given the network externality (bigger is better), network goods are usually supplied by monopolies or oligopolies.  Network goods typically involve one firm providing a dominant standard at a high price.  These markets also usually include a number of other smaller firms offering a slightly different product--------These firms tend to service niche areas in the market. EX: Software: Windows, Word, Excel, Adobe (pdf); Social media, DVD, Railroad gauge, construction (2x4) • Consequences… It is possible that the standard adopted might not be the “best”. (Standard Wars are common.) – A “sub-optimal” equilibrium----------Betamax versus VHS Nash Equilibrium – A situation in which neither player has an incentive to change their behavior or response. This type of game is known as a coordination game. A coordination game is one in which players are better off choosing the same strategy than they are if they choose different strategies and there is more than one strategy on which to coordinate. In the above game, Microsoft is the better choice in the sense that it yields higher total utility (22 compared to 20), but as noted, both (Apple, Apple) and (Microsoft, Microsoft) are Nash equilibria because neither player has an incentive to change his strategy unilaterally if they are in either of those cells. Firms compete for the market rather than in the market . • Competition for the market rather than in the market. • Often results monopoly or oligopoly. • Effects on price and consumer welfare depend on how contestable the market is. A market is contestable if a competitor could credibly enter and take away business from the incumbent A market will be more contestable if: 1. Fixed costs of entry are low. 2. Few or no legal barriers to entry. 3. The incumbent has no unique or hard to replicate resource. 4. Consumers are open to the prospect of dealing with a new product. • Firms may try to limit contestability with consumer loyalty plans (or similar). -The plans increase switching costs: Switching music from Apple to another platform Antitrust and Network Goods: Any time one firm dominates a market, there are always calls for government intervention. However, with network goods it is important to realize that these markets, by their very nature, will likely be dominated by a few sellers. Hence, any government regulation should focus on maintaining competition for the market, e.g., by keeping barriers to entry low, etc. CHAPTER 17: MONOLPOLISTIC COMPETITION AND ADVERTIZING Monopolistic Competition: • Even in markets with lots of firms, assumptions of (perfect) competition may not apply. • In markets for consumer goods (as opposed to commodities like corn, soybeans, petroleum), there is product differentiation. In the mind of the consumers, the products are good, but not perfect, substitutes. The key feature that differentiates monopolistic competition from perfect competition is product differentiation. The fact that the products sold are similar, but not identical, is what provides the firms with a little market power, as some consumers prefer one product over another and, as such, are willing to pay a little more for it. Overall, though, this pricing power is limited because of the wide array of substitute goods available. What produces product differentiation? Advertising is a feature of monopolistically competitive and oligopolistic markets. – Farmer Jones has no need to advertise in a perfectly competitive market. – Monopolies have little reason to advertise either. (USPS – 1 st class mail vs. parcel delivery) Goals of advertising: Increase product differentiation (at least in the minds of consumers), Increase Demand, Reduce price elasticity The Economics of Advertising: • Informative Advertising • Advertising as a signal of product quality • Advertising as part of the product Monopolistic Competition In the short run, a firm in monopolistic competition can make profits exactly like a monopolist. In the long run, however, entry occurs, shifting the demand curve to the left/down until the demand curve is tangent to the AC curve. At this point the firm produces QLR and makes zero profits but P > MC.

