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MICROECONOMICS – ECMA04H A very short summary of what we studied in ECMA04 ! Economics is the science that studies decisions about the use of scarce economic resources to produce goods and services. Scarcity of resources compels the making of choices - the basic cost notion is opportunity cost (the benefit foregone in the next best opportunity). Private individuals try to maximize the surplus of individual benefits over costs; they do this by equating marginal benefits (utility or revenue) with marginal costs (the price of the good, or the marginal cost of production). As economists, we judge economic situations according to whether they maximize the Gain to Society (GTS: the sum of consumer surplus and profit, or the sum of consumer and producer surpluses), that is, whether they maximize efficiency. ! Markets are composed of consumers seeking utility and producers seeking to make profits (surplus of revenues over costs); therefore, we analyze markets by looking at the DEMAND side and the SUPPLY side. When the price of the good changes, there is a movement along the demand curve and supply curve to a different quantity demanded and a different quantity supplied. If any of the other variables in the demand function (price of substitutes, price of complements, income, tastes) changes, there is a corresponding shift of the demand curve; if any of the other variables in the supply function changes (price of labour, price of capital goods, price of a substitute in production, price of a complement in production, technology, etc.), then there is a corresponding shift in the supply curve. The responsiveness of quantity demanded to a change in its own price is summarized in the price elasticity of demand ED = -(dQ/dP x P/Q) the responsiveness of quantity supplied to a change in own-price is summarized in the price elasticity of supply ES = dQ/dP x P/Q When there is excess demand in a market, the price will tend to rise to eliminate the excess demand; when there is excess supply, the price will tend to fall to eliminate the excess supply. In this way, price will tend to move towards an equilibrium where excess demand=excess supply=0. ! The importance of demand and supply elasticities is obvious when we look at which party bears the burden of an excise tax on a particular commodity. The ratio of the buyer's share to the seller's share of a (small) tax in a competitive market will be equal to the ratio of the point elasticity of supply to the point elasticity of demand at the initial equilibrium point. ! Looking at demand from the point of view of the individual consumer, the consumer's decision can be analyzed as an attempt to maximize the surplus of utility over the cost of goods consumed. We presume that utility from additional units of any commmodity diminishes as more are consumed (diminishing marginal utility). The price the consumer is willing to pay for one more unit of the good is based on the dollar value of marginal utility received from each unit. Accordingly, the "optimal purchase rule" says the consumer should purchase units of the commodity until MU (i.e., dTU/dQ)=P. Doing this will maximize the Consumer Surplus received by the consumer (i.e., the excess of total utility from consumption over the purchase cost of the commodity - the area under the individual's demand curve and above the purchase price). The demand curve of the individual is downward sloping (dP/dQ<0). The market demand curve will be the horizontal sum of the individual demand curves. ! Looking at supply from the point of view of the individual producer, the producer's decision can be analyzed as an attempt to maximize the surplus of revenues over costs. The Total Cost of producing any quantity of a commodity depends upon the production function (the technological relationship between the amount of inputs and the amount of output produced), and the per-unit costs of the inputs. Diminishing marginal returns means that the short run marginal cost curve will, in general, be upward sloping (the rate of change of total costs will [eventually] increase as more output is produced, when the amount used of some inputs is fixed in the short run). Producers will maximize profit by setting MR = MC (dTR/dQ = dTC/dQ). For a perfectly competitive firm (price taker) the quantity where MC=P will be the profit-maximizing quantity. The firm will produce this quantity unless P<AVC at this quantity, in which case the firm will do better to shut down even in the short run. The marginal cost curve above the AVC curve will therefore be the short run supply curve of the perfectly competitive firm. The short-run industry supply curve will be the horizontal sum of the supply curves of the individual firms. ! When all inputs are variable (i.e., over the long run), the firm will have a long run average cost curve which is the envelope of the short run average cost curves for different possible plant sizes. Although the competitive firm may earn profits in the short run, the entry or exit of firms which occurs in the long run will continue until economic profit equals zero. In other words, in the long run, the perfectly competitive firm will produce an output such that P=min LRAC (price equals the minimum point on the long run average cost curve). The long run average cost curve of the firm will reflect increasing returns to scale, constant returns to scale, decreasing returns to scale, or perhaps all three of these at different levels of output. If the costs of inputs are constant, the long run industry supply curve will simply be a horizontal line at the minimum point of each firm's LRAC curve (constant cost industry). ! A monopolistic firm faces the entire industry demand curve; the firm's demand curve is, therefore, downward sloping; such a firm chooses a price-output combination (i.e., is a price maker). Marginal revenue for a monopolist lies below the average revenue or demand curve (P>MR); the monopolist profitmaximizes by producing the output where MC=MR, as long as the resulting price at least covers AVC in the short run and AC in the long run. When public authorities regulate a monopoly situation, they may compel the monopolist to set price equal to average cost (π=0) or price equal to marginal cost. ! The output of a perfectly competitive industry is ideal from society's point of view (i.e., efficient) because the Gain to Society is at its maximum. The key indicator of this is that, at the equilibrium output for each firm, P=MC. Therefore, the dollar value of the marginal utility of the last unit consumed (which consumers set equal to price) equals the marginal cost of producing the last unit. Further these marginal costs are, in the long run, associated with the lowest possible average cost of production. This can be compared with the monopoly situation where P>MC in equilibrium, so that the dollar value of the marginal utility of the last unit consumed is greater than the additional cost of producing the last unit; in other words, consumers would benefit more from consuming one more unit than the extra cost of producing this extra unit. However, one more unit will not be produced because this would decrease the monopolist's profits. ! A good which is both non-rival and non-excludable is called a Apublic good@. Non-rivalry implies that the good can be consumed collectively without rivalry. Non-excludability implies that it is practically impossible to exclude consumers from consumption once the good is produced. As a result, there is a Afree rider@ problem and normal markets will fail to produce sufficient quantity of the good. In fact, in general, the good will not be produced at all. The role for governments in either producing the good or ensuring its production is obvious. ! Even competitive markets will not produce efficient results when there are important external costs or benefits of production. In this case, private demand and supply curves do not reflect the full social benefits or costs of producing a certain output. If private negotiations cannot provide a solution, governmental regulation, taxation or subsidies may be necessary. ! Even if one country is better than another at all types of production (uses fewer resources to produce them - i.e., has the absolute advantage), international trade will make good economic sense. The key to this is the different opportunity costs of production in the two countries, a notion which goes under the name of the theory of Comparative Advantage. We can analyze the effects of tariffs on trade between two countries and on the prices that will be charged.