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МІНІСТЕРСТВО ОСВІТИ І НАУКИ УКРАЇНИ СУМСЬКИЙ ДЕРЖАВНИЙ УНІВЕРСИТЕТ До друку та в світ дозволяю на підставі «Єдиних правил», п. 2.6.14 Заступник першого проректора начальник організаційно - методичного управління В.Б. Юскаєв МЕТОДИЧНІ ВКАЗІВКИ до проведення практичних занять з дисципліни ”Мікроекономіка” для іноземних студентів факультету економіки та менеджменту Усі цитати, цифровий та фактичний матеріал, бібліографічні відомості перевірені, запис одиниць відповідає стандартам Укладачі: Ю.М. Петрушенко, Н.М. Костюченко, О.В. Дудкін Відповідальний за випуск В.о. декана факультету економіки та менеджменту О.В. Прокопенко Суми Видавництво СумДУ 2010 О.В. Прокопенко Ministry of Education and Science of Ukraine Sumy State University Methodological Instructions for practical training on Microeconomics for foreign students of the Department of Economics and Management Sumy Sumy State University Publishers 2010 1 Методичні вказівки до проведення практичних занять з дисципліни ”Мікроекономіка” для іноземних студентів факультету економіки та менеджменту / Укладачі: Ю.М. Петрушенко, Н.М. Костюченко, О.В. Дудкін. – Суми: Вид-во СумДУ, 2010. – 37 с. Кафедра економічної теорії Methodological Instructions for practical training on Microeconomics for foreign students of the Department of Economics and Management / Compilers: Y.M. Petrushenko, N.M. Kostyuchenko, O.V. Dudkin. – Sumy: Sumy State University Publishers, 2010. − 37 p. Chair of Economic Theory 2 PART 1. BASIC MICROECONOMIC CONCEPTS Practical class 1 Subject matter and method of Microeconomics Structure of the topic: Thinking like an economist. An economist as a scientist. Scientific method: observation, theory, and more observation. The role of assumptions. Economic models. Тhe circular-flow diagram. The production possibilities frontier. Microeconomics and macroeconomics. An economist as policy adviser. Positive versus normative analysis. Why economists disagree. Differences in scientific judgments. Differences in values. Perception versus reality. Summary Economists try to address their subject with a scientist’s objectivity. Like all scientists, they make appropriate assumptions and build simplified models in order to understand the world around them. Two simple economic models are the circular-flow diagram and the production possibilities frontier. The field of economics is divided into two subfields: microeconomics and macroeconomics. Microeconomists study decision-making by households and firms and the interaction between households and firms in the marketplace. Macroeconomists study the forces and trends that affect the economy as a whole. A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policy advisers than scientists. 3 Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values. At other times, economists are united in the advice they offer, but policymakers may choose to ignore it. Key Concepts Сircular-flow diagram, production possibilities frontier, microeconomics, macroeconomics, positive statements, normative statements. Questions for Review 1. What is Economics like a science? 2. Why do economists make assumptions? 3. Should an economic model describe reality exactly? 4. Draw and explain a production possibilities frontier for an economy that produces milk and cookies. What happens to this frontier if disease kills half of the economy’s cow population? 5. Use a production possibilities frontier to describe the idea of “efficiency.” 6. What are the two subfields into which economics is divided? Explain what each subfield studies. 7. What is the difference between a positive and a normative statement? Give an example of each. 8. What is the Council of Economic Advisers? 9. Why do economists sometimes offer conflicting advice to policymakers? Problem sets 1. Two types of goods are being produced in the country – peaceful goods and military goods. If all the resources are used for manufacturing peaceful goods, 1 million items can be made. If all the resources are used to produce military goods 10000 items can be made. Find the opportunity costs of both goods manufacturing. 2. Five persons on the island with tropical climate are gathering coconuts and eggs. Each of them gathers either 20 coconuts or 10 eggs per day. How will the production possibilities frontier change if 4 new machinery, that enables people to gather 28 coconuts, is brought here (mind that only 3 persons know how to use it). 3. A consumer earns 10 UAH per hour. It takes him one hour to stand in a queue to buy the good at 8 UAH per unit. One doesn’t have to stand in a queue if he/she is ready to pay 12 UAH per unit. How many units of the goods a consumer should buy so that it would be rational to buy cheap goods? Advisable sources: Mankiw N.G., chapter 2; Varian H.R., chapter 1; Colander D.C., chapter 1; Kearl J.R., chapters 1, 2. Practical class 2 Market forces of supply and demand Structure of the topic: Markets and competition. Competitive markets. Competition: perfect and otherwise. Demand. What determines the quantity an individual demands? The demand schedule and the demand curve. Market demand versus individual demand. Shifts in the demand curve. Supply. What determines the quantity an individual supplies? The supply schedule and the supply curve. Market supply versus individual supply. Shifts in the supply curve. Supply and demand together. Equilibrium. Three steps to analyzing changes in equilibrium. How prices allocate resources. 