Download Lecture Notes: Econ 203 Introductory Microeconomics Lecture 1: 10

Lecture Notes: Econ 203 Introductory Microeconomics
Course summary of chapters 1-18
M. Cary Leahey
Manhattan College
Fall 2012
Chapter 1: The nature of economics; what is economics all about
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Allocation of scarce resources
Households: decisions to work, save and spend
Firms: produce, hire/fire, and distribute those goods
Society: dividing those resources
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Chapter 2: economic thinking and practice
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Economists explain the world using models with built-in assumptions
Two simple models are circular flow and the PPF
Micro is the study of individual behavior; macro is on the aggregate
Positive (science) versus normative (values) economics
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Models: circular flow diagram
• Circular flow-visual model of economy
• Two types of economic actors: households and firms
• Two markets: goods and services and factors of production
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Figure 1: The circular-flow diagram
Revenue
G&S
sold
Markets for
Goods &
Services
Firms
Factors of
production
Wages, rent,
profit
Spending
G&S
bought
Households
Markets for
Factors of
Production
Labor, land,
capital
Income
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Models: Production possibilities frontier (PPF)
• The PPF shows the combinations of 2 goods (x, y axis) that can be
produced given available resources
• Review points along the PPF from Figure 2
• PPF is possible and efficiency
• PPF and opportunity cost-shifting resources along the PPF
• Slope of PPF is the opportunity cost—the rise over the run
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Figure 2: PPF Example
Point
on
graph
Production
Computers
Wheat
Wheat
(tons)
6,000
5,000
A
500
E
0
D
4,000
B
400
1,000
C
250
2,500
D
100
4,000
E
0
5,000
3,000
C
2,000
B
1,000
A
0
0
100 200 300 400 500 600
Computers
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Chapter 3 Interdependence and gains from trade
• Interdependence allows everyone to be better off, breaking down
the tie between domestic production and domestic consumption
• Comparative advantage means being able to produce a good at a
lower opportunity cost
• Absolute advantage means being able to produce a good with fewer
inputs.
• Absolute advantage is not needed for comparative advantage.
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Chapter 4 Supply and demand
• Competitive (pure/atomistic) market – many buyers and sellers,
each of whom has no influence on prices. They are price takers.
• Supply and demand curves are simplifying tools (models) used to
study markets.
• Demand curve is downward sloping, as price is inversely related to
quantity demanded.
• Supply curve is upward sloping, as prices in positively related to
quantity supplied.
• Prices move along the curve; other factors shift the curves.
• The intersection of supply and demand determines the equilibrium
price.
• To analyze impacts on markets, see if the example studied shifts
supply, demand or both. Examine the relative shifts in the curve and
where the new equilibrium plays out and is compared to the old one.
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Chapter 5: Elasticities
• Elasticity measures the responsive of Qs and Qd to change in one
of its determinants, usually price.
• Defines as the % change in Qs or Qd / % change in P
• Unitary elasticity = % change in Q = % change in P
• Elastic = % change in Q > % change in P
• Inelastic = % change in Q < % change in P
• Elasticities tend to rise from the short-run to the long-run
• Cross price elasticity of demand measures responsiveness of Qd of
good 1 to change in price of good 2
•
Substitutes have a positive elasticity
•
Complements have a negative elasticity
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Chapter 6: Govt. policies, tax wedges, and incidence
• Price ceiling is a legal maximum of a price of a good or service.
One local example is rent control. If the price is below the
equilibrium price, then the price is binding and causes a shortage.
• A price floor is a legal minimum on the price of a good or service.
One example is the minimum wage. If the price floor is above the
equilibrium price, it is binding and causes a surplus
(unemployment). A minimum wage causes incomes to increase for
those who keep their jobs but also causes unemployment among
unskilled workers.
• A tax is a wedge between the price buyers pay and sellers receive,
causing equilibrium quantity to fall, regardless on whether it falls on
buyers or sellers.
