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Hints for passing the AP Microeconomics REVIEW Ms. Meachum Topics: MC=MR Perfect competition Change in Demand vs. Change in Quantity Demanded MR PARD Labor Markets Indeterminant Prices vs. Costs Sample (capital, capital stock, capital flow) Consumer Surplus/Producer Surplus/Deadweight Economic profit Government Controls Elasticity Externalities Short-term/Long-term Comparative Advantage Economies of Scale Sample AP Question: Externalities Scarcity Derived Demand SHOW ME! GRAPH ME! ANALYZE ME! EXPLAIN ME! MC = MR **Tattoo this on your forehead This equation comes in many forms: MC=MR, MC=MU, MSC=MSB...etc PERFECT COMPETITION MC Price Price S ATC p P D=MR=AR AVC D q Single Farmer Quantity Q Quantity Industry Perfect Competition--MUST use SIDE-BY-SIDE GRAPHS or no credit. PERFECT COMPETITION MC Price Price S ATC p MR=P=AR=D AVC D q Quantity Single Farmer Q Quantity Industry In perfect competition, individual firms are price takers and will take the market price. Hint: memorize this line for the AP test. PERFECT COMPETITION MC Price Price S ATC p Economic Profit AVC MR=P=AR=D D q Single Farmer Quantity Q Quantity Industry MUST show Economic Profit or Loss MAKE SURE THEY SEE A GAP between profit line and ATC When I grew up on the farm, we lived next door to MR. PARD People called him that because he knew so much about perfect competition. When labeling the demand curve for perfect competition, MAKE SURE it is labeled MR = P = AR = D MC Price Price S S1 ATC p p1 D=MR=AR=P MR1=P1=AR1=D1 D 0 q1 q Single Firm Quantity Q Q1 Quantity Industry In the LONG RUN, when Because the firm is a price taker and individuals see the firms are must take the market price, Industry P and Firm p goes down to p1 earning an economic profit Industry Q goes up to Q1 (above normal rates of return), Firms’ q go down (q to q1) more firms will enter the market causing the industry market ATC = MR PARD at supply curve to shift to the right. its lowest point MC Price Price S ATC p1 P D=MR=AR Economic Loss D q Single Firm Quantity Q Quantity Industry How is this chart different from the previous chart reflecting an economic profit? In this situation, P is below ATC at profit-maximizing quantity (q). This chart reflects a loss. MC P p1 p S1 P S ATC MR1=P1=AR1=D1 Economic Loss P=D=MR=AR D q q1 Q Single Firm In the LONG RUN, when individuals see the firms are making an economic loss, firms will leave the market causing the industry market supply curve to shift down. Q1 Q Q Industry Because the firm is a price taker and must take the market price, Industry P and Firm p goes up to p1 Industry Q goes down to Q1 Firms’ q go up (q to q1) ATC = MR PARD at its lowest point A graph is worth a thousand words UNLESS you forget to label it….. GRAPH FIRST, then let the graph tell the story……LABEL, LABEL, LABEL GET TO THE POINT!!! JUST THINK ECONOMICALLY Good decisions using cost-benefit analysis and marginal thinking. Chart V: (D ; S ) S PRICE P0 Be sure to use the word indeterminate when describing price in this graph!! S1 E1 E0 D1 D0 Q0 Quantity will increase Q1 QUANTITY If you see the words longrun, need to double shift. Make it easy for the reader to grade!! Number your responses. ANSWER THE QUESTION clearly and concisely. MAKE SURE YOU USE PROPER ECONOMIC TERMINOLOGY WHEN ANSWERING FREE RESPONSE QUESTIONS. ***When answering free response questions, many students’ explanations do not indicate an understanding of economic principles. Instead they use common words and terms that may make common sense but not economic sense. For example, on the 2004 Micro Exam, Ques 3, part b, students were to indicate: For the monopolistically competitive firm, what happens to output and profit if there is an elimination of a business license fee (a fixed cost). For the monopolistically competitive firm, what happens to output and profit if there is an elimination of a business license fee (a fixed cost). The correct answer is: --output does not change because the license fee is a fixed cost and does not affect marginal cost. --profit will increase since total revenue (p x q) does not change and total cost has decreased. (Note: students could have used average instead of total--be consistent) For the monopolistically competitive firm, what