Microeconomies summary chapter 2-11 PDF

Preview

Summary

Chapter 2: Markets and Prices Demand curve: downward sloping curve o Relationship between quantity demanded and the price of that good Aggregate demand: all individual demand added up Supply curve: upward sloping curve o Relationship between quantity supplied and the price of that good Market equili...

Description

Chapter 2: Markets and Prices   

Demand curve: downward sloping curve o Relationship between quantity demanded and the price of that good Aggregate demand: all individual demand added up Supply curve: upward sloping curve o Relationship between quantity supplied and the price of that good

Market equilibrium: conditions 1. Free entry/exit 2. Homogeneity which means that there are perfect substitutes 3. No market power 4. Transparency 

If these conditions hold, the price will always adapt to the market clearing price which is the market price



Shift of curve to the left or right is always caused by a: non-price determinant



Non-price determinants that shifts demand: o Number of consumers o Consumer preferences o Budget/income o Prices of related goods  complementary good or substitution good Non-price determinants that shifts supply o Number/amount supply o Production costs (go down)  supply goes up o Change in technology (but this also influences production costs) o Government interference





Shift along the curve is always caused by a price change

Price elasticity of demand 

When P then D, the question is by how much D will go down Formula: Ep=P/Q*Q/P

 Q/P  take the first derivative 



The minus sign in elasticity refers to its negative relationship: o PD o PD Unit elasticity: halfway on the curve and Ep= -1

Two extreme situations 1. Perfectly inelastic  Example: Medicine  if there is no substitute people don’t like a price rise but they are not going to demand less because of their dependency on the good.  A change in price has no effect on quantity demanded so Ed = 0 2. Perfectly elastic  Example: there are perfect substitutes, so a tiny change in price leads to an enormous change in demand, the elasticity of demand is infinite so Ed = 



Elasticity is not equal to the slope but if 2 linear demand or supply curves run through a common point, then at a given quantity the curve that is: flatter is more elastic

 What are the determinants for a more or less elastic demand curve? 1. Availability of substitutes (fundamental one) 2. Time horizon  over time consumers can adjust their behavior 3. Category of product either a broad classification or a narrow classification (example: broad classification is food  less elastic or narrow classification is lettuce  more elastic) 4. Necessities versus luxury good  coffee for some a necessity (less elastic) and for some a luxury (more elastic) 5. Purchase size (toothpicks less elastic, cars more elastic)   

If Ed < 1  the demand curve is inelastic If Ed > 1  the demand curve is elastic If Ed = 1  the demand curve is unit elastic (P moves but revenue stays the same)

 Elasticity of demand combined with total revenue  

Inelastic demand curve: R (goes up) = P (goes up by a lot) * Q (goes down by a little)  when prices move up, revenue also increases because Q only decreases by a little and P increases by a lot Elastic demand curve: R (goes down) = P (goes up a little) * Q (falls by a lot)  when prices move up a little, revenue decreases because with elastic demand Q falls a lot with a little increase in Price

Chapter 3: Consumer behavior Consumer behavior theory, three elements: 1. Consumer preference 2. Budget constraints 3. Consumer choices Consumer preference: There are three basic assumptions about preferences: 1. Completeness: consumers need to be able to compare and rank all possible baskets  indifference: a person will be satisfied with either basket on the same indifference curve 2. Transitivity: each consumer is logically consistent in his or her choice 3. More is better than less  if MU = 0 then TU = maximized, and if MUSEx  TEx (giffen good) A fall in prices has two effects: 1. Substitution effect: consumers will tend to buy more of the good that has become cheaper and less of the goods that are now relatively more expensive 2. Income effect: because one of the goods is now cheaper, consumer enjoy an increase in real purchasing power  In other words: o Substitution effect: change in consumption of a good associated with a change in its price, with the level of utility held constant (steeper slope) o Income effect: change in consumption brought about by the increase in purchasing power, with relative prices held constant Important: The direction of the substitution effect is always the same: a decline in prices leads to an increase in consumption of the good, so the substitution effect is always a shift to the right. However, the income effect can move either to the right or the left, depending on whether the good is normal or inferior.  A good is inferior when the income effect is negative, as income rises quantity demanded falls How to go about when determining income and substitution effect in a graph: 1. Determine the Total Effect 2. Determine the Substitution Effect 3. Determine the Income Effect