• The incidence or burden of the tax depends on the elasticities of
supply and demand. If supply is more elastic, the incidence or
burden falls on the buyers rather than the sellers. And vice versa.
• Good example is the surprising incidence of a luxury tax on yachts.
.
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Chapter 7: Welfare
• Another principle fleshed out using welfare economics– market
(under certain restrictions) are pretty good at organizing economic
activity (efficiency).
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Distribution can be another story (equity).
• Modifying these restrictions can invalidate the efficiency outcome.
• Market failures occur:
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when one buyer has market power (monopoly)
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transactions have side effects-externalities (pollution)
• Buzzwords – invisible hand/laissez faire
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Chapter 7: Welfare II
• The height of the D curve reflects the value of the good to buyers—
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their willingness to pay for it.
Consumer surplus is the difference between what buyers are willing
to pay for a good and what they actually pay.
On the graph, consumer surplus is the area between P and the D
curve.
The height of the S curve is sellers’ cost of producing the good.
Sellers are willing to sell if the price they get is at least as high as
their cost.
Producer surplus is the difference between what sellers receive for a
good and their cost of producing it.
On the graph, producer surplus is the area between P and the S
curve.
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Chapter 7: Welfare III
• To measure society’s well-being, we use
total surplus, the sum of consumer and producer surplus.
• Efficiency means that total surplus is maximized, that the goods are
produced by sellers with lowest cost, and that they are consumed by
buyers who most value them.
• Under perfect competition, the market outcome is efficient. Altering
it would reduce total surplus.
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Chapter 8: costs of taxation
• Taxes reduce the welfare of buyers and sellers. This welfare loss
usually exceeds the revenue gain.
• The decline in total surplus (consumer surplus and producer surplus
and tax revenue) is called the deadweight loss of the tax.
• Taxes have deadweight losses because they cause consumers to
buy less and seller to sell less, thus shrinking the market.
• The size of the DWLs depend on the elasticities of supply and
demand. Higher elasticities imply higher DWLs.
• DWLs increases even more than the size of the tax.
• In one extreme case, revenue may actually fall as taxes become too
large. But this rarely happens in real life.
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The effects of a tax
P
Without a tax,
CS = A + B + C
PS = D + E + F
Tax revenue = 0
Total surplus
= CS + PS
=A+B+C
+D+E+F
A
S
B
PE
D
C
E
D
F
QT
QE
Q
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Chapter 9 international trade
• Exporting country. A country will export if the world price is above
the domestic price without trade. Trade raises the producer surplus,
reduces consumer surplus, and raises total surplus.
• Importing country. A country will import a good is the world price is
below the domestic price without trade. Trade lowers the producer
surplus but raises consumer surplus and the total surplus.
• Tariff. A tariff benefits producers and produces revenue for the govt.
but the overall economy loses as the gains are less than the losses
to consumers.
• Common arguments for restricting trade include: protecting jobs,
defending national security, helping infant industries, preventing
unfair competition, and responding to foreign trade restrictions. Only
a few (and under restrictive assumptions) have much merit.
• Free trade is usually the better policy, particularly if the winners can
compensate the losers.
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Summary of the welfare effects from trade
PD < P W
PD > PW
direction of trade
exports
imports
consumer surplus
falls
rises
producer surplus
rises
falls
total surplus
rises
rises
Whether a good is imported or exported,
trade creates winners and losers.
But the gains exceed the losses.
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Chapter 10:externalities
• Negative externality: market Q larger than socially desirable Q
• Positive externality: market Q less than socially desirable Q
• To remedy the problem, internalize the externality
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Tax goods with negative externalities
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Subsidize goods with positive externalities.
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Chapter 11: Public goods
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Characteristics of goods
Excludable-someone can be prevented from using the good
Rival-if the consumption of one can reduce the ability of another to
consume
Private goods are rival and excludable and are the kinds of goods markets
work best with
Public goods are neither excludable nor rival in consumption
This promotes the problem of free riders: consumer do not have to pay, so
firms will be less willing to provide those goods.
