Download AP Micro REVIEW 2

AP Microeconomics
REVIEW
Market Models
Production Possibilities
Price/Quantity Controls
Elasticity of Demand/Supply
Consumer/Producer Surplus & Taxation
Because societies must CHOOSE
between alternatives,
economists use a PRODUCTION
POSSIBILITIES table to list the
different combinations of two
products that can be produced
with a specific set of resources.
The area along the curve represents
MAXIMUM production.
Guns
Let’s
compare
two
markets:
Guns and
Butter.
200 guns, 0 butter
200
150
125
100
75
50
0 guns, 200 butter
25
0
25 50 75 100 125 150 200
Butter
Given the resources available, if maximum
production is equal to 200 units, then
For example:
Guns
200
Point A represents
maximum
production of 125
Guns and
75 pounds of
Butter.
150
125
A
100
75
50
25
125 + 75 = 200
0
25 50 75 100 125 150 200
Butter
Given the resources available, if maximum
production is equal to 200 units, then
For example:
Guns
Point B represents
maximum
production of 75
Guns and
200
150
125
100
125 pounds of
Butter.
125 + 75 = 200
75
A
B
50
25
0
25 50 75 100 125 150 200
Butter
Given the resources available, if maximum
production is equal to 200 units, then
For example:
Guns
Point C represents
underproduction of
50 Guns and
75 pounds of
Butter.
200
150
125
A
100
75
50 + 75 =125
50
This point
underproduces by
75 units
25
0
C
B
25 50 75 100 125 150 200
Butter
Given the resources available, if maximum
production is equal to 200 units, then
For example:
Guns
Point D represents
impossible
production of 150
Guns and
150 pounds of Butter.
200
150
125
100
75
150 + 150 = 300
This point is
impossible to
produce.
D
A
C
B
50
25
0
25 50 75 100 125 150 200
Butter
1) Natural Disasters
In December 2004, the
world’s strongest
earthquake in 40 years
shook the region near the
Indonesian archipelago,
creating a tsunami wave
which killed nearly
200,000 people on three
continents, and
devastation of resources
not counted as yet.
P
Q
This caused the production possibilities curve to shift
inward indicating the reduced ability to produce
goods and services.
2) Wartime production
In the beginning of World
War II, the U.S. had
considerable
unemployment. By
quickly employing idle
resources, the U.S.
economy was able to
produce more.
By contrast, the Soviet
Union entered the war
at capacity production.
Their situation required
considerable shifting of
resources and the
standard of living
dropped.
P
U
Q
Guns
P
Q
Butter
Price and Quantity
Controls
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
at an
average
price of
$2.50.
S
$4
$3
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.
From the
suppliers’
standpoint,
they could
supply at a
lower price but
they CAN get
more. This is
called
PRODUCER
SURPLUS.
S
$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
$2
beer is
shortage
called a
$1
PRICE
D
CEILING.
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
$5
businesses
who want to
$4
hire (demand
$3
for 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?
CONCLUSION:
A price floor stops the market
from reaching equilibrium
and creates a surplus.
A price ceiling stops the
market from reaching
equilibrium and creates a
shortage.
Elasticity of
Demand
Demand for some products is such that
consumers are highly responsive to price
changes; modest price changes lead to
very large changes in the quantity
purchased, for example: restaurant meals,
steak, cars.
The demand for such products is said to be
relatively elastic, or simply ELASTIC.
For other products, consumers are quite
unresponsive to price changes;
substantial price changes result in
only small changes in the amount
purchased, for example: salt, milk,
soap.
For such products, demand is relatively
inelastic or simply INELASTIC.
A way to state the equation would be using the
Greek letter delta, meaning “change in”…….
Qd/Qd
Price Ed =
P/P
Interpretations of Ed
We can interpret the coefficient of price
elasticity of demand as follows:
1) elastic demand
2) inelastic demand
3) unit elasticity
Elastic Demand
Demand is said to be elastic if a specific
percentage change in price results in a larger
percentage change in quantity demanded.
