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Microeconomics James B. Wilcox Resources provided by: The University of Southern Mississippi Center for Economic and Entrepreneurship Education, Mississippi State University, & Virtual Economics Economics… is the study of how individuals and society choose, with or without the use of money, to employ scarce productive resources to produce various commodities over time and distribute them for consumption, now and in the future, among various people and groups in a society. The Economic Way of Thinking: Three Activities to Demonstrate Marginal Analysis 2 2 5 3 9 4 12 3 14 2 15 1 15 0 14 -1 MTE Microeconomics © 2009 South-Western/Cengage Learning Production and Costs • Producers: Maximize profit • Opportunity cost – All resources have an opportunity cost • Explicit costs – Payments for resources • Implicit costs – Opportunity cost of resources owned by the firm / firm owners – No cash payment 9 Alternative Measures of Profit • Accounting profit – Total revenue minus explicit costs • Economic profit – Total revenue minus all costs (implicit and explicit) • Opportunity cost of all resources • Normal profit – “Accounting profit in excess of normal profit” • Accounting profit = Economic + Normal profit 10 Production in the Short Run • Variable resources – Can be varied quickly • Fixed resources – Cannot be altered easily • Short run – At least one resource is fixed • Long run – No resource is fixed 11 Law of Diminishing Marginal Returns • Total product: total output produced • Production function – Relationship between amount of resources employed and total product • Marginal product: the change in total product resulting from a one-unit increase in a resource employed by the firm 12 Law of Diminishing Marginal Returns • Increasing marginal returns: the MP of a variable resource increases as each additional unit of the resource is put into action • Diminishing marginal returns – Marginal product decreases • Law of diminishing marginal returns: as more of a variable resource is added to a given amount of a fixed resource, 13 MP eventually begins to decline Exhibit 3 Total product (tons/day) The total and marginal product of labor (a) Total product 15 Total product 10 5 Marginal product (tons/day) 0 5 4 3 2 1 0 5 Increasing marginal returns 10 Diminishing but positive marginal returns Workers per day (b) Marginal product Negative marginal returns Marginal product 14 5 10 Workers per day Costs in the Short Run • Fixed cost (TFC): any production costs that a firm incurs even when it is not producing output; Ex: overhead—rent, insurance, property taxes • Variable cost (TVC) any production costs that change as output changes; TVC = 0 when the firm is not producing any output; Ex.: labor costs 15 Costs in the Short Run • Total cost TC = TFC + TVC • Marginal cost MC = ∆TC/∆q • Change in TC to produce one more unit of output – Changes in MC reflect changes in marginal productivity – Increasing marginal returns • MC falls – Diminishing marginal returns • MC increases 16 Exhibit 4 Short-run TC and MC data for Smoother Mover (1) Tons moved per day (q) (2) Fixed cost (FC) (3) Workers per day 0 2 5 9 12 14 15 $200 200 200 200 200 200 200 0 1 2 3 4 5 6 (4) Variable cost (VC) (5) Total cost (6) Marginal cost (TC=FC+VC) MC=∆TC/∆q $0 100 200 300 400 500 600 17 •SR TC and MC data for Smoother Mover (1) Tons moved per day (q) (2) Fixed cost (FC) (3) Workers per day 0 2 5 9 12 14 15 $200 200 200 200 200 200 200 0 1 2 3 4 5 6 (4) Variable cost (VC) (5) Total cost (6) Marginal cost (TC=FC+VC) MC=∆TC/∆q $0 100 200 300 400 500 600 $200 300 400 500 600 700 800 $50.00 33.33 25.00 33.33 50.55 100.00 18 Exhibit 5 TC and MC curves for Smoother Mover Total cost Total dollars TC is the vertical sum of FC and VC Variable cost Fixed cost VC starts from origin; increases slowly at first; with diminishing returns, VC increases rapidly $500 200 Fixed cost FC = $200 at all levels of output Cost per ton 0 3 6 9 12 15 Tons per day Marginal cost $50 MC first declines: increasing marginal returns; then increases: diminishing marginal returns 25 0 3 6 9 12 15 Tons per day 19 Average Cost in the Short Run • Average variable cost AVC = VC/q • Average total cost ATC = TC/q • When MC < average cost – The marginal pulls down the average • When MC > average cost – The marginal pulls up the average • U-shape of average cost curves – Law of diminishing marginal returns 20 Exhibit 7 Average and marginal cost curves; Smoother Movers MC When MC is above AVC (ATC), AVC (ATC) is increasing. Cost per ton $150 ATC and AVC: decline, reach low points, then rise. 125 100 ATC 75 AVC 50 When MC is below AVC (ATC), AVC (ATC) is falling 25 0 5 10 15 Tons per day When MC = AVC (ATC), AVC (ATC) is at its minimum. 