Econ Microeconomics Notes

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1 Econ Microeconomics Notes Daniel Bramucci December 1, Section 1 - Thinking like an economist 1.1 Definitions Cost-Benefit Principle An action should be taken only when its benefit exceeds its cost. Economic Surplus The net gain from an action. Opportunity Cost Implicit + Direct Costs. Positive Economics How people do behave Normative Economics How people should behave 1.2 Formulas Economic Surplus = Benefit of an action Opportunity cost of the action Opportunity Cost = Direct Costs + Opportunity cost of the action Opportunity Cost = Direct Costs + ( Benefit of next best action Direct cost of next best action ) 1.3 Three pitfalls to using cost-benefit principle 1. Measuring cost benefits as proportions not absolute values 2. Ignoring implicit costs 3. Failure to think at the margin 1

2 2 Section 2 Supply and Demand Price is on the vertical axis. Demand is on the horizontal axis. 2.1 Definitions Demand Curve A curve representing the quantity that would be bought in a market for a given price. Supply Curve A curve representing the quantity that would be sold for a given price. Buyer s reservation price The maximum price that a buyer would pay to take an action. Seller s reservation price The minimum price that a seller would pay to take an action. Market Equilibrium The point where all buyers and sellers are satisfied. No one has an incentive to change. This is located at the intersection of the demand and supply curves. Shift in Demand A shift in the demand curve itself; a change in the amount purchased for a given price. Shift in Quantity Demanded A shift along the demand curve; a change in the amount purchased for two different prices. Shift in Supply A shift in the supply curve itself; a change in the amount sold for a given price. Shift in Quantity Supplied A shift along the supply curve; a change in the amount sold for two different prices. Complements Two goods are complements if an increase in demand for one good increases demand for another; the two goods are typically used together (e.x. Peanut butter and jelly) Substitutes Two goods are substitutes if an increase in demand for one, decreases demand for the other; these two goods usually replace each other (e.x. Coke and Pepsi) 2

3 Normal Goods An increase in consumer income increases demand for the good (e.x. gas) Inferior Goods An increase in consumer income decreases demand for the good (e.x. Ramen Noodles) Economic Efficiency The sum of buyer and seller surplus 1 Buyers Surplus The difference between the buyers reservation price and the price he pays Sellers Surplus The difference between the sellers reservation price and the price he receives 2.2 Shifts in the Demand Curve 1. Change in price of related good Type of Relationship Price decreases Price Increases Complement Demand Shifts Right Demand Shifts Left Substitute Demand Shifts Left Demand Shifts Right 2. Changes in consumer income Type of good Income Increases Income Decreases Normal Demand Shifts Right Demand Shifts Left Inferior Demand Shifts Left Demand Shifts Right 2.3 Shifts in the Supply Curve 2.4 Shifts in the Demand Curve 1. Change in cost to make Good becomes cheaper to make Good becomes more expensive to make supply shifts right supply shifts left 3 Section 3 - Elasticity Market demand is sum of all individual demand curves. At each price add up the demand of each individual buyer 1 Review this definition 3

4 3.1 Definitions Price Elasticity of Demand The Percentage Change in the Quantity Demanded that results from a 1% change in the price. Perfectly Inelastic Demand A change in price won t change demand (0 = ǫ) Inelastic Demand Percentage quantity demanded changes slower than percentage price (0 ǫ < 1) Unit Elastic Demand Percentage quantity demanded changes at the same rate as percentage price (ǫ = 1) Elastic Demand Percentage quantity demanded changes faster than percentage price (ǫ > 1) Perfectly Elastic Demand Quantity demanded drops to 0 for any increase in price (ǫ = ) 2 Income Elasticity of Demand The Percentage Change in the Quantity Demanded that results from a 1% change in income. Cross-Price Elasticity of Demand The Percentage Change in the Quantity Demanded that results from a 1% change in the price of another good. 3.2 Notation P 1 Price of good 1 Q D 1 Quantity Demand of good 1 ǫ Elasticity Q D Quantity Demanded % Q D Percentage Change in Quantity Demanded % P Percentage Change in Price 2 This isn t completely mathematically rigorous 4

5 3.3 Formulas 3 Formula for Price Elasticity ǫ = % QD % P Derivations Formula for Price Elasticity with Slope Deriving Formula for Price Elasticity with Slope from Formula for Price Elasticity ǫ = % QD % P = Q Q 100 = P P P 100 Q QD D P = P Q 1 = P D P Q 1 D Slope Q D 4 Let Q(P) be the quantity demanded for a given price. ǫ = % QD % P = Q(1.01P) Q(P) Q(P) 1.01P P P }{{} Let h 0 dq Q(P) dp P = P Q(P) 1 dp dq 3.4 Determining factors of price elasticity = P Q D 1 Slope 1. Elasticity is inversely proportional to the availability of substitutes. e 1 Availability of substitutes 2. Elasticity is inversely proportional to the share of income spent on a good 5 1 e share of income spent on a good 3 Note that in this class we always ignore the sign of price elasticity due to the books convention. 4 Mathematically, this derivation needs additional rigor but ends up working in the end 5 This is because as the share of one s income spent on a good increases their incentive to change consumption of the good increases 5