Then Ed > 1.
Example: If a 2 percent decline in a price
results in a 4 percent increase in quantity
demanded, then demand is elastic and
.04
Ed =
.02
=
2
A small percentage change in price leads to
a larger percentage change in quantity
demanded.
P
R
I
C
E
P1
P
P0
D2
Relatively
elastic
demand
Ed > 1
Qd
0
Q1
Q0
QUANTITY
When we say demand is “elastic,” we do not
mean that consumers are completely
responsive to a price change. In that extreme
situation, where a small price reduction
would cause buyers to increase their
purchases from zero to all they could obtain,
economists say demand is perfectly elastic.
You will see in later chapters that such a
demand applies to a firm, for instance, a
blueberry grower, selling its product in a
purely competitive market.
A small percentage change in price will
change quantity demanded by an infinite
amount.
P
R
I
C
E
P1
P0
P
D2
Perfectly
elastic
demand
Ed =
Qd
0 Q1
Q0
QUANTITY
Inelastic Demand
If a specific percentage change in price is
accompanied by a smaller percentage change
in quantity demanded, demand is said to be
inelastic. Then Ed < 1.
Example: If a 3 percent decline in price leads
to only a 1 percent increase in quantity
demanded, demand is inelastic and
.01
Ed =
.03
= .33
A change in price leads to a
smaller percentage change
in quantity demanded.
P
R
I
C
E
P1
Relatively
inelastic
demand
P
P0
Ed < 1
Qd
D1
0
Q1
Q0
QUANTITY
When we say demand is “inelastic,” we do
not mean that consumers are completely
unresponsive to a price change. In that
extreme situtation, where a price change
results in no change whatsoever in the
quantity demanded, economist say that
demand is perfectly inelastic.
Examples include an acute diabetic’s
demand for insulin or and addict’s
demand for heroin.
D1
P
R
I
C
E
The quantity demanded does
not change regardless of the
percentage change in price.
P1
Perfectly
inelastic
demand
Ed = 0
P
P0
0
Q0 = Q 1
QUANTITY
Elastic or
Inelastic
demand?
P
R
I
C
E
When a demand curve is relatively
steep, such as D0 in this graph, its price
elasticity is relatively inelastic.
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
What
influences
the price
elasticity
of
demand?
•Available substitutes
•Proportion of income
•Luxuries vs necessities
•Time
Elastic Demand and Total Revenue
P
A
$10
a
$5
b
0
20
c
40
60
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.
We can also see in the
B
graph that total revenue
has increased because the
area b + c is greater than
Delastic
area a + b, or c > a.
80 100
Q
Inelastic Demand and Total Revenue
P
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.
A
$10
a
B
$5
b
c
Dinelastic
0
10
20
30
40
Q
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.
Applications of Price Elasticity of
Demand:
1) Airline tickets (vacationers vs. business class)
2) Early bird specials
3) Movies vs. matinees
4) Drugs and crime
5) Excise taxes on inelastic goods
If the demand for drugs is inelastic then drug “busts”
reduce the supply of drugs, which raises the price,
and reduces quantity supplied.
Price
of
Drugs
Price
of
Drugs
S2
P2
S1
P1
D
Q2 Q1
Quantity
of Drugs
Quantity
of Drugs
Another option is drug education, which reduces
demand, which lowers the price,
and reduces quantity supplied.
Price
of
Drugs
Price
of
Drugs
S2
S
P1
P2
S1
P2
P1
D
Q2 Q1
D2
Quantity
of Drugs
Q2
Q1
D1
Quantity
of Drugs
Elasticity of
Supply
The PRICE ELASTICITY OF
SUPPLY measures how
much the quantity supplied
responds to changes in
price.
Supply is said to be elastic if the quantity supplied
responds substantially to changes in price.
A small percentage change in price leads to
a larger percentage change in quantity
supplieded.
P
R
I
C
E
P0
S2
P
P1
Relatively
elastic supply
Qd
Ed > 1
0
Q1
Q0
QUANTITY
Supply is said to be inelastic if the quantity supplied
responds slightly to changes in price.