21 Perfect Competition © 2009 South-Western/ Cengage Learning What is Market Structure? • Market structure – Number of suppliers – Product’s degree of uniformity – Ease of entry into the market – Forms of competition among forms • Industry – All firms supplying output to a market 23 Types of Market Structure • Perfect Competition: many sellers; horizontal demand curve • Monopoly: one seller • Monopolistic Competition: many sellers; downward-sloping demand curve • Oligopoly: few sellers 24 Perfectly Competitive Market Structure • • • • • Many buyers and sellers Commodity; standardized product Fully informed buyers and sellers No barriers to entry Individual buyer or seller – No control over priceprice-taker 25 Demand Under Perfect Competition • Market price – Determined by market demand and supply. All firms must use this price on their products. • Demand curve facing one supplier – Horizontal line at the market price – Perfectly elastic 26 Short Run Profit Maximization • Maximize economic profit – Choose the quantity at which total revenue (TR) exceeds total cost (TC) by the greatest amount – TR = PxQ • Profit = TR – TC 27 Golden Rule of Profit Maximization • Marginal revenue: the change in TR from selling an additional unit – ∆TR/∆q • MR = P = AR (perfect competition) • Golden rule: produce where MR = MC – Expand output: MR>MC – Stop before MC>MR 28 Exhibit 2 (1) (2) (3) (4) (5) (6) (7) • Short-run cost and revenue; perfectly Bushels Marginal Total Total Marginal Average Economic of wheat Revenue Revenue Cost Cost Total cost Profit or Loss competitive firm per day;(q) (Price); (p) (TR=q×p) (TC) MC=∆TC/∆q ATC=TC/q TR-TC 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 $5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 $0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 $15.00 19.75 23.50 26.50 29.00 31.00 32.50 33.75 35.25 37.25 40.00 43.25 48.00 54.50 64.00 77.50 96.00 $4.75 3.75 3.00 2.50 2.00 1.50 1.25 1.50 2.00 2.75 3.25 4.75 6.50 9.50 13.50 18.50 $19.75 11.75 8.83 7.25 6.20 5.42 4.82 4.41 4.14 4.00 3.93 4.00 4.19 4.57 5.17 6.00 -$15.00 -14.75 -13.50 -11.50 -9.00 -6.00 -2.50 1.25 4.75 7.75 10.00 11.75 12.00 10.50 6.00 -2.50 29 -16.00 Monopoly © 2009 South-Western/ Cengage Learning Barriers to Entry • Monopoly – Sole supplier of a product with no close substitutes • Barriers to entry 1. Legal restrictions such as a patent 2. Economies of scale – natural monopoly with a downward sloping LRAC 3. Control of essential resources – EX: DeBeers Consolidated Mines 31 (diamonds) Firm’s Costs and Profit Maximization • Monopolist – Choose the price – OR the quantity – ‘Price maker’ • Profit maximization – TR minus TC – Supply quantity where TR exceeds TC by the greatest amount – MR equals MC 32 Exhibit 5 (1) (2) (3) (4) (5) (6) (7) •Diamonds Short-run costs and revenue for a Price Total Marginal Total Marginal Average per day (AR) Revenue Revenue Cost Cost Total cost monopolist (Q) (p) TR=p×Q MR=∆TR/∆Q (TC) (MC) ATC=TC/q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 $7,750 7,500 7,250 7,000 6,750 6,500 6,250 6,000 5,750 5,500 5,250 5,000 4,750 4,500 4,250 4,000 3,750 3,500 0 $7,500 14,500 21,000 27,000 32,500 37,500 42,000 46,000 49,500 52,500 55,000 57,000 58,500 59,500 60,000 60,000 59,500 $7,500 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500 $15,000 19,750 23,500 26,500 29,000 31,000 32,500 33,750 35,250 37,250 40,000 43,250 48,000 54,500 64,000 77,500 96,000 121,000 $4,750 3,750 3,000 2,500 2,000 1,500 1,250 1,500 2,000 2,750 3,250 4,750 6,500 9,500 13,500 18,500 25,000 $19,750 11,750 8,833 7,750 6,200 5,420 4,820 4,410 4,140 4,000 3,930 4,000 4,190 4,570 5,170 6,000 7,120 (8) Total profit or loss (=TR-TC) -$15,000 -12,250 -9,000 -5,500 -2,000 1,500 5,000 8,250 10,750 12,250 12,500 11,750 9,000 4,000 -4,500 -17,500 -36,000 33 -61,500 Monopolistic Competition and Oligopoly Monopolistic Competition • Characteristics – Many producers – Low barriers to entry – Slightly different products • A firm that raises prices: lose some customers to rivals – Some control over price ‘Price makers’ • Downward sloping D curve – Act independently 35 Monopolistic Competition • Product differentiation – Physical differences • Appearance; quality – Location • Spatial differentiation – Services – Product image • Promotion; advertising 36 Oligopoly • Few sellers • Barriers to entry – Economies of scale – Legal restrictions – Brand names – Control over an essential resource – High cost of entry • Start-up