Market demand:

 Market demand curve: curve relating the quantity of a good that all consumers in a market will buy to its price  The market demand curve will shift to the right as more consumers enter the market  Factors that influence the demands of many consumers will also affect market demand  Network externality: situation in which each individual’s demand depends on the purchases of other individuals  Bandwagon effect: positive network externality in which a consumer wishes to possess a good in part because others do (pure price effect small and eternality effect big)  Snob effect: negative externality effect in which a consumer wishes to own an exclusive or unique good (pure price effect big and snob effect relatively smaller than price effect)

Chapter 6: production

 Short run: one of the production inputs cannot be changed, one of them is fixed  Long run: amount of time needed to make production inputs variable  Production with one variable input (labor) Average product of labor: measures the productivity of the firm’s workforce in terms of how much output each worker produces on average  output per unit of a particular unit Formula: output/labor input = q/L Marginal product of labor: the additional output produced as the labor input is increased by 1 unit  additional output produced as an input is increased by 1 unit Formula: change in output/change in input = q/L The slopes of the total, average and marginal product of labor:  When the marginal product is greater than the average product, the average product is increasing  When the marginal product is less than the average product, the average product is decreasing  Therefore, the marginal product must equal the average product when the average product reaches its maximum  When the marginal product crosses the x-axis (y = 0) the total product is at its maximum The average product of labor curve: the average product of labor is given by the slope of the line drawn from the origin to the corresponding point on the total product curve The marginal product of labor curve: the marginal product of labor at a point is given by the slope of the total product at that point Law of diminishing returns: as the use of input increases equally, a point will eventually be reached at which the resulting additions to output decrease  Law of diminishing marginal returns usually applies in the short run when at least on input is fixed  Do not confuse diminishing marginal returns with 1. Changes in quality  DMR only result from limitations on the use of other fixed inputs (like machinery or less efficient labor inputs as workers might be in each others way) 2. Negative returns  DMR describes a declining marginal product not a decreasing one

 Production with two variable inputs (labor and capital)  Isoquant: curve that shows all possible combinations of inputs/production factors that yield the same output (q)  If one wants to see the effect of diminishing marginal returns with two variable inputs, one needs to look at what happens to output levels when one of the two inputs remain fixed (draw a fictional line for capital or labor and compare the values of the isoquants) Substitution among inputs  Marginal rate of technical substitution: amount by which the quantity of 1 input can be reduced when 1 extra unit of another input is used, so that output remains constant  The marginal rate of technical substitution of labor for capital: the amount by which the input capital can be reduced when 1 extra unit of labor is used, so that output remains constant (so on the same isoquant line!!)  We assume there is a diminishing MRTS, this tells us that the productivity of any one input is limited  The marginal rate of technical substitution between two inputs is equal to the ratio of the marginal products of the inputs Formula MRTS: -K/L (for a fixed level of q) Formula MRTS: MPl (labor)/ MPk (capital) Two special cases with production functions: 1. Inputs to production are perfect substitutes for one another  here the MRTS is constant at all points on the isoquant. An example of this is the production of instruments which can be done almost entirely by machine tools (capital) but equally as good as with highly skilled labor (labor) which can both eventually increase output 2. Fixed-proportions production function: it is impossible to make any substitution among inputs to increase output. The isoquant is L-shaped. An example of this is the reconstruction of concrete sidewalks using jackhammers. It takes one person to use a jackhammer – neither two people and one jackhammer will increase output nor one person and two jackhammers will increase output