happens to output and profit if there is an elimination of a business license fee (a fixed cost). The correct answer is: --output does not change because the license fee is a fixed cost and does not affect marginal cost. --profit will increase since total revenue (p x q) does not change and total cost has decreased. (student could have used average instead of total) The term “profit” seems to have given students the most difficulty. A typical student’s response is as follows: For the monopolistically competitive firm, what happens to output and profit if there is an elimination of a business license fee (a fixed cost). The correct answer is: --output does not change because the license fee is a fixed cost and does not affect marginal cost. --profit will increase since total revenue (p x q) does not change and total cost has decreased. (student could have used average instead of total) “Economic profits will also increase because if the license fee is eliminated, there will be more money for the firm which means increased production. More people will buy the product and there will be more of a profit for the firm.” “Economic profits will also increase because if the license fee is eliminated, there will be more money for the firm which means increased production. More people will buy the product and there will be more of a profit for the firm.” **The answer assumed (incorrectly) that output changed. NOT MONEY ***In order to receive the profit point, the student would have to discuss the effect on total revenue (or AR), the effect on total cost (or ATC) and the resulting effect on profit. Economic Profit = total revenue minus all the opportunity costs (implicit & explicit) of production. Accounting Profit = total revenue minus explicit costs Economic Profit Total Opportunity Costs Implicit Costs Explicit Cost$ Accounting Profit Revenue Revenue Explicit Cost$ “Economic profits will also increase because if the license fee is eliminated, there will be more money for the firm which means increased production. More people will buy the product and there will be more of a profit for the firm.” **Since the question involved a monopolistically competitive firm with a downward sloping demand curve, increasing output would bring about a decrease in price. This would not necessarily increase total revenue, depending on the price elasticity of demand. Elastic Demand and Total Revenue At point A, total revenue is $400 ($10 x 40), or area a + b. At point B, the total revenue is $500 ($5 x 100), or area b + c. Total revenue has increased by $100. P A We can also see in the graph that total revenue has increased because the area b + c is greater than area a + b, or c > a. $10 a B $5 b 0 20 c 40 60 Delastic 80 100 Q Inelastic Demand and Total Revenue At point A, total revenue is $300 ($10 x 30), or area a + b. At point B, the total revenue is $200 ($5 x 40), or area b + c. Total revenue has decreased by $100. P A $10 We can also see in the graph that total revenue has decreased because the area a + b is greater than area b + c, or a > c. a B $5 b c Dinelastic 0 10 20 30 40 Q When a demand curve is relatively steep, such as D0 in this graph, its price elasticity is relatively inelastic. P R I C E When a demand curve is relatively flat, such as D1, its price elasticity is relatively elastic. P1 P0 D1 D0 0 Q 2 Q1 Q0 QUANTITY Relatively elastic Relatively inelastic Another area of confusion seems to be short-run vs. long-run: SHORT-RUN refers to a period of time when at least one factor of production (input) is fixed. --It does not refer to a period of time. --Increasing and diminishing marginal returns represent short-run situations. Another area of confusion seems to be short-run vs. long-run: LONG-RUN refers to that time period where all the factors of production are variable. Terms that deal with long-run include: --economies of scale --diseconomies of scale --constant returns to scale ECONOMIES OF SCALE ECONOMIES OF SCALE: When long-run average total cost declines as output increases. DISECONOMIES OF SCALE: When long-run average total cost rises as output increases. CONSTANT RETURNS TO SCALE: When long-run average total cost does not vary with the level of output. Average Total Cost ATC in short run w/small factory ATC in short run w/medium ATC in