5 Summary Economists use the model of supply and demand to analyze competitive markets. In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price. The demand curve shows how the quantity of a good demanded depends on the price. According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward. In addition to price, other determinants of the quantity demanded include income, tastes, expectations, and the prices of substitutes and complements. If one of these other determinants changes, the demand curve shifts. The supply curve shows how the quantity of a good supplied depends on the price. According to the law of supply, as the price of a good arises, the quantity supplied rises. Therefore, the supply curve slopes upward. In addition to price, other determinants of the quantity supplied include input prices, technology, and expectations. If one of these other determinants changes, the supply curve shifts. The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied. The behavior of buyers and sellers naturally drives markets toward their equilibrium. When the market price is above the equilibrium price, there is a surplus of the good, which causes the market price to fall. When the market price is below the equilibrium price, there is a shortage, which causes the market price to rise. To analyze how any event influences a market, we use the supplyand-demand diagram to examine how the event affects the equilibrium price and quantity. To do this we follow three steps. First, we decide whether the event shifts the supply curve, the demand curve, or both. Second, we decide which direction the curve shifts. Third, we compare the new equilibrium with the old equilibrium. 6 In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources. For every good in the economy, the price ensures that supply and demand are in balance. The equilibrium price then determines how much of the good buyers choose to purchase and how much sellers choose to produce. Key Concepts Мarket, competitive market, quantity demanded, law of demand, normal goods, inferior goods, substitutes, complements, demand schedule, demand curve, ceteris paribus, quantity supplied, law of supply, supply schedule, supply curve, equilibrium, equilibrium price, equilibrium quantity, surplus, shortage, law of supply and demand. Questions for Review 1. What is a competitive market? Briefly describe the types of markets other than perfectly competitive markets. 2. What determines the quantity of a good that buyers demand? 3. What are the demand schedule and the demand curve, and how are they related? Why does the demand curve slope downward? 4. Does a change in consumers’ tastes lead to a movement along the demand curve or a shift in the demand curve? Does a change in price lead to a movement along the demand curve or a shift in the demand curve? 5. Popeye’s income declines and, as a result, he buys more spinach. Does spinach belong to inferior or normal goods? What happens to Popeye’s demand curve for spinach? 6. What determines the quantity of a good that sellers supply? 7. What are the supply schedule and the supply curve, and how are they related? Why does the supply curve slope upward? 8. Does a change in producers’ technology lead to a movement along the supply curve or a shift in the supply curve? Does a change in price lead to a movement along the supply curve or a shift in the supply curve? 7 9. Define the equilibrium of a market. Describe the forces that move a market toward its equilibrium. 10. Beer and pizza are complements because they are often enjoyed together. When the price of beer rises, what happens to the supply, demand, quantity supplied, quantity demanded, and the price in the market for pizza? 11. Describe the role of prices in market economies. Problem sets 1. The function of demand for a product is Qd 8 P , the function of supply is QS 7 2 P . Find the consumer surplus. 2. The function of demand for a product is Qd 14 2P , the function of supply is QS 4 2 P . Find the tax rate when equilibrium quantity is 2 units. 3. The function of demand for a product is Qd 7 P , the function of supply is QS 5 2 P . Find the tax rate (in UAH per unit) when the total amount of tax is maximum. 4. The function of demand for a product is Qd 8 P , the function of supply is QS 4 2 P . A tax that is paid by a consumer was provided for goods. The tax rate is 20% of the price of the goods. Find the consumer’s gain: a) before the tax was imposed; b) after the tax was imposed. Advisable sources: Mankiw N.G., chapter 4; Varian H.R., chapters 1, 6, 15, 16, 22, 23; Colander D.C., chapter 34; Kearl J.R., chapters 6, 9, 10. Practical class 3 Elasticity and its application Structure of the topic: 8 Elasticity of demand. Price elasticity of demand and its determinants. Midpoint method: a better way to calculate percentage changes and elasticities. The variety of demand curves. Total revenue and price elasticity of demand. Elasticity and total revenue along a linear demand curve. Other demand elasticities. Elasticity of supply. Price elasticity of supply and its determinants. Computing price elasticity of supply. The variety of supply curves. Three applications of supply, demand, and elasticity. Can good news for farming be bad news for farmers? Why did OPEC fail to keep the oil price high? Summary The price elasticity of demand measures how much the quantity demanded responds to changes in the price. Demand tends to be more elastic if the goods are luxury rather than necessity, if close substitutes are available, if the market is narrowly defined, or if buyers have substantial time to react to a price change. The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If the elasticity is less than 1, so that quantity demanded moves proportionately less than the price, demand is said to be inelastic. If the elasticity is greater than 1, so that quantity demanded moves proportionately more than the price, demand is said to be elastic. Total revenue, the total amount paid for a good, equals the price of the good times the quantity sold. For inelastic demand curves, total revenue rises as price rises. For elastic demand curves, total revenue falls as price rises. The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The crossprice elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. 9 The price elasticity of supply measures how much the quantity supplied responds to changes in the price. This elasticity often depends on the time horizon under consideration. In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. If the elasticity is less than 1, so that quantity supplied moves proportionately less than the price, supply is said to be inelastic. If the elasticity is greater than 1, so that quantity supplied moves proportionately more than the price, supply is said to be elastic. The tools of supply and demand can be applied in many different kinds of markets. This lecture uses them to analyze the market for wheat, the market for oil, and the market for illegal drugs. Key Concepts Elasticity, price elasticity of demand, total revenue, income elasticity of demand, cross-price elasticity of demand, price elasticity of supply. Questions for Review 1. Define the price elasticity of demand and the income elasticity of demand. 