Returns to scale: rate at which output increases as inputs are increased proportionally, 3 options 1. Increasing returns to scale: situation in which output more than doubles when all inputs are doubles (might happen when managers/workers specialize in their tasks and to make use of more sophisticated, large-scale factories and equipment) 2. Constant returns to scale: situation in which output doubles when all inputs are doubled 3. Decreasing returns to scale: situation in which output is less than doubled when all inputs are doubled (likely to be associated with the problems of coordinating tasks and maintaining a useful line of communication between management and workers)

Chapter 7: the cost of production Opportunity cost: cost associated with opportunities that are forgone by not putting the firm’s resources to their best alternative use Sunk cost: expenditure that has been made and cannot be recovered, fixed cost affect the firm’s decisions looking forward, whereas sunk costs do not  Total cost: total economic cost of production, consisting of fixed cost and variable cost  Fixed cost: cost that does not vary with the level of production and that can be eliminated only by shutting down  Variable cost: cost that varies as output varies Marginal cost: increase in cost resulting from the production of 1 extra unit of output Formula: MC=VC/q=TC/q Average total cost: firm’s total cost divided by its level of output (TC/q) Average fixed cost: Fixed cost divided by the level of output (FC/q) Average variable cost: Variable cost divided by the level of output (VC/q)  Cost in the short run  When there is only 1 variable input, the Marginal Cost is equal to the price of the input divided by its marginal product (formula shown below) Formula: MC=VC/q=wL/q  MC=w/MPl(labor)  The shapes of the cost curves o The total cost curve is determined by adding the fixed cost curve to the variable cost curve (the distance between TC and VC is always the amount of the fixed cost) o Whenever the marginal cost lies below average cost, the average cost curve falls o Whenever the marginal cost lies above average cost, the average cost curve rises o When average cost is at a minimum, the marginal cost equals average cost o MC=AVC at its minimum and MC=ATC at its minimum o The slope of the VC curve, a line drawn from the origin to a touching point on the VC curve, measures the average variable cost

o The slope of the VC curve is the MC (it measures the change in variable cost as output increases by 1 unit)  the tangent to the VC curve at .. is the marginal cost of production when output is .. (page 254)  Cost in the long run  User cost of capital: economic depreciation (value of capital) + (interest rate)  also expressed as r=depreciation rate + interest rate  The isocost line: graph showing all possible combinations of labor and capital that can be purchased for a given total cost  The total cost C of producing any particular output is given by the sum of the firm’s labor cost wL and its capital cost rK: o Formula: C=wL+rK  Rewrite this formula for a straight line  K=C/r-(w/r)L  The isocost line has a slope of K/L=-(w/r)  which is the ratio of the wage rate to the rental cost of capital  When a firm minimizes the cost of producing a particular output, the following condition holds: o Formula: MPl/MPk=w/r  rewrite to MPl/w=MPk/r Cost minimization with various output levels  Expansion path: curve passing through points of tangency between a firm’s isocost lines and its isoquants  it describes the combinations of labor and capital that the firm will choose to minimize its costs at each output level  Expansion path = long run total cost curve  To get from the expansion path to the long run total cost curve follow 3 steps 1. Choose an output level represented by an isoquant and then find the point of tangency of that isoquant with an isocost line 2. From the chosen isocost line, determine the minimum cost of producing the output level that has been selected 3. Graph the output-cost combination  Long run versus short run cost curves  Short-run expansion path: one of the 2 inputs are fixed, when a firm wants to increase output the firm is unable to substitute relatively inexpensive capital for more costly labor when it expands production. The short run expansion path begins as a line from the origin and then becomes a horizontal line at the level where capital becomes fixed. (page 267)  Long-run expansion path: inputs are flexible, line goes from origin to right corner with the same slope (constant returns to scale case)  Long-run average cost curve: curve relating average cost of production to output when all inputs are variable (LAC)

 Long-run marginal cost curve: Curve showing the change in long-run total cost as output is increased incrementally by 1 unit  The long run average cost curve is u-shaped just like the short run average cost curve but for the long run it is u-shaped because of increasing and decreasing returns to scale rather than diminishing returns to a factor of production  LMC=LAC where LAC achieves its minimum Economies and diseconomies of scale  Increasing returns to scale: output more than doubles when the quantities of all inputs are doubled  Economies of scale: a doubling of output requires less than a doubling of the cost  Diseconomies of scale: situation in which a doubling of output requires more than a doubling of cost  Economies of scale are often measured in terms of cost-output elasticity Ec o o o o