short runATC in long w/large factory run factory $12,000 Economies 10,000 of Scale Constant Returns to Scale *Mankiw 0 1,000 1,200 CAUSES of economies or diseconomies of scale: 1) Diseconomies of Scale Quantity of Cars per day Specialization of workers will be found in higher production levels of economies of scale. STUMBLING BLOCKS -- Micro --Scarcity --Demand vs. Quantity Demanded --Demand vs. Derived Demand --Price vs. Cost --Direction of a shift: UP instead of increase (right) and DOWN instead of decrease (left). Scarcity: Insufficient supply of something where “insufficient” is interpreted relative to the desires of a group of people. (I.e.) For instance, antiques are valued for their scarcity…. Scarcity is NOT: the same as poverty. (eg. Goods can be scarce in United States AND Somalia. However, scarcity isn’t going away; poverty might.) the same as shortage. (eg. Whether you have a shortage or not depends upon how you handle the rationing problem made necessary by scarcity) CHANGE IN DEMAND vs CHANGE IN QUANTITY DEMANDED The Basic Determinants of Demand are: 1) consumer tastes and preferences 2) number of consumers in the market 3) consumers’ money incomes 4) prices of related goods 5) consumer expectations about future prices and incomes A change in the demand schedule or, graphically, a shift in the location of the demand curve is called a CHANGE IN DEMAND. This is caused by a change in one or more of the determinants of demand. S PRICE P2 P0 P1 E0 E1 D2 D1 Q1 Q0 Q2 D0 QUANTITY By contrast, a CHANGE IN QUANTITY DEMANDED designates the movement of one point to another--from one price quantity to another--on a fixed demand curve, resulting from (i.e.) a change in PRICE. $80 P $70 $60 R I C E $50 $40 $30 $20 D (demand) $10 0 100 200 300 400 500 600 QUANTITY Changes in Quantity Demanded Price of IceCream Cones B $2.00 A tax that raises the price of ice-cream cones results in a movement along the demand curve. A 1.00 D 0 4 8 Quantity of Ice-Cream Cones CHANGE IN SUPPLY vs CHANGE IN QUANTITY SUPPLIED The Determinants of Supply are: 1) resource prices 2) technique of production 3) taxes and subsidies 4) prices of other goods 5) price expectations 6) number of sellers in the market. A CHANGE IN SUPPLY means a change in the entire schedule and a shift of the entire curve, which is caused by a change in one or more of the determinants of supply. S2 P P2 RP 0 I P1 C E S0 E2 E0 E1 D Q2 Q0 Q1 QUANTITY S1 In contrast, a CHANGE IN QUANTITY SUPPLIED is a movement from one point to another on a fixed supply curve. The cause of which is a change in PRICE of a specific product. S (supply) $80 P $70 $60 R I C E $50 $40 $30 $20 $10 0 100 200 300 400 500 600 QUANTITY Change in Quantity Supplied Price of IceCream Cone S C $3.00 A rise in the price of ice cream cones results in a movement along the supply curve. A 1.00 0 1 5 Quantity of Ice-Cream Cones DEMAND vs. DERIVED DEMAND (and other factor market problems) LABELING IMPORTANT IN LABOR MARKET!! MUST indicate demand for labor not just “D” and supply of labor not just “S”. Pric e S WAGES P2 SL W2 P1 W1 DL2 D2 Q1 D 1 Q2 Quantity Product Market DL L1 L2 Quantity of Labor Resource Market There is an increase in demand for a good or service in the product market, which results in an increase in P and Q. Pric e Pric e S P2 P2 P1 P1 SL D2 Q1 Q2 Product Market D 1Quantity DL Q1 Q2 Quantity Resource Market There is a DERIVED DEMAND in the resource market for labor that produces the good or service. Pric e S Wages P2 SL W2 P1 W1 D2 Q1 D 1 Q2 Quantity Product Market DL2 DL QL1 Quantity ResourceQL2 Marketof Labor Because Q increased in the product market, the DERIVED DEMAND in the resource market for labor also increases. Pric e S WAGES P2 SL W2 P1 W1 DL2 D2 Q1 D 1 Q2 Quantity Product Market DL1 L1 L2 Quantity of Labor Resource Market This causes the WAGE RATE to increase (W1 to W2) and quantity of labor to increase (L1 to L2) Pric e S WAGES P2 S W2 P1 W1 DL2 D2 DL D1 Q1 Q2 Quantity Product Market L1 L2 Quantity of Labor Resource Market IMPORTANT: There is a direct relationship between what happens in the product market and what happens to DERIVED DEMAND in the resource market. If demand increases in the product market, derived demand for labor in the resource market will also increase. IMPORTANT: In the