Exam Notes FOR ECO201 PDF

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Differences between accounting profit and economic profit - Accounting profit is the difference between total revenue and explicit cost, while economic profit is the difference between total revenue a firm makes and all cost, including explicit and implicit cost - Explicit cost refers to actual paym...

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1. Differences between accounting profit and economic profit - Accounting profit is the difference between total revenue and explicit cost, while economic profit is the difference between total revenue a firm makes and all cost, including explicit and implicit cost - Explicit cost refers to actual payment a firms makes (normal cost) - Implicit cost refers to opportunity cost of the resources supplied or decision made 2. Quantity demand (Demand is what is wanted) - Quantity of good or service that a consumer is willing and able to purchase at a given price. - When price increase, quantity demand decrease (opposition) - Change can be: consumer income, price of complementary goods, consumer taste, government regulations - Increase in demand – shift demand curve right - Decrease in demand – shift demand curve left 3. Supply (Supply is what is given) - Represents the ability and willingness of suppliers to offer a good or service for sale. - Price of good increase, supply increase - Change can be : price of product, technology, price of factor input (input price increase, supply decrease | input price decrease, supply increase), price of output, government regulations. - Increase in supply – shift supply curve right - Decrease in supply – shift supply curve left 4. Elasticity a) Price elasticity of demand – will always be negative

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Measures responsiveness of the quantity demand in the change of price o Price elasticity of demand is > 1 = elastic demand  The percentage change in quantity demanded is greater than the percentage change in price o Price elasticity of demand is < 1 = inelastic  The percentage change in quantity demanded is lesser than the percentage change in price o Price elasticity of demand is = 1 = unit elastic  The percentage change in quantity demanded is = to the percentage change in price

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What causes price elasticity of demand? o Availability of close substitutes o More elastic as more time passes (on long term – demand curve flatten) o Luxuries vs necessities = luxury will be more elastic than necessity o Consumer’s budget of that good

b) Midpoint formula

x

c) -

Q x2 - Q x1 = 2 P x - P x1

X

( P x1 + P x2 ) / 2 ( Q 1x + Q x2 ) / 2

Elastic The longer the time period, the more elastic the demand and supply gets Demand and supply curve get flatter Increase in price = decreases in revenue | Decrease in price = increase in revenue o When increase 2 unit of price – demand will decrease 4 unit (makes a bigger loss when they increase price) o When decrease 2 unit of price – demand will increase 4 unit (makes profit when they decrease price) Demand and Price are in opposite direction

d) Inelastic – where quantity (Q) does not increase much - Overtime, supply and demand curve becomes steeper - Increase in price = decreases in revenue | Decrease in price = increase in revenue o When increase 2 unit of price – demand will decrease 1 unit o When decrease 2 unit of price – demand will increase 1 unit Demand and price are complementary

Demand

Supply

Example: Consider the differences between short-run and long-run housing supply elasticity. If the increased migration is the same in both the short-run and long-run, use a diagram to explain how the effects on the housing market differs between the short-run and the long-run. In long run, the supply will be more elastic and increases. Cause supply curve to become flatter over time. In long run, the price will increase by a smaller amount from p1 to p3 while quantity increase by a larger amount from q1 to q2

e) Cross price of elasticity of demand - Measure the responsiveness of change in the demand of one good to another.

JULY 17 Example: Consider a telecommunication company which provide both voice calls and Short Message Services (SMS). The price elasticity of demand for voice calls is −1.8 and the cross-price elasticity of demand for SMS with respect to the price of voice call is 0.3. o Price elasticity of demand for voice call shows that it has an elastic demand (-1.8), meaning that the percentage change in price is less than the percentage change in quantity (decrease in Q > decrease in P) o The cross-price elasticity measures the responsiveness of change in the demand of one good to another. SMS and Voice call having a cross price elasticity of 0.3 shows that both are a substitute good. Let’s say voice call has an increase in price of 10%, SMS would have an increase in demand of 3% (10% x 0.3) Example: Suppose the telecommunication firm raises the price of voice calls by 10% while the price of SMS remains unchanged. Calculate the impact on revenues from voice calls and SMS separately. -