Formula: Ec=MC/AC When Ec1 diseconomies of scale When Ec=1 constant returns to scale if input proportions are fixed

 Economies of scope: situation in which joint output of a single firm is greater than output that could be achieved by two different firms when each produces a single product  Diseconomies of scope: situation in which joint output is less than could be achieved by separate firms when each produces a single product

Chapter 8: Profit maximization and competitive supply 

Perfectly competitive markets

 Price taking: firm that has no influence over price and thus takes the price as given  Product homogeneity: products of all of the firms in a market are perfectly substitutable with one another  Free entry and exit: buyers can easily switch from one supplier to another, and suppliers can easily enter or exit a market  Markets are highly competitive in the sense that each firm faces highly elastic demand curves and relatively easy entry and exit 

Marginal revenue, cost and profit maximization

 Profit: (q)=R(q)-C(q)  To maximize profit a firm selects output for which the difference between R and C is the biggest  Marginal revenue: change in revenue resulting from one-unit increase in output, also represents the slope of the revenue curve  Profit maximization: MR(q)=MC(q)  How much output the firm decides to sell will have no effect on the market price of the product  the competitive firm is a price taker  Because of the price taker concept a firm faces a horizontal (completely elastic) demand curve  this demand curve is both the firm’s average revenue curve as its marginal revenue curve. Along this demand curve, marginal revenue, average revenue, and prices are equal  A perfectly competitive firm should choose its output so that marginal cost equals price  MC(q)=MR=P 

Choosing output in the short run (firm)

 Marginal revenue equals marginal cost at a point at which the marginal cost curve is rising  this statement results in the output rule: if a firm is producing any output, it should produce at the level at which marginal revenue equals marginal cost  A firm is losing money when its price is less than average total cost (average variable cost + average fixed cost) at the profit maximizing output (MR=MC)  A firm makes profit when its price is higher than average total cost (average variable cost + average fixed cost) at the profit maximizing output (MR=MC)  In the short run a price taker continues producing when P>AVC because he can then still cover all his variable costs and a part of his fixed costs  Total cost cannot be determined from MC



The competitive firm’s short-run supply curve

 The supply curve of a firm tells us how much output it will produce at every possible price  The firm’s supply curve is a portion of the marginal cost curve for which marginal cost is greater than average variable cost  An increase of the price of inputs of firms causes the firm to reduce its outputs (page 301, figure 8.7) 

The short-run market supply curve

 The short-run market supply curve shows the amount of output that the industry will produce in the short run for every possible price  Elasticity of supply: percentage change in quantity supplied Q in response to a 1percent change in price  because marginal cost curves are upward sloping, the short-run elasticity of supply is always positive  Perfectly inelastic supply: arises when the industry’s plants and equipment are so fully utilized that greater output can be achieved only if new plants are built (as they will in the long run)  Perfectly elastic supply: arises when marginal cost is constant

 Producer surplus in the short run (firm)  Producer surplus: sum over all units produced by a firm of differences between the market price of a good and the marginal cost of production  Alternative way of defining producer surplus: the difference between the firm’s revenue and its total variable cost

o Producer surplus is almost the same as total producer profit. Where producer surplus equals revenue minus variable costs and is called variable profit. Total profit equals revenue minus all costs, both variable and fixed: o Producer surplus: PS=R-VC o Total profit==R-VC-FC o When adding up the producer surplus for all firms the market surplus can be determined 

Choosing output in the long-run (firm and some comparison to industry)

 The long run output of a profit maximizing competitive firm is the point at which long run marginal cost equals the price (MR)  The higher the market price, the higher the profit that the firm can earn  A firm earns zero economic profit when P=ATC or =TR-TC equals zero  Accounting profit: difference ...