2. List and explain some of the determinants of the price elasticity of demand. 3. If the elasticity is greater than 1, is demand elastic or inelastic? If the elasticity equals 0, is demand perfectly elastic or perfectly inelastic? 4. On a supply-and-demand diagram, show equilibrium price, equilibrium quantity, and total revenue received by producers. 5. If demand is elastic, how will an increase in price change total revenue? Explain. 6. What do we call a good, income elasticity of which is less than 0? 7. How is the price elasticity of supply calculated? Explain what this measures. 8. What is the price elasticity of supply of Picasso paintings? 10 9. Is the price elasticity of supply usually larger in the short run or in the long run? Why? 10. In the 1970s, OPEC caused a dramatic increase in the price of oil. What prevented it from maintaining this high price through the 1980s? Problem sets 1. The elasticity of demand in the equilibrium point equals 2, and the elasticity of supply is 0.5. The equilibrium price is 5, and the equilibrium quantity is 10. Find functions of supply and demand curves if the functions are linear. 2. The goods are sold by 3 produces on the market with the following supply functions: Qs1 = 2P – 6; Qs2 = 3P – 15; Qs3 = 5P. Find the field price elasticity of supply if the price is 3 UAH. 3. When the price of the commodity X increased from 10 to 15 UAH per unit, the consumption of the commodity Y grew up from 50 to 75 product units. Find the coefficient of the cross elasticity of demand and identify if these goods are substitutes or compliments. 4. The function of the demand for product X is Qx 14 Px 0.1Py . The price of product X is 6 UAH per unit, and the price of product Y is 10 UAH per unit. Find the cross elasticity of demand for X according to Y price. Advisable sources: Mankiw N.G., chapter 5; Varian H.R., chapter 15; Colander D.C., chapter 2; Kearl J.R., chapter 7. Practical classes 4-5 The theory of consumer choice Structure of the topic: The budget constraint: what the consumer can afford. Preferences: what the consumer wants. Representing preferences with indifference curves. 11 Four properties of indifference curves. Two extreme examples of indifference curves. Optimization: what the consumer chooses. The consumer’s optimal choices. How changes in income affect the consumer’s choices. How changes in prices affect the consumer’s choices. Income and substitution effects. Deriving the demand curve. Summary A consumer’s budget constraint shows possible combinations of different goods he can buy (given his income and the prices of the goods). The slope of the budget constraint equals the relative price of the goods. The consumer’s indifference curves represent his preferences. An indifference curve shows various bundles of goods that make the consumer equally satisfied. Points on higher indifference curves are preferred to points on lower indifference curves. The slope of an indifference curve at any point is the consumer’s marginal rate of substitution − the rate at which the consumer is willing to trade one good for the other. The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve. At this point, the slope of the indifference curve (the marginal rate of substitution between the goods) equals the slope of the budget constraint (the relative price of the goods). When the price of a good falls, the impact on the consumer’s choices can be broken down into an income effect and a substitution effect. The income effect is the change in consumption that arises because a lower price makes the consumer better off. The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper. The income effect is reflected in the movement from a lower to a higher indifference curve, whereas the substitution effect is reflected by a movement along an indifference curve to a point with a different slope. 12 The theory of consumer choice can be applied in many situations. It can explain why demand curves can potentially slope upward, why higher wages could either increase or decrease the quantity of labor supplied, why higher interest rates could either increase or decrease saving, and why the poor prefer cash to inkind transfers. Key Concepts Budget constraint, indifference curve, marginal rate of substitution, perfect substitutes, perfect complements, normal goods, inferior goods, income effect, substitution effect, Giffen goods. Questions for Review 1. A consumer has an income of $3,000. Wine costs $3 for a glass, and cheese costs $6 for a pound. Draw the consumer’s budget constraint. What is the slope of this budget constraint? 2. Draw a consumer’s indifference curves for wine and cheese. Describe and explain four properties of these indifference curves. 3. Pick a point on an indifference curve for wine and cheese and show the marginal rate of substitution. What does the marginal rate of substitution tell us? 4. Show a consumer’s budget constraint and indifference curves for wine and cheese. Show the optimal consumption choice. If the price of wine is $3 for a glass and the price of cheese is $6 for a pound, what is the marginal rate of substitution at this optimum? 5. A person who consumes wine and cheese gets a raise, so his income increases from $3,000 to $4,000. Show what happens if both wine and cheese are normal goods. Now show what happens if cheese belongs to inferior goods. 6. The price of cheese rises from $6 to $10 for a pound, while the price of wine remains $3 for a glass. Show what happens to consumption of wine and cheese for a consumer with a constant income of $3,000. Decompose the change into income and substitution effects. 7. Can an increase in the price of cheese induce a consumer to buy more cheese? Explain. 13 8. Suppose that a person who buys only wine and cheese is given $1,000 in food stamps to supplement his $1,000 income. The food stamps cannot be used to buy wine. Might the consumer be better off with $2,000 in income? Explain in words and with a diagram. Problem sets 1. Utility function is ТU = 2х1х2. Income is 70 UAH per unit. Find the prices of goods х1 and х2 if optimal set is х1 = 4, х2 = 7. 