Arguments in favor of advertising: …. against advertising: Informs consumers - can be manipulative May enhance enjoyment of the product - can increase monopoly power Lowers prices of some products: Google, newspapers, TV - provides a barrier to entry CHAPTER 18: LABOR MARKETS: The Demand for Labor and the Marginal Product of Labor: • A firm is willing to hire a worker when the worker increases the firm’s revenues more than the firm’s costs. • The increase in revenue created by hiring an additional worker is called the Marginal Product of Labor (MPL). • The increase in costs from hiring an additional worker is (for a competitive firm) simply the worker’s wage. • So, a firm will hire a worker if MPL > Wage. • The marginal product of labor falls as more labor is used. • The Law of Diminishing Returns is the concept that, after some point, each individual worker that is hired will add less value than the one hired previously. Not because the worker has lower skills but because the other necessary resources (e.g. capital) are divided up among too many people. Labor Market Equilibrium: Equilibrium in the labor market occurs at the intersection of the market supply and demand curves for labor.A firm will hire workers whenever the marginal product of labor exceeds the market wage ( MPL > W). Thus, at equilibrium in the labor market, the marginal product of labor equals the market wage (MPL = W). Human Capital Theory: Human capital theory treats acquisition of education and training as “investment” decisions by individuals. Assumes individuals treat these decisions as rational investment decisions and compare benefits (future earnings gains) against costs (opportunity cost of time, tuition, etc.). Labor Market Issues: Compensating Differentials • The real wage of a job includes not just the pay but also other non-monetary factors. • A Compensating Differential is a difference in wages that offsets differences in working conditions. • Fewer people are willing to work in dangerous or unpleasant jobs, so the supply of labor is reduced, and the wage is increased. • Another factor that leads to wage differentials is that not all jobs are equally safe or equally enjoyable. Hence, workers must be paid a premium to work in unsafe or unpleasant job conditions. Labor Market Issues: Do Unions Raise Wages? Unions do NOT drive wage differentials across countries It is true that wages in unionized jobs tend to be higher than those in non-unionized jobs. Given that the firm hires fewer workers in the presence of a union, there are fewer job opportunities for workers not in the union. As a result, these workers will either be unemployed or will end up working in lower-paying jobs. Hence, unions help some workers (their members) while hurting other workers (those not in the union but with similar skill levels). Labor Market Discrimination: Types of Discrimination: Statistical Discrimination- Decisions about individuals based on group characteristics Sometimes banning statistical discrimination can harm the groups who are the intended beneficiaries. Preference-based discrimination Employer-based-I prefer to hire group X over group Y. Employers who practice employment-based discrimination are not maximizing profits. Employers who do not discriminate will earn higher profits than those who do. In a competitive market, discriminating employers will be displaced by employers who do not discriminate in the long run. In this sense, competitive markets tend to erode discrimination. Employee-based- I prefer to work with group X over group Y. Discrimination can also arise from workers who do not wish to mix with people from different groups. The profit incentive doesn’t necessarily break down this sort of discrimination. Customer-based- I prefer services from group X over group Y. More difficult to “compete away” Firms that employ these workers may lower costs on account of the lower wages, but the firms may also earn lower revenues as customers avoid their establishments. Discriminating customers create an economic incentive for firms to discriminate.; Fewer legal remedies Over time, trade may increase interactions between people from different groups and, as a result, may work to change preferences, but there is no guarantee of this. Governmental- Government power used to favor one group over another. Government policies now generally reduce race and sex discrimination. Not always true historically. Governments have supported discrimination or segregation. CHAPTER 19: PUBLIC GOODS AND TRAGEDY OF THE COMMONS Rival / Non-rival: A good is non-rival if one person’s use of the good does not reduce the ability of another person to use the same good. Tofu is a rival good. Cable TV is not rival. Excludable / Non-excludable: A good is excludable if people who don’t pay for the good can easily be prevented from obtaining it. Tofu is excludable. Tuna in the ocean is non-excludable. Private Goods are excludable and rival. Most goods are private goods.Private goods can be efficiently provided in competitive markets.Because they are excludable, there is a strong incentive to pay for and, thus, produce them. Because they are rival, excludability does not lead