Principles of Microeconomics

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1 University of Central Oklahoma Principles of Microeconomics ECON 2103 Dr. Travis Roach Fall 2017

2 2

3 3 The Scope and Method of Economics Q: What is the meaning of economics from your point of view? Draw it!

4 4 Some Definitions Positive economics Normative economics Descriptive economics Ceteris Paribus (all else equal) - This assumption is used to try and single out the effect attributed to a change in a single variable EX - What would my grade have been if I studied one more hour, ceteris paribus? i.e. EX - What will be the cost of a parking permit if student enrollment triples, ceteris paribus? i.e. Efficiency vs. Equity Efficiency will be a major theme for the course that will be developed in many contexts such as Perfect competition Consumer/producer problems Market and government intervention For now, consider efficiency as something that provides the greatest benefit (utility, profit, welfare) while incurring the smallest cost (harm, expenditure, loss) Equity has implications with normative economics. For instance, how do we define what is fair? Whose job is it to determine this?

5 5 Q: What should take precedence, equity or efficiency? What if we are talking about welfare checks, minimum wage, GI benefits? Common Fallacies Post Hoc Example and discussion Freakonomics (correlation vs. causation) Composition Division EX - Border patrol

6 6 The Economic Problem: Scarcity and Choice Scarcity The fundamental question of economics is how to choose among an array of option with limited (scarce) resources EX I want to live in a mansion, never cook or clean, and wear nice clothes, but I only make $2,000 a month EX My plane just crashed and I m alone on an island. Should I catch fish or climb and get coconuts? Time is a scarce resource too! To make these difficult decisions we use the concept of opportunity cost Opportunity Cost EX Choosing a date In microeconomics we model this as a choice between producing two different goods on a production possibilities frontier (PPF) EX Crops on a farm Given how much land and equipment you have (Ceteris paribus) you must give up one crop to plant another

7 7 EX The Gap Notice, that Gap has a choice between making: Only women s clothes Only men s clothes A combination What is the opportunity cost of going from A C? What about from C D, D E, E B? Thus,

8 8 Q: What would a PPF look like if the opportunity cost was not constant? EX - Schlotzky s What is the opportunity cost of making 10 sandwiches instead of 5? (C D) What is the opportunity cost of making 20 sandwiches instead of 15? (E B) Inefficiency Anywhere on the of the PPF curve - In the Schlotzky s example this could be an employee sitting around - In the Gap example this could be a piece of equipment not being used - In the farm example this could be a stretch of land not being used

9 9 PPF Review The PPF shows The factors of production (inputs) The outer bound shows all bundles that use resources efficiently Note: Generally, a point like C is only reached after there has been an increase in the factors of production, but most commonly comes about because of better technology or an innovation

10 10 EX - Ford Q: What happened to the PPF of the United States when the internet became widely used? Q: Using the PPF how could we model what happened in the United States after the recent financial crisis? Q: Abstract question Can we use the concept of a PPF to show the efficiency-equity tradeoff? If so, what does it look like? What is the opportunity cost like when switching from an equitable society to an efficient society?

11 11 Economic Systems Command Economy Central authority, or planner, directs all economic decisions i.e. who makes what, how much, and for what price all decided by the government Problems Free-Market Economy (LF) People and firms are Free to Choose all activities i.e. you may work as little or as much as you want and buy and sell whatever you want - Price is the main coordinating mechanism/signal - This guarantees that there are no shortages or surpluses EX Problems Mixed Economy Hybrid of the two systems. Government plays a role (to varying degrees) in economic decisions Problems

12 12 Demand, Supply, and Market Equilibrium The Circular Flow Model

13 13 Demand Class experiment: How much would you buy if. The law of demand The most interesting law of demand

14 14 EX What will happen to the quantity demanded of college classes if tuition increases? EX The quantity demanded of parking permits has increased. This is likely due to a Q: What factors (other than the price level) can affect the demand curve? I. II. III. IV. V. - These are known as the determinants of demand I.

15 II. 15

16 16 EX What happens to demand for movie tickets, assuming movie tickets are normal, when income decreases, CP? EX What happens to demand for Keystone, assuming Keystone is inferior, when income decreases, CP? III. The difference between income and wealth EX What happens to charitable giving, assuming it is normal, when you receive a large inheritance, CP?

17 17 IV. V.

18 18 EX What will happen to the demand for popcorn when the price of movie tickets increases, CP? EX What will happen to the demand for coffee when the price of tea increases assuming they are substitutes for one another, CP?