2. A consumer having an income of 100 UAH buys 4 items of product X, and 9 units of product Y. Find the prices of products X and Y if the marginal rate of substitution of X by Y is 4. 3. A consumer likes tea with sugar. He always puts 2 teaspoons of sugar per cup. If the proportion is changed, he will refuse drinking tea. A tea-with-sugar day costs are 4 UAH. The price of a sugar teaspoon is 5 kop. The price of a cup of tea without sugar is 15 kop. Find graphically the equilibrium point of consumer. What quantity of tea and sugar is optimal in the constraints of the budget? Advisable sources: Mankiw N.G., chapter 14; Varian H.R., chapters 3, 4, 5; Colander D.C., chapter 6; Kearl J.R., chapter 5. 14 PART 2. MARKET STRUCTURE TYPES Practical class 6 The costs of production Structure of the topic: What are costs? Total revenue, total cost, and profit. Costs as opportunity costs. The cost of capital as an opportunity cost. Economic profit versus accounting profit. The production function. From the production function to the total-cost curve. The various measures of cost. Fixed and variable costs. Average and marginal costs. Cost curves and their shapes. Typical cost curves. Costs in the short run and in the long run. The relationship between short-run and long-run average total costs. Economies and diseconomies of scale. Summary The goal of firms is to maximize profit, which equals total revenue minus total cost. When analyzing a firm’s behavior, it is important to include all the opportunity costs of production. Some of the opportunity costs, such as the wages that are paid to workers by a firm pays its workers, are explicit. Other opportunity costs, such as the wages the firm owner gives up by working in the firm rather than taking another job, are implicit. A firm’s costs reflect its production process. A typical firm’s production function gets flatter as the quantity of an input increases, displaying the property of diminishing marginal product. As a result, a firm’s total-cost curve gets steeper as the quantity produced rises. 15 A firm’s total costs can be divided between fixed costs and variable costs. Fixed costs are costs that do not change when the firm alters the quantity of output produced. Variable costs are costs that do change when the firm alters the quantity of output produced. From a firm’s total cost, two related measures of cost are derived. Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost would rise if output were increased by 1 unit. When analyzing firm behavior, it is often useful to graph average total cost and marginal cost. For a typical firm, marginal cost rises with the quantity of output. Average total cost first falls as output increases and then rises as output increases further. The marginalcost curve always crosses the average-total-cost curve at the minimum of average total cost. A firm’s costs often depend on the time horizon being considered. In particular, many costs are fixed in the short run but variable in the long run. As a result, when the firm changes its level of production, average total cost may rise more in the short run than in the long run. Key Concepts Total revenue, total cost, profit, explicit costs, implicit costs, economic profit, accounting profit, production function, marginal product, diminishing marginal product, fixed costs, variable costs, average total cost, average fixed cost, average variable cost, marginal cost, efficient scale, economies of scale, diseconomies of scale, constant returns to scale. Questions for Review 1. What is the relationship between a firm’s total revenue, profit, and total cost? 2. Give an example of an opportunity cost that an accountant might not count as a cost. Why would the accountant ignore this cost? 3. What is marginal product, and what does it mean if it is diminishing? 16 4. Draw a production function that exhibits diminishing marginal product of labor. Draw the associated total cost curve (In both cases, be sure to label the axes). Explain the shapes of the two curves you have drawn. 5. Define total cost, average total cost, and marginal cost. How are they related? 6. Draw marginal-cost and average-total-cost curves for a typical firm. Explain why the curves have the shapes that they do and why they cross where they do. 7. How and why does a firm’s average-total-cost curve differ in the short run and in the long run? 8. Define economies of scale and explain why they might arise. Define diseconomies of scale and explain why they might arise. Problem sets 1. Put the data into the blanks. Table 1 Output Fixed costs (FC) Variable costs (VC) Total costs (TC) 0 100 200 300 400 500 600 700 $500 $500 $500 $0 $700 $1,300 $500 $1,200 $500 $500 $2,500 $3,300 $4,300 $5,500 Change in total costs (ΔTC) $700 $600 $500 $2,300 $3,800 $4,800 $6,000 $800 2. Put the data into the blanks. Assume that the fixed costs are 60$, and the total variable costs are illustrated in the table 2. Table 2 Total product 1 0 1 FC VC TC MC AFC AVC ATC 2 $60 3 0 $45 4 5 $45 6 $60 7 $45 8 $105 $105 17 Table 2 continuation 1 2 3 4 5 6 7 8 9 10 2 3 $85 $120 $150 $185 $225 $270 $325 $390 $465 4 5 $40 6 $30 7 $42.5 8 $72.5 3. According to the data in problem set 2 draw the curves FC, VC, and TC. Draw all the curves at one graph. What is the difference between fixed costs and total costs? Advisable sources: Mankiw N.G., chapter 21; Varian H.R., chapters 20, 21; Colander D.C., chapter 7, 8; Kearl J.R., chapters 1, 9, 10. Practical class 7 Firms in competitive markets Structure of the topic: What is a competitive market? The meaning of competition. The revenue of a competitive firm. Profit maximization and the competitive firm’s supply curve. The marginal-cost curve and the firm’s supply decision. The firm’s short-run decision to shut down. Sunk costs. The firm’s long-run decision to exit or enter a market. Measuring profit for the competitive firm. The supply curve in a competitive market. The short run: market supply with a fixed number of firms. 