Principles of Microeconomics Module 1.1. Scarcity, Limited Resources and Opportunity Costs

Transcription

1 Principles of Microeconomics Module 1.1 Scarcity, Limited Resources and Opportunity Costs

2 What is Economics? Economics is the study of how people and society allocate scarce resources Scarce resources: For people: Time, Money ect. For firms: Factors of Production à Land, Labor and Capital Since we don t have an infinite amount of resources what do we do with what we have?

3 Tradeoffs in Decisions People face tradeoffs in decisions because of scarce resources Cannot do everything, buy everything, make everything Need to choose how to allocate our time, our money, our resources When you make one choice you give up the other option

4 Opportunity Costs Opportunity Cost: What you give up to get something Example: How many times can you hit the snooze button? Benefit Opportunity Cost Hit it once More Sleep Feel rushed in the morning Hit it twice More Sleep Feel rushed Skip breakfast Hit it three times More Sleep Feel rushed Skip breakfast Skip the gym Hit it four times More Sleep Feel rushed Skip breakfast Skip the gym Late for work

5 Opportunity Cost Opportunity Costs are subjective to the individual and change depending on circumstances What if it was Saturday morning and you hit the snooze button? Benefits of more sleep may outweigh any costs if you don t have to wake up! What if you work in the afternoon? You do not have the same constraints as someone who needs to go to work in the morning!

6 Opportunity Costs Opportunity Costs drive the decisions we make every day We face them all the time We weigh the costs and benefits of each decisions consciously or subconsciously and make a choice Test yourself: What was a recent decision you made? What did you give up when you made that choice? What was the opportunity cost for you?

7 Principles of Microeconomics Module 1.2 Opportunity Costs and Production Possibilities Frontier 7

8 Production Possibilities Frontier Production possibilities frontier (PPF) represents the opportunity costs an economy faces in the production of two goods. All economies have scarce resources -- need to decide how to allocate those resources to produce goods. If you produce more of one good need to produce less of the other (with no change in available resources) 8

9 PPF Exercise Consider an economy that produces two goods: Leather jackets and leather boots. A B C D E Boots Jackets Draw the PPF curve for this economy As we move from one point to the next calculate the change in the number of boots produced and the number of jackets produced. What does this tell you about how opportunity costs change? 9

10 PPF Exercise A B C D E Boots Jackets Δ Boots Δ Jackets As we move along the PPF curve: Opportunity Cost changes O.C. RISES as give up more of the good that is SCARCE O.C. is LOWER when the good is in relative ABUNDANCE 10

11 PPF Exercise Suppose now that there is a shortage in rubber. - What happens in the boot industry? - What happens in the jacket industry? 11

12 PPF Exercise With a shortage in rubber, this affects the production of boots relatively more than the production of jackets Bias shift of PPF If there is a change in resources need to consider the impact this has on both industries equal or bias? 12

13 Key Takeaway All economic agents face tradeoffs when making decisions Whatever they choose comes with an opportunity cost what they could otherwise do with their time, money, resources Apply this concept to understand how an economy makes choices between the production of goods in the PPF 13

14 Principles of Microeconomics Module 1.3 Comparative advantage, specialization, and trade 14

15 How can we satisfy our needs/wants? 1. Economic Self-sufficiency: Produce all of the goods we need/want to consume ourselves 2. Specialization and Trade: Produce one good that we have a Comparative Advantage in and trade with others for what we need GAINS FROM TRADE: We can CONSUME MORE while working the same amount. 15

16 Trade Exercise Time to Produce One Unit Amount Produced in One Day (8hrs of work) Bread Sweaters Bread Sweaters Seamstress 60 minutes = 1 loaf 120 minutes = 1 sweater Baker 20 minutes = 1 loaf 60 minutes = 1 sweater How much bread and sweaters can each agent produce in one day of work? 16

17 Trade Exercise Time to Produce One Unit Amount Produced in One Day (8hrs of work) Bread Sweaters Bread Sweaters Seamstress 60 minutes 1 loaf 120 minutes 1 sweater (60/60)*8hrs = 8 loaves (60/120)* 8hrs = 4 sweaters Baker 20 minutes 1 loaf 60 minutes 1 sweater (60/30)*8hrs = 24 loaves (60/60)*8hrs= 8 sweaters Who is better at producing bread? Who is better at producing sweaters? If they split their time evenly between producing both goods, how much can they consume (no trade)? 17

18 Economic Self-Sufficiency 18

19 Trade Exercise Based on opportunity cost: Seamstress has a lower opportunity cost in making sweaters For the seamstress, if she produces one more sweater, she gives up baking 2 loaves of bread in that time Baker has a lower opportunity cost in baking bread For the baker if he produces one more loaf of bread, he gives up making 3 sweaters in that time Amount Produced in One Day Opportunity Cost Bread Sweaters Bread Sweaters Seamstress 8 loaves 4 sweaters ½ Sweater 2 Breads Baker 24 loaves 8 sweaters 1/3 Sweater 3 Breads Opportunity Cost determines specialization 19

20 Trade Exercise What happens if the baker and seamstress want to trade? Suppose the agents agree that: Baker will spend 5 hours on bread, 3 hours on sweaters Seamstress will spend 8 hours on sweaters How much do they produce? How much will they consume? Will they gain from the trade? 20

21 Trade Exercise AMOUNT PRODUCED Bread Sweaters Seamstress 0 (60/120)* 8hrs = 4 sweaters Baker (60/20)*5hrs = 15 loaves (60/60)*3hrs = 3 sweaters What if they agree to trade 2 sweaters for 5 loaves of bread? How much will they consume? 21

22 Trade Exercise AMOUNT CONSUMED Bread Seamstress 0 bread + 5 bread = 5 bread Baker 15 bread - 5 bread = 10 bread Sweaters 4 sweaters 2 sweaters = 2 sweaters 3 sweaters + 2 sweaters = 5 sweaters Has the seamstress gained from this trade? Has the baker gained from this trade? 22

