Microeconomics Final Review PDF

Preview

Summary

ECO1001: Microeconomics Professor O’Neill March 20, 2016Microeconomics Final Study GuideCHAPTER 4: BASICS OF SUPPLY AND DEMAND*DEMANDWhat factors cause shifts in demand? 1. Number of buyers (direct relationship) - Increase in buyers = increase in demand 2. Income - Demand for normal good, a good (di...

Description

ECO1001: Microeconomics Professor O’Neill March 20, 2016

Microeconomics Final Study Guide CHAPTER 4: BASICS OF SUPPLY AND DEMAND *DEMAND What factors cause shifts in demand? 1. Number of buyers (direct relationship) - Increase in buyers = increase in demand 2. Income - Demand for normal good, a good (direct relationship) - Demand for inferior good (indirect relationship) 3. Prices of Related Goods - Substitutes (direct relationship) ex: Increase in price of coke, increase in demand of Pepsi - Complements (indirect relationship) ex: increase in price of bagels, decrease in demand of cream cheese 4. Tastes (direct relationship) - Increase in taste toward a good, increase in demand for that good. - Decrease in taste toward a good, decrease in demand for that good. 5. Expectations - affects people’s buying decisions ex: expected increase in income = increase in demand What causes movements along a demand curve? The price of the good itself will cause a movement along the curve.

*SUPPLY Which factors cause a shift in supply? 1. Input prices (indirect relationship) - If the price of inputs increase, the supply will decrease. ex: A decrease in wages will increase supply. An increase in wages will decrease supply. 2. Technology - cost-saving technological advancement will shift curve to the right. 3. Number of sellers (direct relationship) - more sellers = more supply 4. Expectations ex: expected higher oil prices, sellers will reduce supply to sell later at a higher price What causes a movement along a supply curve? The price of the good itself. What determines the equilibrium price? Where quantity supplied equates quantity demanded. What causes shortages/surplus?

Surplus – fixed by raising price  Quantity supplied is greater than quantity demanded. Shortage – fixed by lowering price  Quantity demanded is greater than quantity supplied. How do normal goods differ from inferior goods? Normal Goods: positively related to income. ex: An increase in income will cause an increase in quantity demanded. Inferior Goods: negatively related to income. ex: An increase in income will cause a decrease in quantity demanded. Substitutes vs. complements? Substitutes: an increase in the price of one causes an increase in the demand for the other. ex: increase in price of Coke causes an increase in demand for Pepsi. Complements: an increase in the price of one causes a decrease in the demand for the other. ex: increase in price of bagels causes a decrease in demand for cream cheese.

CHAPTER 5: ELASTICITY Elasticity – the numerical measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants, such as its own price, the price of related goods or income. Inelastic: Elasticity is < than 1 Elastic: Elasticity is > than 1 Unit Elastic: Elasticity = 1 Perfectly Inelastic: Elasticity = 0 Perfectly Elastic: Elasticity = infinity Revenue = Price x Quantity **The flatter the curve through a given point, the bigger the elasticity. The steeper the curve, the more inelasticity. STEEP CURVE = INELASTIC FLAT CURVE = ELASTIC PRICE ELASTICITY OF DEMAND - Measures how much quantity demanded responds to a change in price. % change∈Quantity Demanded Price Elasticity of Demand = % change ∈ Price Determinants  Availability of Close Substitutes - price elasticity is higher when close substitutes are available.  Definition of the market - Price elasticity is higher for narrowly defined goods than broadly defined ones. ex: Food is less elastic than vanilla ice cream. Vanilla can be substituted by other flavors, but there isn’t really a substitute for food.  Necessities vs. Luxuries - Price elasticity is higher for luxuries than for necessities  Time Horizon