18 The long run: market supply with entry and exit. Why do competitive firms stay in business if they make zero profit? A shift in demand in the short run and long run. Why the long-run supply curve might slope upward. Summary Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm’s average revenue and its marginal revenue. To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost. Thus, the firm’s marginal cost curve is its supply curve. In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost. In a market with free entry and exit, profits are driven to zero in the long run. In this long-run equilibrium, all firms produce at the efficient scale, price equals the minimum of average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price. Changes in demand have different effects over different time horizons. In the short run, an increase in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to losses. But if firms can freely enter and exit the market, then in the long run the number of firms adjusts to drive the market back to the zero-profit equilibrium. Key Concepts Competitive market, average revenue, marginal revenue, sunk cost. 19 Questions for Review 1. What is meant by a competitive firm? 2. Draw the cost curves for a typical firm. For a given price, explain how the firm chooses the level of output that maximizes profit. 3. Under what conditions will a firm shut down temporarily? Explain. 4. Under what conditions will a firm exit a market? Explain. 5. Does a firm’s price equal marginal cost in the short run, in the long run, or both? Explain. 6. Does a firm’s price equal the minimum of average total cost in the short run, in the long run, or both? Explain. 7. Are market supply curves typically more elastic in the short run or in the long run? Explain. Problem sets 1. It is known that the firm’s fixed costs are 55 UAH. Marginal costs’ function is МС = 22 + 3Q3 + 2Q2 − 8Q. Calculate firm’s profit, if the revenue at the output of 5 units is 1000 UAH. 2. The formula of the average costs of competitive firm is АС = 40 + 2Q. In what a way the output will change, if the product’s price declines from 200 to 100 UAH per unit. 3. It is known that the formula of the competitive firm’s costs is ТС = 16 + Q2. If the market price for the product declines, what should the output be that the firm will get no economic profit in the short run? 4. The firm acts under the perfect competition conditions. The total costs function is TС = 0.1Q2 + 15Q + 200. a) What output should the firm choose if the price is 25 UAH per unit? b) What should the price be that the firm was closed in the short run? Advisable sources: Mankiw N.G., chapter 14; Varian H.R., chapters 22, 23; Colander D.C., chapter 9; Kearl J.R., chapter 11. 20 Practical classes 8-9 Monopoly Structure of the topic: Why monopolies arise. Monopoly resources. Government-created monopolies. Natural monopolies. Monopoly versus competition. A monopoly’s revenue. Profit maximization. A monopoly’s profit. The welfare cost of monopoly. The deadweight loss. The monopoly’s profit − a social cost? Public policy towards monopolies. Increasing competition with antitrust laws. Regulation. Public ownership. Price discrimination. The analytics of price discrimination. The prevalence of monopoly. Summary Monopoly is a firm that is the sole seller in its market. A monopoly arises when a single firm owns a key resource, when the government gives a firm the exclusive right to produce a good, or when a single firm can supply the entire market at a smaller cost than many firms could. Because a monopoly is the sole producer in its market, it faces a downward-sloping demand curve for its product. When a monopoly increases production by 1 unit, it causes the price of its good to fall, which reduces the amount of revenue earned on all units produced. As a result, a monopoly’s marginal revenue is always below the price of its good. 21 Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost. The monopoly then chooses the price at which that quantity is demanded. Unlike a competitive firm, a monopoly firm’s price exceeds its marginal revenue, so its price exceeds marginal cost. A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus. That is, when the monopoly charges a price above marginal cost, some consumers who value the good more than its cost of production do not buy it. As a result, monopoly causes deadweight losses similar to the deadweight losses caused by taxes. Policymakers can respond to the inefficiency of monopoly behavior in four ways. They can use the antitrust laws to try to make the industry more competitive. They can regulate the prices that the monopoly charges. They can turn monopolist into a government-run enterprise. Or, if the market failure is deemed small compared to the inevitable imperfections of policies, they can do nothing at all. Monopolists often can raise their profits by charging different prices for the same goods based on a buyer’s willingness to pay. This practice of price discrimination can raise economic welfare by getting the goods to some consumers who otherwise would not buy it. In the extreme case of perfect price discrimination, the deadweight losses of monopoly are completely eliminated. More generally, when price discrimination is imperfect, it can either raise or lower welfare compared to the outcome with a single monopoly price. Key Concepts Monopoly, natural monopoly, price discrimination. Questions for Review 1. Give an example of a government-created monopoly. Is creation of this monopoly necessarily a bad public policy? Explain. 2. Define natural monopoly. What does the size of a market have to do with whether an industry is a natural monopoly? 3. Why is a monopolist’s marginal revenue less than the price of its good? Can marginal revenue ever be negative? Explain. 22 4. Draw the demand, marginal-revenue, and marginal-cost curves for a monopolist. Show the profit-maximizing level of output. Show the profit-maximizing price. 5. In your diagram from the previous question, show the level of output that maximizes total surplus. Show the deadweight loss from the monopoly. Explain your answer. 6. What gives the government the power to regulate mergers between firms? From the standpoint of the welfare of society, give a good reason and a bad reason that two firms might want to merge. 