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the change in demand due to the 10% increase in price for voice calls: o 0.1 x - 1.8 = - 0.18 (change in price x price elasticity of demand) Therefore, Revenue = Price x Quantity o R = (1+0.1) x (1 – 0.18) = 0.902 Voice calls will have a decrease in revenue of o 1-0.902 = 0.098 = 9.8% o Hence the increase in Voice calls price of 10% will result in a decrease in revenue of 9.8% As SMS and Voice calls are substitutes, the increase in voice call price of 10% will allow an increase in demand of SMS by 10% x 0.3 = 3% o Hence, SMS will have an increase in revenue by 3%

f) Price elasticity of supply – always positive

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Measures responsiveness of the quantity supplied in the change of price What causes o Flexibility and mobility of inputs o Availability of production capacity o Adjustment of time

g) Income elasticity of demand - Measures the responsiveness of quantity demanded to change in income o Positive but less than 1 = normal and necessity (MILK) o Positive but greater than 1 = Normal and a luxury (CAVIAR) o Negative = Inferior (High fat meat)

TO MEMORISE 1. Surplus Consumer surplus = difference between willingness to pay and the price paid by consumer (budget vs product price) – top part of equilibrium / above price Producer surplus = difference between the willingness to product and price received by supplier (product price vs cost price) - bottom part of equilibrium / below price Economic surplus = CS + PS 2. Prisoner Dilemma Game = - Is a game with an inferior outcome where both party plays their dominant strategy and one party loses - Only when there is a non–Nash equilibrium option which is better off for both for party. 3. Asymmetric information - When either buyer or seller is better informed about the goods 4. Adverse selection - Selection among poor quality buyers - Example: insurance. o Adverse selection increase insurance premium – so low risk (best customer for insurance company) people wont buy cause no point for them. Example: For insurance purchased by company, it covers people who are both of high and low risk. Hence the average risk / chances of worker claiming the insurance is lower than individual who purchase insurance. This lowers the cost incurred by the insurance company. Base on adverse selection – which refers to selection amount poor quality customer, increase insurance premiums Individuals who purchases insurance individually tend to be of higher risk and likely to make claims, hence their insurance are of premium level – more costly 5. Moral hazards and deductibles - Moral hazards are where people change their behavior once they have insurance = people take more risk with their insured goods / activity o This causes insurance premium cost to increase even more - Deductibles is where only certain amount can be claim = co payment o Forces consumer to be more cautious as not all are full covered / insured

6. Bertrand model (competition based on price) - Leaders can set price so low that it takes in a lot of the demand for the product that no other firms can enter the market – also known as price limiting 7. Cournot model (competition based on quantity) - Each firm treat the output of the competitors as fixed. - All firms decide simultaneously how much to product. Firms will adjust its output base on what it thinks the other firms are producing - Has no leading firm 8. Stackelberg model (Leadership) - Is based on the assumption that one leading firm sets an output level first, which forces other firms to react and follow to it - Has a leading firm 9. Positive externality - Exist when an individual /firm making a decision, doesn’t take in the full benefit that the decision can give. - Hence the benefit of the individual is less than the benefit to the society. - Marginal Social Benefit (MSB) is more than the Marginal private benefit (MPB) o When QMKT is less than QSOC = market efficient (QMKT < QSOC) o Demand = MPB o MPB = the marginal benefit enjoyed by consumer when they actually consume the product o MSB = the social value of the product o In positive externality - MSB = MPB + marginal external benefit - With positive externality it means less is produced and consumed than the optimal level - Dead weight loss exist cause too little of the product is produce than the optimal output - Solving positive externalities o Subsidies can be given o This will help to increase the marginal external benefit (MEB) o Subsidy can be equivalent to the MEB so that MSB can be equal to MPB can create market efficiency (MSB = MPB)

10. Negative externality - Exist when third parties are harmed by the consumption or production of the good without it (the harm/ cost) being part of the market transaction (cost of harm are not taken in) for example, pollution (air, water and noise)  Producer doesn’t take in responsibility of the external cost which is then pass on to the society. o Hence Marginal Social Cost (MSC) is more than Marginal Private Cost (MPC) - Negative externalities represent the part of social costs that are not fully recognized as part of private costs, and therefore not adequately accounted for in making decisions. o The developer will consider the MPB (demand curve) and MPC (supply curve) and then optimize on the market equilibrium quantity. But doesn’t consider the MSB and MSC. Hence market inefficiency. o When QMKT more than QSOC = market inefficiency - Solving Negative efficiency o Government can impose tax on developer will cause an increase to the marginal private cost. Tax imposed can be equivalent to the marginal external cost (MEC), allowing developer to produce at QSOC where market is efficient (QSOC = QMKT) - Supply is with MPC - Deadweight loss exist cause too much of the product is produce than the optimal output