23 With Trade 23

24 Comparative Advantage Agent with the lower opportunity cost in producing the good will have a comparative advantage in its production Opportunity Costs Bread Sweaters Seamstress 1 more bread = ½ sweater 1 more sweater = 2 bread COMPARATIVE ADVANTAGE Baker 1 more bread = 1/3 sweater COMPARATIVE ADVANTAGE 1 more sweater = 3 bread No single agent can have a comparative advantage in both goods. As long as the opportunity costs between two agents differ both can gain from trade. 24

25 Key Takeaway Trade and specialization make everyone better off because consume more without working more Trade can be beneficial even when one economic agent is much better at producing both goods To determine which goods an economic agent will produce need to understand comparative advantage (or) opportunity cost in producing each good 25

26 Principles of Microeconomics Module 1.4 (A) Economic Systems 26

27 Economic Systems Economic systems are systems of Production Resource Allocation Exchange Distribution of goods and services 1. What to produce? 2. How much to produce? 3. Who receives the output? 27

28 Property Rights and Economic Systems Property rights are an important component of economic systems Because an economy is trying to answer the previous three questionsà who owns what influences the type of system we have Property Rights determine who owns a resource and who decides how it is used. Individuals Associations Government 28

29 Property Rights and Economic Systems Property rights are an important component of economic systems Because an economy is trying to answer the previous three questionsà who owns what influences the type of system we have Property Rights determine who owns a resource and who decides how it is used. Individuals Associations Government 29

30 Property Rights and Economic Systems Property rights are an important component of economic systems Because an economy is trying to answer the previous three questionsà who owns what influences the type of system we have Property Rights determine who owns a resource and who decides how it is used. Individuals Associations Government 30

31 Four Components of Property Rights 1. The right to use the good 2. The right to earn income from the good 3. The right to transfer the good to others 4. The right to enforce property rights 31

32 Economic Systems OWNERSHIP Planned Private Allocation Planned Socialist Planned Economy Command Capitalism Private Market Socialism Capitalism 32

33 Market-based Economy 33

34 Principles of Microeconomics Module 1.4 (B) Marginal Analysis 34

35 In this video we will discuss marginal analysis and how changes in incentives will change decisions of firms and consumers

36 Marginal Analysis Marginal analysis: examination of the associated costs and potential benefits of specific business activities or financial decisions. Goal: to determine if the costs associated with the change in activity will result in a benefit that is sufficient enough to offset them. Instead of focusing on business output as a whole, the impact on the cost of producing an individual unit is most often observed as a point of comparison.

37 Marginal Analysis Marginal analysis: examination of the associated costs and potential benefits of specific business activities or financial decisions. Goal: to determine if the costs associated with the change in activity will result in a benefit that is sufficient enough to offset them. Instead of focusing on business output as a whole, the impact on the cost of producing an individual unit is most often observed as a point of comparison.

38 Marginal Analysis Marginal analysis: examination of the associated costs and potential benefits of specific business activities or financial decisions. Goal: to determine if the costs associated with the change in activity will result in a benefit that is sufficient enough to offset them. Instead of focusing on business output as a whole, the impact on the cost of producing an individual unit is most often observed as the best point of comparison.

39 Example of Marginal Analysis A manufacturer wishes to expand its production A marginal analysis of the costs and benefits is necessary. COSTS Additional manufacturing equipment BENEFITS Estimated increase in sales attributed to the additional production Additional employees for increased output Larger or New Facilities Additional materials for production

40 Example of Marginal Analysis If the increase in income > the increase in cost, the expansion may be a wise investment COSTS Additional manufacturing equipment BENEFITS Estimated increase in sales attributed to the additional production Additional employees for increased output Larger or New Facilities Additional materials for production

41 Incentives People face trade-offs in the every decisions that they make Weigh the costs/benefits associated with their choices Choose what fits their needs/wants best Incentives change costs/benefits of a decision Because they alter the costs or benefits of doing something they may change the choice a person makes 41

42 Examples of Incentives and Disincentives INCENTIVES DISINCENTIVES Retail store sales: Buy-one get-one sales Attendance policies in class Taxes on cigarettes, alcohol ect. Calorie reports at fast-food restaurants Tax subsidy for new green technology Pollution tax

43 Examples of Incentives and Disincentives INCENTIVES DISINCENTIVES Retail store sales: Buy-one get-one sales Attendance policies in class Taxes on cigarettes, alcohol ect. Calorie reports at fast-food restaurants Tax subsidy for new green technology Pollution tax

44 Key Takeaways Marginal analysis is used frequently by firms to weigh the benefits and drawbacks of business decisions People do this too! They weigh the costs and benefits of various decisions and make a choice Incentives/disincentives change the costs or benefits of a choice, therefore may alter the decision someone makes

45 Principles of Microeconomics Module 2.1 (A) Supply and Demand in the Market for Goods and Services 45

46 What are competitive markets? Competitive Markets: Bring together the decentralized decisions of buyers and sellers Decentralized Decisions of Buyers: Drive them to try to get the lowest possible price for the goods they want Decentralized Decisions of Sellers: Drive them to try to get the highest possible price for the goods they are selling When these decisions come together competitive markets yield: Best possible price for the product Produced at the lowest possible cost Most efficient allocation of resources 46

47 What are competitive markets? Fundamental Assumptions of Supply + Demand Model: 1. Operating under Perfect Competition Lots of buyers and sellers Goods sold are identical No cost to entering or leaving the market 2. Equal access to information 3. Externalities do not exist No single economic agent can unilaterally exert any price control 47

48 What is Demand? Demand comes from the buyer of a good/service Each buyer is trying to get the lowest price possible for the good/service that they want Law of Demand: As price of a good declines, people want to buy more of it Price Q demanded 48