resource market S = MFC (marginal factor cost) and D = MRP (marginal revenue product). Pric e Wage S MFC S W1 D1 D Quantity Product Market W MRP1 D1 MRP D L L1 Quantity Resource Market MARGINAL REVENUE PRODUCT is the change in total revenue resulting from the use of one additional unit of a resource, or TR MRP = --------------------Q of resource MARGINAL RESOURCE COST is the change in total cost resulting from the use of one additional unit of a resource, or TC (resource) MRC = --------------------Q (resource) The profit maximizing rule for employing resources is: MRP = MRC A firm can maximize TP by hiring the #workers at MRP of labor = MFC of labor. Hire labor MRP > MFC, stopping with the unit for which MRP = MFC. Do not hire any MRP < MFC. Wages MFC S W MRP D L Resource Market Quantity of Labor In this perfectly competitive market, how many workers would be employed if wages were: Workers 0 1 2 3 4 5 6 7 Output *MPP 0 7 13 18 22 25 27 28 ]- 7 ]- 6 ]- 5 ]- 4 ]- 3 ]- 2 ]- 1 Price TR $2 0 $2 14 $2 26 $2 36 $2 44 $2 50 $2 54 $2 56 MRP $13.95 ]- 14 ]- 12 ]- 10 ]- 8 ]- 6 ]- 4 ]- 2 1 $11.95 2 $ 9.95 3 $ 7.95 4 In this imperfectly competitive market, how many workers would be employed if wages were: Workers MRP 0 1 2 3 4 5 6 7 Output *MPP 0 7 13 18 22 25 27 28 ]- 7 ]- 6 ]- 5 ]- 4 ]- 3 ]- 2 ]- 1 Price $13.95 TR 2.80 0 2.60 18.20 2.40 31.20 ]- 8.40 2.20 39.60 ]- 4.40 2.00 44.00 ]- 2.25 1.85 46.25 1.75 47.25 1.65 46.20 ]- 18.20 ]- 13.00 1 $11.95 2 $ 9.95 2 ]- 1.00 $ 7.95 ]- -1.05 3 MC P ATC p REMINDER: in any firm…… AVC P** q Q Single Farmer SHUTDOWN = if P < AVC = if TR < VC = if TR/Q < VC/Q Things have prices... Decisions have costs….. INVESTMENT Some students use the term “investment” incorrectly. They do not relate investment to machinery, tools, and equipment. Instead, they use the term as it relates to stocks and bonds. CAPITAL is another term that confuses students: CAPITAL: refers to the machinery, tools, and equipment used to produce other goods and services. It is NOT money. CAPITAL STOCK: refers to the current market value of machinery, tools, equipment and inventories available to the firm. It does NOT refer to stock of a corporation. CAPITAL FLOW is another term students should know. For example on the 2002 Macro Exam, question 3, students were asked, “ how and why will capital flows be affected by this change in the real interest rates?” The question referred to a change in real interest rates in the U.S. and abroad. ***In this case, capital flow refers to the purchase of foreign assets. Preparing for 2006: Efficiency & welfare economy. Consumer Surplus Producer Surplus Deadweight Loss What happens when prices are “fixed” by the government? Let’s look at a graph which shows the average consumption of beer in the United States. In this example, the average beers consumed per week is 6 S $4 $3 at an average price of $2.50. E $2 $1 D 0 1 2 3 4 5 6 7 Beers per week Ge This chart illustrates the effects upon people if they were forced to go from Ge to zero. You might be willing to pay $4 for your first beer, but price is $2.50 …..now you are $1.50 better off. This is called CONSUMER SURPLUS. S $4 $3 E $2 $1 D 0 1 2 3 4 5 6 7 Beers per week Ge The 9th beer is worth to people what it is worth to people. It is different for everybody. S From the suppliers’ standpoint, they could supply at a lower price but they CAN get more. This is called PRODUCER SURPLUS. $4 $3 E $2 $1 D 0 1 2 3 4 5 6 7 Beers per week Ge The colored area is the $4 total value $3 to society of the cost $2 of 6 beers. S Consumer Surplus E Producer Surplus D $1 0 1 2 3 4 5 6 7 Beers per week Ge What if government mandate limited the maximum price of a beer to $1.00? $4 NOTE: Another example of this is the price ceiling on gasoline during the Nixon administration. $3 However, suppliers would not want to produce as much beer. E $2 $1 S Consumers would want to buy more beer. D 0 1 2 3 4 5 6 7 Beers10per week Ge REMEMBER: Producers will not want to produce for low prices. If government limited the maximum price of a beer to $1.00, it would create a shortage. S $4 $3 E $2 $1 shortage D 0 1 2 3 4 5 6 7 Beers per week Ge The legal maximum price that can be charged is called a PRICE CEILING. A legal minimum price that can be charged is called a PRICE FLOOR. Price ceilings