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Micro Review! • As long as Total Revenue is increasing with every decrease in price, Demand is elastic **Marginal Revenue is positive • When Total Revenue begins to decrease with every decrease in price, Demand becomes inelastic **Marginal Revenue is negative Price Elasticity of Demand • Price-elasticity coefficient and formula Ed = Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product X 6-3 Price Elasticity of Demand • Calculation problem • $4-$5 is 25% increase • $5-$4 is 20% decrease • Starting point matters • Midpoint formula Ed = Change in Quantity ÷ Sum of Quantities/2 Change in Price Sum of Prices/2 6-4 Interpretations of Elasticity Elastic Demand Ed = .04 .02 =2 .01 .02 = .5 .02 .02 =1 Inelastic Demand Ed = Unit Elasticity Ed = 6-5 Cross Elasticity of Demand • Responsiveness of sales to change in price of another good Exy = Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product Y 6-6 Cross Elasticity of Demand • Substitute goods • Positive sign • Complementary goods • Negative sign • Independent goods • Zero or near zero • Coke and Sprite Example • Mergers 6-7 Income Elasticity of Demand Ei = Percentage Change in Quantity Demanded Percentage Change in Income • Responsiveness of sales to change in income • Income increases 20%, and quantity decreases 15% then the good is a(n)… • INFERIOR GOOD • Normal goods – positive sign • Inferior goods– negative sign • How can this help you profit from a recession? 6-8 Efficiency Loss of a Tax P S’ 14 Tax Paid by Consumers Price (Per Bottle) 12 S Tax $2 10 8 6 4 2 0 Efficiency Loss (or Tax Paid by Deadweight Loss) Producers 5 10 15 20 Quantity D 25 (Millions of Bottles Per Month) Q 17-9 Tax Incidence (Who pays?) ST S ST S ST S ST S ST S D D D D D Perfectly Inelastic Relatively Inelastic Unit Elastic Tax burden paid entirely by consumers Tax burden mostly on consumers Tax burden shared by consumers and producers Copyright ACDC Leadership 2015 Relatively Elastic Perfectly Elastic Tax burden Tax burden paid mostly on producers entirely by producers 10 Efficiency Revisited • Productive and allocative efficiency S Price (Per Bag) Consumer Surplus Equilibrium Price = $8 P1 Producer Surplus D Q1 Quantity (Bags) 6-11 Are Price Controls Good or Bad? To be “efficient” a market must maximize consumers and producers surplus P S Pc DEAD WEIGHT LOSS The Lost CS and PS. CS INEFFICIENT! Price CEILING PS D Copyright ACDC Leadership 2015 Qceiling Qe 12 Are Price Controls Good or Bad? To be “efficient” a market must maximize consumers and producers surplus P S Price FLOOR Pc CS DEAD WEIGHT LOSS INEFFICIENT! PS Not Maximizing CS and PS D Copyright ACDC Leadership 2015 Qfloor Qe 13 0 1 2 3 4 5 6 7 0 10 18 24 ] ] ] ] 28 ] 30 ] 30 ] 28 How many tacos will you eat? What KEY piece of information are we missing? 10 8 4 2 0 -2 Total Utility 30 TU 20 10 0 6 Marginal Utility (Utils) Let’s go to… (1) (2) (3) Tacos Total Marginal Consumed Utility, Utility, Per Meal Utils Utils Total Utility (Utils) Graphing Utility 1 2 3 4 5 6 Units Consumed Per Meal 7 Marginal Utility 10 8 6 4 2 0 -2 MU 1 2 3 4 5 6 7 Units Consumed Per Meal 7-14 Utility Maximizing Rule The consumer’s money should be spent so that the marginal utility per dollar of each goods equal each other. MUx = MUy Px Py You use this rule subconsciously every day! Copyright ACDC Leadership 2015 15 $10 Utility Maximization # Times Going Marginal Utility (Movies) 1st 2nd 3rd 4th 30 20 10 5 $5 (Price =$10) Marginal Utility (Go Carts) (Price =$5) 3 2 1 .50 10 5 2 1 2 1 .40 .20 MU/P MU/P If you only have $40, what combination of movies and go carts maximizes your utility? 