19 19 A change in quantity demanded vs. a shift in demand A change in the quantity of a good demanded happens because the price changes it is a movement along the curve. Note: Along the demand curve things like the price of other goods and income are held constant (ceteris paribus) EX Intuitive explanation: A shift in demand is the result of a change in one of the determinants of demand. This means that demand increases (or decreases) for a good regardless of the price level. Recall - The determinants of demand are I. II. III. IV. V.

20 20 Supply The law of supply The determinants of supply I. II. III. EX Environmental Economics Pigouvian Tax

21 21 EX The Wedge Supply & Demand Market Clearing Condition

22 22 Comparative Statics Comparative statics explain the resulting increase or decrease in the equilibrium price and quantity in a market as a result of changing determinants of supply and demand. EX Milk, food, and other necessities Assume there has been a Pigouvian tax set on carbon emissions. What effects could there be on the price and quantity of other goods?

23 23 Should We Tax People for Being Annoying? 1 BY ADAM DAVIDSON IT S THE ECONOMY NEW YORK TIMES Driving home during the holidays, I found myself trapped in the permanent traffic jam on I-95 near Bridgeport, Conn. In the back seat, my son was screaming. All around, drivers had the menaced, lifeless expressions that people get when they see cars lined up to the horizon. It was enough to make me wish for congestion pricing a tax paid by drivers to enter crowded areas at peak times. After all, it costs drivers about $16 to enter central London during working hours. A few years ago, it nearly caught on in New York. And on that drive home, I would have happily paid whatever it cost to persuade some other drivers that it wasn t worth it for them to be on the road. Instead, we all suffered. Each car added an uncharged burden to every other person. In fact, everyone on the road was doing all sorts of harm to society without paying the cost. I drove about 150 miles that day and emitted, according to E.P.A. data, about 140 pounds of carbon dioxide. My very presence also increased (albeit infinitesimally) the likelihood of a traffic accident, further dependence on foreign oil and the proliferation of urban sprawl. According to an influential study by the I.M.F. economist Ian Parry, my hours on the road cost society around $10. Add up all the cars in all the traffic jams across the country, and it s clear that drivers are costing hundreds of billions of dollars a year that we don t pay for. This is how economists think, anyway. And that s why a majority of them support some form of Pigovian tax, named after Alfred Pigou, the early-20th-century British economist. Pigou developed the idea of externalities: the things we do that affect others and that the market is unable to price. A negative externality is like the national equivalent of what happens when you go to dinner with three friends and, knowing that you ll pay only a fourth of the bill, decide to order an expensive entree. Pigou argued that there are so many damaging things that we do play music too loudly, drive aggressively and that we d probably do less if we had to pay for them. The $10 I cost the economy was based on Parry s algorithm, which calculates that drivers should pay a tax of at least $1.25 a gallon. Forty percent of that price, he says, is the cost that each vehicle adds to congestion. Another 40 cents or so offsets the price of accidents if we divided the full cost more than $400 billion annually by each gallon of gas consumed. (Only about 32 cents would be needed to offset the impact on the environment.) According to Parry s logic, if we 1

24 24 paid a tax of $1.25 per gallon instead of the current average of 50 cents, the price of gas would increase by about 25 percent to around $4 a gallon, which is still well below what much of Europe pays. But it would still encourage us to drive less, pollute less, crash less, lower the country s dependence on foreign oil and make cities more livable. Not surprisingly, several studies have found that people especially in Europe, where the gas tax is around $3 a gallon drive a lot less when they have to pay a lot more for gas. The idea of raising taxes to help society might sound like the ravings of a left-wing radical, or an idea that would destroy American industry. Yet the nation s leading proponent of a Pigovian gas tax is N. Gregory Mankiw, chairman of President George W. Bush s Council of Economic Advisers and a consultant to Mitt Romney s 2012 campaign. Mankiw keeps track of others who support Pigovian taxes, and his unofficial Pigou Club is surely the only group that counts Ralph Nader and Al Gore along with leading conservatives like Charles Krauthammer, Alan Greenspan and Gary Becker as members. Republican economists, like Mankiw, normally oppose tax increases, but many support Pigovian taxes because, in some sense, we are already paying them. We pay the tax in the form of the overcrowded roads, higher insurance premiums, smog and global warming. Adding an extra fee at the pump simply makes the cost explicit. Pigou s approach, Mankiw argues, also converts a burden into a benefit. Imposing taxes on income and capital gains, he notes, punishes the work and investment that improve society; taxing negative externalities allows the government to make money while discouraging activity that hurts the overall economy.