and floors keep markets from reaching equilibrium. Politically popular ideas include: --$ minimums on inputs (wages). --$ maximums on outputs (prices/rent control). When POLITICS vs. ECONOMICS => Politics always wins A price ceiling keeps the market from reaching equilibrium. The S government mandating $4 the maximum $3 E price of a beer is called $2 shortage a PRICE CEILING. $1 D 0 1 2 3 4 5 6 7 Ge Beers per week The shortage created from the price ceiling will result in increased demand. S $4 NOTE: Another example of a price ceiling is rent control. $3 E $2 shortage $1 0 1 2 3 4 5 6 7 X D Ge Beers per week What if government mandate limited the maximum number of beers one could drink to 4 per week? Government Mandated Supply S $4 Four beers is not enough (too little, inefficient) ….This is called DEADWEIGHT loss. $3 E $2 $1 D 0 1 2 3 4 5 6 7 Beers per week Ge The increased demand and a willingness to pay higher prices will result in a BLACK MARKET for beer. NOTE: This is what happened during prohibition when (legal) supply was limited to zero. When the government mandates a the minimum price of something, it is called a PRICE FLOOR. S $5 NOTE: The minimum wage is an example of a price floor. $4 E $3 $2 $1 D 0 1 2 3 4 5 6 7 Ge Labor The minimum wage increases the number of people who want to work (supply of labor). . . . . . And decreases the number of businesses who $5 want to hire $4 (demand for $3 labor) $2 Creating a SURPLUS of labor. S SURPLUS E $1 D 0 1 2 3 4 5 6 7 Ge Labor RESULTS: •Those who continue to work are better off. (90%) •Some people are worse off (10%) •Prices rise for some goods using low skilled labor. •Discrimination is created in the labor market. •Some people leave home to make more money creating larger unemployment and disemployment. Easy to show overall: •Costs > return of benefits •Total welfare higher => those working incur higher costs •Output will fall => fewer people working Extreme case: What would happen if the government raised the minimum wage to $100 an hour? Even though water is essential for life and diamonds are not, water is cheap and diamonds are expensive? Why? It has to do with the elasticity of the supply curve and the amount of consumer/producer surplus With DIAMONDS, supply is very inelastic. S P With WATER, supply is very elastic. Consumer Surplus Producer Surplus S P D Q Quantity D Q Quantity NASH EQUILIBRIUM is a situation where economic actors interacting with each other each choose their best strategy given the strategies that others have chosen. This is GAME THEORY. also called ***Kinked demand curve is out!! John Nash 1994 Nobel Prize, Economics Game Theory can be illustrated by what is called THE PRISONER’S DILEMMA. The police have enough evidence to convict Bonnie and Clyde of possession of an illegal firearm so that each would spend 1 year in jail. But they suspect that the two have pulled off some bank robberies but they have no evidence. They put Bonnie and Clyde in separate rooms and offer a deal. “Right now, we can lock you up for one year. But if you testify against your partner, we will set you free and your partner will get 20 years in prison. If you both confess to the crime, we can avoid the cost of a trial and you both get 8 years.” Each prisoner has two strategies, confess or remain silent. However, the sentence that each gets depends upon the actions of the other. Bonnie’s Decision confess confess Clyde’s Decision 8 years each Remain Bonnie goes free silent Clyde - 20 yrs. Remain silent Bonnie - 20 yrs Clyde goes free 1 year each OR you can use the PAYOFF MATRIX B: 8 years C: 8 years Clyde’s Decison B: free Bonnie’s Decison C: 20 years B: 20 years Clyde’s Decison C: free B: 1 year C: 1 year In the real world, this dilemma is played out by real players. Once a negotiation is reached, each country must decide whether they should keep their agreement. Iraq’s Decision High prod. Iran’s Decision High prod. $40 billion each Low Iraq - $60 billion prod. Iran - $30 billion Low prod. Iraq - $30 billion Iran - $60 billion $50 billion each It can be used in the arms race…... U.S.’s Decision Arm. Arm USSR’s Decision Disarm Both at risk Disarm US at risk USSR safe US safe USSR at risk Both safe It can be used in the everyday economic decisions……Consider 2 firms which must