6 3. Time changes elasticity, some things like gasoline prices can t be reacted to quickly but in the long run will change dramatically. 3.5 Graph Elasticity At middle of graph, elasticity = 1. At bottom of graph elasticity = 0. At Top of graph Elasticity =. Price Change Elastic Demand Inelastic Demand P increase Tot. Exp. Dec. Tot. Exp. Inc. P Dec. Tot. Exp. Inc. Tot. Exp. Dec. 3.6 Income Elasticity of Demand ǫ I > 0 for normal goods and ǫ I < 0 for inferior goods. 3.7 Cross-Price Elasticity of Demand ǫ C > 0 for substitute goods and ǫ C < 0 for complement goods. 4 Section 3 - Elasticity 4.1 Definitions Short Run period of time short enough that some inputs can t be changed Long Run period of time long enough that all inputs can be changed fixed Unchangeable Fixed Cost Expenditures on fixed inputs Variable Cost Expenditures on variable inputs Law of Diminishing Marginal Returns In the short-run, because at least one input is fixed, a firm eventually requires increasing amounts of additional variable input to get additional production. 6

7 4.2 Notation q = individual firm s production P = market price Q = market quantity 4.3 Formulas Derivations Profit = Revenue Cost 4.4 In a perfectly competitive market Producers decide how much to produce, they don t decide the price If they raise the price above market no one will buy their product. If they lower it, everyone will buy their product. Revenue for a firm = P q Cost for a firm = Expenditures on factors of production 4.5 Production in the short-run In the short-run at least one factor of production is fixed. A firm s supply curve is its marginal cost curve because the firm will produce until its marginal cost is equivalent to its profit. 6 A change in fixed input cost does not change the output level or the price. If profit is negative, you stay in business as long as you can pay variable input costs. 4.6 Determinants of Market Supply Changes in technology move the supply curve because they reduce the marginal cost which pushes each firm to make more. 6 Danny consider describing how some of these distinctions can be ignored when one thinks about this as a question of not fixed and variable inputs but rather inputs dependent on quantity produced. 7

8 5 Section 5 - Efficiency, Exchange and the Invisible Hand In Action 5.1 Definitions The Invisible Hand Actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resources. Accounting Profit = Total Revenues Direct Cost 7 Economic Profit = Total Revenues Direct Cost Implicit Cost Normal Profit = Accounting Profit Economic Profit = Implicit Cost Economic Rent The part of a payment for a factor of production that exceeds the owner s 8 reservation price. Efficient - Situation where it is impossible to make some people better off without hurting someone else. 5.2 Implicit cost The implicit cost of using their machinery is due to the depreciation of the equipment and what else it could be used for. We could sell our equipment for its value and invest the money into the best alternative business opportunity. 5.3 The Invisible Hand Price The Rationing Function of price. Price rations out resources. Changes in price distribute scarce goods to buyers who value it the most. This means that only the buyers who benefit the most from a good get it. This maximizes the total buyers surplus. The Allocative Function of Price. Changes in price direct productive resources away from overcrowded markets and towards underserved markets. 8 Of that factor of production 8

9 5.4 Economic Rent In the long-run economic rent will not go to zero in a perfectly competitive market. Economic rent is high when the factors of production are hard to replicate. 5.5 Efficiency Looking at a supply-demand curve pick a price between the curves and both seller and buyer benefit. The maximum efficiency comes to a maximum at the market equilibrium 5.6 Market equilibrium and social optimum Production a good generate pollution Seller does not pay for cost of pollution. Supply curve does not reflect full cost of production. 6 Section 6 Monopoly, Oligopoly, Monopolistic competition This section will cover firms in imperfectly competitive markets. 6.1 Definitions Monopoly The only supplier of a unique product with no close substitutes. Monopolistic competition Industry structure in which a large number of firms produce slightly differentiated products that are close substitutes of each other. Oligopoly An industry structure in which a small number of large firms produce close or perfect substitutes. Market Power A firm s ability to raise its price without losing all its sales. 9

10 Natural Monopoly Monopoly that results from economies of scale. Marginal Revenue The marginal benefit for a firm producing one additional unit of output. Price Discrimination Sell the same good to different buyers at different prices. Perfect Price Discrimination Occurs when the monopoly knows the reservation price of every buyer and sells them the good at that price. 6.2 Imperfect Competition Perfectly competitive firms face a perfectly elastic demand curve so they don t want to change the price. Imperfect competitive firms face a downward sloping demand curve so they can change the price and not lose all of their customers. Firms in non competitive markets have market power. They will want to find the location on the demand curve where profits are the highest. They have to find both the price and their output Sources of market power 1. Exclusive Control Over important inputs 2. Patents and Copyright Laws 10 Exclusive ownership on intellectual property. 3. Government Licenses and Franchises 4. Economies of Scale See section on the subject 5. NetworkEconomies Asmorepeopleuseagooditincreasesitsbenefit to consumer. 6. Large Start-Up costs In some industries the start-up cost of a business is much larger than the marginal cost of production Note that this is constrained by the market demand curve 10 This is really the first source 11 Causes include R&D, Engineering, setting up a factory... 10