25 Practice Problems 25

26 26 Price as a Coordinating Mechanism Shortages Surpluses

27 27 EX Oklahoma Teacher Shortage EX Fracking, OPEC, and the price of oil

28 28 Market Intervention What happens if a price is set above or below the equilibrium level? Price Floor Examples: When there is a price floor, quantity supplied is than quantity demanded Price Ceiling Examples: When there is a price ceiling, quantity supplied is than quantity demanded

29 29 Q: When is government intervention in the market beneficial to society? Q: If the price of a good is manipulated from the market equilibrium, whom does it help and who does it hurt? Consumer and Producer Surplus Consumer Surplus

30 30 EX - Netflix Producer Surplus EX iphones

31 Proposition: Markets operating efficiently maximize the sum of consumer and producer surplus (total welfare). 31

32 32 Recall - Q: If the price of a good is manipulated from the market equilibrium, whom does it help and who does it hurt? In the case of a price ceiling In the case of a price floor

33 33 Practice Problems 1) That which we forgo, or give up, when we make a choice or decision is called A) out-of-pocket cost. B) marginal cost. C) real cost. D) opportunity cost. 2) The amount of education that one has is an important factor in the determination of his or her wage rate. This is best described as A) a positive statement. B) an example of the fallacy of composition. C) a normative statement. D) an example of marginalism. 3) Whenever the Democrats gain control of the Congress, spending on social programs increases; whenever Republicans gain control of the Congress, spending on defense increases. Hence, we know what the next party in control will do. This statement is an example of A) fallacy of inductive reasoning. B) post hoc, ergo propter hoc fallacy. C) fallacy of composition. D) ceteris paribus fallacy. 4) Which of the following would an economist classify as capital? A) a $50 bill B) a corporate bond C) a post office employee D) a guitar used by a musician Refer to the information provided in Figure 2.4 below to answer the questions that follow. Figure 2.4 5) According to Figure 2.4, the point where only motorcycles are produced is A) A. B) B. C) C. D) E.

34 34 6) According to Figure 2.4, the optimal point for the economy is A) A. B) B. C) F. D) indeterminate from the information given. 7) According to Figure 2.4, which point cannot be produced with the current state of technology? A) A B) B C) C D) F 8) Which of the following is an element of a command economy? A) The market decides distribution. B) The means of production are privately owned. C) Production decisions are centralized. D) The market decides what will be produced. 9) In a laissez-faire economy, what gets produced, how it is produced, and who gets it. A) the behavior of buyers and sellers determines B) the central government authority determines C) firms but not consumers determine D) consumers but not firms determine 10) Which of the following will NOT cause a shift in the demand curve for compact discs? A) a change in income B) a change in wealth C) a change in the price of downloadable online music D) a change in the price of compact discs 11) According to the law of demand, as prices rise, ceteris paribus A) demand increases. B) demand decreases. C) quantity demanded decreases. D) quantity demanded increases.

35 35 Refer to the information provided in Figure 3.2 below to answer the questions that follow. Figure ) Refer to Figure 3.2. Which of the following would be most likely to cause the demand for macaroni and cheese to shift from D1 to D0? A) an increase in the price of macaroni and cheese B) an increase in the price of flour used to make macaroni and cheese C) an increase in income, assuming macaroni and cheese is a normal good D) an increase in the quantity demanded for macaroni and cheese 13) If the demand for sardines increases as income decreases, sardines are a(n) A) normal good. B) inferior good. C) substitute good. D) complementary good. SCENARIO 3.1: Rented DVDs and movies shown in theaters are substitutes. Rented DVDs and plasma TVs are complements. Plasma TVs and movies shown in theaters are normal goods. People watch rented DVDs more often in the winter than in the summer. 14) Refer to Scenario 3.1. Most plasma TVs sold in the United States are imported from Japan. If the United States government reduces the number of plasma TVs that can be imported into the United States, ceteris paribus, what would happen? A) The price of plasma TVs and the rental price of DVDs would decrease. B) The price of plasma TVs would decrease, and the rental price of DVDs would increase. C) The price of plasma TVs would increase, and the rental price of DVDs would decrease. D) The price of plasma TVs and the rental price of DVDs would increase.

36 36 Refer to the information provided in Figure 3.16 below to answer the questions that follow. Figure ) Refer to Figure The supply curve for hula hoops shifts from S0 to S1. This could be caused by A) an decrease in the price of hula hoops. B) a decrease in the number of firms selling hula hoops. C) a decrease in the demand for hula hoops. D) either B or C. 16) Suppose that video game discs are a normal good. If the income of video game players increases, you predict that in the market for video games, A) both equilibrium price and quantity will fall. B) both equilibrium price and quantity will increase. C) equilibrium price will increase, and quantity will decrease. D) equilibrium price will fall, but quantity will increase.

