Review Chapters 1 & 2 ECON 1 Midterm 1 Review Session Scarcity or No Free Lunch Principle. Cost-Benefit Principle. Reservation Price. Economic Surplus = Benefit Cost. Opportunity Cost (DO NOT FORGET!!). Sunk Cost (DO NOT FORGET!!). Oct. 7 th, 2002 ECON 1 MT1 Review Session Page 1 ECON 1 MT1 Review Session Page 2 Review Chapters 1 & 2 (cont d) Review Chapters 1 & 2 (cont d) Remember: Cost-Benefit Principle: Keep doing it if MB > MC Or in another words, if Economic Surplus = BENEFIT COST > 0. DO NOT FORGET OPPORTUNITY COST OF FORGONE ACTIVITY!!!!! PV: Amount we put in the bank today to earn M at a future time T with given interest rate r. PV = M /( 1+ r) T So, PV and M depend on r and T. ECON 1 MT1 Review Session Page 3 ECON 1 MT1 Review Session Page 4 Review Chapters 1 & 2 (cont d) Marginal vs Average Average costs: TC / Q Average benefits: TB / Q Marginal costs: additional costs of adding a unit Marginal benefits: additional benefits of adding a unit Optimal output: where MB = MC This maximizes economic surplus (benefit -cost). Three way to ensure a bad grade: Ignore Opportunity Costs Fail to Ignore Sunk Costs Use Average rather than Marginal Review Chapters 4 & 5 Supply Curve (slope, what is plotted) Demand Curve (slope, what is plotted) S & D diagram (labeling of axes) Equilibrium Disequilibrium (ES, ED, P vs equilibrium P) Free market equilibrium P (efficiency; MB=MC; social optimum) Government Intervention (ceiling, floor: examples, who likes each) Movement Along vs Shift of D & S curves (technology, regulation, input price, complements, substitutes) ECON 1 MT1 Review Session Page 5 ECON 1 MT1 Review Session Page 6
Supply: Curve showing the total quantity of a good that sellers wish to sell at each price. Trick: Think in marginal cost. Demand: Curve showing the total quantity of a good that buyers wish to buy at each price. Trick: Think in income. Utility: Satisfaction consumers derive from activities. Rational Spending Rule: Spending allocated across goods so MU per dollar (MU / P) is same for each good. Total Expenditure = P*Q = Total Revenue (TR). Price elasticity of demand: percentage change in quantity demanded divided by percentage change in price. Q P Q / = Q P P P * Q ECON 1 MT1 Review Session Page 7 ECON 1 MT1 Review Session Page 8 Trick for elasticity: Elastic. Inelastic. Remember: Utility Maximization: allocation of time and income to maximize satisfaction. Marginal Utility: Additional utility gained from consuming one additional unit of a good. Rational Spending Rule: Ratio of marginal utility to price must be the same for each good the consumer buys. MUc MUs = Pc Ps ECON 1 MT1 Review Session Page 9 ECON 1 MT1 Review Session Page 10 Remember: Law of Diminishing Marginal Utility: when consumption of a good increases beyond some point, MU of each additional unit declines (Assumption based upon observation). ECON 1 MT1 Review Session Page 11 Also: GOOD PRICE ELAST. SUBSTs.? TR? Elastic >1 Yes if P Inelastic <1 Few if P Price elasticity of demand relatively high if substitutes are readily available. If share of budget is high (big ticket items), have higher price elasticity of demand Timeframe: Price elasticity is higher in long run than in short run, since substitutions can be made. ECON 1 MT1 Review Session Page 12
Review Chapter 6 Perfectly Competitive Market: no individual supplier has influence on market price of product (price taker). Competitive market has many sellers with free entry and exit. The Demand Curve Facing Perfectly Competitive Firm Review Chapter 6 (cont d) How much to produce? Firm should increase output if MB = MR > MC For perfectly competitive firm MR = P, So choose output where P = MC Changes in Suppply (other than P): Technology (important long-run determinant) Input Prices (important short-run determinant) Expectations about future prices Changes in prices of other possible products to supply Profit Maximization Profit: total revenue (P * Q) minus total costs. ECON 1 MT1 Review Session Page 13 ECON 1 MT1 Review Session Page 14 Review Chapter 6 (cont d) Remember: Price elasticity changes along a straight-line demand curve (see F&B page 127). A = P Q * 1 slope GOOD PRICE ELAST. TR? Elastic >1 if P Inelastic <1 if P Review Chapter 7 Total economic surplus = Consumer Surplus + Producer Surplus. Free markets promote efficiency. Maximize output at minimum cost. Pareto efficient outcome: No change is possible that will help some people without harming others. Price Ceilings and price floors effect on economic surplus. ECON 1 MT1 Review Session Page 15 ECON 1 MT1 Review Session Page 16 Review Chapter 8 Economic rent. Payment to factor of production that exceeds owner s reservation price. In the long run, economic rent accrues to inputs that cannot be reproduced easily (entry is constrained and supply not competitive). Short-run rents are windfalls (like cost saving innovations). Invisible Hand: Resources flow to markets in which economic profit is positive and out if is negative. Perfectly Competitive Firm. Price taker: firm that must take market price. Imperfectly Competitive Firm. Price setter: firm with some latitude to set its own price Essential Difference: D curve. Perfectly competitive firm: perfectly elastic demand curve at market P. Higher P: cannot sell output Lower P: no advantage in selling output ECON 1 MT1 Review Session Page 17 ECON 1 MT1 Review Session Page 18
