Download Review of chapters 1-4

MBA 525 Microeconomics
FRANK & BERNANKE
CHAPTERS 1-4:
THE HIGHLIGHTS
Lecture 1
2
Basic concepts in economics
 Micro Economics vs. macro economics
 Opportunity cost, scarcity, “no free lunch”
 Opportunity cost examples
 “Reservation prices” (WTP
 The Cost-Benefit Principle and “rational behavior”
 Marginal analysis and quantity decisions
 Economic surplus (consumer surplus and producer
surplus)
 Decision Pitfalls
Lecture 2
3
The principle of comparative advantage
 Generalizing vs. specializing at the individual level
 “Low hanging fruit”
 The principle of comparative advantage
 Examples illustrating gains from trade
 If trade is good, why do we see opposition to trade?
Lecture 3
4
Supply and Demand (price determination)
 Definition of a “market”
 “Demand” (MB, WTP), Demand schedule, Demand curve
 “Supply” (MC, WTA), Supply schedule, supply curve
 Market equilibrium (equilibrium principle and efficiency
principle)
 Shortages and surpluses
 Changes (shifts) in supply and demand
 Price controls
Lecture 4
5
Elasticity measures
 The price elasticity of demand
 Elastic vs. Inelastic demand
 Determinants of demand elasticity
 Changes in price elasticity of demand along the length of
a demand curve
 Changes in revenue from price changes depend on the
price elasticity of demand
 The income elasticity of demand
 The cross-price elasticity of demand
 The price elasticity of supply
Overall themes
6
“Economic Naturalism”
 Using insights from economics to make sense of
observations from everyday life

E.G. Look for differences in costs and benefits
 Recognizing and appreciating resource scarcity
and opportunity costs
 Understanding the way markets work
7
Lecture 1 key concepts
Opportunity Cost
8
 Opportunity Cost: The value of the next-best
alternative that must be forgone in order to
undertake an activity
Decisions depend upon opportunity costs
 It is not the combined value of all other forgone activities, just the
next best one

Cost-Benefit Principle
9
 Take an action if, and only if, the extra benefits from
taking the action are at least as great as the extra
costs
 Measuring the costs and benefits is often difficult


One may have to use assumptions and/or approximations
Helps us answer “yes/no” questions
 Economists assume that people make decisions this
way. i.e. we assume that people are “rational”.
 “Rational” here means only pursuing actions where
the benefits are at least as great as the costs.
Reservation Prices
10
 For a consumer, reservation price is the highest
price one would be willing (and able) to pay for
a good.

This “maximum willingness-to-pay (WTP)” should be the
same as the benefit (value) received from the good.
 For a producer, reservation price is the lowest
price one would be willing (and able) to accept
for a good or service.

This “minimum willingness-to-accept (WTA)” should be the
same as the cost (expense) incurred in producing the good.
Economic Surplus
11
 The benefit of taking an action minus its cost
 Rational decision makers take all actions that yield a positive
economic surplus
 Should you buy or sell an item if surplus = 0?
 Consumer surplus = reservation price – actual price
 Producer surplus = actual price – reservation price
Marginal Analysis
12
 Comparing incremental or additional costs and benefits
to help make quantity decisions.
 Marginal Benefit

The increase in total benefit that results from carrying out one
additional unit of the activity
 Marginal Cost

The increase in total cost that results from carrying out one
additional unit of the activity
 Can be considered more powerful than traditional CBA,
because marginal analysis leads us to the “best” answer
(maximum surplus), while CBA only allows for “good”
answers (non-negative surplus).
Marginal Analysis
13
 Example: How
Q
MC
MB
$1.50
$4.00
$1.50
$3.00
3
$1.50
$2.00
4
$1.50
$1.00
many slices of pizza
to eat?
1
 Assume: P = $1.50
per slice
2
Note: P = cost of an
additional unit =
marginal cost
Finding the optimal quantity
14
 If the marginal benefit is greater than marginal
cost

Increase output (consume or produce more)
 If the marginal benefit is less than the marginal
cost

Decrease output (consumer or produce less)
 Optimal output is where marginal benefit
equals marginal cost

MB = MC
The principle of diminishing marginal benefit
15
 The additional satisfaction received from units of a
good tends to diminish as more units are consumed.
 Marginal benefit curves will be downward-sloping


Assumes all units are of the same quality
Addictive goods may be an exception
Decision Pitfalls
16
 It is a mistake to use proportions to make decisions
(use dollars instead).
 It is a mistake to ignore opportunity costs (opp costs
are real economic costs that should influence our
decisions).
 It is a mistake to use average costs and benefits to
make quantity decisions (use marginal costs and
benefits).
 It is a mistake to consider sunk costs (sunk costs are
unrecoverable and they do not affect opportunity
costs or marginal costs).
17
Lecture 2 key concepts
The Principle of Comparative Advantage
18
 If nations (or individuals) specialize in producing
goods for which they have low opportunity cost and
trade for goods for which they have high opportunity
cost, then they can consume more via trade.