37 37 Refer to the information provided in Figure 3.12 below to answer the questions that follow. Figure ) Refer to Figure 3.12 The market is initially in equilibrium at Point A. If demand shifts from D1 to D2, the new equilibrium price will be and the new equilibrium quantity will be. A) $3.00; 250 B) $6.00; 250 C) $4.00; 350 D) $4.00; ) Papayas and grapefruit are substitute goods. A drought in California destroyed a good portion of the grapefruit crop. Ceteris paribus, A) the price of both papayas and grapefruit will increase. B) the price of both papayas and grapefruit will fall. C) the price of grapefruit will increase, and the price of papayas will fall. D) the price of grapefruit will fall, and the price of papayas will increase.

38 38 Refer to the information provided in Figure 3.18 below to answer the questions that follow. Figure ) Refer to Figure The current price of a bag of pretzels is $1.10. You accurately predict that in this market, A) price tends to remain constant, and quantity supplied increases. B) price, quantity demanded, and quantity supplied decrease. C) price and quantity demanded increase, and quantity supplied decreases. D) price and quantity supplied decrease, and quantity demanded increases. 20) Equilibrium is the condition that exists A) whenever there is no government intervention in the market. B) when the demand curve intersects the price axis. C) when quantity demanded equals quantity supplied. D) when the demand curve intersects the quantity axis.

39 39 Elasticity Elasticities What they measure: Inelastic Demand Elastic Demand Inelastic Supply Elastic Supply

40 40 Price Elasticity of Demand E D = % Q d % P Elastic Demand: If the price elasticity coefficient is, demand is said to be elastic because the given price change causes a relatively large change in quantity demanded. I.E. Buyers are relatively sensitive to a change in price over the given price range Unit Elastic Demand: If the price elasticity coefficient is, demand is said to be unit elastic because a given percentage change in price causes quantity demanded to change by the same percentage Inelastic Demand: If the price elasticity coefficient is, demand is said to be inelastic because the given price change causes a relatively small change in quantity demanded. I.E. Buyers are not very responsive to a change in price over a given price range Calculating Elasticity Coefficients 1) Suppose the price of Birkenstocks increased by 10%, and as a result quantity demanded fell by 35% The elasticity coefficient is and demand is said to be 2) Suppose the price of parking on campus decreased by 12%, and as a result quantity demanded rose by 12% The elasticity coefficient is and demand is said to be 3) Suppose the price of textbooks increased by 25%, and as a result quantity demanded fell by 8% The elasticity coefficient is and demand is said to be Calculating percentage change using the midpoint formula E D = Q 2 Q 1 ( Q 2 + Q 1 2 ) P 2 P 1 ( P 2 + P 1 2 )

41 41 Using the graph below, what is the elasticity coefficient when price increases from $6 to $8 What is the elasticity coefficient when price decreases from $6 to $5 What is the elasticity coefficient when price falls from $5 to $4 P Between $6 and $5 demand is Between $5 and $4 demand is

42 42 Total Revenue and Price Elasticity of Demand Price elasticity of demand information is very important for firms because it directly affects their total revenue Total revenue is defined as: Price Quantity Total Revenue TR Q D

43 43 P 10 Price-Elastic where TR increases as price falls Price-Inelastic where TR decreases as price falls TR Quantity where demand is unit-elastic maximizes total revenue 0 50 Q If demand is price-elastic: 1) As price decreases, total revenue 2) As price increases, total revenue If demand is price-inelastic: 1) As price decreases, total revenue 2) As price increases, total revenue

44 44 Applied Economics Healthcare economics: The elasticity of demand for life-saving drugs 1) Estimates of the price elasticity of demand for prescription medication range from to Using an intermediate value of -0.20, determine the impact (decrease in quantity demanded) of the price increase. (Hint: use the midpoint formula) 2) What are the real-life impacts of such a price increase? What are some normative conclusions one could draw using your estimate of the decrease in quantity demanded? 3) Some have called for government intervention into this market. Describe the difficulties and inefficiencies of implementing a price ceiling in the healthcare industry.

45 45 Income Elasticity of Demand EX Busses EX Art Museum Note: The magnitude (size) of the income elasticity coefficient doesn t matter, only the sign of the coefficient (+ or -)

46 46 Cross-Price Elasticity of Demand This is how we determine if goods are substitutes or compliments Q: Can you develop a measure of the cross-price elasticity and interpret it to find out whether or not a good is a substitute of a compliment? Is there a rule of thumb? EX Apple vs. Samsung Suppose the price of a Samsung Note decreased by 5%, and subsequently quantity demanded of the ipad decreased by 4% What is the cross-price elasticity of the ipad with respect to the Note?