decide whether to make a new product or not…. Firm 1 Yes Yes Firm 2 No No Firm 1: $1.5m Firm 1: 0 Firm 2: $1.5m Firm 2: $2m Firm 1: $2m Firm 1: 0 Firm 2: 0 Firm 2: 0 GAME THEORY • • • • Prisoners' Dilemma Battle of the Sexes Dominant Strategies Nash Equilibria By David Anderson, PhD Centre College, Danville, KY The Payoff Matrix Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD The Payoff Matrix Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD The Payoff Matrix Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD The Payoff Matrix Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD The Payoff Matrix Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD The Circle Trick Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD The Circle Trick Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD The Circle Trick Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD The Circle Trick Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD Chris has a Dominant Strategy: The “Confess” strategy is best regardless of Pat’s move. Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD Checking Pat’s Options Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD Checking Pat’s Options Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD Checking Pat’s Options Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD Checking Pat’s Options Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD Pat has a dominant strategy: Confess Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD Nash Equilibrium: Neither side has a desire to switch strategies given what the other is doing. Pat Confess Confess Chris Deny Deny 5, 5 1,10 10, 1 2, 2 David Anderson, PhD Battle of the Sexes Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD John Analyses the Possibilities Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD John Analyses the Possibilities Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD John Analyses the Possibilities Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD John Analyses the Possibilities Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD Sarah Analyses the Possibilities Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD Sarah Analyses the Possibilities Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD Sarah Analyses the Possibilities Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD Sarah Analyses the Possibilities Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD Two Nash Equilibria, No Dominant Strategies Sarah Rally John Town Hall Rally 20, 30 9, 4 Town Hall 10, 16 40, 27 David Anderson, PhD Chicken Sarah Straight Straight John Swerve Swerve -10,-10 +5, -5 -5, +5 0, 0 David Anderson, PhD COMPARATIVE ADVANTAGE Comparative Advantage: an individual (or country) has comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than for other people. Absolute Advantage: an individual (or country) is said to have absolute advantage if they (he/she) can do it better than anyone else. Having an absolute advantage is not the same thing as comparative advantage. Let’s say we have 2 individuals named Adam and Eve, who are the only people in the world. Can they benefit from trading with each other? Let’s take a look at the Production Possibilities curve for each person. Quantity of apples Adam’s PPC Eve’s PPC Quantity of apples 30 20 Adam’s consumption without trade 9 Eve’s consumption without trade 8 0 28 40 Quantity of Fish 0 6 10 Quantity of Fish The slope of Adam’s line is 3/4. That is for every 4 additional fish that Adam chooses to catch, he gathers 3 fewer apples. Quantity of apples The slope of Eve’s line is -2. Eve is less productive: the most she can produce is 10 fish or 20 apples. She is particularly bad at fishing. Eve’s PPC Adam’s PPC Quantity of apples 30 20 Adam’s consumption without trade 9 Eve’s consumption without trade 8 0 28 40 Quantity of Fish 0 6 10 Quantity of Fish Adam & Eve’s Opportunity Cost Adam’s Opp Cost Quantity of apples One fish 3/4 apple One apple 4/3 fish Eve’s Opp Cost 2 apples 1/2 fish Eve’s PPC Adam’s PPC Quantity of apples 30 20 Adam’s consumption without trade 9 Eve’s consumption without trade 8 0 28 40 Quantity of Fish 0 6 10 Quantity of Fish GAINS FROM TRADE Without Trade Production Adam Eve Fish Consumption With Trade Production Gains from Trade Consumption 28 28 40 30 +2 