11. Deadweight Loss - Is the loss of economic efficiency such that the optimal efficiency is not achieved - Is the cost to society due to market inefficiency - Producing too much or too little will result in deadweight loss - loss of economic surplus due to quantity different from market equilibrium

12. Short run - Short run is where, a period of time, at least one of the firm’s factor of production is fixed and cannot be varied - Hence to increase production in a short run, firms can only increase variable cost, such as workers, operation time - However, in a long run, when more variable inputs are working on the same amount of fixed input (example capital/ machine), the marginal output of the variables will eventually decline. (so in long run, fixed input must increase) Short run cost - TFC + TVC - Fixed cost remains unchanged even in output (Q) increases - Only variable cost change - Short run marginal cost = 0 + TVC (cause TFC doesn’t change) - Example: fixed cost for 1 year is 12,000 and variable cost is 200 / worker Short run cost: 12,000 + 200Q 13. Long run - Long run is where a period of time, all factors of production are variable. - Hence to increase production, both variable and fixed factors can increase o Machine, workers and capital Long run cost = TVC (FC / month + VC) Example: fixed cost for 1 year is 12,000 and variable cost is 200 / worker Long run cost = (12,000/12 months)Q +200Q =1,200Q

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Determine short run and long run prices (sem 2 question 9) o Means finding the optimal output where P = MR o P = short run / long run cost o then sub optimal output (Q from P=MR) into demand curve equation to find P EXAMPLE: MR= 2500 – 20Q || Demand curve = 2500- 10Q|| Short run cost = 200 || Long run = 1200 Short run P = MR 200 = 2500 – 20Q Q = 115 Therefor price of short run = 2500 – 10(115) = $1,350 Long run P=Mr 1200 = 2500 – 20Q Q = 65 Therefore, price of long run = 2500 – 10(65) = $ 1850

14. Monopoly In short run - Monopolist will operate at optimal output where MR = MC and charge the price base on where the optimal output Q* will be on the demand curve - Equilibrium / OPTIMAL quantity – MR = MC - PRICE = DEMAND CURVE AT Q - P > ATV = PROFIT - P = ATV = NORMAL PROFIT - P < ATV = LOSS In long run - Due to barrier to entry, monopolist can still make profit.

Demand = a-Bq MR= a-2bq MC = b+2cq

Example : JUL 2018 Although DEH used to be a monopolist, after several competitors entered the industry the market is now competitive. DEH observes that the new competitors are charging prices lower than long-run variable costs, which are known to be similar across firms in the industry. Based on market equilibrium theory, explain what DEH should do in response. -

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Even though competitors are charging price below their Long run variable cost, the price could still be higher than their short run variable cost, hence they are still making a profit but temporary. In long run, price should be equal to THE LONG RUN AVERAGE VARIABLE COST to incur normal profit and stay in the industry. Hence if the competitors are constantly pricing below their long run variable cost, they will soon have a price below the average total cost and have to exit the market DEH should continue on their current pricing and take in the temporary loss till the competitor starts making a loss and exit the market. However, if DEH can’t endure the temporary loss, they should exit the market now.

15. Perfect competition Firms in perfect competition will take the market price as given. Hence in order to max out their profit, they will produce at the amount where marginal cost = marginal revenue. (MR = MC – firms earn 0 economic) At MR = MC, firm earns 0 economic profit, and will be satisfied in the existing business. & since there is no economic profit, no new firms will enter. - In perfect comp – MR = MC = P (MR : DEMAND = SUPPLY) - Profit maximizing quantity – P = MC - Equilibrium quantity – Demand curve = supply curve - The optimal output is MR = MC which is P = MC In short run - Due to the free entry and exit nature of the market, the short run profit will attract new firms into the market, which will increase supply and decrease price. This continues till there are no eco profit where MR = MC - Zero eco profit = perfect competition market - The short run shut down condition: P < AVC or TR < TVC -

