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Microeconomics 1000 Lecture 20 Revision Copyright © 2004 South-Western Gains from trade • If trade is voluntary and the parties are rational, both parties must gain from trade (or at least not lose) • How to measure gains from trade? Copyright © 2004 South-Western Willingness to pay • The willingness to pay is the maximum amount of money the buyer is willing to pay • Note: in general, w.t.p. ≠ price, which is what the buyer actually pays (if he purchases the good) • For a rational buyer who purchases the good, w.t.p. ≥ price • The difference is consumer surplus Copyright © 2004 South-Western Demand • Rational consumers will buy the good if price is lower than wtp • As the price increases, fewer consumers will want to buy the good • This creates a decreasing relationship between price and quantity demanded • Ranking consumers according to their wtp, each point (step) of the demand curve will correspond to a different consumer Copyright © 2004 South-Western Elasticity of demand • Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. • Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. Copyright © 2004 South-Western Costs • The goal of firms is to maximize profit, which equals total revenue minus total cost. • A firm’s total costs can be divided between fixed and variable costs. • Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced. Copyright © 2004 South-Western Average and marginal costs • Average total cost is total cost divided by the quantity of output. • Marginal cost is the amount by which total cost would rise if output were increased by one unit. • The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC. Copyright © 2004 South-Western Perfect competition • In a perfectly competitive market, all agents are price taker • This requires that each agent is so small, relative to the size of the market, that it can have no substantial impact on price Copyright © 2004 South-Western Market equilibrium • Market equilibrium is determined by the intersection of the supply and demand curves. • At the equilibrium price, the quantity demanded equals the quantity supplied. • An auctioneer, or the behavior of buyers and sellers, naturally drives markets toward their equilibrium. Copyright © 2004 South-Western Price controls • Price controls include price ceilings and price floors. • A price ceiling is a legal maximum on the price of a good or service. An example is the cap on university fees. • A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage. Copyright © 2004 South-Western Taxation • Taxes are used to raise revenue for public purposes and for other purposes (such as internalising externalities or reducing consumption of demerit goods). • When the government levies a tax on a good, the equilibrium quantity of the good falls. • A tax on a good places a wedge between the price paid by buyers and the price received by sellers. Copyright © 2004 South-Western Taxation • The incidence of a tax refers to who bears the burden of a tax. • The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. • The incidence of the tax depends on the price elasticities of supply and demand. • The burden tends to fall on the side of the market that is less elastic. Copyright © 2004 South-Western Supply curve • To maximize profit, a perfectly competitive firm chooses the quantity of output such that marginal revenue equals marginal cost. • For a price taking firm, marginal revenue equals price • Thus, at the optimum price equals marginal cost. • Therefore, the firm’s marginal cost curve is its supply curve. Copyright © 2004 South-Western Market efficiency • An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. • Under certain conditions, the equilibrium of a perfectly competitive market is efficient. • This result is also known as the First Fundamental Theorem of Welfare Economics Copyright © 2004 South-Western Market failures • A market economy delivers the efficient allocation of resources • However, efficiency is not guaranteed in the presence of • • • • Market power Externalities Public goods Asymmetric information Copyright © 2004 South-Western Externalities • When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. • Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. • Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity. Copyright © 2004 South-Western Externalities • The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently. • When private parties cannot adequately deal with externalities, then the government steps in. • The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits. Copyright © 2004 South-Western Public goods • Goods differ in whether they are excludable and whether they are rival. • A good is excludable if it is possible to prevent someone from using it. • A good is rival if one person’s enjoyment of the good prevents other people from enjoying the same unit of the good. Copyright © 2004 South-Western Public goods • Public goods are neither rival nor excludable. • Because people are not charged for their use of public goods, they have an incentive to free ride when the good is provided privately. • Governments may provide public goods, making quantity decisions based upon costbenefit analysis. Copyright © 2004 South-Western Asymmetric information • This term refers to situation where there is uncertainty, and different agents are differently informed • Three types of phenomena • Adverse selection • Moral hazard • Signalling Copyright © 2004 South-Western Adverse selection • In general, the term Adverse Selection refers to any situation where some information is hidden • To be more precise, it describes the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uniformed party • With adverse selection, trades which should occur do not take place, and the market can completely vanish Copyright © 2004 South-Western Four Types of Market Structure Number of Firms? Many firms Type of Products? One firm Few firms Differentiated products Monopoly (Chapter 15) Oligopoly (Chapter 16) Monopolistic Competition (Chapter 17) • Tap water • Cable TV • Tennis balls • Crude oil • Novels • Movies Identical products Perfect Competition (Chapter 14) • Wheat • Milk Copyright © 2004 South-Western Copyright © 2004 South-Western Monopoly • A monopoly is a firm that is the sole seller in its market. • It faces a downward-sloping demand curve for its product. • A monopoly’s marginal revenue is always below the price of its good. Copyright © 2004 South-Western Monopoly • A monopoly maximizes profit by producing the quantity at which marginal cost and marginal revenue are equal. • The price exceeds the monopoly’s marginal revenue, so