Microeconomics Exam Notes

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1 Microeconomics Exam Notes Opportunity Cost What you give up to get it Production Possibility Frontier Maximum attainable combination of two products (Concept of Opportunity Cost). Main Decision Makers: Households (Consume) Firms (Produce) Government Factors of Production: LAND LABOUR CAPITAL ENTERPISE Rational people think at a Margin Comparing costs and Benefits, People Respond to incentives. Market group of Buyers and sellers of a particular good or service Quantity Demanded amount of a good that buyers are willing and able to purchase at a given price. Law of Demand Holding everything else constant, when price falls, quantity demanded will increase vice versa. Willingness to Pay maximum a buyer will pay. Consumer Surplus Buyer s willingness to pay minus the amount paid Factors which shift Demand: Prices of Related Goods (Substitutes and Compliments) Income (Normal or Inferior Goods) Tastes Population and Demographics Expected Future Price Quantity Supplied amount sellers are willing and able to sell at a given price.

2 Law of Supply Holding everything constant, increases in price causes increases in quantity supplied (vice versa). Producer Surplus amount seller is paid minus the sellers cost. Factors which shift supply: Input prices Technology Expectations Number of Sellers Surplus quantity supplied is greater than quantity demanded Shortage quantity demanded is greater than quantity supplied Elasticity responsiveness of quantity demanded/supplied to changes in price (ceteris paribus). Price Elasticity of Demand % Change Quantity demanded / % Change Price Strong Elastic = More than 1 Weak Elastic (inelastic) = Less than 1

3 Unit Elastic = Same Percentage Change in Price and Quantity Demanded o (I.e. 22% Change in Price led to 22% Change in Quantity Demanded) Income Elasticity quantity demanded responsiveness to consumer income. % Change Quantity Demanded/ % Change Income Types of Goods: Increase in Income decreases the demand for that good = Inferior Good. Increase in Income Increases the demand for that good = Normal Good. Cross Price Elasticity % Change Quantity Demanded / % Change Price of Related Good Economic Efficiency: Marginal Benefit = Marginal Cost Economic Surplus: Producer + Consumer Surplus Price Floor Minimum Price (Only Effective Above Equilibrium) Price Ceiling Maximum Price (Only Effective Below Equilibrium Incidence of Tax Burden of tax between buyers and sellers Dependent on price elasticity of demand and supply Tax will have more effect if demand or supply is more elastic. Deadweight Loss More elastic, therefore more deadweight loss

4 More Gains from trade loss Subsidy (Negative Tax) Benefits of tax fall on sellers (primarily because of inelastic supply (i.e. First home owner grants). Demand Labour Demand for the good or service that labour produces Value of Marginal Product additional output a firm produces as a result of hiring one more worker. Marginal Product of Labour = Change in Quantity / Change in Labour Value MPL = MPL x Price Shifts in Labour Demand Output price Technological Change Supply of other factors (Capital) Labour Supply Trade off between leisure and wage Higher wage = Higher opportunity cost. Shift in Labour Supply Increase or Decrease Population Changing Demographics Expansion or contraction of Industries Availability and level of unemployment benefits Exports Consumer Surplus Decreases and Producer Surplus increases Imports Consumer Surplus Increase and Producer Surplus Decreases Import Tariffs (Tax) to protect domestic producers Outcome: o Consumer Surplus Decreases o Producer Surplus Increases

5 o Government collects tariff revenue o Overall Total Surplus decreases. Import Quota Limit on Imports Outcome: o Consumer Surplus Decreases o Producer Surplus Increases o Outa Licensees collect quota rent o Total Surplus decreases. Positive Externality i.e. Academic Research Negative Externality i.e. Congestion, Pollution Coarse Theorem If Parties bargain costlessly over the allocation of resources, they can solve the problems of externalities. Conditions: o Efficacy of Bargaining No Transaction Costs o Effective Legal System that can implement and enforce contracts. Government Solutions to Externalities: Command and Control Policies o Prohibition, standard setting and enforcement Market-Based Instruments o Price Based (Tax and Subsidy)