Trade leads to higher standards of living.
 “Comparative advantage” means being able to do
something at lower opportunity cost than someone
else.

Sources of Comparative Advantage?
Principle of Increasing Opportunity Cost
19
 AKA “The Low Hanging-Fruit Principle”
 In expanding the production of any good, first employ those
resources with the lowest opportunity cost, and only afterward
turn to resources with higher opportunity costs
Why trade barriers & opposition to trade?
20
 International trade does increase the total value of
all goods and services, but certain industries may
be harmed.
 Putting all your eggs in one basket may be unwise
if trading partners have unstable economies or
politics
 Putting all your eggs in one basket may be unwise
if the future market for that commodity or product
is uncertain
Example of Comparative Advantage and Mutual Gains from Trade
21
Assume that Lara and Leah can spend the day either washing cars or
mowing lawns. The table below shows how much of each task they
could accomplish in one day if they spent the whole day doing just that
task. For example, Lara could wash 20 cars or mow 5 lawns in one day.
______________________________________________
Lara
Leah
______________________________________________
Cars washed
20
15
Lawns mowed
5
3
______________________________________________
Question: Use the principle of comparative advantage to illustrate how
specialization can make them more productive than they can be alone.
22
Lecture 3 key concepts
An Introduction to Supply and Demand
23





What is a market?
Where do prices come from?
What happens if prices are set “too high”?
What happens if prices are set “too low”?
Do markets really achieve equilibrium?
Demand
24
 Shows the total quantity of a good or service that
buyers wish to buy at each price
On a graph = demand curve
 In a schedule = demand schedule

 Inverse relationship between P and QD
 As price rises, consumers want fewer items
People switch to substitutes
 People cannot afford as much


At higher quantities, consumers are willing to pay less
(application of the principle of diminishing marginal
utility/benefit)
Daily Demand Curve for Hamburgers
25
Supply
26
 Shows the quantity of a good or service that sellers
wish to sell at each price
On a graph = supply curve
 In a schedule = supply schedule

 Positive relationship between P and QS
 As price rises, a higher quantity can be sold because more
opportunity costs can be covered
 Application of the “low-hanging fruit principle”
 Reflects the rising marginal costs of producing additional
units
Daily Supply Curve of Hamburgers
27
Market Equilibrium
28
 When all buyers and sellers are satisfied with their
respective quantities at the market price
There is a stable, balanced, unchanging situation
 The supply and demand curves intersect
 This results in the equilibrium price



This results in the equilibrium quantity


The price the good sells for
The quantity that will be sold
Do markets really exist in equilibrium?
The Equilibrium Price and Quantity of Hamburgers
29
Disequilibrium
30
 Excess supply



“Market Surplus”
Price is higher than equilibrium price
Sellers are dissatisfied
 Excess demand



“Market Shortage”
Price is lower than equilibrium price
Buyers are dissatisfied
 Free markets have an automatic tendency to eliminate
excess supply and excess demand


A market surplus serves as a signal to sellers that price is too high
and therefore leads producers to decrease the price
A market shortage serves as a signal to sellers that price is too low
and therefore leads producers to increase the price
Markets and Efficiency
31
 Efficiency Principle
 Efficiency is an important social goal
 Everyone can have a larger slice of a larger pie
 Equilibrium Principle
 A market in equilibrium leaves no unexploited
opportunities for individuals
 No “cash on the table” remains
 All opportunities for profit have been exploited
 Efficiency occurs when
 the market-demand curve captures all the marginal
benefits of the good
 the market-supply curve captures all the marginal
costs of the good
Shifting supply and demand
32
 Several factors cause changes in demand or supply
 If there is a “change in demand”, we shift of the entire
demand curve
 If there is a change in supply”, we shift of the entire
supply curve
 Change in supply or demand cause equilibrium price to
change.
 Price changes are the RESULT of shifts, not the CAUSE of
shifts
Shifts in Demand
33
Change in price of complement goods
Change in price of substitute goods
Change in consumer Income
1.
2.
3.

normal v. inferior goods
Change in consumer preferences
Change in consumer expectations about price
Change in consumer expectations about income
4.
5.
6.