Govts tend to provide public goods, guided by cost benefit analysis to figure
ought how much to provide.
Common resources are rival in consumption but not excludable, such as
grazing land, air/water, and congested roads.
The line between private/public goods/common resources is not always
clean.
People tend to overuse common resources so govts try to limit their use by
taxes or regulation.
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Chapter 12: taxation, equity, and efficiency
• We introduced a host of new concepts as well as a review of the US
tax system
• The US tax system finds that federal taxes are dominated by income
taxes on households while state and local govt taxes are more
equally distributed between income, property and sales taxes.
• Efficiency of the tax system refers to the costs imposed beyond the
revenues raised. One measure is the DWL of the distortions.
• Equity of the tax system refers to fairness which is harder to agree
upon than efficiency. The benefits principle refers to those that
benefit more pay more in taxes. Ability to pay refers to the ability to
handle the burden. The US has a progressive tax system in which
higher incomes pay a higher proportion in taxes.
• Tax incidence can mean that those who bear the tax burden may not
ultimately pay the taxes.
• Policymakers face the tradeoff between goals of efficiency and
equity. Notions of horizontal and vertical equity may conflict
(example of the marriage tax).
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Chapter 13: costs of production
• Costs are both explicit (in cash) or implicit (no cash outlay but an
opportunity cost). Both are important to the firm’s decision making
• Accounting profit is revenue less cash outlays; economic profit is
revenue less all (explicit and implicit) costs
• Production function shows relationship between inputs and output.
• Marginal production is the increase in output coming from one
additional input. Labor is the most common example.
• Marginal product usually diminishes with insensitivity of use. As
output rise the production function becomes flatter (the delta
declines) and the total cost curve becomes steeper (delta increases)
• Variable costs vary with output; fixed costs do not
• Marginal cost is the increase in total cost from an extra (incremental)
unit of production,. The MC curve is usually upward sloping.
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Chapter 13: costs of production II
• Average variable cost is variable cost divided by output
• Average fixed cost is fixed cost divided by output. AFC always falls
as output rises.
• Average total cost (cost per unit or unit cost) is total cost divided by
the quantity of output. ATC curve is usually U-shaped.
• The MC curve intersects the ATC curve at the minimum average
total cost
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MC < ATC, ATC falls as Q rises
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MC > ATC, ATC rises as Q
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In the long-run, all costs are variable
Economies of scale: ATC falls as Q rises
Diseconomies of scale: ATC rises as Q rises
Constant returns to scale: ATC remains the same as Q rises
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EXAMPLE 2: ATC and MC and profit maximization
When MC < ATC,
ATC is falling.
$175
$150
ATC is rising.
$125
Costs
When MC > ATC,
The MC curve
crosses the
ATC curve at
the ATC curve’s
minimum.
ATC
MC
$200
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
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Chapter 14: competitive markets
• Competitive market is efficient
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Profit maximization
MC = MR
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Perfect competition
P = MR
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With competitive equilibrium
P = MC
• Since MC is the cost of the last extra unit equal to the value to
buyers of that marginal unit, then the competitive equilibrium
maximizes total (consumer and producer) surplus
• Shutdown: a will shut down if P < AVC
• Exit:
a firm will exit if P < ATC
• With free entry and exit, profits are zero in the long-run, where
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P = minimum ATC (= MC)
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SR & LR effects of an increase in demand
A firm begins in
…but then an increase in …leading to SR profits
long-run eq’m…
Over time, profits induce entry,
shifting S to the right, reducing P…
P
for the firm.
demand raises P,…
…driving profits to zero
and restoring long-run eq’m.