3 Movies and 2 Go Carts Copyright ACDC Leadership 2015 Identify the three stages of returns # of Workers (Input) Total Product(TP) PIZZAS 0 1 2 3 4 5 6 7 8 0 10 25 45 60 70 75 75 70 Marginal Average Product(MP) Product(AP) - - 10 10 15 12.5 20 15 15 15 10 14 5 12.5 0 10.71 -5 8.75 Increasing Marginal Returns Decreasing Marginal Returns Negative Marginal Returns Total Product, TP Law of Diminishing Returns 30 20 10 0 Marginal Product, MP TP 1 2 3 Increasing Marginal 20 Returns 4 5 6 7 8 9 Negative Marginal Returns Diminishing Marginal Returns 10 AP 1 2 3 4 5 6 7 8 9 MP 8-18 Profit • Accounting profit –Total revenue less explicit cost • Normal profit –Equal to implicit cost • Economic or pure profit –Total revenue less economic cost 8-19 Profits Compared Economic Implicit Costs (Including a Normal Profit) Explicit Costs Total Revenue Economic (Opportunity) Costs Economic Profit Accounting Accounting Profit Accounting Costs (Explicit Costs Only) 8-20 Different Economic Costs Total Costs FC = Total Fixed Costs VC = Total Variable Costs TC = Total Costs Per Unit Costs AFC = Average Fixed Costs AVC = Average Variable Costs ATC = Average Total Costs MC = Marginal Cost Copyright ACDC Leadership 2015 21 Total Cost Curves TC Costs FC + VC = TC VC Fixed Cost $10 Copyright ACDC Leadership 2015 FC Quantity 22 MC ATC Costs $20 $18 $16 $14 $12 $10 $8 $6 $4 $2 AVC ATC and AVC get closer and closer but NEVER touch Average Fixed Cost AFC 1 2 3 4 5 6 Quantity 23 Graphical Relationships Average Product and Marginal Product Production Curves AP MP Quantity of Labor MC Cost (Dollars) AVC Cost Curves Quantity of Output 8-24 Shifts in Cost Curves • Practice: Which curves shift and how? – Decrease in union wage requirements? • AVC, ATC, MC shift DOWN – Increase in rent? • AFC, ATC, shift UP – Increase in cost of materials? • AVC, ATC, MC shift UP – More efficient production technology is discovered? • AVC, ATC, MC shift DOWN Average Total Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Output Any number of short-run optimum size cost curves can be constructed 8-26 Average Total Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Long-Run ATC Output The long-run ATC curve just “envelopes” the short run ATCs 8-27 Long Run AVERAGE Total Cost Costs Economies of Scale Constant Returns to Scale Diseconomies of Scale Long Run Average Cost Curve 0 Copyright ACDC Leadership 2015 1 100 1,000 100,000 1,000,0000 Quantity Cars 28 Profit Maximization • Profit = Total Revenue - Total Cost • Total Cost = Fixed Cost + Variable Cost • Fixed vs. Variable… examples? – Fixed – rent, loan payments, utilities – Variable – labor, raw materials • Firms want TR > TC… • But how do they maximize this profit? • MARGINAL ANALYSIS!!!! Profit maximization • Marginal Cost = ∆ Price of Inputs / ∆ Output MC = ∆ Variable Cost/ ∆ Quantity • Marginal Revenue = Price each unit is sold for • MC and MR are PER UNIT measurements • Profit Maximization: -As long as MR > MC, producers will continue to produce. -Reach the point where MR = MC Production Function.notebook Four Market Structures Perfect Competition Monopolistic Competition Oligopoly Monopoly Imperfect Competition Characteristics of Perfect Competition: • Many small firms • Identical products (perfect substitutes) • Low Barriers- Easy for firms to enter and exit the industry • Seller has no need to advertise • Firms are “Price Takers” The seller has NO control over price. Copyright ACDC Leadership 2015 31 Perfect Competition LRATC • Example: – Agriculture Output Perfect Competition Lets put costs and revenue together to calculate profit. Firm Industry P S P (price taker) MC $7 $7 Demand ATC D Copyright ACDC Leadership 2015 10,000 