- Price elasticity is higher in the long run than the short run. ex: If there is an increase in price of gasoline, in the short run people can’t do much other than ride the bus or carpool. In the long run people can buy smaller cars or live closer to where they work. What is the relation between elasticity and revenues? - If demand is elastic a price increase causes a decrease in total revenuel. ELASTIC: PRICE INCREASE = DECREASE REVENUE - If demand is inelastic then an increase in price will cause an increase in total revenue. INELASTIC: PRICE INCREASE = INCREASE IN REVENUE PRICE ELASTICITY OF SUPPLY - Measures how much quantity supplied responds to a change in price. It measures the price-sensitivity of sellers’ supply. Price elasticity of supply = % change in quantity supply / % change in price Determinants  The more easily sellers can change the quantity they produce, the greater the price elasticity of supply.  For most goods price elasticity of supply is greater in the long run than in the short run. INCOME ELASTICITY OF DEMAND % change in quantity demanded / % change in income CROSS PRICE ELASTICITY OF DEMAND % change in quantity demanded for good 1 / % change in price of good 2

CHAPTER 6: SUPPLY, DEMAND, AND GOV’T POLITICS Price Ceiling: a legal maximum price of a good or service.

Price Floor: a legal minimum price of a good or service.

Binding: illegal. Causes a shortage or surplus. Equilibrium is above the price ceiling. Equilibrium is below the price floor. Non-binding: has no effect on the market outcome Equilibrium is below the price ceiling. Equilibrium is above the price floor.

CHAPTER 7: CONSUMERS, PRODUCERS AND THE EFFICIENCY OF MARKETS Willingness to Pay (WTP): maximum amount a buyer is willing to pay for a good

Consumer Surplus: amount a buyer is willing to pay minus the amount the buyer actually pays. - Higher price causes CS to decrease because buyers are leaving the market. - CS = WTP – P - CS = area below the demand curve and above the price

Producer Surplus: the amount a seller is paid for a good minus cost of production. - Lower price causes PS to decrease since sellers are leaving the market.

-

PS = P – Cost PS = area below the price and above the supply curve

Marginal Seller: seller who’d leave market if price was any lower.

CHAPTER 8: THE COSTS OF TAXATION Welfare Economics: applied to measure gain and losses from a tax

Size of Deadweight loss (DWL) depends on the price elasticities of supply and demand. Increase in tax = increase in DWL

Laffer curve (parabola): shows relationship between the size of the tax and tax revenue

CHAPTER 9: International Trade PW = the world price of a good that prevails in global market PD = the domestic price without trade  If PD > PW the country has a comparative advantage. - under free trade the country would export good.  If PW > PD the country doesn’t have a comparative advantage - under free trade the country would import good Small Economy: is a price taker in world markets. Its actions have no effect

on PW..

TARIFF: tax on imports

CHAPTER 21: THEORY OF CONSUMER CHOICE Budget Constraint: limit on the consumption bundles that a consumer can afford. Consumption Bundle: particular combination of goods. Ex: 40 fish, 300 mangos.

Indifference Curve  Shows consumption bundles that give the consumer the same level of satisfaction.  Downward sloping and bowed inward

 Indifference curves can’t cross  Higher indifference curves are preferred to lower ones.  Indifference curves for close substitutes are not very bowed.  Indifference curves for close complements are very bowed. Marginal Rate of Substitution (MRS): the rate at which a consumer is willing to trade one good for another. MRS = Slope of indifference curve

Effect of an Increase in Income  Increase in income will shift the budget constrain outward Effects of a Price change  If the price decreases for one good then the budget constraint will rotate outward. INCOME EFFECT  The change in consumption that results from the movement to a higher indifference curve. SUBSTITUTION EFFECT  The change in consumption that results from being at a point on an indifference curve with a different marginal rate of substitution (moving along the curve). Giffen Good: a good for which an increase in price raises the quantity demanded.  Income effect > substitution effect

CHAPTER 13: THE COST OF PRODUCTION PROFIT = TOTAL REVENUE – TOTAL COST Total Revenue: the amount a firm receives for the sale of its output. TOTAL REVENUE = QUANTITY x PRICE Total Cost: the market value of the inputs a firm uses in production. - Including opportunity costs  Explicit costs and implicit costs Economic Profit: total revenue minus total cost, including both explicit and implicit costs ECONOMIC PROFIT = TOTAL REVENUE – TOTAL OPPORTUNITY COST (EXPLICIT + IMPLICIT COSTS)

Accounting Profit: total revenue minus total explicit cost ACCOUNTING PROFIT = TOTAL REVENUE – TOTAL EXPLICIT COST

Accounting profit is usually larger than economic profit, since it ignores

implicit costs. Production Function: the relationship between quantity of inputs used to make a good and the quantity of output of that good.