Apples 9 9 0 10 +1 Fish 6 6 0 10 +4 Apples 8 8 20 10 +2 So here’s how it works: Adam specializes in the catching of fish (40/week) and gives 10 to Eve. Meanwhile, Eve specializes in the picking of apples (20/week) and gives 10 to Adam. As you can see by the table above, both Adam and Eve have gains from trade. They both increase their consumption of both commodities. It is better for Adam to catch the fish because his opportunity cost of a fish is only 3/4 of an apple not picked versus 2 apples for Eve. Another way to say it is because Adam is so good at catching fish, his opportunity costs of picking apples is high: 4/3 fish not caught for every apple picked. Because Eve is a poor fisherman, her opportunity cost of picking apples is less: only 1/2 a fish per apple. Compare the following two countries and assume they only produce these two goods. Microwaves Refrigerators Slovenia Bohemia 12 10 4 6 1) What is Slovenia’s opportunity cost of making microwaves? 4/12 = 1/3 For every microwave, it must give up 1/3 of a Refrigerator. 2) What is Bohemia’s opportunity cost of making microwaves? 6/10 =3/5 For every microwave, it must give up 3/5 of a refrigerator Compare the following two countries and assume they only produce these two goods. Microwaves Refrigerators Slovenia Bohemia 12 10 4 6 3) What is Slovenia’s opportunity cost of making refrigerators? 12/4 = 3 For every refrigerator, it must give up 3 of a microwaves. 4) What is Bohemia’s opportunity cost of making refrigerators? 10/6 = 5/3 For every refrigerator, it must give up 1 2/3 of a microwave. Compare the following two countries and assume they only produce these two goods. Microwaves Refrigerators 5) Which country has absolute advantage in microwaves? Slovenia Bohemia 12 10 4 6 Slovenia 12 Slovenia/10 Bohemia 6) Which country has absolute advantage in refrigerators? Bohemia 6 Bohemia/4 Slovenia Compare the following two countries and assume they only produce these two goods. Microwaves Refrigerators Slovenia Bohemia 12 10 4 6 7) Which country has comparative advantage in microwaves? Slovenia 1/3 Slovenia vs. 3/5 Bohemia 8) Which country has absolute advantage in refrigerators? Bohemia 5/3 Bohemia vs 3 Slovenia Compare the following two countries and assume they only produce these two goods. Microwaves Refrigerators Slovenia Bohemia 12 10 4 6 9) Which country should produce what? Slovenia should produce microwaves and Bohemia should produce refrigerators because microwaves and refrigerators will then be produced by the lower-cost country. The TOTAL OUTPUT of microwaves and refrigerators will be higher. Compare the following two countries and assume they only produce these two goods. Microwaves Refrigerators Slovenia Bohemia 12 10 4 6 10) Use the law of comparative advantage to explain why selfsufficiency leads to a lower standard of living. If people and countries do not trade on the basis of comparative advantage, there will be fewer goods and services for people to enjoy. People will be poorer. Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 minutes 1) What is Karen’s opportunity cost of cleaning the kitchen in terms of mowing the lawn. 60/30 = 2 Mowing 2 lawns. 2) What is Charlie’s opportunity cost of cleaning the kitchen in terms of mowing the lawn? 20/15 = 4/3 Mowing 4/3 lawns. Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 minutes 3) What is Karen’s opportunity cost of mowing the lawn in terms of cleaning the kitchen? 30/60 = 1/2 Cleaning 1/2 kitchen 4) What is Charlie’s opportunity cost of mowing the lawn in terms of cleaning the kitchen? 15/20 = 3/4 kitchen Cleaning 3/4 Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 minutes 5) Who has absolute advantage in cleaning the kitchen? Charlie 20 minutes 6) Who has absolute advantage in mowing lawns? Charlie 15 minutes Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 minutes 7) Who has comparative advantage in cleaning the kitchen? Charlie 4/3 to 2 8) Who has comparative advantage in mowing lawns? Karen 1/2 to 3/4 Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 minutes 9) Who should do which chore and why? Charlie should clean the kitchen and Karen should mow the lawn and they will finish sooner. The person with the lower opportunity cost should perform the chore. SAMPLE AP TEST QUESTION The production