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Micro Cost Curves of the Individual Firm Total Fixed, Total Variable, and Total Costs Average Total Cost, Average Variable, and Marginal Costs Long-Run Avg. Costs Total Cost (TC) – the amount a firm pays to buy the inputs for production (TC=FC+VC) Fixed Cost (FC) – costs that do NOT vary with the quantity of output produced Variable Cost (VC) – costs that DO vary with the quantity of output Average Total Costs (ATC) – total costs divided by the quantity of output (TC/Q) Average Fixed Costs (AFC) – fixed costs divided by the quantity of output (FC/Q) Average Variable Costs (AVC) – variable costs divided by the quantity of output (VC/Q) Marginal Costs – the increase in total cost that arises from an extra unit of production (TC/Q) Average and Marginal Costs: Average Variable and Average Total Costs decrease as long as Marginal Costs are less than Average. When MC=ATC or MC=AVC, the average costs are at their minimum. When marginal costs are greater than average costs, average costs are rising. The Sum of the MC curve greater than AVC is the “supply” curve for the firm. Therefore, the sum of MC’s for the firms makes up the Supply curve for the entire market. Law of Diminishing Marginal Return: As additional resources are added to increase output, the marginal output (MP) will decrease after a point. Total output will be a maximum where MP=0. Marginal Costs (MC) are inverse to Marginal Product(MP) Total Output (TP) Average & Marginal Product Micro Production Possibilities Curve: Shows possible outputs for alternative uses of inputs Shows Opportunity Cost of various production levels Optimal point on PPC is where MB=MC Incremental increases in producing one alternative causes increasing costs of the other given up (Law of Increasing Opportunity Costs Production inside the PPC is inefficient/wasteful Production outside the PPC is essentially impossible in long-run Economic Growth: Outward movement of PPC. Caused by: More resources Technology Investment in Human Capital Specialization Productive Resources: Natural (Land) Human (Labor) Capital Entrepreneurial Supply and Demand Supply Price $60 40 20 Demand 0 50 100 150 200 Quantity Demand Income Effect Substitution Effect Law of Diminishing Marginal Utility Causes of Shifting Demand: -Income -# Consumers -Tastes -Prices of Substitutes, Complements -Situation -Expectation of future price Supply Law of Diminishing Marginal Return Direct Price/Quantity relationship The sum of market firm’s Marginal Costs Causes of Shifting Supply: -Change in variable costs -# of producers in market (Long-run) -Expectation of future price Micro Shortage Surplus Producer/Consumer Surplus Price Elasticity: Ep (Q 2 Q1) / ( P 2 P1) / 2 ( P1 P 2) (Average) 2 %Q (Q 2 Q1) /(Q1) (Point) %P ( P 2 P1) /( P1) Ep=1 Unitary Ep>1 Elastic Ep<1 Inelastic Demand Elasticity Determinants: Necessity of product Expense of product (as % of budget) Number of Substitutes for product Amt. of time to adjust to price changes Supply Elasticity Determinants: Complexity of production process # of different resources used Amt. of time to adjust production when prices change Ec %Qx %Py Cross Elasticity: X and Y are related products Ey %Q %Y Income Elasticity: Normal and Inferior Products (Y=income) Demand Elasticity and Total Revenue Ep (Q1 Q 2) Micro Perfect Competition: Very many firms Homogenous product Perfect information Easy entry, exit Long-run Normal profits P=MR=AR=d MR=MC= Profit Maximization or Loss Minimization output Cost changes for one firm will NOT impact Market Supply Short-Run: Some cost(s) is/are Fixed. A change in variable costs will shift market supply. Changes in Fixed Costs (S-R) will NOT change firm or market output or pricing Allocative Efficiency (P=MC) Productive Efficiency (P=MC=ATC) Long-Run: All costs are variable. Market Supply shifts with firm entry/exit. Monopolistic Competition Several Firms Differentiated, but similar products Easy Entry, Exit P>MR MR=MC=Profit Max. or Loss Min. Inefficient in Long-Run (Cost of Variety) Normal Profits in Long-Run Firm demand shifts with MR as firms enter or exit the market Shutdown: (Short-Run) AVC<P when MR=MC Operate: (Short-Run) AVC>P when MR=MC w/Short-Run Losses Cost changes for one firm will NOT impact Market Supply, Firms tend to have extensive Constant Returns to Scale in Long-Run Costs Remember !!: Short-Run changes to variable costs (AVC) ONLY will shift Market Supply Costs do NOT change in the Long-Run. All firms are Constant Cost Industries (CB promise) Micro Game Theory Oligopolies Few firms dominate market Products are very similar Barriers to Entry Long-Run profits possible Theories: Game Theory Kinked Demand (Non-collusive, interdependent) Cost Plus pricing Collusive Oligopoly (Shared Profit Cartel) Non-Collusive Kinked Demand Oligopoly Notes: Oligopolies are tough to analyze. Note the assumptions. Cartels are fragile. There is high incentive to cheat. In Game Theory, find the Nash Equilibria and the dominant strategy. There won’t always be one! Oligopolists rely on advertising to try to differentiate. Very little price competition, if any. Price Leadership is very common. Firms will very often follow the pricing strategies of competitors. Pricing and output tend to be relatively stable. There is extremely little opportunity for new firms to enter these markets. Positive profits are very common in the Long-Run. Micro Pure Monopoly in Long-Run Equilibrium Monopolies: One dominant firm No entry. Substantial barriers (Monopoly Rent Seeking Allocatively and Productively Inefficient P>MR MR=MC is optimal output Monopolies are illegal under Sherman AntiTrust Act. (Remember ATT, Microsoft) Types: Pure Natural Geographic (Local) Natural Monopoly (graph left) Definition: Costs decline through the range of Demand due to extensive Economies of Scale. They are desirable due to these low cost production capabilities. Regulation: F.R.=Fair Return. Firm is allowed to earn Normal profits S.O.=Socially Optimal. Firm is controlled to permit Allocative Efficiency. Typically they must be subsidized to continue Long-Run operations. P Monopoly Price Discrimination: MC ATC D=P=AR=MR Total Revenue Q1 Q Condition: Control of the market Ability to segregate buyers Ability to prevent resales Product is sold to each buyer at the highest price that the buyer will pay. No consumer surplus exists. Monopolist will sell Q1 units, and total revenue will equal the sum of the selling prices. (MR=P) Monopolists can also price discriminate based on elasticity of different consumer groups. Micro Factor Markets The market demand for resources is DERIVED from the market for products. Some Important Formulas: TR TP Dresource MRP MR TP QLabor TFC MFC QLabor TFC QLabor * Wage TC MRC QLabor MP MRP MP * MR Optimal Resource Utilization occurs where: MRP=MFC TR TP * TP QLabor Notes: Changes in productivity will affect both MRP and MC (opposite directions) Changes in product demand in one market MAY NOT shift demand for a resource, but will shift MR and MRP for the firm Resource prices in the market are a function of Supply and Demand for that resource Slope of MRP curve for firm will be greater the LESS competition in the product market Least-Cost Resource Combination: MPL MPK MPN PL PK PN Profit Maximizing Resource Combination: MRPL MRPK MRPN 1 1 1 MFCL MFCK MFCN Micro Factor Markets (Cont’d) Monopsony Single resource buyer Optimizes resource use where MRP=MFC MFC>Wage Pays lower wage and employs fewer than competitive resource market Market Failures and Government Intervention Negative Externalities (Spillover Costs): MSC>MPC Some market costs are paid by parties outside the market (Ex: pollution) Overallocation Positive Externalities (Spillover Benefits): MSB>MPB Benefits are received by parties outside the market for the product (Ex: lighthouses) Underallocation Government can correct externalities with: Taxes Regulations Fines Subsidies Public Goods Tax Policies: Negative Externality Correction MSC MPC Progressive vs. Regressive taxes Positive Externality Corrections MPC MSC MSB Benefits-Received vs. Ability-to-Pay taxes MSB MSC Tax Incidence MPB MSB Micro Income Distribution Inequities caused by: Abilities Discrimination Preferences Education Wealth Chance Income Disparity has increased because of: increased demand for skilled workers increased international trade (lower world wages) decreased influence of labor unions shift to service oriented economy (lower income jobs) Argument FOR Inequality: Income inequality provides incentives for individuals to innovate and grow the economy as a means of increasing personal income Argument AGAINST Inequality: Redistribution of income will result in increased Total Utility in society. Economics of Public Policy Inefficient Voting Public programs may be implemented (or not implemented) because of the distribution of benefits vs. costs within the society. Inefficient “Yes” Voting – policies pass when policy costs to society are greater than society’s benefit. Inefficient “No” Voting – policies are rejected by voters even though total costs to society are lower than total benefit to society. Logrolling Inefficient programs are implemented because policy-makers garner support for their program by promising support to fellow policy-makers in their inefficient programs. Benefits vs. Costs Public policies that involve immediate benefits but delayed costs are favored over policies that involve immediate costs with delayed benefits. Total Benefits vs. Costs are not a factor of decision making.