47 47 EX Pizza & Beer Suppose the price of beer increased by 6%, and subsequently the quantity demanded of pizza decreased by 12% What is the cross-price elasticity of pizza with respect to beer? Note: Again, the magnitude (size) of the coefficient doesn t matter, only the sign of the coefficient (+ or -) Applications of Demand Elasticities Implementing a tax what is the effect on consumer and producer surplus? If demand is elastic

48 48 If demand is inelastic This is one reason why we typically see taxes on things like cigarettes, oil, alcohol, etc. Immigration Policy What will happen to the demand and wage paid to American born workers if a more stringent immigration policy is put into place?

49 49 Price Elasticity of Supply Very similar to the price-elasticity of demand E S = % Q S % P If E S > 1, then supply is If E S < 1, then supply is Elasticity of Labor Supply Measures

50 50 Q: What would you do if you currently worked 20 hours a week and your income doubled? Work more? Work less? What does the labor supply curve look like in each case? For those that would work more For those that would work less

51 51 Practice Problems 1) When the price of tea increases 7%, quantity demanded decreases 12%. The price elasticity of demand for tea is, and total revenue from tea sales will. A) inelastic; increase B) inelastic; decrease C) elastic; increase D) elastic; decrease 2) The All Smiles Greeting Card Company wants to increase the quantity of greeting cards it sells by 10%. If the price elasticity of demand is -2.5, the company must A) increase price by 4.0%. B) decrease price by 4.0%. C) increase price by 0.25%. D) decrease price by 0.25%. 3) A government wants to reduce electricity consumption by 5%. The price elasticity of demand for electricity is The government must the price of electricity by. A) raise; 100.0% B) raise; 10.0% C) raise; 1.0% D) lower; 20% Refer to the information provided in Figure 5.2 below to answer the questions that follow. Figure 5.2 4) Refer to Figure 5.2. If the price of a hamburger decreases from $10 to $8, the price elasticity of demand equals. Use the midpoint formula. A) B) -3.0 C) -30. D) -300

52 52 5) Refer to Figure 5.2. If the price of a hamburger decreases from $4 to $2, the price elasticity of demand equals. Use the midpoint formula. A) B) -2.0 C) -3.0 D) ) Price and total revenue move in the same direction when demand is A) price elastic. B) price inelastic. C) unit price elastic. D) perfectly price elastic. 7) A firm is currently producing in the inelastic portion of its demand curve. What course of action do you recommend for it, assuming it wants to raise revenue? A) Continue producing at the current output level, because it maximizes its total revenue by producing in the inelastic portion of its demand curve. B) Reduce price, because if it reduces price and demand is inelastic, total revenue will increase. C) Increase price, because if it increases price and demand is inelastic, total revenue will increase. D) Continue selling at the same price, but increase the amount it produces. 8) If income decreases by 20% and, in response, the quantity of housing demanded decreases by 14%, then the income elasticity of demand for housing is A) -1. B) C) 0.7. D) ) The income elasticity of demand for education is 3.5. Thus, a 6% decrease in income will A) decrease the quantity of education demanded by 3.5%. B) decrease the quantity of education demanded by 21%. C) increase the quantity of education demanded by 6%. D) increase the quantity of education demanded by 21%. 10) Cross-price elasticity of demand measures the response in the A) price of a good to a change in the quantity of another good demanded. B) income of consumers to the change in the price of goods. C) quantity of one good demanded when the quantity demanded of another good changes. D) quantity of one good demanded to a change in the price of another good. 11) If the cross-price elasticity of demand between shrimp and oysters is 4, then a 2% increase in the price of shrimp will result in a in the quantity of oysters demanded. A) 0.5% increase B) 8% increase C) 4% increase D) 2% decrease

53 53 12) The cross-price elasticity of demand between good X and good Y is Given this information, which of the following statements is true? A) The demand for goods X and Y is elastic. B) Goods X and Y are substitutes. C) Goods X and Y are complements. D) The demand for goods X and Y is income elastic. Refer to the information provided in Figure 5.5 below to answer the question that follows. Figure ) Refer to Figure 5.5. As the price of good W decreased, the demand for good Y shifted from D1 to D2. The cross-price elasticity of demand between W and Y is A) positive. B) negative. C) zero. D) indeterminate from this information. 14) A mass transit authority charges subway fares of $2.50 during morning rush hours but only $1.50 during late morning non-rush hours. Economists explain the fare difference by the fact that the demand for subway rides during the morning rush hours is, but during the late morning it is. A) more elastic; more inelastic B) perfectly elastic; perfectly inelastic C) more inelastic; more elastic D) unit elastic; relatively inelastic 15) Which of the following, if true, would most effectively back the argument that raising cigarette taxes reduces the number of people who smoke cigarettes? A) The demand for cigarettes is relatively inelastic. B) The demand for cigarettes is relatively elastic. C) The supply for cigarettes is relatively inelastic. D) The supply for cigarettes is relatively elastic.