costs; advertising • Crowding out the competition 37 Collusion and Cartels • Collusion – Agreement among firms to • Divide the market • Fix the price • Cartel – Group of firms that agree to collude • Act as monopoly • Increase economic profit • Illegal in U.S. 38 Comparisons Across Market Structures Perfect Monopolistic Characteristics Competition Competition Oligopoly Monopoly Sellers Many Many Few One Products Identical Close substitutes, but not identical Identical (ex: oil) OR Different (ex: cereal) No close substitutes Prices Price-taker Price-maker Price-maker Price-maker Entry and Exit No barriers No barriers Barriers Barriers Demand horizontal Downwardsloping Downwardsloping Downwardsloping Profits MR=MC MR=MC MR=MC MR=MC Long-Run Economic Profits Zero Zero Greater than zero Greater than zero 39 Public Goods and Public Choice © 2009 South-Western/ Cengage Learning Characteristics of Pure Public Goods • Nonrival: more than one person can consume the good or service at the same timeMC of an additional user is zero • Nonexcludable: difficult or impossible to exclude others from deriving the benefits of the public good 41 Private, Public Goods, and in Between 1. Private goods – Rival in consumption – Exclusive – Provided by private sector 2. Public goods – Nonrival in consumption – Nonexclusive – Provided by government 42 Private, Public Goods, and in Between 3. Natural monopoly – Nonrival but exclusive – With congestion: private goods – Provided by private sector or government 4. Open-access good – Rival but nonexclusive – Regulated by government 43 Exhibit 1 • Categories of goods 44 Paying for Public Goods • Tax = marginal valuation – Free-rider problem • People try to benefit from the public goods without paying for them – Ability to pay 45 Externalities and the Environment © 2009 South-Western/ Cengage Learning Externality • Externality—costs or benefits from the production process that are not reflected in the market price and affect the welfare of others not necessarily using the product or service. • Externalities can be positive (reflecting a benefit) or negative (reflecting a cost.) 47 Negative versus Positive • Person smoking in a crowded room • Firm producing honey located next to an apple orchard • Person talking loudly on their cell phone at the table next to yours • Colorful English country garden in your next door neighbor’s yard • Pollution from a coal-burning utility plant 48 Negative Externality • Marginal Private Cost (MPC): private costs of production such as wages, costs of materials, rent, insurance, taxes, etc. • Marginal External Cost (MEC): valuation of marginal damage caused by negative externality • Marginal Social Cost (MSC): = MPC + MEC 49 Exhibit 1 Dollars per kilowatt-hour Total social gain $0.14 c b Marginal social cost a 0.10 D 0 35 Marginal social cost curve includes marginal private cost and marginal external cost. Marginal private cost; 50 Marginal million kilowatt-hours of private cost electricity are produced per month. The marginal external cost of production is imposed on society. 50 Millions of kilowatt-hours of electricity per month Marginal social cost; only 35 millions kilowatts-hour are produced, which is the optimal output. 50 Public Responses to Negative Externalities • Tax the polluter: levy a tax on each level of output produced by the polluter in an amount equal to the MEC inflicted at the socially efficient level of output. • Subsidize the polluter: pay the polluter not to pollute • Environmental regulation: Government tells the polluter to reduce pollution or face sanctions (1990 Clean Air Act) 51 Public Responses to Negative Externalities • Economic efficiency approach: marketable permits—government sells producers permits to pollute (pollution rights) 52 Positive Externality • Marginal Private Benefit (MPB): private benefits of production or consumption • Marginal External Benefit (MEB): valuation of marginal benefit created by positive externality • Marginal social benefit = MPB + MEB 53 Positive Externalities • Beneficial externalities • Education – Personal benefits – Benefits to society • Positive externality • Public policy – To increase quantity beyond private optimum 54 Exhibit 7 • Education and Marginal positive externalities S Dollars per unit cost e’ e Marginal social benefit D’ Marginal private benefit 0 E E’ D No government intervention: equilibrium quantity of education (E); marginal private benefit of education equals the marginal cost as reflected by the supply curve. Education also confers a positive externality on the rest of society, so the social benefit exceeds the private benefits. Quantity