normal v. inferior goods
 Demand curve shifts rightward
 higher equilibrium price and higher equilibrium quantity
 Demand curve shifts leftward
 lower equilibrium price and lower equilibrium quantity
Shifts in Supply
34
Change in input or factor prices
2. Change in current production technology
3. Change in prices of other goods that can be produced
with the same inputs
4. Change in the number of sellers in the market
1.
 Favorable changes to the producer shift supply curve
rightward

lower equilibrium price and higher equilibrium quantity
 Unfavorable changes to the producer shift supply
leftward

higher equilibrium price and lower equilibrium quantity
Example: An Increase in Demand
35
Sequence of events:
1. Conditions change such that consumers want
more units at any price. Egs: lower price of
complement good, higher price of a substitute,
higher income, …
2. Higher Qd at all prices means rightward shift
in the demand curve
3. Demand shifts right (along supply) resulting in
higher P* and Q*
The Effect on the Market for Tennis Balls of a
Decline in Court Rental Fees
36
Example: An Increase in Supply
37
Sequence of events:
1. Conditions become more favorable to firms.
Eg: lower cost of inputs
2. Firms now can earn higher per-unit profits
at any price, so they wish to sell more units
at all prices.
3. Firms increase Qs for all Prices = shift right
in the supply curve (along demand).
4. Shift results in lower P* and higher Q*
The Effect on the Market for New Houses of a Decline
in Carpenters’ Wage Rates
38
Simultaneous Shifts
39
 In reality, several factors may be changing at the
same time.
 Example: suppose that consumer income is falling
while technology used in production is advancing.

Demand decreases (shifts left) and supply increases (shifts
right)
 Demand shift implies a lower price & lower quantity
 Supply shift implies a lower price, higher quantity
 We can predict that price will fall
 But, what happens to quantity?
 We must know the magnitude of the shifts
Legislation and Markets
40
 Legislators protect producers and consumers by
using price controls


Price ceilings
Price floors
Price controls
41
 price ceilings – intended to help consumers
 A maximum allowable price specified by law because the
true equilibrium price was deemed “too high”
 Price ceiling price < P* so now consumers want too much
 e.g. rent controls, limits on the price of gasoline
 Result in permanent shortages
 price floors – intended to help producers




A minimum allowable price specified by law
For example, agricultural price supports, minimum wages
Price floor price is > P* so now sellers want to sell more
Result in surpluses
42
Lecture 4 key concepts
Price Elasticity of Demand
43
 In order to predict what will happen to sales and
expenditures (revenue) firms must know how
much quantity will change when the price
changes.
 The price elasticity of demand is

the percentage change in the quantity demanded that
results from a one-percent change in its price
% Q

 P %P
D
D
Price Elasticity
44
 Demand is said to be “elastic” if quantity
demanded changes by a lot when price changes
even a little

price elasticity is greater than one
 Demand is said to be “inelastic” if quantity
changes by a little even if price changes a lot

price elasticity is less than one
 Demand is said to be “unit elastic” if quantity
changes by the same amount as the price change

price elasticity equals one
Price Elasticity and Expenditures
45
 If demand is elastic:
 Quantity demanded is highly responsive to price
changes
 Percentage change in quantity dominates
 An increase in price will reduce total expenditure
 A decrease in price will increase total expenditure
 If demand is inelastic:
 Quantity demanded is not very responsive to price
changes
 Percentage change in price dominates
 An increase in price will increase total expenditure
 A decrease in price will decrease total expenditure
Determinants of Elasticity
46
 Substitution possibilities
 Price elasticity of demand will be relatively high if it is
easy to substitute between products – Why?
 Budget share
 The larger the share of the budget the good uses tends
to have higher price elasticities of demand – Why?
 Time
 Because substitution takes time, price elasticity will
be higher in the long run than in the short run
Examples?
47
 What are some goods that will have very elastic
demand?


Can demand be perfectly elastic?
What does an elastic demand curve look like?
 What are some goods that will have very inelastic
demand?


Can demand be perfectly inelastic?
What does an inelastic demand curve look like?
Other Elasticities of Demand
48
 Income Elasticity of Demand
 The amount by which the quantity demanded changes in
response to a one-percent change in income
 Positive for normal goods
 Negative for inferior goods
 Cross Price Elasticity of Demand
 The amount by which the quantity demanded of one good
changes in response to a one-percent change in the price of
another good
 Positive for substitutes
 Negative for complements
Price Elasticity of Supply
 The percentage change in the quantity
supplied that will occur in response to a onepercent change in its price

% Q


%P
S
S
P
Q
Q
P
P

P
Q
1
slope
49
Elasticity of Supply
50
 What determines whether the supply of a
particular good will be elastic or inelastic?

Availability of resources used to produce the good –
how quickly and easily can producers respond to a
price change?

Eg of good with inelastic supply?
Eg of good with elastic supply?

Perfect Elasticity
51
 Perfectly Inelastic
 Elasticity of supply is zero
 Whether the price is high or low, the same amount is
available
 Perfectly Elastic
 Elasticity of supply is infinite
 When additional units can be produced using the
same combination of inputs purchased at the same
prices
Naturalist Questions
52
 Why do you pay $6 for a beer in the airport when you
can buy the same beer for less than $1 outside the
airport?
 Why do you get a discounted airfare when you stay
over a Saturday night?
 Why are there so many personalized license plates in
Virginia vs. NC?