54 54 Household Behavior and Consumer Choice Q: Which is more valuable, diamonds or water? Two different values: To overcome the diamond/water paradox economists use the concept of utility Total Utility - Marginal Utility -

55 55 EX Fuzzy s fish tacos # of Tacos Total Utility Marginal Utility Graph: The law of diminishing marginal utility - Examples:

56 56 Q: How is the law of demand related to the law of diminishing marginal utility? Utility Maximization Remember, a central focus in economics is the study of scarcity and how we confront it. As most college students are well aware of money can be a very scarce thing. For that reason, we must begin to account for prices and budgets. EX-Helicopter rides and Myriad Gardens

57 57 The Utility Maximizing Rule Utility is maximized if the price-weighted marginal utility of one good is equal to the priceweighted marginal utility of another good. i.e. EX Suppose the marginal utility of seeing a movie is 20 and the price of a movie is $10, and that the marginal utility of playing laser tag is 50 and the price of playing laser tag is $20. What should you do after class, see a movie or play laser tag? Budget Constraint

58 58 EX - Assume that you derive utility from eating pizza and burgers. If your weekly income is $40, pizza costs $10, and burgers cost $5, what is your budget constraint? What is the maximum amount of pizzas you can buy? What is the maximum amount of burgers you can buy? Use this information to graph the budget constraint. Pizzas Burgers

59 59 Complete the values in the table below: Pizzas TU MU MU/P Burgers TU MU MU/P What is the total utility from gained by having 4 pizzas and 0 burgers? Is this bundle affordable? What is the total utility from having 2 burgers and 3 pizzas? Is this bundle affordable? What is the total utility from having 6 burgers and 1 pizza? Is this bundle affordable? What is the total utility from having 4 burgers and 2 pizzas? Is this bundle affordable? Which of the above bundles maximizes utility? Does this bundle follow the utility maximizing rule?

60 60 Budget Constraints and Opportunity Cost The budget constraint shows the set of all affordable bundles of goods. We can also use the budget constraint to see what the opportunity cost of consuming one good is in terms of another. Recall: opportunity cost EX - Flip-flops and Toms Assume that the price of flip-flops is $10, and that the price of Toms are $40. 1) If Income Price Toms = 40, what is your income? 2) Draw the budget constraint FF Toms 3) According to the budget constraint, buying one more pair of toms means you must give up flip flops i.e. by not buying Toms I can buy pairs of flip-flops

61 61 4) According to the budget constraint, buying one more pair of flip-flops means you must give up pairs of Toms i.e. by not buying a pair of flip-flops I can buy pairs of Toms 5) Suppose the price of Toms has increased to $60, how will this affect your budget constraint? FF Toms

62 62 Income and Substitution Effects: Q: Will a price decrease (increase) of one good modify what/how much you buy? How? Income Effect EX - The price of gas has fallen leaving you with more money to spend. What will happen to demand for: i) Spaghettios (inferior) ii) Movie tickets (normal) Substitution Effect EX - The price of physical textbooks has risen. What will happen to your demand for ebooks?

63 63 Summary of income and substitution effects: - Price increase when a good is normal - Price decrease when a good is normal Q: What happens when there is a price increase for an inferior good? Is it possible for demand to no longer be downward sloping?

64 64 Appendix: Indifference Curves and the Calculus of Utility Maximization Utility can be expressed graphically by an indifference curve The indifference curve shows: With a budget constraint we can find the optimal bundle The utility maximizing rule revisited

65 65 Practice Problems 1) Hector has $1,000 a month to spend on clothing and food. The price of clothing is $50 and the price of food is $20. The clothing and food pairs in Hector's choice set include units of clothing and units of food. A) 50; 50 B) 20; 50 C) 15; 25 D) 8; 30 Refer to the information provided in Figure 6.1 below to answer the questions that follow. Figure 6.1 2) Refer to Figure 6.1. Assume Tom is on budget constraint AC and the price of a hamburger is $5.00. Tom's monthly income is A) $4. B) $60. C) $80. D) $100. 3) Refer to Figure 6.1. Assume Tom's budget constraint is AC. Given his current monthly income he will not have enough income to purchase the bundle represented by point A) A. B) B. C) E. D) D. 4) Refer to Figure 6.1. Along budget constraint AC, the opportunity cost of one hot dog A) is 1/4 of a hamburger. B) is 1/2 of a hamburger. C) is 2 hamburgers. D) changes as you move down along the budget constraint.