its price exceeds marginal cost. • A monopoly causes deadweight losses. Copyright © 2004 South-Western Monopoly power • Monopoly power is the monopoly’s ability to profitably charge price above unit cost • This determines both the profitability of the monopoly and the magnitude of the deadweight loss that it imposes on society • The assessment of monopoly power is also a preliminary, key step in the implementation of antitrust policy Copyright © 2004 South-Western Lerner index 𝑝−𝑐 1 = 𝑝 𝑒 • The left-hand side is a measure of monopoly power (Note: the price in the formula is the optimal monopoly price, i.e. the most profitable price) • The right-hand side tells you that the only determinant of monopoly power is the elasticity of demand! Copyright © 2004 South-Western Causes of monopoly • Monopoly is due to barriers to entry • Barriers to entry in turn have various sources: • Ownership of a key resource. • The government gives a single firm the exclusive right to produce some good. • A producer may be much more efficient than any other firm • Costs of production make a single producer more efficient than a large number of producers. Copyright © 2004 South-Western Prisoners’ dilemma • The prisoners’ dilemma shows that self-interest can prevent people from maintaining cooperation, even when cooperation is in their mutual self-interest. • The logic of the prisoners’ dilemma applies in many situations, including oligopolies. Copyright © 2004 South-Western Oligopoly • Oligopolists would maximise their total profits by forming a cartel and acting like a monopolist. • However, if oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. • Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition. Copyright © 2004 South-Western Monopolistic competition • A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry. • The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost. Copyright © 2004 South-Western Monopolistic competition • There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost. • The number of firms can be too large or too small. Copyright © 2004 South-Western Consumer theory • A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods. • The slope of the budget constraint equals the relative price of the goods. • The consumer’s indifference curves represent his preferences. Copyright © 2004 South-Western Consumer theory • Points on higher indifference curves are preferred to points on lower indifference curves. • The slope of an indifference curve at any point is the consumer’s marginal rate of substitution. • The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve. Copyright © 2004 South-Western The Consumer’s Optimum Quantity of Pepsi Optimum B A I3 I2 I1 Budget constraint 0 Quantity of Pizza Copyright©2004 South-Western Copyright © 2004 South-Western Consumer theory • A price change has two effect on the optimal consumption bundle • The income effect is the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve. • The substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution. Copyright © 2004 South-Western The Work-Leisure Decision Consumption $5,000 Optimum I3 2,000 I2 I1 0 60 100 Hours of Leisure Copyright©2004 South-Western Copyright © 2004 South-Western An increasing labour supply curve (a) For a person with these preferences. . . Consumption . . . the labor supply curve slopes upward. Wage Labor supply 1. When the wage rises . . . BC1 BC2 I2 I1 0 2. . . . hours of leisure decrease . . . Hours of Leisure 0 Hours of Labor Supplied 3. . . . and hours of labor increase. Copyright©2004 South-Western Copyright © 2004 South-Western A decreasing labour supply curve (b) For a person with these preferences. . . Consumption . . . the labor supply curve slopes backward. Wage BC2 1. When the wage rises . . . Labor supply BC1 I2 I1 0 2. . . . hours of leisure increase . . . Hours of Leisure 0 Hours of Labor Supplied 3. . . . and hours of labor decrease. Copyright©2004 South-Western Copyright © 2004 South-Western Demand for labour • Firms produce output using factors of production. • The three most important factors of production are labour, land, and capital. • The demand for a factor, such as labour, is a derived demand that comes from firms that use the factors to produce goods and services. Copyright © 2004 South-Western Demand for labour • Competitive, profit-maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price. Copyright © 2004 South-Western Labour demand Quantity of Corn 3000 Supply of corn E 0 Demand for labour 1000 Quantity of Labour Copyright © 2004 South-Western Copyright©2003 Southwestern/Thomson Learning General equilibrium • Partial equilibrium analysis focuses on a single market • It is based on the ceteris paribus (i.e. all else equal) assumption • But changes in one market may also affect several other markets • Hence the need for general equilibrium analysis Copyright © 2004 South-Western The Circular Flow Revenue Goods and services sold MARKETS FOR GOODS AND SERVICES •Firms sell •Households buy Wages, rent, and profit Goods and services bought HOUSEHOLDS •Buy and consume goods and services •Own and sell factors of production FIRMS •Produce and sell goods and services •Hire and use factors of production Factors of production Spending MARKETS FOR FACTORS OF PRODUCTION •Households sell •Firms buy Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Copyright © 2004 Copyright © 2004South-Western South-Western General equilibrium • • • • Only relative prices matter With two goods, only one relative price With n goods, only n – 1 relative prices By Walras law, if n – 1 markets clear, the nth market also clear • Thus, n – 1 prices can clear n markets Copyright © 2004 South-Western Efficiency of the General equilibrium Quantity of Corn 3,000 E 2,200 0 600 1,000 Quantity of Leisure Copyright © 2004 South-Western Copyright©2003 Southwestern/Thomson Learning Comparative advantages • Each person consumes goods and services produced by many other people both in our country and around the world. • Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. Copyright © 2004 South-Western Comparative advantages • There are two ways to compare the ability of two people, or two countries, producing a good. • The person who can produce a good with a smaller quantity of inputs has an absolute advantage. • The person with a smaller opportunity cost has a comparative advantage. Copyright © 2004 South-Western Comparative advantages • The gains from trade are based on comparative advantage, not absolute advantage. • Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. • The principle of comparative advantage applies to countries as well as people. Copyright © 2004 South-Western