Price For any firm, in the long run economic profit=0, P=MC=min AC. Industry supply curve adjusts (free entry and exit) until zero profits (lowest cost to society), which is a P where MC=AC for the firm. MARKET (long run) Price ANY FIRM (long run) S A =MC A Imperfectly competitive: Firm faces downward-sloping demand curve Charging a price different from competitors may be advantageous P Q S P D A D Quantity Q A Quantity AC ECON 1 MT1 Review Session Page 19 ECON 1 MT1 Review Session Page 20 Economies of Scale!!!!!. Average cost of production falls as output increases High start-up costs relative to MC First mover has market advantage Marginal Revenue Curve for Monopolist with Straight- Line Demand Curve. Remember: TR = P*Q and P = a-bq so TR = aq-bq 2. 2 dtr d(aq - bq ) MR = = = a 2bQ dq dq ECON 1 MT1 Review Session Page 21 ECON 1 MT1 Review Session Page 22 Profit-Maximizing Rule: Set Q where MR = MC. Then set P off of demand curve (for given Q) But: Review Chapter 9 & 10 Chapter 9: Monopoly and efficiency: Deadweight loss. Price Discrimination, types, benefits. Chapter 10: Elements of a game. Dominant strategies. Nash Equilibrium. Prisoner's dilemma. ECON 1 MT1 Review Session Page 23 ECON 1 MT1 Review Session Page 24
Review Chapter 9 & 10 (cont d) Deadweight loss due to monopoly. Monopolist produces LESS than socially efficient level of output (Not efficient). Price discrimination. Charging different buyers different prices for same good or service. So monopolists will increase Q by reducing P in some units. Review Chapter 9 & 10 (cont d) Perfect price discrimination. Charge each buyer exactly her reservation price (move down D curve): no consumer surplus for these transactions. Perfect P discrimination results in transfer of consumer surplus to producer surplus. So a monopolist has an incentive to price discriminate Hurdle method of price discrimination. Seller offers discount to all buyers who overcome an obstacle. Game Theory: The payoff of many actions depends upon the actions of others. Basic elements, payoff matrix. Dominant Strategy, Nash equilibrium. Prisoner s dilemma. ECON 1 MT1 Review Session Page 25 ECON 1 MT1 Review Session Page 26 Review Chapter 11 & 12. Chapter 11: Positive and Negative Externality. Socially optimal outcome. Coase Theorem. Tragedy of Commons. Chapter 12: Rational Information Gathering/Search. Free Rider Problem. Fair Gamble and taste for risk. Asymmetric Information. ECON 1 MT1 Review Session Page 27 Review Chapter 11 & 12 (cont d) Externality: a cost or benefit of an activity that does not accrue to buyer or seller. External cost (negative externality): cost that falls on people other than those who pursue the activity. External benefit (positive externality): benefit received by people other than those who pursue the activity. ECON 1 MT1 Review Session Page 28 Review Chapter 11 & 12 (cont d) With externalities present (XB and XC): free markets do not provide optimal outcome. Social MC = Private MC + XC (Ext. cost) Social demand = private D + XB (Ext. Benefit) Review Chapter 11 & 12 (cont d) Coarse Theorem: If people can negotiate the purchase and sale of the right to perform activity with externalities, they will arrive at efficient solutions. Assumes: No cost of negotiation Perfect information Optimal amount of negative externalities is not zero, but when MC=MB to society. Tragedy of commons: Resources with no price will be used until MB = 0 (since private MC=0 although social MC>0). ECON 1 MT1 Review Session Page 29 ECON 1 MT1 Review Session Page 30
Review Chapter 11 & 12 (cont d) Information: No one is fully informed. Consumers can collect information but it takes time, so stop when MB = MC. Free-rider problem. Occurs when non-payers cannot be excluded from using a valuable good or service. Too little of good is produced. Expected value of a gamble: Sum of possible outcomes multiplied by their probabilities. Risk neutral: accept gamble that is fair (EV=0) or better (EV>0). Risk averse: accept only better-than-fair gambles. Asymmetric information: reduces the average quality of used goods offered for sale (reduces economic surplus), and so P falls (Lemons model), then sellers have incentive to lower quality of goods for sale, quality lowers, (downward spiral) Review Chapter 14 & 15 Chapter 14: Policies to regulate natural monopoly. Marginal cost pricing of public services. Taxation of pollution. Chapter 15: Public Goods. Provision of public goods (demand curve, free rider problem, elasticity) What should we tax? ECON 1 MT1 Review Session Page 31 ECON 1 MT1 Review Session Page 32 Review Chapter 14 & 15 (cont d) Public policy: apply cost-benefit principle. Natural monopoly and Four Types of Government Control. Pricing Public Services (Health Care Delivery) Environmental regulation. Taxing pollution. Types of public goods. Demand curve. Paying for Public goods. ECON 1 MT1 Review Session Page 33