49 Factors that Shift Demand Change in Income Normal Goods Inferior Goods Change in Tastes and Preferences Change in Price of Related Goods Change in Number of Buyers Change in Future Expectations 49

50 What is Supply? Supply comes from the seller of a good/service Each seller is trying to get the highest price possible for the good/service that they produce Law of Supply: As price of a good increases, people want to sell more of it Price Q demanded 50

51 Factors that Shift Supply Change in Price of Inputs Change in Production Technology Change in Number of Sellers Change in Future Expectations 51

52 Key Takeaway Demand is determined by the buyers of a good. Buyer always want to get the lowest price they can! Hence, demand is downward sloping Supply is determined by the sellers of the good. Sellers always want to get the highest price they can! Hence, supply is upward sloping Certain factors affect each of the curves and cause them to shift. The shifts come from an underlying change to the willingness to buy or willingness to sell. 52

53 Principles of Microeconomics Module 2.1 (B) Supply and Demand in the Market for Goods and Services 53

54 Market Equilibrium Price Supply P* Q* Demand Quantity 54

55 Market Equilibrium Price SURPLUS Supply P P* Qd Qs Demand Quantity 55

56 Market Equilibrium Price Supply P* P SHORTAGE Qd Qs Demand Quantity 56

57 Test your Understanding Consider the market for oranges. Draw out the supply and demand curves based on the following supply and demand schedule: Price QD QS $ $ $ $ $ $ Draw out the supply and demand curves based on this information. Where is the equilibrium price and quantity? 2. Suppose there is an exceptionally cold winter in Florida with frosts ruining many groves. What happens to this market? Illustrate. 3. What happens if the price of apples falls? Illustrate. 57

58 Equilibrium P = $3 Equilibrium Q = 30 58

59 When there is a frost increases the cost of production (weather input in production) SUPPLY CURVE SHIFTS (IN or LEFT) At $3: S1 < D shortage in the market for oranges Prices must adjust to P2 movement along demand curve 59

60 If there is a decrease in the price of apples change in the price of a related good DEMAND CURVE SHIFTS This is a substitute good so if the price of apples falls more people buy apples and demand less oranges SHIFTS IN or LEFT Equilibrium price falls Equilibrium quantity falls No change in willingness of sellers movement along the supply curve! 60

61 If happens simultaneously with frost (shifts in both curves) Definite fall in equilibrium quantity Ambiguous impact on equilibrium price 61

62 Key Takeaway Market Equilibrium brings together the decentralized decisions of buyers and sellers Because each agent is looking out for their own best interest we get the optimal results in the model Shifts in the S or D curve must come from a change in one of the factors that change either willingness to sell or willingness to buy S-D Graph is critical in helping us find equilibrium and analyze/understand changes in the market. 62

63 Principles of Microeconomics Module 2.1 (C ) Price Controls 63

64 In this video, we will discuss what happens when the government imposes a price control in a market. We will see how this distorts the equilibrium outcomes in the supply and demand model 64

65 Price Controls In economics, we argue: Best possible outcomes occur with no gov t interference Yields most efficient allocation of resources When policies to control the price interfere in the market, they create distortions These distortions cause: Shortages Surpluses 65

66 What are Price Controls? Price controls Setting a price maximum (price ceiling) or price minimum (price floor) in a given market Non-binding price control: the equilibrium is not distorted and the market outcomes are efficient Binding price control: the equilibrium cannot be reached and the market outcomes are inefficient (shortage or surplus) 66

67 What are Price Controls? Price controls Setting a price maximum (price ceiling) or price minimum (price floor) in a given market Non-binding price control: the equilibrium is not distorted and the market outcomes are efficient Binding price control: the equilibrium cannot be reached and the market outcomes are inefficient (shortage or surplus) 67

68 What are Price Controls? Price controls Setting a price maximum (price ceiling) or price minimum (price floor) in a given market Non-binding price control: the equilibrium is not distorted and the market outcomes are efficient Binding price control: the equilibrium cannot be reached and the market outcomes are inefficient (shortage or surplus) 68

69 Test your Understanding Consider two labor markers where a lawyer s wage rate is approximately $100/hr and a housecleaner s wage rate is approximately $8/hr. The government decides to impose a minimum wage law of $12/hr. 1. What impact does this have on the market for lawyers? Draw out the supply and demand model. 2. What impact does this have on the market for housecleaners? Draw out the supply and demand model. 69

70 Minimum Wage Laws Market for Lawyers Market for Housecleaners P $100 S Market Equilibrium P S $8 Market Equilibrium D D Q Q 70

71 Minimum Wage Laws Market for Lawyers Market for Housecleaners P S P S $100 Price Floor Min. Wage $12 $12 $8 Price Floor Min. Wage D D Q Q 71

72 Minimum Wage Laws Market for Lawyers Market for Housecleaners P S P S $100 Price Floor Min. Wage $12 $12 $8 Price Floor Min. Wage D D Qd = Qs Q Qd Qs Q 72

73 Minimum Wage Laws Market for Lawyers Market for Housecleaners P S P S $100 Price Floor Min. Wage $12 $12 $8 Price Floor Min. Wage D D Qd = Qs Q Qd Qs Q Qd = Qs: No effect of the market for lawyers 73

74 Minimum Wage Laws Market for Lawyers Market for Housecleaners P S P S $100 Price Floor Min. Wage $12 $12 $8 Price Floor Min. Wage D D Qd = Qs Q Qd Qs Q Qd < Qs: At $12: Surplus of Housecleaners 74

75 Key Takeaways Government policies can cause distortions in the market for goods and services by preventing supply and demand to reach equilibrium These distortions create Shortages Surpluses Mismatch between prices for buyers and sellers Policies are put in place many times due to the social benefits outweighing the economic costs 75

76 Principles of Microeconomics Module 2.2 (A) Price Elasticity of Demand and Supply 76

77 In this video, we will introduce the concept of elasticity which allows us to calculate the size of changes we observe in the supply and demand model 77