(a) The production function gets flatter as the number of workers increases, reflection diminishing marginal product. (b)The total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product. Marginal Product: the increase in output that arises from an additional unit of input. Diminishing Marginal Product: the property whereby the marginal product of an input declines as the quantity of the input increases. Fixed Costs: costs that do not vary with the quantity of output produced. Variable Costs: costs that vary with the quantity of output produced. Average Total Cost: total cost divided by the quantity of output. ATC = TOTAL COST / QUANTITY Average total cost curve is U-Shaped Average Fixed Cost: fixed cost divided by the quantity of output. Average Variable Cost: variable cost divided by the quantity of output. Marginal Cost: the increase in total cost that arises from an additional unit of prodution. MC = CHANGE IN TOTAL COST / CHANGE IN QUANTITY Marginal cost rises with the quantity of output. **The marginal-cost curve (MC) crosses the average-total-cost curve (ATC) at the minimum of average total cost. **Whenever marginal cost is less than ATC, ATC is falling. Whenever marginal cost is greater than ATC, ATC is rising. **

Efficient Scale: the quantity of output that minimizes average total cost. Minimum of ATC.

Relationship between short-run and long-run Average Total Cost - Many decisions are fixed costs in the short run but variable costs in the long run. - Short-run curve differs from long-run curve

Economies of Scale: the property whereby long-run average total cost falls as the quantity of output increases. Diseconomies of Scale: the property whereby long-run average total cost rises as the quantity of output increases. Constant Returns to Scale: the property whereby long-run average total cost stays the same as the quantity of output changes.

CHAPTER 14: FIRMS IN COMPETITVE MARKETS Competitive Market: a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker. Firms can freely enter or exit the market. Buyers and sellers have to accept the price the market determines, and therefore said to be price takers. Average Revenue = Total Revenue / Quantity Sold Marginal Revenue: change in total revenue from an additional unit sold. MR = CHANGE IN TOTAL REVENUE / CHANGE IN QUANTITY **For competitive firms, marginal revenue equals the price of the good. Profit Maximization: - If marginal revenue is greater than marginal cost, the firm should increase its output. - If marginal revenue is less than marginal cost, the firm should decrease its output.

-

At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal.

Marginal Cost and Supply Curve Relationship - Because the firm’s marginal-cost revenue curve determines the quantity of the good the firm is willing to supply at any price, the marginal-cost curve is also the competitive firm’s supply curve. Competitive Firms in the Short Run - The firm shuts down if the revenue that it would earn from producing is less than its variable costs of production. - Shuts down if P < AVC - Competitive firm’s supply curve is the portion of its marginal revenue that lies above average variable cost. Sunk Cost: a cost that has already been committed and cannot be recovered, should be ignored in business strategy because they can’t be changed. (ex: fixed costs in the short-run). Competitive Firms in the Long Run - The firm exits the market if the revenue it would get from producing is less than its total costs. - Exit if P < ATC - Enter if P > ATC - The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost SHORT RUN SUPPLY CURVE LONG RUN SUPPLY CURVE

Short-Run: Market Supply with a Fixed Number of Firms - To derive the market supply curve, add the quantity supplied by each firm in the market.

Long Run: Market Supply with Entry and Exit

-

-

-

-

If firms in the market are profitable, then new firms will have the incentive to enter the market. If firms in the market are making losses, existing firms will exit the market. **At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit. The process of entry and exit ends only when price and average total cost are driven to equality. o PROFIT = (P – ATC) x Q In the long run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale (level of production with lowest average total cost Long run market supply curve must be horizontal at the price where there is zero profit (the minimum of average total cost).