66 66 Refer to the information provided in Figure 6.3 below to answer the questions that follow. Figure 6.3 5) Refer to Figure 6.3. Molly's budget constraint is AB. It would swivel to AD if the price of A) cassette tapes increased. B) cassette tapes decreased. C) CDs increased. D) CDs decreased. 6) Carlos can buy either sushi or eggrolls. If the prices of sushi and eggrolls triple and so does Carlos's money income, we can deduce that Carlos's budget constraint will A) shift in but remain parallel to the old one. B) shift out but remain parallel to the old one. C) swivel in so that the slope of the budget constraint is tripled. D) remain unchanged.

67 67 Refer to the information provided in Figure 6.8 below to answer the questions that follow. Figure 6.8 7) Refer to Figure 6.8. The marginal utility of the second movie rental is A) 0. B) 10. C) 25. D) 40. 8) Refer to Figure 6.8. The total utility of four movie is and the fourth movie's marginal utility is. A) 15; 0 B) 25; 10 C) 28; 3 D) 28; 0 9) Daisy is consuming X and Y so that she is spending her entire income and MUx/Px = 12 and MUy/Py = 10. To maximize utility, she should A) continue to consume the same amount of X and Y since she is already maximizing utility. B) consume less of both X and Y. C) consume more X and less Y. D) consume less X and more Y.

68 68 Refer to the information provided in Table 6.1 below to answer the questions that follow. Table 6.1 Dozens of Oysters per Day Total Utility Marginal Utility Number of Beers per Day Total Utility Marginal Utility ) Refer to Table 6.1. The marginal utility of the third dozen oysters per day is A) 10. B) 30. C) 44. D) ) Refer to Table 6.1. Diminishing marginal utility sets in after the dozen oysters per day. A) first B) second C) third D) fourth 12) Refer to Table 6.1. The total utility of five beers per day is A) 70. B) 128. C) 184. D) indeterminate from this information. 13) Refer to Table 6.1. If the price of a beer is $4, the price of a dozen oysters is $12, and Tyler has $28 of income, Tyler's utility maximizing combination of beers and oysters per day is A) 1 beer and 2 dozen oysters. B) 4 beers and 1 dozen oysters. C) 3 beers and 1.5 dozen oysters. D) indeterminate from this information.

69 69 14) The law of refers to a consumer's decrease in additional satisfaction as she consumes more and more units of a good. A) consumer choice B) diminishing marginal utility C) utility maximization D) infinite demand 15) For normal goods, the substitution and income effects of a price increase will do which of the following? A) Both will decrease the quantity of the good demanded. B) Both will increase the quantity of the good demanded. C) The substitution effect will increase the quantity of the good demanded while the income effect will decrease the quantity of the good demanded. D) The substitution effect will decrease the quantity of the good demanded while the income effect will increase the quantity of the good demanded.

70 70 The Production Process: The Behavior of Profit-Maximizing Firms Review:

71 71 Profit from an economist s point of view Total (economic) Costs EX A painter earns $30,000 a year by painting houses, and he spends $15,000 on paint supplies. If he wasn t a painter his next best alternative is getting paid $10,000 a year as a waiter. What is this painter s accounting profit? What is this painter s economic profit? If π > 0 If π < 0 If π = 0

72 72 Economic Costs Total economic costs include all obvious costs (explicit costs) like how much you pay workers and how much you pay in rent as well as the opportunity cost of the inputs (implicit costs) For example, the opportunity cost of investing money in a business is the rate of return you could make on the next best alternative (generally assumed to be a short term government bond) This is commonly known as the normal rate of return Note: this is why when π = 0 it is referred to as a normal economic profit Including economic costs, the economic profit equation then becomes: Application: Net Present Value

73 73 Short-run vs. Long-run Q: Using the concept of economic profit, identify why firms would enter or exit an industry o Examples: o Examples:

74 74 Total, Marginal, and Average Product - Assume that K is fixed at its current level Total Product Marginal Product The law of diminishing returns Average Product

75 75 EX Jamba Juice # of Employees Total Product MP L AP L Q: If you pay each worker $7.50 and can sell a smoothie for $5, how many workers should you hire? VMP

76 76 Short-run Costs and Output Decisions In order for a firm to profit maximize they must minimize costs EX - Suppose production technique A, B, and C can all produce the same quantity. If P L = $3 and P K = $5, which input combination will a firm choose? L K TC A 10 2 B 5 3 C 2 6 Q: At what price will firms begin to substitute capital for labor? So in general,

77 77 Total Cost Total Fixed Cost Total Variable Cost Average Total Cost

78 78 Q: Using the formula for average total cost, develop a measure of average fixed cost and average variable cost. AVC = AFC = Q: Assuming that we are in the short-run, why does AVC Fall at first and eventually rise? For the same reason, the marginal cost curve looks like Marginal Cost