78 Ways that Demand and Supply Change Changes in demand and supply come from: Movement along the curve some factor changes that does not directly affect the willingness of buyer to pay or seller to sell Shift in the curve some factor changes that directly affects the willingness of buyer to pay or seller to sell 78

79 Ways that Demand and Supply Change Changes in demand and supply come from: Movement along the curve some factor changes that does not directly affect the willingness of buyer to pay or seller to sell Shift in the curve some factor changes that directly affects the willingness of buyer to pay or seller to sell 79

80 Price Elasticity Price Elasticity of Demand: By how much does Qd change when there is a price change? Movement along the demand curve from A to B Responsiveness of quantity demanded to price change Price Elasticity of Supply: By how much does Qs change when there is a price change? Movement along the supply curve from A to B Responsiveness of quantity supplied to price change 80

81 Price Elasticity Price Elasticity of Demand: By how much does Qd change when there is a price change? Movement along the demand curve from A to B Responsiveness of quantity demanded to price change Price Elasticity of Supply: By how much does Qs change when there is a price change? Movement along the supply curve from A to B Responsiveness of quantity supplied to price change 81

82 Midpoint Method for Price Elasticity Change in Quantity =!"#!$ %&'%( ) Change in Price = +"#+$,&',( ) Price Elasticity = Change in Quantity Change in Price Qb Qa Qb + Qa 2 / Pb Pa Pb + Pa 2 82

83 Elasticity of Curves Any change in price yields a large change in quantity demanded: - Luxury goods: designer jeans à not a necessity - Gourmet foods: $15lb cheese à many substitutes - Kit kat bars à many substitutes 83

84 Elasticity of Curves Change in price yields a small change in quantity demanded: - Medicine - Food - Peak railroad tickets 84

85 Elasticity of Curves Change in price yields a large change in quantity supplied: Firm operating below capacity Any increase in price will definitely produce more 85

86 Elasticity of Curves Change in price yields a small change in quantity supplied: Agriculture in the short term can t immediately produce more Nuclear power 86

87 Principles of Microeconomics Module 2.2 (B) Price Elasticity of Demand and Supply 87

88 Price Elasticity of Demand Suppose a grocery store owner is deciding to increase the price of smoked salmon by 10% from $11.00 to $ The quantity of smoke salmon he can sell falls from 40 units to 25 units. What is the price elasticity of demand for smoked salmon? Is it elastic or inelastic? 88

89 Price Elasticity of Demand If he increases in the price of smoked salmon by 10% from $11.00 to $12.10, the quantity of smoke salmon he can sell falls from 40 units to 25 units. Change in Q = LM#NO )P'QR ) Change in P = XL.XO #XX Y).YR'YY ) = = Ped = O.N]L = 4.86 > 1 ELASTIC O.O^M 89

90 Price Elasticity of Supply Now suppose that this grocer observes that his neighborhood is changing, and many new people are moving in. The number of buyers is increasing. As a result, the price of his goods, on average increases from $5 to $7 and the quantity of grocery goods supplied increases from 1000 to What is the price elasticity of supply? 90

91 Price Elasticity of Supply Now suppose that this grocer observes that his neighborhood is changing, and many new people are moving in. The number of buyers is increasing. As a result, the price of his goods, on average increases from $5 to $7 and the quantity of grocery goods supplied increases from 1000 to Change in Q = Change in P = c # M d'p = 0.33 ) = 0.22 Pes = O.LL O.gg = < 1 INELASTIC 91

92 Principles of Microeconomics Module 2.2 (C) Price Elasticity of Demand and Supply 92

93 Income Elasticity of Demand By how much does Qd change when there is a change in income? Change in Quantity = jl#jx k)'ky ) lmnopq L#lmnopq X Change in Income= rstuvw )'rstuvw Y ) Income Elasticity = Change in Quantity Change in Income Q2 Q1 Q2 + Q1 2 / Income 2 Income 1 Income 2 + Income

94 Income Elasticity Magic Hat and suppose the average income of a 23 year-old is $45,000. The 23 year-old consumes on average 5 Magic Hats a month. When his income rises to $50,000, he consumes 9 Magic Hats per month. What is his income elasticity of demand? Is this a normal good or an inferior good? 94

95 Income Elasticity Magic Hat and suppose the average income of a 23 year-old is $45,000. The 23 year-old consumes on average 5 Magic Hats a month. When his income rises to $50,000, he consumes 9 Magic Hats per month. Magic Hat: Change in Q = = Change in Income = MO #NM PRŠ'QPŠ = ) Ied = = 5.43 Magic Hats are a normal good 95

96 Cross Price Elasticity of Demand By how much does Qd change when there is a change in the price of a related good? Change in Quantity (GOOD A) = jl #jx k)œ'k)œ ) Change in Price (GOOD B)= LŽ# XŽ ) ' Y ) Cross Price Elasticity = Change in Quantity of Good A Change in Price of Good B Q2A Q1A Q2A + Q2A 2 / P2B P1B P2B + P1B 2 96

97 Cross Price Elasticity Consider, once again, the market for beer. When the price of pretzels moves from $4 to $3, the consumption of beer increases from 100 units to 120 units. 1. What is the cross price elasticity of demand for beer when the price of pretzels rises? 2. How are these markets related? 97

98 Cross Price Elasticity Consider, once again, the market for beer. When the price of pretzels moves from $4 to $3, the consumption of beer increases from 100 units to 120 units. Beer and Pretzels: Change in Q = = Change in Price of pretzels = g#n Q'Ÿ = ) XPed = O.X L #O.L c = Pretzels are a complimentary good to beer 98

99 Key Takeaways Understanding elasticity allows us to quantify the changes in demand and supply. Provides an additional analysis to understand how responsiveness demand and supply are to price changes, income changes and changes in prices of related goods. 99

