Econ Notes - ECON 1B03:Introductory Microeconomics Instructor: Aleksandra Gajic PDF

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ECON 1B03:Introductory Microeconomics
Instructor: Aleksandra Gajic...

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Econ 1B03 Notes Chapter 4 – Market Demand & Supply Income 1. When income increases and you buy more of a good, this good is a normal good (or if income falls and you buy less). 2. When income increases and you buy less of a good, this good is an inferior good (or if income falls and you buy more). o Kraft Dinner & bus rides Prices of related goods 1. If an increase in the price of one good leads to an increase in demand for another good (or vice versa), these goods are substitutes. o Examples: Coke and Pepsi, satellite dishes and cable TV, new cars and used cars. 2. If an increase in the price of a good leads to a decrease in demand for another good (or vice versa), these goods are complements. o Examples: TVs and DVD players, automobiles and gasoline, shoes and shoelaces. Change in Demand • A change in demand is a shift of the demand curve due to a change in a determinant of demand other than price. • An increase in demand will shift the demand curve to the right: demand is higher at every price. • A decrease in demand will shift the demand curve to the left: demand is lower at every price. Shift factors for Demand Consumer Income o As income increases, the demand for a normal good will increase – curve shifts to the right. o As income increases, the demand for an inferior good will decrease – curve shifts to the left. Prices of related goods • When a fall in the price of one good reduces the demand for its substitute, the demand for the substitute shifts to the left. • When a fall in the price of one good increases the demand for its complement, the demand for the complement shifts to the right. Markets not in equilibrium

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There will be a surplus, or excess supply at a price above equilibrium price where Qs > Qd. Firms will want to decrease inventory by lowering P. As P i, consumers purchase more of the good. Eventually we return to eqm. P where Qd = Qs with no further pressures on price. There will be a shortage, or excess demand at a price below equilibrium price where Qd > Qs. Too many buyers will bid up P and firms will start to supply more. As P h, firms supply more and consumers purchase less of the good. Eventually we return to eqm. P where Qd = Qs with no further pressures on price.

Chapter 5 – Elasticity Price elasticity • Ep = percentage change in Qd percentage change in P = % change in Qd % change in P o Inelastic Demand • Quantity demanded does not respond strongly to price changes. • The % change in Qd < % change in P • Ep < 1 • The demand curve would be fairly steep o Elastic Demand • Quantity demanded responds strongly to changes in price. • The % change in Qd > % change in P • Ep > 1 • The demand curve would be fairly flat. o Perfectly Inelastic Demand • Quantity demanded does not respond to price changes at all. • Ep = 0 • The demand curve is vertical. o Perfectly Elastic Demand • Quantity demanded changes infinitely with any change in price. • Ep => infinity • The demand curve is horizontal. o Unit Elastic • Quantity demanded changes by the same percentage as the price • Ep = 1 • The demand curve is non-linear.

Ep = (Q2 – Q1) / ([Q2 + Q1] / 2) (P2 – P1) / ([P2 + P1] / 2) • • •

Elasticity is not the same as slope. Slope measures rates of change. Elasticity measures percentage changes.

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With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. The gain to TR from the P increase will outweigh the loss to TR from a decrease in Q. A firm would only lose a few sales but make up for it by getting a higher price for the sales it does make. TR will increase if P increases if demand is inelastic.

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With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. The gain to TR from the P increase will be outweighed by the loss in TR from lost sales. A firm would lose so many sales that even with a higher price on the sales it does make, it still ends up with less total revenue. TR will decrease if P increases if demand is elastic. If demand is unit elastic, the gain to TR from a P increase will be exactly offset by the decrease in Q. No change in P will increase TR, so TR must be at a maximum when Ep = 1.

Income elasticity of demand o measures how much the quantity demanded of a good responds to a change in consumers’ income. o EI = % ∧ in Qd % ∧ in I EI = (Q2 – Q1) / ([Q2 + Q1] / 2) (I2 – I1) /([I2 + I1] / 2) o If EI > 0 - the good is a normal good - as I increases Qd increase o If EI < 0 - the good is an inferior good - as I increase, Qd decrease • •

If EI is between -1 and 1, the good is income inelastic. If EI is greater than 1 or less than -1, the good is income elastic.