11 6.4 Economies of scale If you double all inputs for production what happens to your output? If it more than doubles than you experience Increasing returns to scale. This means that the cost per unit of a good decreases with larger firms. If it less than doubles than you experience the opposite. 6.5 Section Firms in Imperfectly Completive Markets Maximize Profit Profit-Maximization Output for Monopoly Monopoly will follow the cost benefit principle, they will produce as long as the marginal benefit of one additional unit of output is greater than the marginal cost. 12 For a competitive firms, the market price is equal to their marginal revenue but for a monopoly this equality doesn t hold true. Any price discrimination can make a monopoly more efficient. Because the demand curve is downward sloping the marginal revenue for a monopoly is always less than the price they charge. 13. Due to the law of diminishing marginal returns the marginal cost will increase with respect to marginal quantity 14. Is the monopolies decision efficient? Ans: no, Their are still trades left to be made where both seller and buyer benefit. In this class we only have straight lines. 7 Section 7 Externalities and Property Rights 7.1 Definitions Externality An external cost or benefit of an activity received by people other than the actors As convention firms will produce if they are indifferent. 13 An increase in price loses sales 14 dp dq > 0 15 Anybody taking part in that activity 11

12 Coase Theorem If at no cost, people can negotiate the purchase and the sale of the right to perform activities that cause externalities, then people can always arrive at an efficient solutions to the problems caused by externalities. Tragedy of the Commons What happens when a scarce resource, is not owned and has no price. 7.2 Externalities An External Benefit or Positive Externalities helps people not involved in an activity while and external cost or negative externalities hurts others. If not all benefits or costs accrue to those people who pursue an activity, the level of activity that is best for the individual participant is lower or greater, respectively, than what is best for society. With externalities total economic surplus isn t as large as it could be not efficient competitive allocation is not efficient invisible hand theory breaks down Solutions Coase Theorem If at no cost, people can negotiate the purchase and the sale of the right to perform activities that cause externalities, then people can always arrive at an efficient solutions to the problems caused by externalities. Laws and regulations Compensatory taxes and subsidies. 16 Sometimes negotiation is costly, coase theorem breaks down. In this case, Laws and Regulations can deal with externalities. Compensatory taxes can make it so that externalities now will cost an individual the appropriate amount. Subsidies do the same for external benefits. The optimal amount of negative externalities is not 0. Some benefits of activities can exceed their externalities cost. We expect the cost of reducing 16 If an individual does not bear all of the cost of an activity, than you can make that activity more costly by taxing it. 12

13 negative externalities increases as you reduce externalities while the benefit of reducing the externalities decreases. Apply the cost benefit principal to reducing negative externalities. 7.3 External Benefits or Positive Externalities Benefits others 7.4 Property Rights and The Tragedy of the Commons The tragedy of the commons means that if a resource has no price, it will be used as long as the marginal benefit is greater or equal to zero. But the cost-benefit principle says that a resource should be used as long as the marginal benefit exceeds the marginal cost. This means that the resource will be overused. Assigning property rights to the commons prevents the tragedy. 8 Politics 9 Section 11 International Trade and Trade Policy 9.1 Definitions Absolute Advantage Being able to produce a good with fewer inputs than another Comparative Advantage Having a lower opportunity cost than another Closed Economy An economy that does not trade with the rest of the world Open Economy An economy that trades with other countries World Price The price at which a good or service is traded on international markets 13

14 Protectionism The view that free trade is injurious and should be restricted Tariff A tax imposed on an imported good. Quota A legal limit on the quantity of a goodthat may be imported. 9.2 Notation 9.3 Formulas Derivations 9.4 Trade can benefit everyone See example from slides Nations as a whole gain from a transition from a closed economy to an open economy. Although everyone can gain from trade not everyone will gain (ex. workers from industries whose goods are being imported) When a country goes fromaclosed to anopen economy, the price changes to the world price for all markets in the country. If the world price is below the market price, then quantity demanded will be greater than quantity supplied and the difference will be imported. If the world price is above the market price, then quantity supplied will be greater than quantity demanded and the difference will be exported. 9.5 Winners and Losers from Trade Winners are consumers of imported goods and producers of exported goods. Losers are producers of imported goods and consumers of exported goods. 9.6 Tariffs and Quotas Tariffs give the government tax revenue and help domestic produces and hurts domestic consumers. Quotas are like tariffs except foreign produces get the extra revenue Other barriers to trade include, red-tape barriers and regulations. 14

15 9.7 Protectionism Protectionism is inefficient by preventing countries from taking full advantage of their comparative advantages. Those hurt by free trade (specific industries) may be better politically organized than those who benefit from free trade (consumers) By having in place systems that guarantee some compensation of losers by winners it may be possible to reduce opposition to free trade (ex. worker retraining programs). 15