P
R
I
C
E
S2
P0
P1
A small percentage
change in price leads to a
smaller percentage
change in quantity
supplieded.
P
Relatively
inelastic supply
Qd
Ed < 1
0
Q1
Q0
QUANTITY
Elasticity of Supply is dependant upon the
sellers’ flexibility in changing the amount they
produce.
For example: Beachfront property in
Florida has an inelastic supply because we
cannot produce more of it.
Manufactured goods such as microwave
ovens, televisions, and cars are elastic
because the producers can easily adjust
production of a good more or less.
How do
government
policies
(taxes) affect
market
outcomes?
When a tax on tea is levied on consumers, the sellers
will share part of the tax burden.
P0 is the
equilibrium
price WITHOUT
the tax.
PRICE
($2.50)
($2.20)
($2.00)
S
P2
E w/o tax
P0
P1
($.50)
P1 is the price
sellers will
receive.
P2 is the price
consumers will
pay.
($.50)
D0
D1
0
Q1
Q0
QUANTITY
A payroll tax
puts a
wedge
between the
price that
workers
receive and
the amount
producers
pay.
Plabor
Slabor
$5
$4
$3
E
$2
$1
0 1 2 3 4 5 6 7 8 9 10
Dlabor
Qlabor
When supply is more elastic than demand, the
burden of the tax falls primarily on consumers.
Pconsumers pay
P
S
$5
Pw/o tax
$4
$3
Pproducers receive
E
$2
$1
0 1 2 3 4 5 6 7 8 9 10
D
Q
In the late 1980s, Governor
Martinez of Florida placed a tax on
luxury items in the State of Florida.
Why was this tax repealed a few
years later??
When demand is more elastic than supply, the
burden of the tax falls primarily on producers.
Pconsumers pay
P
S
$5
Pw/o tax
$4
$3
Pproducers receive
E
D
$2
$1
0 1 2 3 4 5 6 7 8 9 10
Q
Consumer Surplus
and
Producer Surplus
Suppose I am willing to pay $4 each for 10 widgets.
However, the price is $1.50 EACH.
P
6
5
4
D
$2.50
3
This results in
CONSUMER
SURPLUS, which
is the difference
between D and P
$4.00
- 1.50
$2.50
x 10
2
1
P
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Price
$25.00
Q
P
So, Consumer Surplus is the TOTAL
BENEFIT consumers receive from having a
market in the good.
$4.00
6
- 1.50
5
$2.50
4
D
$2.50
3
2
x 10
$25.00
1
P
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Price
Q
Now, let’s graph this problem using an economist’s
demand curve.
The equation for this line would be:
P = 4 - .25Q
If Q=0, then P=__
P
P = 4 - .25 (0)
6
P=4-0
5
P=4
4
If P=0, then Q=__
3
0 = 4 - .25Q+ .25Q
.25Q = 4
2
.25 .25
1
Q = 16
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
The area betweenthe demand ($4.00) and the price
($1.50) is the CONSUMER SURPLUS.
P
Mathematically, P < 4 - .25Q, P > 1.50, Q > 0
6
Area of a triangle = 1/2bh
5
Consumer Surplus = 1/2 (10 x 2.50) =
4
$12.50
3
2
1
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
So….how much do
producers benefit from this
transaction?
Suppose that a firm is willing to sell the good for
$.50 but the price is $1.50 for 10 widgets.
PRODUCER
SURPLUS is the
difference between
suppliers price and
the price of the
product.
P
6
5
4
3
Price
2
1
$1.00
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Supply (willing to
sell cost)
Q
Let’s graph the supply curve on the old graph.
P = .15Q
P
6
If the price is set at 1.50, then
1.50 = .15Q
.15
5
10 = Q
4
3
2
1
0
.15
S
Price
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
Remember the area of a triangle = 1/2bh, so…..