100 Principles of Microeconomics Module 2.3 Consumer Surplus and Producer Surplus 100

101 Welfare Economics How the allocation of resources and market outcomes affect economic well-being Reaching equilibrium: maximizes welfare (in most cases) Welfare Economics: Consumer Surplus, Producer Surplus and Total Surplus 101

102 Consumer Surplus Willingness to pay price actually paid Every buyer has a maximum price they are willing to pay for every good At lower prices, his consumer surplus is larger he is better off because not paying his full maximum price 102

103 Consumer Surplus Willingness to pay price actually paid Every buyer has a maximum price they are willing to pay for every good At lower prices, his consumer surplus is larger he is better off because not paying his full maximum price 103

104 Consumer Surplus Consider what you would pay for a bottle of water at a summer concert P $2.50 CS If the price of water is actually $2.50 per bottle, would you buy the water? If your max price is $5 then yes! Your consumer surplus is $2.50 If your max price is $2 then no Q What happens if the price falls to $70 per day? If your max price is $100: Your consumer surplus rises to $30 If yous max price is $85 now you buy the tickets and have positive consumer surplus of $15 104

105 Consumer Surplus Consider what you would pay for a bottle of water at a summer concert P $2.50 CS If the price of water is actually $2.50 per bottle, would you buy the water? If your max price is $5 then yes! Your consumer surplus is $2.50 If your max price is $2 then no $1.50 NEW CS Q What happens if the price falls to $1.50 per day? If your max price is $5: Your consumer surplus rises to $3.50 If your max price is $2 now you buy the water and have positive consumer surplus of $1 105

106 Producer Surplus Price actually received willingness to sell Every seller faces a minimum value they are willing to accept to sell their goods This reflects the cost of production At higher prices, his producer surplus is larger he is better off from selling his goods above cost 106

107 Producer Surplus Price actually received willingness to sell Every seller faces a minimum value they are willing to accept to sell their goods This reflects the cost of production At higher prices, his producer surplus is larger he is better off from selling his goods above cost 107

108 Producer Surplus Consider independent food and beverage vendors at the summer music festival, each with the following willingness to sell a bottle of water: Willingness to sell Vendor A $3.00 Vendor B $2.75 Vendor C $

109 Producer Surplus P If the price of a bottle of water is $2.25, how many vendors will sell water? Only vendor C P.S. will be $0.25 $2.25 PS Q What happens if the price rises to $3.50 per bottle? All vendors will sell water PS Vendor A: $0.50 PS Vendor B: $0.75 PS Vendor C: $

110 Producer Surplus P $3.50 $2.25 New PS PS Q If the price of a bottle of water is $2.25, how many vendors will sell water? Only vendor C P.S. will be $0.25 What happens if the price rises to $3.50 per bottle? All vendors will sell water PS Vendor A: $0.50 PS Vendor B: $0.75 PS Vendor C: $

111 Total Economic Surplus Combines consumer surplus and producer surplus Total Surplus = Value to Buyers Cost to Sellers 111

112 Total Surplus and Free Market Outcomes GOODS WILL BE ALLOCATED TO: Buyers who value them most highly, as measured by their willingness to pay. P $2.75 CS PS Sellers who can produce them at the lowest cost. Q The free market yields an equilibrium quantity and price that maximizes both consumer and producer surplus 112

113 Total Surplus and Free Market Outcomes GOODS WILL BE ALLOCATED TO: Buyers who value them most highly, as measured by their willingness to pay. P $2.75 CS PS Sellers who can produce them at the lowest cost. Q The free market yields an equilibrium quantity and price that maximizes both consumer and producer surplus 113

114 Key Takeaways Welfare Economics is the analysis of the economic well-being of producers and consumers Assume that market outcomes lead to maximized total surplus 114

115 Principles of Microeconomics Module 2.4 Taxation 115

116 Taxes in the Supply and Demand Model Taxes cause: Price paid by buyer > Price received by seller Insert wedge in the Supply and Demand model Tax wedge creates deadweight loss: Loss of total surplus or economic well-being as a result of the policy 116

117 Sales Taxes P PB TAX PS Taxes insert a wedge between the price paid by buyers (Pb) and price received by sellers (Ps) Regardless of who pays the tax (sellers or buyers) both share the tax burden Qt Qe Q Tax = Pb Ps Tax revenue = Tax*Qt Tax burden (buyer) = Pb Pe Tax burden (seller) = Pe - Ps 117

118 Sales Taxes P PB TAX PS Taxes insert a wedge between the price paid by buyers (Pb) and price received by sellers (Ps) Regardless of who pays the tax (sellers or buyers) both share the tax burden Qt Qe Q Tax = Pb Ps Tax revenue = Tax*Qt Tax burden (buyer) = Pb Pe Tax burden (seller) = Pe - Ps 118

119 Sales Taxes P Taxes insert a wedge between the price paid by buyers (Pb) and price received by sellers (Ps) PB PS TAX REVENUE Regardless of who pays the tax (sellers or buyers) both share the tax burden Qt Qe Q Tax = Pb Ps Tax revenue = Tax*Qt Tax burden (buyer) = Pb Pe Tax burden (seller) = Pe - Ps 119

120 Understanding Taxes Consider the market for socks, where the equilibrium price of socks is $5 per pair and the equilibrium quantity is 300. The government imposes a $1 tax on the market to be paid by the seller, causing a fall in the quantity sold to 200. What happens when the tax is imposed? Draw out the supply and demand model showing the market before the tax and after the tax 120

121 Understanding Taxes P S Pe = $5 Qe = 300 D Q 121

122 Understanding Taxes P S Pb = $5.50 Tax: Pb Ps $1 Pe = $5 Pb = $4.50 Qt = 200 Qe = 300 D Q 122

123 Understanding Taxes P S Tax: Pb Ps $1 Pb = $5.50 Pe = $5 Tax Revenue = Tax*Qt $1 * 200 = $200 Pb = $4.50 Qt = 200 Qe = 300 D Q 123