of education per period At E, the marginal social benefit exceeds the marginal cost, so more education increases social welfare. In this situation, government tries to increase education to E’, where the 55 marginal social benefit equals the marginal cost. Income Distribution and Poverty © 2009 South-Western/ Cengage Learning Income Distribution by Quintiles • Distribution of income – U.S. households – Ranked by income – Five groups of equal size (quintiles) • Percentage of income received in 1970 – Poorest 20% of population • 4.1% of income – Richest 20% of population • 43.3% of income 57 Exhibit 1 • Share of aggregate household income by quintile: 1970, 1980, 1990, and 2005 58 Income Distribution by Quintiles • Richest 20% of population – Increased share of income – Two-earner households • Poorest 20% of population – Decreased share of income – Single-parent household 59 The Lorenz Curve • Lorenz curve: graphical representation of the size of the income distribution • The diagonal line represents equal distribution or perfect income equality. Each 20 percent of the population receives 20 percent of total income. 60 Income (cumulative percent) Exhibit 2: Lorenz Curve a 1970 b 2005 Point a: in 1970, the bottom 80% of households received 56.7% of all income. Point b: in 2005, the share of all income going to the bottom 80% of households was lower than in 1970. If income were evenly distributed across households, the Lorenz curve would be a straight line. Households (cumulative percent) Lorenz curve: convenient way of showing the % of total income received by any given % of households when households are arrayed from smallest to largest. 61 Why Incomes Differ • • • • Number of household members working Education, ability, job experience Productivity High-income household • Well-educated couple; both spouses employed • Low-income household • One person living alone • Single-parent, female • Poorly educated 62 A College Education Pays More • Median wage, past 20 years – Only high-school diploma: decreased 6% • Industry deregulation; declining unionization • Information technology – College degree: increased 12% • Information technology • Higher rewards for education 63 Redistribution Programs • Official U.S. poverty level – Family of four: $19,971 in 2005 – $13.70 per person per day – Pretax money income – Includes cash transfers – Excludes value of non-cash transfers » Food stamps; Medicaid; Subsidized housing » Employer-provided health insurance – Recessions: Increase in poverty • International poverty line: • $1 per person per day 64 Exhibit 3 (1959-2005) • Number and percentage of US population in poverty 65 Social Insurance 1. 2. 3. 4. • Social security Medicare Unemployment insurance Workers’ compensation Deducted from workers’ pay – Aimed at people with work history • Income redistribution • From rich to poor • From young to old 66 Income Assistance • Welfare programs • Means-tested program: only individuals with incomes below a certain level qualify 1.Cash transfers programs – Temporary assistance for needy families: TANF replaced AFDC – Supplemental security income – General assistance aid – Earned-income tax credit 67 Income Assistance 2. In-kind transfer programs – Medicaid: basic medical care for the poor – Food stamps – Housing assistance – Support for day care, school lunches – Energy assistance – Education and training 68 Percent of population living in poverty by state 69 Welfare Reform • Welfare-to-work programs • 1997: Temporary assistance for needy families – States: more control • Maximum time to receive benefits: 5 years • Work participation rates: must work after 2 years of receiving benefits • Benefit levels are reduced less than dollar for dollar when one obtains a job 70 Welfare-to-work is working? • Welfare recipients – Declined 71% below the peak • Increased employment among mothers – Higher income • Increased welfare spending per recipient • Earned-income tax credit • Higher price of going on welfare 71 Statistics from U.S. GAO QuickTime™ and a TIFF (Uncompressed) decompressor are needed to see this picture. Andrea’s Software Business 73 $60 $60 -$49 (loss) $145 $56 $112 $56 -$33 (loss) $180 $35 $56 $168 $60 $210 $30 $56 $224 $56 $14 (profit) $60 $245 $35 $280 $56 $35 (profit) $285 $40 $56 $336 $56 $60 $330 $45 $56 $392 $60 $385 $55 $65 $60 $60 $525 $448 $56 $56 $560 $62 (profit) $56 $63 (profit) $56 $54 (profit) $56 $35 (profit) 74 Microeconomics James B. Wilcox Resources provided by: The University of Southern Mississippi Center for Economic and Entrepreneurship Education, Mississippi State University, & Virtual Economics