of Good X creates an externality. Is this a negative or positive externality? Price Marginal Social Cost 13 12 Negative Marginal Private Cost 7 Why? 4 D-MSB MR 0 Q1 Q2 Quantity of Good X Q3 MR MSC > MPC The production of Good X creates an externality. Price Identify the socially optimum output. Marginal Social Cost 13 12 Marginal Private Cost 7 Q2 Why? 4 D-MSB MR 0 Q1 Q2 Quantity of Good X Q3 MR MSC=MSB Suppose that good X is produced by a profitmaximizing monopoly. Identify the unregulated firm’s output. Price Marginal Social Cost 13 Q1 12 Why? Marginal Private Cost 7 4 D-MSB MR 0 Q1 Q2 Quantity of Good X Q3 MR At Q1, MPC = MR Suppose that good X is produced by a profitmaximizing monopoly. Price To produce socially optimum output, should the government tax or subsidize the firm? subsidize Marginal Social Cost 13 How much will it be? Marginal Private Cost $3 Why? 12 7 4 D-MSB MR 0 Q1 Q2 Quantity of Good X Q3 MR Optimum Quantity at Q2 = MR Suppose that good X is produced in a perfectly competitive industry. Price Identify equilibrium output in the absence of regulation. Q3 Marginal Social Cost 13 12 Marginal Private Cost 7 4 MR 0 Q1 Q2 Q3 D-MSB Quantity of Good X Why? D=MPC or MSB=MPC Suppose that good X is produced in a perfectly competitive industry. Price To produce at socially optimum output, should the government tax or subsidize? Tax Marginal Social Cost 13 12 Marginal Private Cost 7 4 MR 0 Q1 Q2 Q3 D-MSB Quantity of Good X How much? $5 STUDENTS SHOULD: --recognize the importance of understanding terminology. --be expected to use economic terms in discussion, essays, and analysis --identify the economic terms in the exam questions --ANSWER THE QUESTION. Simply restating a question will not earn points. HINTS for taking THE AP MICROECONOMICS EXAM Pay attention to the instruction words. Identify, state, list, define = Don’t explain the logical sequence. Explain and discuss = Explain the logical sequence, the linkages. Graphs can be the explanation at times. Draw and show = Draw a graph or diagram, label with care. Use abbreviations! MR=MC, P and Q, Δ, ATC, AVC, P=MR=d, MCS or MSC, , , etc., etc., etc. Words frequently explain better, but symbols can be inserted when appropriate or short on time. For example, “If the purely competitive firm has eco profits in the SR, then other firms will enter the market S↑ P↓, Q↑ for the industry.” When writing . . . Use correct terminology, such as “income” or “profit”, not “money”, unless the topic is really money. Use outline numbers like “a” or “i” to reference an answer. Emphasize the logical sequence, the line of reasoning. Use the 10-minute planning time to script out answers on the green question pages of the FRQ exam. When writing . . . May answer questions in any order. Do not restate question. It is a waste of time. Draw graphs well-labeled. MC Price p1 p S1 Pric e S ATC MR1=P1=AR1=D1 Economic Loss P=D=MR=AR D q q1 Single Firm Quantit y Q1 Q Industry Quanti ty MISTAKES MADE ON THE AP MICROECONOMICS EXAM GENERAL MISTAKES •Label both axes on all graphs and all curves. No labels, no points awarded. •Not knowing the difference between a change in quantity demanded and a change in demand and the resultant movement along a demand curve versus shifting a demand curve -- and the same for supply or any other curve. •Confusing comparative advantage calculations •Double shifts resulting in a change in one variable, but the other “indeterminant” •Differences in “normal” and “economic” profits MICROECONOMIC MISTAKES •Failing to remember how to shade the area of economic profit, especially in the case of a monopoly model •Not understanding how a per unit subsidy leads to an increase in output through either lower MC or an increase in demand. •Not being able to calculate average fixed cost •Getting confused between product and factor markets •Not knowing the elasticity of demand and TR relationship (total revenues) MICROECONOMIC MISTAKES •Confusing the different types of efficiency: economic efficiency = P=MC=ATC, allocative efficiency = P=MC, productive efficiency = P=ATC •Failing to use side by side graphs of the market and the industry •Not knowing that “market” and “industry” are the same thing. •Not knowing that “imperfect markets” can be anything except perfect competition •Game theory