6 o Quantity Based (Emission Permits) Information Failure Markets and Supply of Information o Markets do not generate information optimally o Firms under invest in research or Knowledge Asymmetric Information Failure o Product Markets o Labour Markets Employer knows more than employee o Capital Markets Firm knows more than Government o Insurance Markets Consumer knows more than insurer. Solutions: Product Information Regulation of Advertising (Consumer Act) Merit Goods (Preference Failure) Merit Goods Compulsory education and seat belts De-Merit Goods Alcohol, Gambling, Tobacco. Costs of Production Profit = Total Revenue Total costs Explicit Costs Money flowing out of the firm Implicit Costs Opportunity cost of resources owned and used by the firm Short Run At least one of the firms inputs are fixed. Long Run Allows a firm to vary all it s inputs (New Technoloyg, Change Physical plant size Etc.) Production Function Relationship of inputs and outputs. Marginal Product = Change in Total Production / Change in Labour Additional output for one more unit of labour Average Product = Total Output / Total Labour Diminishing Marginal Product = Where Marginal Product declines a inputs increase.

7 Fixed Costs do not vary with increased output, incurred even if the firm products nothing. Variable Costs vary with the quantity of output. Total Costs Fixed + Variable costs ATC = Total Costs / Quantity of Output AFC = Fixed Costs / Quantity of Output AVC = Variable Costs / Quantity of Output Marginal Costs = Change in Total Costs / Change in Quantity U-Shaped Cost Curve Bottom indicates quantity that minimises ATC (Efficient Scale) Marginal Cost Intersecting ATC = low level of output. Marginal Cost above ATC = High output, marginal unit increases ATC Long Run Average Cost Lowest cost at which a firm is able to produce at a given quantity. Long Run Costs Impact Scale Economies of Scale LRAC decreases as scale of production and output increases. Constant Returns to Scale LRAC remain unchanged as scale of production and output increases. Diseconomies of Scale LRAC increases as scale of production and outputs increase. Firms in Competitive Markets Market Structures: o Perfect Competition o Monopolistic Competition o Oligopoly o Monopoly Perfect Competition: Many buyers and sellers (Price Takers) Firms sell identical products No barriers to exit and entry in the long-run Because Firm is a Price Taker their Price = Marginal Revenue

8 MR = AR Profit Maximising Level of Output: MR = MC Profit Maximising Quantity: P = MC Shutdown Rule Short Run Price is less than AVC Firm losses money through fixed costs if it shuts down. Entry/Exit Long-run Shutdown: Price < ATC Enter: P > ATC Long Run Supply if firms are profitable, new firms will enter, therefore quantity increases and pushes prices down (vice versa). At the End of Entry/Exit, firms in the market make zero economic profit (P = ATC) Monopoly & Monopolistic Competition Monopoly only one seller of a good or service without any close substitutes. Sources of Market Power:

9 o Exclusive ownership of a key resource o Government created o Network economies (Value to Customer i.e. Facebook) o Natural Monopoly Economies of scale so large that one firm can supply the entire market at a lower ATC. Monopoly Price Setter (Influence Price) Profit Maximisation - Monopoly MC Intersect MR

10 Monopolistic Competition Many sellers Product Differentiation (Price Taker Downward Sloping demand, with slightly different products). Price Set above Marginal Cost Greater the product differentiation, the greater the switching costs. As in Perfect Competition Firms make zero economic profit in the Long-run

11 Socially Efficient Level = Demand Intersecting MC Allocative Inefficiency Mark up > Marginal Cost, buyer who value the good more than the marginal cost of product, but less than the price will stop buying it creating a deadweight loss. Productively Inefficient Long run output is less than efficient scale. Oligopoly Few sellers offering similar or identical products Interdependent firms Best off cooperating as a monopolist (Producing small quantity and pricing above marginal cost) Nash Equilibrium situation whereby economic actors interacting with each other choose their best strategy given the strategies the other actors have chosen. Elements of Game Theory: Rules for actions allowed Strategies employed. Payoffs with regards to strategy. Equilibriums: Cooperative (Mutual Payoff) Non-Cooperative (Own self-interest)

12 Prisoners Dilemma Similar to oligopolistic competition Dominant Strategy Best Strategy for a player regardless of the strategies chosen by other players. Nash equilibrium every player chooses their dominant strategy Escaping Prisoner s Dilemma Losses for not cooperating (Greater in repeated games) Retaliation strategies against those whom don t cooperate More likely to see cooperative behaviour in repeated games.