7. Describe the two problems that arise when regulators tell a natural monopoly that it must set a price equal to marginal cost. 8. Give two examples of price discrimination. In each case, explain why the monopolist chooses to follow this business strategy. Problem sets 1. The function of demand in monopolized market is Qd = 301− Р, the function of monopoly’s total costs is ТС = 120 + Q + Q2. What will the product price be, if the monopoly maximizes: a) profit; b) revenue? 2. A monopoly practicing no price discrimination owns two enterprises producing the same goods but with different total costs: ТС1 = 10Q1, TC2 = 0,25Q22. The demand function is Q = 200 – 2Р. What quantity of goods will the monopoly produce at different enterprises? 3. There are 5 firms in the market producing 2%, 3%, 5%, 10% and 30% of market output. The last part of output is made by small firms, each producing approximately 1% of market output. Make a conclusion about the level of monopolization of the market. 4. The demand function of the monopoly is Qd = 100 – Р. The function of monopoly’s total costs is TС = 10Q + 0.5Q2. Find the deadweight loss of the society because of monopoly. Advisable sources: Mankiw N.G., chapter 15; Varian H.R., chapter 24; Colander D.C., chapter 10; Kearl J.R., chapter 13. 23 Practical class 10 Oligopoly Structure of the topic: Between monopoly and perfect competition. Markets with only a few sellers. A duopoly example. Competition, monopolies, and cartels. The equilibrium for an oligopoly. How the size of an oligopoly affects the market outcome? Game theory and the economics of cooperation. The prisoners’ dilemma. Oligopolies as a prisoners’ dilemma. The prisoners’ dilemma and the welfare of society. Why people sometimes cooperate? Public policy towards oligopolies. Restraint of trade and the antitrust laws. Controversies over antitrust policy. Summary Oligopolists maximize their total profits by forming a cartel and acting like monopolists. Yet, if oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. The larger the number of firms in the oligopoly, the closer the quantity and price will be to the levels that would prevail under competition. The prisoners’ dilemma shows that self-interest can prevent people from maintaining cooperation, even when cooperation is in their mutual interest. The logic of the prisoners’ dilemma applies in many situations, including arms races, advertising, common-resource problems, and oligopolies. Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition. The application of these laws can be controversial, because some behavior that may seem to reduce competition may in fact have legitimate business purposes. 24 Key Concepts Oligopoly, monopolistic competition, collusion, cartel, Nash equilibrium, game theory, prisoners’ dilemma, dominant strategy. Questions for Review 1. If a group of sellers could form a cartel, what quantity and price would they try to set? 2. Compare the quantity and price of an oligopoly to those of a monopoly. 3. Compare the quantity and price of an oligopoly to those of a competitive market. 4. How does the number of firms in an oligopoly affect the outcome in its market? 5. What is the prisoners’ dilemma, and what does it have to do with oligopoly? 6. Give two examples other than oligopoly to show how the prisoners’ dilemma helps to explain behavior. 7. What kinds of behavior do the antitrust laws prohibit? 8. What is resale price maintenance, and why is it controversial? Problem sets 1. The market demand function is Р = 240 – 3Q. There are two firms in the market competing under Cournot model. Find the marginal costs of the firm, if the total output of the market is Q = 32. Draw firms’ reaction curves and find the equilibrium quantity and equilibrium price. 2. The market demand curve for Bertrand duopoly is described by the equation Р = 10 – Q. The marginal costs of both firms are constant МС = 2. Find: a) equilibrium price and output for each firm; b) economic profit for each firm; c) illustrate the solution graphically. 3. Assume that a firm A is trying to break the monopoly of a firm B in the market of one product. The firm A is deciding whether to enter the market or not, and the firm B is deciding whether to 25 Firm A decrease the output or not if the firm A enters the market. The variants of these decisions are given in the Table 3. Table 3 Firm B Not to decrease To decrease the output the output To enter the -6; -4 8; 8 market Not to enter 0; 20 0; 20 the market Find all the types of equilibrium. Analyze the problem that is characterized by this model. Advisable sources: Mankiw N.G., chapter 16; Varian H.R., chapters 27, 28; Colander D.C., chapter 11; Kearl J.R., chapter 14. Practical class 11 Monopolistic competition Structure of the topic: Competition with differentiated products. The monopolistically competitive firm in the short run. The long-run equilibrium. Monopolistic versus perfect competition. Monopolistic competition and welfare of society. The debate over advertising. Advertising as a signal of quality. Brand names. Summary A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry. The equilibrium in a monopolistically competitive market differs from that in a perfectly competitive market in two related ways. First, 26 each firm has excess capacity. That is, it operates on the downwardsloping portion of the average-total-cost curve. Second, each firm charges a price above marginal cost. Monopolistic competition does not have all the desirable properties of perfect competition. There is the standard deadweight loss of monopoly caused by the mark-up of price over marginal cost. In addition, the number of firms (and thus the variety of products) can be too large or too small. In practice, the ability of policymakers to correct these inefficiencies is limited. The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names. Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition. Defenders of advertising and brand names argue that firms use them to inform consumers and to compete more vigorously on price and product quality. Key Concepts Monopolistic competition, differentiated products. Questions for Review 1. Describe the three attributes of monopolistic competition. What are the common features of monopolistic competition and perfect competition? 