Lecture 3 Mankiw chapters 4 and 5

In-Class Exam 1 1) Efficiency is not the same than equity. Why? Give an example in which an efficient allocation has been achieved but it creates significant inequalities. 2) Explain each of the following statements: a. When good weather starts in Boston, the hotel prices in the Caribbean go down. b. When the gasoline price increases, more people commute by train. 2

Lecture 3 Mankiw chapters 4 and 5 3

Supply 4

Supply Curve The function (or graphical representation) that shows the amount that sellers are willing (and able) to sell at every possible price of the good. 5

The law of supply The law of supply states that there is a positive relationship between the price and the quantity supplied 6

What is behind a MARKET SUPPLY curve? 7

The Marginal Cost The marginal cost is the increase in cost associated to producing one extra unit. Assume a firm has the following costs: 1 unit 100. 2 units 200. 3 units 600. 4 units 1200. What are its marginal costs? 8

do not confuse MARGINAL cost with TOTAL COST and with AVERAGE cost 9

My Marginal Cost Curve Units MgC 1 100 Price (x100 ) 2 100 3 400 4 600 5 700 6 700 my costs are increasing 7 900 Number of watches 11

.more fine running 12

Why is marginal cost increasing? THE LAW of DECREASING MARGINAL RETURN 13

EXAMPLES 14

Why is the law of decreasing marginal returns reasonable? Assume a landowner has its land divided in 9 plots. Each plot requires a farmer who gets paid 1000 The plots are not identical. What is the marginal cost curve? 1 Tm 1 Tm ¼ Tm 1 Tm ½ Tm ¼ Tm ½ Tm ¼ Tm ¼ Tm In general, one can concentrate in the most productive resources, when producing small amounts, but not when producing large amounts. 15

then if we have decreasing marginal returns.. then the marginal cost is increasing! then 16

only for the intrepid... 17

in reality, the marginal cost curve has the form of a U 18

Supply of price-taking firm Units MgC Price(x100 ) 1 100 2 100 3 400 4 600 5 700 6 700 7 900 Number of Watches 20

Supply Curve of a Firm is its Marginal Cost Curve 21

Which of the following affects MY supply curve? Salary Increase A drop in the price of meet. Salary Increase in BURGER NIGHTMARE I buy the Miracle Grill SPEEDY Burger 22

Changes in the quantity supplied versus changes in supply Changes in the quantity supplied Movement along the supply curve. It is caused by a change in the market price of the product. 23

Changes in the quantity supplied Price S 3.00 C An increase in the price produces a movement along the supply curve 1.00 A 0 1 5 Quantity 24

Shifts of the supply Price S 3 S 1 S 2 Supply reduction Supply increase 0 Quantity 25

SOME APPLICATIONS OF YOUR NEW KNOWLEDGE 26

ELASTICITY 29

Computing the price elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in the price. 30

Computing the Price Elasticity of Demand Price elasticity of demand = Percentage change in quantity demanded Percentage change in price Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: ( 10 8) 100 10 ( 2. 20 2. 00) 100 2. 00 20% = = 10% 2 31 Copyright 2004 South-Western/Thomson Learning

The formula Demand Elasticity = Percentage % change in Quantity Demanded Percentage % change in the Price 32

Elastic or Inelastic demand? 33

Values of the elasticities Perfectly elastic E S = Relatively elastic E S > 1 Unit elastic E S = 1 Relatively inelastic E S < 1 Perfectly Inelastic E S = 0 34

Elastic or Inelastic Demand? Price 10 5 Demand 1 10 Quantity 35

Figure 1 The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 1. An increase in price... 4 0 100 Quantity 2.... leaves the quantity demanded unchanged. 36 Copyright 2003 Southwestern/Thomson Learning

Figure 1 The Price Elasticity of Demand Price (e) Perfectly Elastic Demand: Elasticity Equals Infinity 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 0 3. At a price below $4, quantity demanded is infinite. Quantity 37

It is important the concept of elasticity? 38

Method 2: Price elasticity of demand = Percentage change in quantity demanded Percentage change in price Elasticity = DQ/Q DP/P = DQ/DP x P/Q :Example - If Q =10-0,5 P and P =10, find the elasticity. 39 Copyright 2004 South-Western/Thomson Learning

toothpaste? Elastic or inelastic? 40

Markets with close substitutes have a very elastic INDIVIDUAL demand 41

Why Alcampo reduces prices and makes more money? 42

SUPPLY ELASTICITY 43

Elastic? Inelastic?44

1. Explain the relationship between decreasing marginal returns and a firm s product supply. Provide examples which show the law of diminishing marginal returns. 2. Explain the relationship between total cost, marginal cost and average cost. Give examples where the average cost increases or decreases depending on whether marginal cost is above or below average cost. 3. What is the difference between a movement along the supply curve and a shift of the supply curve? Give some examples where factors that affect the supply change the quantity supplied (movements along ) or change the supply itself (shift of...). 4. What is the price elasticity of supply and the price elasticity of demand? Give examples of supply and demand curves which are very elastic or very inelastic. 5. Given the supply function Q = 4p 20, compute the elasticity when the offered quantity equals 380 units. 45

6. The cost of one additional barrel of oil for the company Skull-Oil is 10 dollars if it produces up to 1 million barrels and 50 dollars if it produces between 1 and 4 million. Its maximum production capacity is 4 million barrels. a. What is the supply curve of Skull-Oil, if the oil market is perfectly competitive? b. If there are 20 companies like Skull-Oil in the market, what is the supply curve of the market? c. The price elasticity of supply in the long run is usually greater than that in the short run. Explain why this is true in general, and also in the particular case of Skull-Oil. d. Skull-Oil produces the first million barrels in Nigeria, and the rest in Norway. What will happen to the oil supply curve of Skull-Oil if for various reasons the cost of producing an additional barrel of oil in Nigeria is now $20 instead of $10? 46

Houses built during a month Total monthly cost in thousand Euros 0 0 1 50 2 80 3 110 4 140 5 173 6 211 7 254 8 303 9 356 10 413 Marginal cost (Cost of building an additional house) 8. José is the owner of a construction firm. The following table shows the monthly total cost of the firm as a function of the number of houses built each month. a) Complete the table above and comment on the shape of the marginal cost. b) If the house price is 53.000 and José knows that he can sell as many houses as he wants at that price but no one at a higher price (that is, he is a price-taker), how many houses per month should he build in order to maximize its profits? Compute José s profit. c) Answer the previous question for house prices of 43.000 and 33.000. d) Find the supply curve for José s firm. e) Obtain the supply curve of the house market if there are 50 firms identical to José s company. 47

1 If a firm in a perfectly competitive market decides to increase its price above the market price, then a) Its total revenue will increase. b) Its profit will increase. c) It will not sell anything. d) None of the previous answers is correct, as the demand curve of the firm has a positive slope. 2. The marginal cost of a tennis school only depends on the wage of its instructors. The tennis instructors labour union negotiates a 7% increase in instructors wages. Then, a) The supply curve shifts towards the left. b) The supply curve shifts towards the right. c) The supply curve changes its slope from positive to negative, because of the reduction in the number of clients due to the higher cost. d) None of the above. 48