Goods consumers regard as necessities tend to be income inelastic. • Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. • Examples include sports cars, jewelry, Buffalo Bills season tickets and expensive foods. Cross-Price Elasticity of Demand •

cross-price elasticity measures the response of Qd of a good “a” to a change in price of good “b”. • Eab = % ∧ in Qd of good “a” %∧ in P of good “b” • The midpoint formula is: Eab = (Q2a – Q1a) / (Q2a + Q1a) / 2 (P2b – P1b) / (P2b + P1b) / 2 o If elasticity is > 0, an increase in P of “b” will lead to an increase in Qd of “a” the goods are substitutes o If elasticity is < 0, an increase in P of “b” will lead to a decrease in Qd of “a” the goods are complements

Elasticity of Supply o Es, a measure of how much the quantity supplied of a good responds to a change in the price of that good. o Since P and Qs always move in the same direction, Es will always be > 0.

Es = %∧ in Qs %∧ in P Es = (Q2 – Q1) / ([Q2 + Q1] / 2) (P2 – P1) / ([P2 + P1] / 2) where Q = quantity supplied. Perfectly Inelastic Supply • Es = 0 • Supply curve is vertical. • Examples: agricultural products, rare art. Inelastic Supply o Es between 0 and 1 (a fraction). o Supply curve is fairly steep. o A large change in P only leads to a small change in Q supplied. Elastic Supply • Es > 1 • Supply curve is fairly flat. Perfectly Elastic Supply • Es => infinity • Supply curve is horizontal. Unit elastic supply • Es = 1 • • •

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If D is inelastic, P* decreases to PI and Q* increases to QI If D is elastic, P* decreases to PE and Q* increases to QE If D is inelastic, an increase in S will decrease P by more and increase Q by less than if demand was elastic.

If S is elastic, P* increase to PE and Q* increase to QE If S is inelastic, P* increase to PI and Q* increase to QI If S is inelastic, an increase in D will increase P by more and increase Q by less than if supply was elastic.

Chapter 7- Consumers, Producers & the Efficiency of Markets •

Willingness-to-pay: the maximum amount that a buyer will pay for a good.

Producer Surplus

PS = area of triangle DEF = ½(bh) = ½*450*40 = $9000

Consumer Surplus = Value to buyers – Amount buyer pays and Producer Surplus = Amount sellers receive – Cost to sellers Since amount buyer pays = amount sellers receive Total Surplus = Consumer Surplus + Producer Surplus or Total Surplus = Value to buyers – Cost to sellers Total Surplus is maximized at equilibrium.

Chapter 10 – Externalities Externalities • Sometimes there are benefits and costs that arise in the market that go uncompensated. • These are called externalities. • A positive externality is a benefit that is enjoyed by society, but society doesn’t pay to receive it. • A negative externality is a cost suffered by society, and the instigator isn’t made to pay for the damage they do. o Negative externalities lead markets to produce more than is socially desirable. o Positive externalities lead markets to produce less than is socially desirable. Negative Externality

o The government can internalize an externality by imposing a tax on the producer to get them to produce less – to produce the socially desirable quantity. o This tax is known as a Pigovian Tax, levied on each unit of output sold Positive Externality

The Coarse Theorem • • • •

This is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the externalities problem on their own. However, property rights have to be well defined for bargaining to work. A property right is the exclusive authority to determine how a resource is used, whether that resource is owned by government or by individuals. Private property rights have two other attributes in addition to determining the use of a resource: • One is the exclusive right to the services of the resource. • Second, a private property right includes the right to delegate, rent, or sell any portion of the rights by exchange or gift at whatever price the owner determines (provided someone is willing to pay that price).

Chapter 6 & 8 – Supply, Demand & Government Policies Price Ceilings • A price ceiling is a legal maximum on the price at which a good can be sold. • The price ceiling is not binding (not effective) if it is set above equilibrium price. • The price ceiling is binding (effective) if set below equilibrium price, leading to a shortage.

In eqm., Qd = Qs 1700 – 2P = 2P – 900 4P = 2600 P = 650 Qd = 1700 – 2(650) = 400 = Qs = Q* What if the province imposes a rent ceiling of $500? If P = 500 Qd = 1700 – 2(500) = 700 Qs = 2(500) – 900 = 100 Shortage = Qd – Qs = 600

Price Floors • • •

A price floor is a legal minimum on the price at which a good can be sold. The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus.

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Excess supply = Qs – Qd

A quota is a quantity control. • An upper limit on the quantity of a good that can be sold. • The government usually issues quota licences that give producers the right to produce a specified amount of a good. • • • •

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The quota is set at 9 million litres per week. At Q = 9 million, consumers are willing to pay $1.80 per litre (this is the demand price). But, at that Q, producers would normally be happy to receive $ .60 per litre. The difference between these 2 prices is the quota rent: quota owners receive an additional $1.20 per litre per week. This is also the value of the quota.