**Because firms can enter and exit more easily in the long run than in the short run, the long run supply curve is typically more elastic than the short run supply curve. AN INCREASE IN DEMAND IN THE SHORT RUN AND LONG RUN (ALL 6 GRAPHS)

CHAPTER 15: MONOPOLY Monopoly: a firm that is the sole seller of a product without close substitutes. - The fundamental cause of a monopoly is BARRIERS TO ENTRY: 1. MONOPOLY RESOURCES: a key resource required for production is owned by a single firm. 2. GOVERNMENT REGULATION: the government gives a single firm the exclusive right to produce some good or service. 3. THE PRODUCTION PROCESS: a single firm can produce output at a lower cost than can a larger number of firms. Natural Monopoly: a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. DEMAND CURVES FOR COMPETITIVE AND MONOPOLY FIRMS

Biggest difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output. - Average revenue = price of the good - A monopoly’s marginal revenue is always less than the price of its good (average revenue curve). - When a monopoly increases the amount it sells, this action has two effects on total revenue (P x Q): o OUTPUT EFFECT: more output is sold, so Q is higher, which tends to increase total revenue. o PRICE EFFECT: price falls, so P is lower, which tends to decrease total revenue. Profit Maximization for a Monopoly - The monopolist’s profit-maximizing quantity of output is determined by the intersection of the marginal revenue curve and the marginal cost curve. **On demand curve. -

Monopolist’s Profit = (P – ATC) x Q

-

The socially efficient quantity is found where the demand curve and the marginal cost curve intersect. The monopolist produces less than the socially efficient quantity of output. Inefficiency of Monopoly: because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buys it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. Causing a deadweight loss.

Price Discrimination: the business practice of selling the same good at different prices to different consumers. Perfect Price Discrimination: when the monopolist knows exactly each customer’s willingness to pay and can charge each customer a different price. Raises profit, raises total surplus and lowers consumer surplus.

Examples of Price Discrimination - MOVIE TICKETS: cheaper tickets for children and seniors. - AIRLINE PRICES: charging lower prices to separate business from leisure travelers. - DISCOUNT COUPONS: offering coupons to those who are willing to cut coupons out etc. Richer customers are less likely to do so since they have a higher willingness to pay. - FINANCIAL AID: wealthier students pay more for college than lower income students. - QUANTITY DISCOUNTS: buy one get one free, 1 for $2, 3 for $5. Public Policy toward Monopolies - By trying to make monopolized industries more competitive - By regulating the behavior of the monopolies - By turning some private monopolies into public enterprises - By doing nothing at all

CHAPTER 16: MONOPOLISTIC COMPETITION Oligopoly and monopolistic competition are considered to be imperfect competition. Oligopoly: a market structure in which only a few sellers offer similar or identical products. Monopolistic Competition: a market structure in which many firms sell products that are similar but not identical. - MANY SELLERS: there are many firms competing for the same group of customers. - PRODUCT DIFFERENTIATION: each firm produces a product that is at least slightly different from those of other firms. Thus, rather than being a price taker, each firm faces a downward-sloping demand curve. - FREE ENTRY AND EXIT: firms can enter or exit the market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero.

MONOPOLISTIC COMPETITION IN THE SHORT RUN

MONOPOLISTIC COMPETITION IN THE LONG RUN

-

As in a monopoly market, price exceeds marginal cost. This conclusion arises because profit maximization requires marginal revenue to equal

marginal cost and because the downward-sloping demand curve makes marginal revenue less than the price. - As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic profit to zero. Monopolistic vs. Perfect Competition - The perfectly competitive firm produces at the efficient scale, where average total cost is minimized. - A monopolistically competitive firm produces at less than the efficient scale. Resulting in EXCESS CAPACITY. - Price equals marginal cost under perfect competition, but price is above marginal cost under monopolistic competition.

CHAPTER 16: OLIGOPOLY Concentration Ratio: the percentage of the market’s total output supplied by its fours largest firms. Higher the ratio the less competition. Oligopoly: a market structure in which only a few sellers offer similar or identical products. - Strategic behavior in oligopoly: A firm’s decisions about P or Q can affect other firms and cause them to react. The firm will consider these reactions when making decisions. Game Theory: the study of how people behave in strategic situations. Duopoly: oligopoly with only two members. Simplest type of oligopoly. Collusion: an agreement among firms in a market about quantities to produce or prices to charge. Cartel: a group of firms acting in unison. Nash Equilibrium: a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. Increasing output has two effects on a firm’s profits: - Output effect: If P > MC, increasing output raises profits. - Price effect: Raising output increases market quantity, which reduces price and reduces profit on all units sold. - If output effect > price effect, the firm increases production. - If price effect > out...