124 How do taxes affect Market Participants? Analyze the following before tax vs. after tax is imposed: Consumer Surplus Producer Surplus Total Surplus Government Revenue How does the tax change economic welfare? 124

125 Consumer Surplus BEFORE TAXES AFTER TAXES P S P S Pe Consumer Surplus Pb Pe Consumer Surplus Ps Qe D Q Qt Qe D Q 125

126 Producer Surplus P BEFORE TAXES S P AFTER TAXES S Pb Pe Pe Producer Surplus Ps Producer Surplus Qe D Q Qt Qe D Q 126

127 Government Tax Revenue P BEFORE TAXES S P AFTER TAXES S Pb Pe Producer Surplus Pe Gov t Tax Revenue Ps Qe D Q Qt Qe D Q 127

128 Deadweight Loss P BEFORE TAXES S P AFTER TAXES S Pb Pe Producer Surplus Pe DWL Ps Qe D Q Qt Qe D Q 128

129 Elasticity and the Tax Burden 129

130 Key Takeaways We can think of taxation in the context of supply and demand model in terms of How it affects prices and quantities How it affects economic well-being via welfare economics Since taxes cause distortions in the market (tax wedge) they yield inefficient market outcomes Why do we have them? Derive some benefits from government revenue. 130

131 Principles of Microeconomics Module 3 Theory of Consumer Choice and Deriving the demand curve 131

132 Understanding Consumer Choice To understand how consumers make decisions we need two factors: 1. Budget Constraint - what a consumer can buy 2. Indifference Curves - what a consumer wants to buy Combination of income and preferences determines consumer choices 132

133 Budget Constraint A consumer s budget constraint determines what they can afford to buy All consumers have income Use income to purchase goods they need and want Constrained in their choices based on how much income they have 133

134 Budget Constraint Example Suppose Charlie has $100/month to spend on two goods pizza and soda. The price of pizza is $10 and the price of soda is $2. How much pizza would he buy if he spent all his money on pizza? How much soda would he buy if he spent all his money on soda? If he wants to consume more pizza, how much soda does he have to give up? 134

135 Budget Constraint Example Cont. To consume one more pizza, he needs to give up 5 sodas. Slope of the budget constraint: rate at which a consumer can trade one good for another Yields relative price of good X in terms of good Y Slope: ΔY / ΔX = -50 / 10 = 5 Px = $10 Py = $2 Slope = Px/Py = 10/2 = 5 Budget Constraint: limits the consumption bundles a consumer can afford 135

136 Budget Constraint Example Cont. To consume one more pizza, he needs to give up 5 sodas. Slope of the budget constraint: rate at which a consumer can trade one good for another Yields relative price of good X in terms of good Y Slope: ΔY / ΔX = -50 / 10 = 5 Px = $10 Py = $2 Slope = Px/Py = 10/2 = 5 Budget Constraint: limits the consumption bundles a consumer can afford 136

137 Budget Constraint Example Cont. To consume one more pizza, he needs to give up 5 sodas. Slope of the budget constraint: rate at which a consumer can trade one good for another Yields relative price of good X in terms of good Y Slope: ΔY / ΔX = -50 / 10 = 5 Px = $10 Py = $2 Slope = Px/Py = 10/2 = 5 Budget Constraint: limits the consumption bundles a consumer can afford 137

138 Budget Constraint Example Cont. To consume one more pizza, he needs to give up 5 sodas. Slope of the budget constraint: rate at which a consumer can trade one good for another Yields relative price of good X in terms of good Y Slope: ΔY / ΔX = -50 / 10 = 5 Px = $10 Py = $2 Slope = Px/Py = 10/2 = 5 Budget Constraint: limits the consumption bundles a consumer can afford 138

139 Changes in the Budget Constraint If a consumer s income changes: can afford more or less If the price of one good changes: trade-offs between the two goods change different slope Consumer can consume only ON B.C. not past it 139

140 Change in a Consumer s Income What if Charlie s income falls to $500/month? Must consume less of both goods Budget Constraint shifts in No change in relative prices = no change in slope of B.C. 140

141 Change in the Price of a Good What if the price of pizza rises to $12.50? Can consume only 8 pies/month at max Still can consume 50 sodas/month at max Relative price of pizza to soda has changed = change in slope! New slope = 12.50/2 = 6.25 Now pizza is more expensive in terms of soda give up more soda for same amount of pizza bigger trade-off! 141

142 Consumer Preferences Income is not the only factor that influences consumer choice Each consumer has different preferences in what they want to consume Capture consumer preferences by Indifference Curves Consumers will be indifferent between two bundles goods if the bundles equally satisfy his needs/wants 142

143 Consumer Preferences Income is not the only factor that influences consumer choice Each consumer has different preferences in what they want to consume Capture consumer preferences by Indifference Curves Consumers will be indifferent between two bundles goods if the bundles equally satisfy his needs/wants 143

144 Indifference Curves A consumer is indifferent or equally satisfied between consumption bundles along the same indifference curve Always prefer: D > B > A Indifferent between B and C Always prefer any point on a higher indifference curve 144

145 Four Properties of Indifference Curves 1. Higher indifference curves preferred to lower ones 2. Indifference curves are downward sloping 3. Indifference curves never cross 4. Indifference curves are bowed inward 145

146 Marginal Rate of Substitution Rate at which consumer is willing to trade one good for another MRS = slope at each point on indifference curve Not constant! Depends on how much of each good already consuming More abundant good more willing to trade Less abundant good less willing to trade 146

147 Marginal Rate of Substitution Rate at which consumer is willing to trade one good for another MRS = slope at each point on indifference curve Not constant! Depends on how much of each good already consuming More abundant good more willing to trade Less abundant good less willing to trade 147