1/2 (10 x 1.50) = $7.50
P
6
PRODUCER SURPLUS
5
4
S
3
2
Price
1
0
=
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
In this case, both consumers and producers gain:
CS + PS = 12.50 + 7.50 =
P
6
5
$20.00
TOTAL BENEFIT TO
SOCIETY
4
S
3
2
Price
1
0
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
Now, let’s suppose a tax of $.80 is added to the
price of gasoline. This adds to the cost of
producing the widgets.
P
6
If 0 widgets, then P = 0 + .80 = .80
If 10 widgets, then P = 1.50 + .80 = 2.30
5
4
S1
S
3
2
Price
1
0
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
This changes our point of equilibrium.
What happens to consumer surplus?
P
What happens to producer surplus?
What does the pink rectangle represent?
6 The green triangle represents DEADWEIGHT
5 loss, or the amount of sales you give up with the
higher price.
4
S1
3
2
1
0
TAX REVENUE
S
Price
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
What is the new Quantity?
P
Demand
P = 4 - .25Q
Supply
P = .15Q
Supply w/tax
P = .15Q + .80
4-.25Q = .15Q +.80
4-.25Q+.25Q = .15Q+.25Q+.80
4 - .80 = .40Q +.80 - .80
3.20 = .40Q
6
.40
5
4
3
2
8=Q
S1
(8, 2)
.40
S
P = .15(8)
Price
+ .80
1
D
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
P = 2.00
Q
Consumers pay: $2 per unit, including the tax….. (they
used to pay $1.50)
P
Producers receive after they pay the tax: $2 - .80 = $1.20
(they used to receive $1.50)
6
5
4
3
S1
(8, 2)
S
2
1
0
Price
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
D
Q
So….who pays the $.80 ?
Consumers pay: $ .50
Producers pay:
$ .30
In this case, consumers pay most (BUT NOT ALL) of the
tax. Tax incidence depends on the elasticity of demand and
the elasticity of supply. In short, whomever is less flexible
in adjusting to changes in price will pay more of the tax.
Consumers avoid paying the whole of the tax by buying
less of the product at a lower quantity.
What is the height for the new Consumer Surplus
triangle?
P
6
4 - 2.00 = 2.00 * 8 * 1/2 = $8.00 new CS
(compared to $12.50 old CS)
5
4
3
2
1
0
S1
S
Price
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
What is the height for the new Producer Surplus
triangle?
1.20 = h
P
6
5
4
3
2
1
0
8=b
1.20 * 8 * 1/2 =
$4.80 new PS
(compared to $7.50 old PS)
S1
S
Price
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
So…..using the equation 1/2bh (area of a
triangle)
1/2 * 8 * 1.70 = $8.00 = New CS
1/2 * 8 * .80 = $4.80 = New PS
P
6
5
4
3
2
1
0
.80 * 8 = $6.40 = Tax Amount
8.00 + 4.80 + 6.40 = $19.20 Total Benefit
(compared to $20.00 old TB)
S1
S
Price
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
Compare the New Total Benefit
of $19.20 to the Old Total
Benefit of $20.00.
Do excise taxes benefit society?
Economists do not support taxes
which do not benefit society, such
as excise taxes.
Good taxes include: property
taxes, income taxes, and estate
taxes.
GAINS FROM TRADE:
Consumer Surplus = 1/2 * 8 * (4 - 2) = $8.00
Producer Surplus = 1/2 * 8 * (1.20 - 0) = $4.80
P
6
5
4
3
2
1
0
Tax Revenue = $. 80 * 8 = $6.40
GAINS FROM TRADE = 8 + 4.80 + 6.40 = $19.20
Deadweight Loss = 20.00 - 19.20 = $ .80
S1
S
Price
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q
Even though water is
essential for life and
diamonds are not,
water is cheap and
diamonds are
expensive?
Why?
The answer has to do with
the consumer surplus and
producer surplus for both
products.
Consider the following graphs for CS and PS:
Diamonds
S
P
Water
Inelastic
supply
curve
Elastic
supply
curve
D
P
S
D