A tax on Consumers o Example: the government imposes a tax of $ .50 per bottle on consumers of beer.

o Now there’s a new eqm at P = $2.80 and Q = 90. o But, the consumers must pay the $ .50 tax. o They end up paying a price PC = $3.30, while the firm (the bar) receives PF = $2.80. o The government receives $.50 x 90 = $45.00 in tax revenue. After the tax, • Consumers pay $ .30 more per bottle • Sellers receive $ .20 less per bottle. • In this case, the consumers bear the larger burden of the tax: $.30 versus $.20. A Tax on Suppliers o Example: the government levies the tax on bar owners. • Sellers react by supplying less beer at every price. • The supply curve will shift up by the amount of the tax.

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The burden on the tax is the same: Consumers pay $ .30 more than before &Sellers receive $ .20 less than before. The consumer bears the larger burden of the tax.

The side of the market which is more inelastic (steeper curve) bears a larger burden of the tax.

o The area of ∧C and ∧E is surplus no one gets because of the tax. o Consumers used to get ∧C and suppliers used to get ∧E before the tax. o ∧C + ∧E represent the deadweight loss due to taxation, DWL = the loss in total surplus that results from a tax

The greater the elasticities of demand and supply: • the larger the decline in equilibrium quantity and • the greater the deadweight loss of a tax.

Example: • •

The market for pizzas is represented by the following equations for demand and supply: Qd = 20 – 2P Qs = P - 1 In eqm, Qd =Qs 20 – 2P = P – 1 P = $7 Q=6

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Now suppose a tax on trans fats results in a $3 tax per pizza for pizza firms. The new supply curve is Qs = P – 4 For consumers, Pc is determined where the new Qs = Qd P – 4 = 20 – 2P P = $8

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For pizza firms, we need to know what the new Q will be first, and then we can solve for the price they receive. • To find Q, substitute P = 8 into either the new Qs or Qd: (I’ll use the new Qs) • Qs = P – 4 Qs = 4 So, with the tax, only 4 pizzas are traded in the market. • Now, substitute Q =4 into the old Qs to get the price firms receive: Qs = P – 1 4=P–1 PF = $5 • So, consumers pay $8 and firms receive $5. • The government’s tax revenue is $3 x 4 = $12 If we wanted to compare CS before and after the tax. • We need the P-intercept for the demand curve. • Set Qd = 0 in eqn for demand: 0 = 20 – 2P P = 10

Chapter 13 – Costs of Production o Total Revenue, TR o Total Cost, TC o Profit = Total revenue – Total cost P = TR - TC

Economic profit = total revenue minus total cost, including both explicit and implicit costs, i.e., opportunity costs. Accounting profit = total revenue minus only the firm’s explicit costs. Marginal product of any input in the production process is the increase in output that arises from an additional unit of that input. • MP is the slope of the total product function. MP = change in total output = ∧Q change in # of inputs ∧L Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. TP is maximized when the slope of the TP function is zero. • Since the slope of the TP function is MP, • TP is maximized when MP = 0 Average Product, AP = ____Q_____ # of inputs • AP tells us the quantity of output per input • AP intersects MP at max AP • Whenever MP > AP, AP must be increasing • Whenever MP < AP, AP must be decreasing Fixed costs are those costs that do not vary with the quantity of output produced. • Examples: rent, loan payments, salaried administrative staff Variable costs are those costs that do vary with the quantity of output produced. • Examples: labour costs, raw material costs Short Run, SR: the period of time in which at least one input into production is fixed. Long Run, LR: the period of time in which all inputs into production can vary. Total Cost = Total Fixed Cost + Total Variable Cost • TC = TFC + TVC ATC = TC / Q is average total cost AFC = TFC / Q is average fixed cost AVC = TVC / Q is average variable cost

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ATC = AFC + AVC

Marginal Cost (MC) - the increase in total cost that arises from an extra unit of production. MC = change in total cost = ∧TC change in total output ∧Q MC is the slope of the total cost function. It measures the rate of change in total costs as total product changes. As MC increases, MP decreases • Where MP is at a maximum, MC is at a minimum. • MC is pretty much the inverse of MP • • • •

MC intersects AVC at min AVC. MC intersects ATC at min ATC. Whenever MC < AVC or ATC, AVC and ATC must be falling. Whenever MC > AVC or ATC, AVC and ATC must be rising.