2. Draw a diagram depicting a firm in a monopolistically competitive market that is making profits. Show what happens to this firm as new firms enter the industry. 3. Draw a diagram of the long-run equilibrium in a monopolistically competitive market. How is price related to average total cost? How is price related to marginal cost? 4. Does a monopolistic competitor produce too much or too little output compared to the most efficient level? What practical considerations make it difficult for policymakers to solve this problem? 5. How might advertising reduce economic well-being? How might advertising increase economic well-being? 27 6. How might advertising with no apparent informational content in fact convey information to consumers? 7. Explain two benefits that might arise from the existence of brand names. Problem sets 1. The demand function of monopolistic competitor is Qd = 300 – 5Р, the function of total cost is TС = 200 + 30Q. Find the optimal quantity and price that will maximize profit. 2. Marginal revenue of monopolistic competitor is MR = 20 – Q, the function of marginal cost is МС = 3Q – 10. Find the firm’s overcapacity in product units, if minimal long-term average costs are 11 UAH. 3. The average costs of the firm acting in terms of monopolistic competition equal 200 UAH when 200 units are produced, 201 UAH when 201 units are produced, 202 UAH when 202 units are produced. At the moment the firm is maximizing its profit producing 201 units of the good. The consumer is ready to pay 300 UAH for only the 202-nd unit. Should the firm accept the offer if the production and sale of the 202-nd unit don’t affect other firm’s sales. Advisable sources: Mankiw N.G., chapter 17; Varian H.R., chapter 25; Colander D.C., chapter 11; Kearl J.R., chapter 14. 28 PART 3. RESOURCE MARKETS AND INSTITUTIONAL ASPECTS OF THE MARKET Practical classes 12-13 Resource markets Structure of the topic: The demand for labor. The competitive profit-maximizing firm. The production function and the marginal product of labor. The value of the marginal product and demand for labor. What causes the labor demand curve to shift? The supply of labor. The trade-off between work and leisure. What causes the labor supply curve to shift? Shifts in labor supply. Shifts in labor demand. The other factors of production: land and capital. Equilibrium in the markets for land and capital. Linkages among the factors of production. Summary The economy’s income is distributed in the markets for the factors of production. The three most important factors of production are labor, land, and capital. The demand for factors, such as labor, is a derived demand that comes from firms that use the factors to produce goods and services. Competitive, profit maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price. The supply of labor arises from individuals’ trade-off between work and leisure. An upward-sloping labor supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours. The price paid to each factor allows to balance the supply and demand for that factor. Because factor demand reflects the value of 29 the marginal product of that factor, in equilibrium each factor is compensated according to its marginal contribution to the production of goods and services. Because factors of production are used together, the marginal product of any factor depends on the quantities of all factors that are available. As a result, a change in the supply of one factor alters the equilibrium earnings of all the factors. Key Concepts Factors of production, production function, marginal product of labor, diminishing marginal product, value of the marginal product, capital. Questions for Review 1. Explain how a firm’s production function is related to its marginal product of labor, how a firm’s marginal product of labor is related to the value of its marginal product, and how a firm’s value of marginal product is related to its demand for labor. 2. Give two examples of events that could shift the demand for labor. 3. Give two examples of events that could shift the supply of labor. 4. Explain how the wage can adjust to balance the supply and demand for labor while simultaneously equaling the value of the marginal product of labor. 5. If the population of the United States suddenly grew because of a large immigration, what would happen to wages? What would happen to the rents earned by the owners of land and capital? Problem sets 1. A firm is a perfect competitor in commodities market and in the market of factors of production. Its production function is Q = 200L – 2L2 for a given amount of capital. Find the firm’s demand function for labor. 2. Production technology is described by the production function: Q L0,5 K . The firm has 40 units of capital (K). Wage rate (w) is 30 5 UAH per unit. The price of the product (Р) is 1 UAH per unit. What quantity of labor will the firm use if it is trying to maximize profit? 3. Acreage is 120 hectares. Demand for land is Qd = 180 – 3r, where r – rental rate per 1 hectare. Interest rate is 10% per year. Find the price of 1 hectare of land? 4. There are to ways to get income. In the variant A income is 2000 UAH which is paid out by equal portions during the year: 1000 UAH today and another 1000 UAH in a year. In the variant B income is also 2000 UAH which is paid out in several stages: 500 UAH today, 1000 UAH in a year, and 500 UAH in two years. Interest rate is r = 10%. a) What variant would you chose? b) What must the interest rate be to make you change your mind? Advisable sources: Mankiw N.G., chapter 18; Varian H.R., chapter 26; Colander D.C., chapters 19, 20; Kearl J.R., chapters 21, 22. Practical class 14 Externalities Structure of the topic: Externalities and market inefficiency. Welfare economics: a recap. Negative externalities in production. Positive externalities in production. Externalities in consumption. Private solutions to externalities. The types of private solutions. The Coase theorem. Why private solutions do not always work? Public policies toward externalities. Regulation. 