148 Marginal Rate of Substitution Rate at which consumer is willing to trade one good for another MRS = slope at each point on indifference curve Not constant! Depends on how much of each good already consuming More abundant good more willing to trade Less abundant good less willing to trade 148

149 Marginal Rate of Substitution Rate at which consumer is willing to trade one good for another MRS = slope at each point on indifference curve Not constant! Depends on how much of each good already consuming More abundant good more willing to trade Less abundant good less willing to trade 149

150 Consumer s Optimal Choice Optimal point of consumption where the ability to buy meets the willingness to buy Where budget constraint meets HIGHEST indifference curve 150

151 Consumer s Optimal Choice IC tangent to BC MRS = Relative Price of 2 goods Relative Price = rate at which the market is willing to trade one good for another MRS = rate at which the consumer is willing to trade one good for the other MRS = MRS = = = Marginal Rate of Substitution is equal to the relative price at the optimum Marginal Rate of Substitution reflects the relative level of satisfaction in consumption of Good X and Good Y At the optimum: Marginal Utility per dollar spent on Good X is equalto themarginal utility per dollar spent on Good Y Rate of satisfaction we get from each dollar we spend on Good X is equal to the satisfaction from each dollar spent on Good Y 151

152 Income and Substitution Effects Income Effect: The change in consumption that results when a price change moves the consumer to a higher or lower indifference curve When the price of Good X falls, income does not change but we feel wealthier because each dollar in our pocket can buy more of Good X and more of Good Y With a price fall in Good X à move to a new consumption bundle on a higher indifference curve Substitution Effect: The change in consumption that results when a price change moves the consumer along the same indifference curve to a point with a new MRS When the price of Good X falls, Good X is now cheaper in terms of Good Y. The relative price of Good X has changed. In other words Good Y has become more expensive in terms of good Good X Consume more of Good X and less of Good Y 152

153 Income and Substitution Effects Income Effect: The change in consumption that results when a price change moves the consumer to a higher or lower indifference curve When the price of Good X falls, income does not change but we feel wealthier because each dollar in our pocket can buy more of Good X and more of Good Y With a price fall in Good X à move to a new consumption bundle on a higher indifference curve Substitution Effect: The change in consumption that results when a price change moves the consumer along the same indifference curve to a point with a new MRS When the price of Good X falls, Good X is now cheaper in terms of Good Y. The relative price of Good X has changed. In other words Good Y has become more expensive in terms of good Good X Consume more of Good X and less of Good Y 153

154 Income and Substitution Effect Assume that the Price of Good X falls Good Y A IC.1 BC.1 Good X 154

155 Income and Substitution Effect Good Y Budget constraint shifts out on a bias A IC.1 BC.1 BC.2 Good X 155

156 Income and Substitution Effect Good Y A With the substitution effect à Good Y is now more expensive in terms of Good X A Move to a new point of consumption on the existing IC.1 A IC.1 BC.1 BC.2 Good X 156

157 Income and Substitution Effect Good Y A A A A With the income effect à We can buy more of both! Move to a new point of consumption on the new IC IC.2 IC.1 BC.1 BC.2 Good X 157

158 Income and Substitution Effect Good Y A A In reality: Both Income and Substitution Effect occur simultaneously! A Consumer moves from Point A to Point B A B Which dominates? A IC.2 IC.1 BC.1 BC.2 Good X 158

159 Determining Demand Oranges As the Price of Good X falls Consumer will have new optimal points of consumption and new quantities of apples he consumes A Price of Apples Quantity of Apples A $ A B C IC.3 IC.2 IC.1 B $ C $ BC.1 BC.2 BC.3 Apples 159

160 Determining Demand Oranges Consumer Choice Between Oranges and Apples A Price of Apples Demand for Apples $1.99 A B C IC.3 $1.49 IC.2 IC.1 $0.99 BC.1 BC.2 BC.3 Apples Quantity of Apples 160

161 Key Takeaways Consumer s optimal choice depend on both how much they can afford (budget constraint) and what the prefer (indifference curves) Changes in a consumer s income as well as changes in the price of goods will affect the optimal consumption choice How consumers respond to the change in the price of a good will determine the demand curve 161

162 Principles of Microeconomics Module 4 Understanding Production Costs 162

163 Production Choices of Firms All firms have one goal in mind: MAX PROFITS PROFITS = TOTAL REVENUE TOTAL COST Two ways to reach this goal: Maximize total revenue Total Revenue = Price X Quantity Minimize total costs Total Costs = Fixed Costs + Variable Costs 163

164 Determining Production via Production Function Production Function: Relationship between quantity of inputs and total output Q = f(land, Labor, Capital) Example: Determine the production of good A if its production function is: Q = 100 K 1/ L 1/2 Assume the firm uses one machine and increases its workers by

165 Determining Production via Production Function Production Function: Relationship between quantity of inputs and total output Q = f(land, Labor, Capital) Example: Determine the production of good A if its production function is: Q = 100 K 1/ L 1/2 165

166 Production Function Example Q = 100 K 1/ L 1/2 CAPITAL LABOR Prod. Function OUTPUT No. of Machines Constant *1 1/2 + 25*5 1/ *1 1/2 + 25*6 1/ *1 1/2 + 25*7 1/ *1 1/2 + 25*8 1/ *1 1/2 + 25*9 1/ *1 1/2 + 25*10 1/

167 Production Function Example Q = 100 K 1/ L 1/2 CAPITAL LABOR Prod. Function OUTPUT *1 1/2 + 25*5 1/ *1 1/2 + 25*6 1/ *1 1/2 + 25*7 1/ *1 1/2 + 25*8 1/ *1 1/2 + 25*9 1/ *1 1/2 + 25*10 1/2 179 No. of Workers Increasing by 1 167