In short run: When making economic profit (Price above ATC) PROFIT : (PRICE – ATC) x OUTPUT

ATC – lowest point of ATC curve | Optimal output (Q*): MR = MC | -

In short run : when break even (P = ATC)

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In short run: when making a loss (price below ATC)

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In long run Due to the free entry and exit nature of perfect competition, it will result in movements of firms When there is a short run profit (1st diagram ^), where P = MC = MR > ATC, the profit will attract more firms to enter the market o Increase in firms will result to an increase in supply and decrease in price.  Profit will decrease for the existing and new firms will decrease

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o When firm keeps entering, the profit will decrease and breakeven (P=ATC), hence all firms will start earning normal profit where economic profit is zero. When there is a short run loss – firms will leave the industry o This will result in decrease in supply (existing and remaining firms will have higher share) and increasing of price until firm breaks even and make normal profit When there is a break even in short run – no firms will be attracted to enter hence no movement In long run, o P > ATC = PROFIT o P = ATC = BREAKEVEN (NORMAL PROFIT) o P < ATC – LOSS (SHUT DOWN) In long run, firms in perfect competition will always break even where P = ATC

Example: Sem 2 Question 4 Analyze the effects of the following news on price and quantity in the tofu market as well as the profit and output of the individual tofu producer “It is discovered that tofu is health-enhancing”. Explain both the short run and the long run equilibria and support your answers with suitable diagrams. -

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In short run, with the news on tofu being health-enhancing, it will increase the demand for it, shifting the demand curve to the right, resulting in a higher price and larger quantity. The increase in price will cause the MR line to shift up and produce at a larger output hence earning an economic profit where P = MR = MC > ATC In long run, due to the free entry and exit nature of perfect competition market, the short run profit in the tofu market, will attract more tofu producers to enter the market. Causing the market supply to increase, shifting supply curve to the right and the market price to decrease. This decrease in price will cause MR line to shift downwards and produce at a lower quantity, where P = MR = MC = ATC. All tofu producers will eventually earn normal profit (breakeven) in the long run.

EXAMPLE: SEM 2 QUESTION 6 Explain why in the long run, economic profits in perfect competition are of less concern, from a public welfare perspective, than economic profits from monopoly. In monopoly, due to the barrier to entry nature of the market, competitors are unable to enter the market. Hence monopolist is able to earn economic profit even in the long run, resulting in long term loss of economic surplus However, in perfect competition, due to the free entry and exit nature of the market, the economic profit will attract firms to enter the market. This will cause an increase in supply resulting in decrease in price hence the profit of new and existing firms will eventually decrease in a long run. In a long run, all firms in perfect competition will break even and make normal profit. 16. Marginal Utility = Benefit gained from consuming 1 additional unit Marginal Utility = Total Utility / Quantity Optimal utility – MU of product A = MU of product B Total Utility and Marginal Utility (JUL 2016) - Marginal Utility = Total Utility / Quantity - Optimal Quantity = Marginal Utility / Price - Rational Spending Rule: Q1 = Q2

M U PA

A

=

M U PB

B

17. Incidence of Taxes - Taxes can be imposed on demand or supply side - On supply = rise cost of production - On demand = reduce benefits of consumption - More inelastic the demand and supply = more tax is collected o Hence, passenger doesn’t pay full tax amount (ep : $2) they will pay lesser than $2 unless demand and supply is perfect inelastic. o Tax are usually shared between buyer and seller o Price will increase but less than $2. o Sem 1 question 4 Tax on Supply

Tax on demand

The passengers need not pay $2.00 more after tax, unless demand or supply is perfectly inelastic. The incidence of a tax depends on the relative elasticity of supply and demand and is usually shared between buyers and sellers. Thus the price will increase but by less than $2.

18. Public and private good - Public goods are non-rival and non-excludable o Marginal social benefit curve is the sum of individual private benefit (P1 + P2) ** when they ask for marginal social benefit = public good so use sum of Price of both goods = MSB o Represented by P in the demand curve - Private good are rival and excludable o Total market demand curve is the sum of quantities demanded by consumer (Q1 + Q2) **when they ask for market demand = private good so use sum of quantity of both goods = market demand...