Q Q 33 •How much output should be produced? •How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much? P $9 MC 8 7 6 5 4 3 2 1 MR=D=AR=P Profit = $18 Total Cost=$45 Total Revenue =$63 1 2 3 4 5 6 7 8 9 10 Q Copyright ACDC Leadership 2015 ATC 34 Cost and Revenue •How much output should be produced? •How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much? MC $9 8 ATC 7 6 Loss =$7 5 MR=D=AR=P 4 3 2 Total Cost = $42 Total Revenue=$35 1 1 2 3 4 5 6 7 8 9 10 Q 35 Short-Run Supply Curve Firms produce where MR=MC Cost and Revenues (Dollars) Examine the MC for the Competitive Firm MC Above AVC Becomes the Short-Run Supply Curve Break-even (Normal Profit) Point e P5 P3 P2 P1 MC MR5 d P4 S ATC c AVC b a MR4 MR3 MR2 MR1 Shut-Down Point (If P is Below) 0 Q2 Q3 Q4 Quantity Supplied Q5 9-36 Side-by-side graph for perfectly completive industry and firm in the LONG RUN Is the firm making a profit or a loss? Why? P S P MC ATC $15 MR=D $15 D 5000 Industry Copyright ACDC Leadership 2015 Q 8 Q Firm (price taker) 37 Long-Run Equilibrium Single Firm P=MC=Minimum ATC (Normal Profit) Market MC S Price Price ATC MR P P D 0 Qf Quantity 0 Qe Quantity Productive Efficiency: Price = minimum ATC Allocative Efficiency: Price = MC Pure competition has both in its long-run equilibrium What about in the short run? 9-38 Four Market Structures Perfect Competition Monopolistic Competition Oligopoly Monopoly Characteristics of Monopoly: Examples: The Electric Company, De Beers • One large firm (the firm is the market) • Unique product (no close substitutes) • High Barriers- Firms cannot enter the industry • Monopolies are “Price Makers” • Some advertising – why? 39 Copyright ACDC Leadership 2015 Pure Monopoly LRATC • Examples: – Allegheny Power – Monsanto Monopoly Revenue A monopoly will only produce in the elastic Why? range of it’s Demand Curve!! $200 Demand and Marginal-Revenue Curves Elastic Inelastic Price 150 100 50 D MR 0 2 4 Total Revenue $750 6 8 10 12 Total-Revenue Curve 14 16 18 500 250 0 TR 2 4 6 8 10 12 14 16 18 10-41 Profit Maximization Conclusion: A monopolist produces where MR=MC, but charges the price consumers are willing to pay identified by the demand curve. Price, Costs, and Revenue $200 175 MC 150 Pm=$122 125 100 75 Economic Profit ATC A=$94 D MR=MC 50 25 0 MR 1 2 3 4 5 6 7 8 9 10 Quantity 10-42 Monopolies vs. Perfect Competition Allocative Efficiency Where is CS and PS for a monopoly? P S = MC CS Total surplus falls. Now there is DEADWEIGHT LOSS Pm PS Monopolies underproduce and over D charge, decreasing CS and increasing PS. MR Copyright ACDC Leadership 2015 Qm Q 43 Allocative Efficiency Perfect Competition vs. Monopoly Regulated Monopoly Dilemma of Regulation Why does this problem exist? Price and Costs (Dollars) Monopoly Price Pm Fair-Return Price f Pf a Socially Optimal Price (No DWL) ATC Pr r D MR 0 b Qm What is the problem with the socially optimal price? MC Qf Quantity Qr Economies of Scale… 10-45 Perfect Competition Monopolistic Competition Oligopoly Pure Monopoly Characteristics of Monopolistic Competition: • Relatively Large Number of Sellers • Differentiated Products • Some control over price • Easy Entry and Exit (Low Barriers) • A lot of non-price competition (Advertising) Copyright ACDC Leadership 2015 46 Monopolistic Competition LRATC • Examples: – Restaurants – Clothing Stores (as well as most retail…) LONG-RUN EQUILIBRIUM Quantity where MR =MC up to Price = ATC P MC ATC PLR D MR QLR Q 48 Long- Run Equilibrium Not Allocatively Efficient because P MC Not Productively Efficient because not producing at Minimum ATC P MC ATC PLR D MR Copyright ACDC Leadership 2015 QLR QProd Efficient QSocially Optimal