168 Production Function Example Q = 100 K 1/ L 1/2 CAPITAL LABOR Prod. Function OUTPUT *1 1/2 + 25*5 1/ *1 1/2 + 25*6 1/ *1 1/2 + 25*7 1/ *1 1/2 + 25*8 1/ *1 1/2 + 25*9 1/ *1 1/2 + 25*10 1/2 179 Use Production Function To calculate how much we produce 168

169 Production Costs Rent Price of Capital = $800 à FIXED COST Wages of workers = $25 à VARIABLE COST Cost of CAPITAL Cost of LABOR TOTAL COST

170 Marginal Product of Labor Marginal Product Increase in output resulting from an increase in one of the inputs MPL = Change in Output / Change in Labor LABOR OUTPUT MPL

171 Increasing Labor Only Diminishing Marginal Returns: Output is increasing at a decreasing rate 171

172 Production Costs K * $100 L * $25 Fixed + Variable LABOR OUTPUT FIXED COST VARIABLE COST TOTAL COST AFC AVC ATC MC To analyze the production decisions of a firm, recall that a firm conducts marginal analysis Decisions are based on per-unit calculations Therefore, need to calculate costs/unit 172

173 Production Costs FC/Q VC/Q TC/Q LABOR OUTPUT FIXED COST VARIABLE COST TOTAL COST AFC AVC ATC MC Costs per unit of output produced 173

174 Average Fixed Cost Curve Cost AFC Q 174

175 Average Variable Cost Curve Cost AVC Q 175

176 Average Total Cost Curve Cost ATC Q 176

177 Marginal Cost Curve Cost MC ATC Q When MC < ATC à ATC is falling When MC > ATC à ATC is rising MC crosses ATC at minimum EFFICIENT SCALE 177

178 Long Run vs. Short Run Total Cost ATC SRATC 1 SRATC 2 SRATC 3 LRATC 1 Output Economies of Scale ATC is falling with increase in output Diseconomies of Scale ATC is rising with increase in output 178

179 Key Takeaways All firms are profit maximizing and therefore want to minimize their costs To make their production decisions need to consider ATC, AVC, AFC and MC NEXT: Merge cost curves with revenue to understand how different types of firms make production decisions 179

180 Principles of Microeconomics Module 5.1 Understanding Profit 180

181 Production Choices of Firms All firms have one goal in mind: MAX PROFITS PROFITS = TOTAL REVENUE TOTAL COST Two ways to reach this goal: Maximize total revenue Total Revenue = Price X Quantity Minimize total costs Total Costs = Fixed Costs + Variable Costs 181

182 Production Choices of Firms All firms have one goal in mind: MAX PROFITS PROFITS = TOTAL REVENUE TOTAL COST Two ways to reach this goal: Maximize total revenue Total Revenue = Price X Quantity Minimize total costs Total Costs = Fixed Costs + Variable Costs 182

183 Economic Costs Economic Costs for producers include explicit and implicit costs - Explicit Costs: Financial costs - Implicit Costs: Opportunity costs Example: Caroline can use $300,000 of her savings to start her firm which is in a savings account paying 5% interest. OR Caroline borrow $200,000 from a bank at the same interest rate and used $100,000 from her savings. Which should she do? 183

184 Economic Costs Economic Costs for producers include explicit and implicit costs - Explicit Costs: Financial costs - Implicit Costs: Opportunity costs Example: Caroline can use $300,000 of her savings to start her firm which is in a savings account paying 5% interest. (OR) Caroline borrow $200,000 from a bank at the same interest rate and used $100,000 from her savings. Which should she do? 184

185 Example of Economic Costs Choice A: Caroline s cost to start her business: Explicit Cost = $300,000 Implicit Cost = ($300,000 X 5%) = $15,000 Total Economic Cost = $315,000 Total Accounting Cost = $300,000 Choice B: Caroline s cost to start her business: Explicit Cost = $200,000 + $100,000 + ($200,000 X 5%) = $310,000 Implicit Cost = ($100,000 X 5%) = $5,000 Total Economic Cost = $315,000 Total Accounting Cost = $310,

186 Example of Economic Costs Choice A: Caroline s cost to start her business: Explicit Cost = $300,000 Implicit Cost = ($300,000 X 5%) = $15,000 Total Economic Cost = $315,000 Total Accounting Cost = $300,000 Choice B: Caroline s cost to start her business: Explicit Cost = $200,000 + $100,000 + ($200,000 X 5%) = $310,000 Implicit Cost = ($100,000 X 5%) = $5,000 Total Economic Cost = $315,000 Total Accounting Cost = $310,

187 Key Equations Total Revenue (TR) = Price x Quantity Marginal Revenue = Change in TR/ Change in Q Marginal Cost= Change in TC/ Change in Q Marginal Revenue captures the change in a firm s revenue from one additional unit produced Marginal Cost captures the change in a firm s cost from one additional unit produced 187

188 Key Equations Total Revenue (TR) = Price x Quantity Marginal Revenue = Change in TR/ Change in Q Marginal Cost= Change in TC/ Change in Q Marginal Revenue captures the change in a firm s revenue from one additional unit produced Marginal Cost captures the change in a firm s cost from one additional unit produced 188

189 Profit Maximizing Point of Production Firms will maximize their profits by producing at the point where MR = MC If MR > MC: Increase profits by producing more If MR < MC: Increase profits by producing less 189

190 Profit Maximizing Point of Production Where MR = MC tells us that the additional revenue generated from the last unit produced is equal to the additional cost of producing it The firm cannot increase their profits by producing any more or any less than at the point where MR = MC, in other words marginal profit = 0 190

191 Profit Maximizing Point of Production Where MR = MC tells us that the additional revenue generated from the last unit produced is equal to the additional cost of producing it The firm cannot increase their profits by producing any more or any less than at the point where MR = MC, in other words marginal profit = 0 191

192 Key Takeaways All firms are profit maximizing Point of maximizing profits is where MR = MC for all firms Where MR = MC, profit is at its highest and the firm cannot produce any more or less to increase profit further 192