to inefficiency. The only people excluded from consuming a private good in a competitive market are those who are not willing to pay for it. Non-rival and excludable (“Club Goods”) Private provision: Cable TV , Wi-Fi, Movie theater Market provision is generally good (but may have P > MC).Advertising versus exclusion; Google, Facebook, etc. Public goods (non-rival, non-excludable) National defense; Mosquito control; Public sanitation / public health; Lighthouses Governments usually produce public goods. Common Resources (Rival, non-excludable)Ocean Fishing; Open ocean (outside of 200 mile limit); Air; Grazing land; The water table Market failure: Private markets underprovide public goods due to non-excludability, and since public goods are non-rival, the DWL from this underproduction can be quite large. “Free rider” problem: Governments can increase welfare by providing the good (and paying for it through taxation). Since the government has the ability to tax its citizens, it essentially circumvents the free rider problem. If the government is going to tax the public and provide the good, what is the efficient level of output? Add the demand curves vertically. Problems with Government Public Good Provision: Forced Riders – Someone who pays a share of the costs of a public good (through taxation) but who does not • enjoy the benefits. • Determining WTP is difficult.: Voting and other democratic processes can help to identify optimal amounts of public goods. When “public goods” aren’t public goods: • The term “public good” is often misused. A good is a public good if: It is non-rival; It is non-excludable. • A good is NOT A PUBLIC GOOD just because the government provides it (or if it is provided at no charge). • Tragedy of the Commons: Overuse of a common property resource No one owns the resource, so all of the users have an incentive to overuse it. CHAPTER 20: POLITICAL ECONOMY AND PUBLIC CHOICE: Positive and normative statements A normative statement expresses a value judgment about whether a situation is subjectively desirable or undesirable. Often there is an explicit or implicit “should”. A positive statement is a statement that is in principle testable or that can be disproven. It does not express a value judgment. Positive economics is describing, explaining, or predicting economic events. Normative economics is recommendations or arguments about what public policy should be. Ways that governments can fix market failures (“fix” = reduce DWL, increase gains from trade) Pigovian taxes; Subsidies; Regulation; Production of public goods Reduction of resource overuse with common property resources This is one way to think about government policy, but there are others: Governments should fix market failures. Leave private goods alone. ------Perhaps redistribute income. Public Choice: The study of political behavior using the tools of economics. Positive economic analysis of what governments actually do versus what we believe they should do.“Government failure” Rational Ignorance: Benefits of being informed are less than the costs of becoming informed. As consumers we have strong incentives to be informed. As voters much less so. Diffused costs, Concentrated benefits: Costs of a policy are spread very widely. Benefits are highly concentrated in a small interest group. Example: Sugar quotas (American consumers of candy, soda, and other products end up paying over $2,000,000,000 more for these goods than they would without the quota.) Interest group = 1% of population. $100 benefit (transfer) to the group costs society at large $4000. Will they support it? Their share of cost = 0.01 x $4000 = $40. $100 > $40 Now suppose the interest group is 20% of the population. Will they support the $100 benefit, now? No. 0.2 x $4000 = $800 > $100: Smaller groups are less concerned with overall welfare costs. Median Voter Model: how we model the behavior of governments; Median – 50% above and below; Median US income < Average US income Voting Paradoxes: Private preferences display certain logical properties. Example: A = (2 lbs. tofu, 3 lbs. beef). B = (2 lbs. chicken, 4 lbs. beef) C = (1 concert ticket, 1 haircut) Consumers can rank these (or rate them as equal): Suppose C is preferred to A and A is preferred to B. It follows that C is preferred to B; In math, C > A, A > B  C > B. This property is called Transitivity. Can a voting rule be designed so that aggregate preferences are always transitive? No. There is no voting rule that can guarantee a collective ranking that is transitive. Arrow Impossibility Theorem Implication of the median voter theorem: We would not expect to see large differences in policy positions b/w two candidates in the same race. But what about political polarization? Some apparent differences are more perceptual than actual. Tribal thinking------Example: Mitt Romney, Arne Duncan, and class sizes If a candidate is too far away from voters’ positions, the voters may not vote; More than one issue at play (not uni-dimensional) An Apology for Democracy Positive: Voting doesn’t work as well as markets in meeting individual needs or using resources efficiently. Normative: It may be better to use markets wh...