Download MICROECONOMICS – ECMA04H A very short summary of what we

MICROECONOMICS – ECMA04H
A very short summary of what we studied in ECMA04
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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.
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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.
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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.
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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.
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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.
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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).
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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.
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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.
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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.
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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.
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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.