Min ATC is the point of efficient scale • Any Q greater or less than the Q at min ATC has a higher ATC. • If we’re producing Q such that we’re at efficient scale, we are minimizing ATC. •

The MC curve is the “inverse” of the MP curve and ATC is the “inverse” of AP.

LR Average Cost curve – LRAC Economies of scale, EOS: long-run average total cost falls as Q increases. • Also called increasing returns to scale (IRS) or scale economies Diseconomies of scale, DOS: long-run average total cost rises as Q increases. • Also called decreasing returns to scale (DRS) Constant returns to scale, CRS: long-run average total cost stays the same as Q increases

Chapter 14 – Perfect Competition

TR = (P × Q) Average revenue, AR, tells us how much revenue a firm receives for the typical unit sold. AR = TR = PQ = P Q Marginal revenue = the change in total revenue from an additional unit sold. • MR =∆TR/ ∆Q • MR is the slope of the total revenue function. • MR = P for a perfectly competitive firm • P = AR = MR A profit-maximizing firm will produce a quantity of output at the point where • MR = MC • In perfect competition, a firm will produce where • P = MR = MC that is, where P = MC • The firm maximizes profit by producing the quantity at which MC = MR… Where P = MC When MR > MC, the firm should increase Q (producing one more good will add more to TR than to TC: at Q1). When MR < MC, the firm should decrease Q (producing that good adds more to TC than to TR : at Q2). When MR = MC, profit is maximized (at Q*). If a firm shuts down: TR < TVC PQ < TVC PQ < TVC Q Q But, TVC/Q is AVC So, P < AVC  a firm will shut down in the SR if P ATC, a firm makes positive economic profit. When P < ATC, a firm makes negative economic profit, a loss. P = ATC, a firm makes zero economic profit. • The breakeven point for a firm occurs where P = min ATC A firm will exit an industry if P < min ATC A firm will enter an industry if P > min ATC

When P = min ATC, there is no entry into or exit out of the industry: This is LR equilibrium in the Industry LR equilibrium: • Firms maximize SR profits such that • P = SR MC • Profit = 0 so there’s no entry or exit, so • P = min SR ATC • LRAC is at a minimum, so P = min LRAC • Firms produce at efficient scale

Example:o Qd = 100 – P o Qs = 3P The firm’s MC = 5Q and its ATC of a crate is constant at $15. 1. What is eqm market P and Q? In eqm, Qd = Qs P* = 25 Qs = 3P = 3*25 = 75 (thousand crates) 2. How many crates do Seacrest and Simon supply? Set P = MC for this competitive firm: 25 = 5Q Q = 5 (thousand crates) 3. What is the firm’s profit? Its ATC is $15 per crate. P = (P – ATC)Q = (25 – 15)*5 = $50 000 (remember, Q is measured in thousands of crates) 4. How many identical firms currently are there in the orange industry? Since market supply is 75 000, and each firm produces 5000, there are 15 firms. 5. Is the industry in LR eqm? No. Since firms are making positive economic profits, new firms will enter the industry. 6. How many firms will there be in the LR and what will be supplied? In LR eqm, P = min ATC = $15 (ATC is constant) A single firm will produce where P = MC 15 = 5Q Q = 3 000 At a price of $15, market Qd = 100 – 15 = 85 000 = Qs If each identical firm produces 3000, there will be 85000/3000 = 28.3 firms (round to 28).

Chapter 15 – Monopoly & Market Power Monopoly • The firm is a price setter • One seller of a product • Product doesn’t have a substitute Monopolies arise b/c of barriers to entry: 1. A single firm owns a key resource that no other firm can access or has a close substitute for. 2. 2. The government gives one firm the exclusive right to produce and sell some good. Patents and copyrights are an example. • An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. • A monopoly is the only seller and has to service the entire market. - Its demand curve is the market demand curve. - So, the monopoly faces a downward sloping demand curve. • SO if the firm wants to increase the Q sold, it has to lower its P. • Therefore, it gets less revenue for each additional good it sells. So, o MR is always lower than P o The profit-maximizing monopolist will always choose to produce a level of output Q such that o MR = MC < P o Profit = TR – TC  P = (P-ATC)Q  Monopoly = (Monopoly Price – ATC)*Profit-maximizing quantity {intersection of MC & MR) Deadweight Loss due to Monopoly o Monopoly - P > MC b/c P is on the demand curve where MR=MC o In perfect competition (non-monopoly) – P = MC o Similar to DWL caused by a tax – but govt gets revenue from tax, private firm gets monopoly profit Inefficiency o A competitive equil maximizes CS & PS o Society’s welfare is maximized (P = MC) o The competitive outcome is the sociall...