Q 49 FOUR MARKET MODELS Perfect Competition Monopolistic Competition Oligopoly Pure Monopoly Characteristics of Oligopolies: • A Few Large Producers (Less than 10) • Homogeneous or Differentiated Products • High Barriers to Entry • Control Over Price (Price Maker) • Mutual Interdependence •Firms use Strategic Pricing Copyright ACDC Leadership 2015 50 Oligopoly LRATC • Examples: – Cell Service – Cars Because firms are interdependent There are 3 types of Oligopolies 1. Price Leadership (no graph) 2. Colluding Oligopoly 3. Non Colluding Oligopoly Copyright ACDC Leadership 2015 53 If this firm increases it’s price, other firms will ignore it and keep prices the same As the only firm with high prices, Qd for this firm will decrease a lot (Qe to Q1) P P1 Pe Copyright ACDC Leadership 2015 NonCollusive Oligopoly Q1 Qe D Q 54 Resource Markets Perfect Competition Monopsony Perfectly Competitive Labor Market Characteristics: •Many small firms are hiring workers •No one firm is large enough to manipulate the market. •Many workers with identical skills •Wage is constant •Workers are wage takers •Firms can hire as many workers as they want at a wage set by the industry Copyright ACDC Leadership 2015 55 Wage is set by the market Demand/MRP falls SL Wage Wage SL=MRC WE QE Copyright ACDC Leadership 2015 Industry DL Q DL=MRP Qe Firm Q 56 The least cost rule can be used to minimize cost at any output, but only one output maximizes profits. Profit Maximizing Rule for Combining Resources MRPx = MRPy = MRCx MRCy 1 This means that the firm is hiring where MRP = MRC for each resource x and y Copyright ACDC Leadership 2015 57 Resource Markets Perfect Competition Monopsony Imperfect Competition: Monopsony Characteristics: • One firm hiring workers • The firm is large enough to manipulate the market • Workers are relatively immobile • Firm is wage maker • To hire additional workers the firm must increase the wage Examples: Central American Sweat Shops Midwest small town with a large Car Plant NCAA Copyright ACDC Leadership 2015 58 Monopsony If the firm can’t wage discriminate, where is MRC? MRC Wage SL WE DL=MRP Copyright ACDC Leadership 2015 QE The Four Market Failures We will focus on four different market failures: 1. Public Goods 2. Externalities (third person side effects) 3. Monopolies 4. Unfair (inefficient?) distribution of income In each of the above situations, the government steps in to allocate resources efficiently. 60 Copyright ACDC Leadership 2015 Market for Cigarettes If the market produces QFM why is it a market failure? P MSC S=MPC At QFM the MSC is greater than the MSB. Too much is being produced so there is deadweight loss Overallocation D=MSB Copyright ACDC Leadership 2015 QOptimal QFree Market Q 61 Market for Flu Shots P At QFM the MSC is less than the MSB. Too little is being produced S = MSC Marginal Social Benefit Underallocation Copyright ACDC Leadership 2015 QFM QOptimal Q 62 The Lorenz Curve 100 Lorenz Curve (actual distribution) Percent of Income 80 Perfect Equality 60 55 40 The size of the banana shows the degree of income inequality. 30 20 15 5 0 Copyright ACDC Leadership 2015 20 40 60 80 Percent of Families 100 63 Gini Ratios • Gini Ratio by country • Gini Ratio by state Three Types of Taxes 1. Progressive Taxes -takes a larger percent of income from high income groups (takes more from rich people). Ex: Current Federal Income Tax system 2. Proportional Taxes (flat rate) –takes the same percent of income from all income groups. Ex: 20% flat income tax on all income groups 3. Regressive Taxes –takes a larger percentage from low income groups (takes more from poor people). Ex: Sales tax; any consumption tax. 65