One firm
Market
P
S1
MC
Profit
S2
ATC
P2
P2
P1
P1
Q
(firm)
B
A
C
long-run
supply
D1
Q1 Q2
Q3
D2
Q
(market)
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Chapter 15: monopolies
• In the real world, pure (natural) monopoly is rare but many firms
have market power due to unique products or few competitors
• Monopoly firm is a sole seller in the market. They arise due to
barriers to entry: key resource, govt. granted patent, and economies
of scale.
• Monpolies face a downward sloping demand curve. So price must
be lowered on all quantity demanded in order to sell
• As a result P > MR = MC, leading to a DWL
• Monopolies earn profits by price discriminating, in which they based
pricing decisions to TWP (along the demand curve).
• Public policy may respond by regulation by creating antitrust laws,
breaking up trusts, or by takeovers.
• All public policies are :issues,” meaning that the best policy may be
no policy
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The monopolist’s profit
Costs and
Revenue
As with a competitive firm,
the monopolist’s profit equals
(P – ATC) x Q
MC
P
ATC
ATC
D
MR
Q
Quantity
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The welfare cost of monopoly
Competitive eq’m:
quantity = QC
P = MC
total surplus is maximized
Monopoly eq’m:
quantity = QM
P > MC
deadweight loss
Price
Deadweight
MC
loss
P
P = MC
MC
D
MR
Q M QC
Quantity
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Chapter 16: monopolistic competition
• A MC market has many forms, differentiated products,
and free entry/exit.
• The market is inefficient because of excess capacity and
pricing over marginal cost. There may be too much or
too little product variety.
• So a MC market is less desirable than a PC market. MC
describes many markets and industries but provides little
policy guidance about how to reduce the inherent
inefficiencies, since long-run profit in the industry is zero.
• The goal of product differentiation leads to advertising
and branding which may lead to results that are
suboptimal.
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Comparing different kinds of firms
Perfect
Competition
Monopolistic
competition
Monopoly
Number of sellers
Many
Many
One
Free entry/exit
Yes
Yes
No
Long-run econ profits
Zero
Yes, positive
Yes, positive
Product differentiation
Identical
Differentiate
d
Differentiated
Market power
Price taker
Price maker
Price maker
Demand curve
Horizontal
Downward
Downward
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Chapter 17: oligopoly
• Oligopolies can end up looking like monopolies or like perfect
competitors depending on the number of firms and how cooperative
the behavior is.
• Prisoners’ dilemma shows how hard cooperation is, even when it is
in all participants best interest.
• Public policy can employ antitrust laws to increase competition and
prevent predatory pricing. The scope of those actions is
controversial.
• Oligopolies maximize profit if they cooperate, form a cartel, and split
the monopoly profits.
• However, self interest leads to an output of greater output and lower
price, close to the societal desired outcome. The more firms and the
less cooperation leads to a more competitive outcome.
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Chapter 18: factors of production
• This is the neoclassical theory of income distribution, in which factor
prices are determined by supply and demand and that each factor is
paid his value of marginal product.
• The three factors of production-labor, land and capital.
• Factor demand is derived from the its supply of output.
• Competitive firms maximize profits by hiring each factor up to the
point where the value of its marginal product equals its rental price.
• The supply of labor is determined by the work-leisure tradeoff,
yielding an upwardly sloping supply curve.
• The price paid to each factor balances the supply and demand for
each factor. In equilibrium, each factor is paid the value of its
marginal product.
• Factors of production are used in conjunction with one another. A
change in the quantity of one factor changes the marginal products
and earnings of all other factors of production.
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Equilibrium in the labor market
The wage adjusts to balance
supply and demand for labor.
W
S
The wage always equals VMPL.
W1
D
L1
L
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How the rental price of capital Is determined
Firms decide how much
capital to rent by comparing
the price with the value of
the marginal product
(VMP) of capital.
The rental price of capital
adjusts to balance supply
and demand for capital.
P
The market
for capital
S
P
D = VMP
Q
Q
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