79 79

80 80 The Relationship Between AVC, ATC, and MC Perfect Competition Characteristics

81 81 The Profit Maximizing Rule Calculating Profit from a Graph We know that Step 1: Step 2: Step 3:

82 82 EX Graphical Proof of the profit maximizing rule

83 83 Q: Is MR=MC also a loss minimizing rule? Why or why not? The Shut-down Decision

84 84 Four Scenarios (review)

85 85 Changing Market Supply and Demand EX

86 86 Long-Run Costs and Output Decisions Increasing Returns to Scale (economies of scale) Constant Returns to Scale

87 87 Decreasing Returns to Scale (diseconomies of scale) The Long-Run Average Cost Curve

88 88 Long-Run Competitive Equilibrium EX Energy Economics

89 89 Practice Problems SCENARIO 7.1: You own and are the only employee of a company that writes computer software that gamblers use to collect sports data. Last year your total revenue was $90,000. Your costs for equipment, rent, and supplies were $50,000. To start this business you invested an amount of your own capital that could pay you a $40,000 a year return. 1) Refer to Scenario 7.1. During the year your economic costs were A) $40,000. B) $60,000. C) $90,000. D) $100,000. 2) Refer to Scenario 7.1. Your accounting profit last year was A) $10,000. B) $30,000. C) $40,000. D) $60,000. 3) Refer to Scenario 7.1. Your economic profit last year was A) -$40,000. B) -$10,000. C) $0. D) $10,000. 4) In the short run, a firm A) has at least one fixed factor of production. B) cannot enter an industry where positive profits are being earned. C) can exit an industry, and all of its factors of production are variable. D) both A and B are correct. 5) marginal returns implies marginal costs. A) Diminishing; decreasing B) Increasing; increasing C) Diminishing; increasing D) Increasing; constant

90 90 Refer to the information provided in Figure 7.4 below to answer the questions that follow. Figure 7.4 6) Refer to Figure 7.4. The marginal product of the third worker is A) 10. B) C) 32. D) 42. 7) Wilbur's Widgets, a widget company, produces 100 widgets. Its average fixed cost is $6 and its total variable cost is $400. The total cost of producing 100 widgets is A) $306. B) $400. C) $600. D) $1,000.

91 91 Refer to the information provided in Table 8.2 below to answer the questions that follow. Table 8.2 Number of Earnings TVC MC AVC TFC TC AFC ATC ) Refer to Table 8.2. If Danica produces two pairs of earrings, her marginal cost is A) $20. B) $ C) $ D) $ Refer to the information provided in Table 8.5 below to answer the following questions. Table 8.5 Number of TFC TVC Fruit Baskets TC MC 0 $100 $0 $ ) Refer to Table 8.5. Assume that Polynesian Fruit sells fruit baskets in a perfectly competitive market. The market price of a fruit basket is $44. To maximize profits, Polynesian Fruit should sell fruit baskets and their profit is. A) three; $10 B) four; $14 C) five; $28 D) six; $28

92 92 Refer to the information provided in Figure 9.1 below to answer the questions that follow. Figure ) Refer to Figure 9.1. The profit maximizing quantity of wheat is bushels. A) 6 B) 9 C) 12 D) 16 11) Refer to Figure 9.1. This farmer's shutdown point price is A) $0. B) $4. C) $7. D) $10. 12) Assume Cathy's Cupcake Company operates in a perfectly competitive market producing 10,000 cupcakes per day. At this output level, price exceeds the firm's marginal and average variable costs. It follows that producing one more cupcake will cause this firm's A) total cost to decrease. B) profits to increase. C) profits to decrease. D) profits to remain unchanged.

93 93 Refer to the information provided in Figure 9.7 below to answer the questions that follow. Figure ) Refer to Figure 9.7. In the $6-$7 price range, the firm will A) shut down. B) continue to operate but at a loss. C) break even. D) earn a profit. 14) Refer to Figure 9.7. Suppose demand for wheat is initially D2. If the price of rice (a substitute for wheat) rises, then demand for wheat will shift to. This will the equilibrium price of wheat, and individual profit maximizing firms will produce bushels of wheat. A) D3; increase; 15 B) D1; increase; 13 C) D3; decrease; 10 D) D1; decrease; 0 15) A perfectly competitive firm, Paula's Pineapple Farm, is incurring a loss, but the price is still above minimum AVC. In the short run it should, and in the long run, if there is no change in economic conditions, it should. A) shut down; exit the industry B) shut down; expand C) produce where MR = MC; exit the industry D) produce where MR = MC; expand

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