31 Pigovian taxes and subsidies. Tradable pollution permits. Objections to the economic analysis of pollution. Summary When transaction between a buyer and seller directly affects a third party, the effect is called externality. Negative externalities, such as pollution, cause socially optimal quantity in a market to be less than the equilibrium quantity. Positive externalities, such as technology spillovers, cause socially optimal quantity to be greater than the equilibrium quantity. Those affected by externalities can sometimes solve the problem privately. For instance, when one business confers an externality on another business, the two businesses can internalize the externality by merging. Alternatively, the interested parties can solve the problem by negotiating a contract. According to the Coase theorem, if people can bargain without cost, they can always reach an agreement in which resources are allocated efficiently. In many cases, however, reaching a bargain among many interested parties is difficult, so the Coase theorem does not apply. When private parties cannot adequately deal with external effects, such as pollution, the government often steps in. Sometimes the government prevents socially inefficient activity by regulating behavior. Other times it internalizes an externality using Pigovian taxes. Another way to protect the environment is for the government to issue a limited number of pollution permits. The final result of this policy is largely the same as imposing Pigovian taxes on polluters. Key Concepts Externality, internalizing an transaction costs, Pigovian tax. externality, Coase theorem, Questions for Review 1. Give examples of negative externality and positive externality. 2. Use a supply-and-demand diagram to explain the effect of negative externality in production. 32 3. In what way does the patent system help society solve an externality problem? 4. List some of the ways to solve problems without governmental intervention that are caused by externalities. 5. Imagine that you are a non-smoker sharing a room with a smoker. According to the Coase theorem, what determines whether your room-mate smokes in the room? Is this outcome efficient? How do you and your room-mate reach this solution? 6. What are Pigovian taxes? Why do economists prefer them over regulations as a way of environmental protection? Problem sets 1. A firm that produces pulp also emits smelly pollution. The more pulp it produces, the more pollution it emits. The pollution primarily affects the people who live in the area. Suppose the pulp is solid in a perfectly competitive market and that the firm has linear marginal cost (MC), which increases with pollution. Suppose also that the marginal cost of pollution (ME – the marginal cost of externality) increases proportionally to the quantity produced, and is approximately 1/3 as large as the firm’s marginal cost. a) Draw a diagram with quantity of pulp on the X-axis and cost/revenue on the Y-axis. Indicate the profit maximising choice of quantity given the assumptions. b) How should the social cost be represented in the graph? c) Show in the graph how to find the socially optimal quantity. Will that quantity be higher or lower than in the answer to a)? d) Suggest the solution how to motivate the firm to produce the socially optimal quantity. Advisable sources: Mankiw N.G., chapter 10; Varian H.R., chapter 34; Colander D.C., chapter 17; Kearl J.R., chapter 16. 33 Practical class 15 Public goods and common resources Structure of the topic: Kinds of goods. Public goods. The free-rider problem. Some important public goods. A difficult job of cost-benefit analysis. Common resources. The tragedy of the commons. Some important common resources. The importance of property rights. Summary Goods differ in whether they are excludable and whether they are rival. Goods are excludable if it is possible to prevent someone from using them. Goods are rival if one person’s enjoyment of the goods prevents other people from enjoying the same unit of the goods. Markets work best for private goods, which are both excludable and rival. Markets do not work as well for other types of goods. Public goods are neither rival nor excludable. Examples of public goods include fireworks displays, national defense, and creation of fundamental knowledge. Because people are not charged for their use of the public goods, they have an incentive to free ride when the goods are provided privately. Therefore, governments provide public goods, making their decision about the quantity based on cost-benefit analysis. Common resources are rival but not excludable. Examples include common grazing land, clean air, and congested roads. Because people are not charged for their use of common resources, they tend to use them excessively. Therefore, governments try to limit the use of common resources. Key Concepts Excludability, rivalry, private goods, public goods, common resources, free rider, cost-benefit analysis, tragedy of the commons. 34 Questions for Review 1. Explain what is meant by goods being “excludable.” Explain what is meant by goods being “rival.” Is pizza excludable? Is it rival? 2. Define and give an example of public goods. Can the private market provide these goods on its own? Explain. 3. What is cost-benefit analysis of public goods? Why is it important? Why is it hard? 4. Define and give an example of a common resource. Will people use these goods too much or too little without governmental intervention? Why? Problem sets 1. Two individuals, A and B, have decided to arrange a small park between their respective houses. However, they have very different opinions how big this park should be. In Figure 1, we see their different marginal willingness to pay. We have also drawn the marginal cost (MC) of producing different quantities of park. Show how A and B can decide on the optimal size of park. $ MC DB DA q Figure 1 Advisable sources: Mankiw N.G., chapter 11; Varian H.R., chapter 36; Colander D.C., chapters 15, 16; Kearl J.R., chapter 17. 35 REFERENCES 1. Mankiw, Gregory N. Principles of Microeconomics / Gregory N. Mankiw. – 2nd edition. – Harcourt College Pub, 2000. – 495 р. 2. Varian, Hal R. Intermediate Microeconomics – A Modern Approach / Hal R. Varian. – 7th edition. – Norton, 2006. – 776 р. 3. Colander, David C. Microeconomics / David C. Colander. – Homewood, IL : Irwin, 1993. – 531 p. 4. Kearl, James R. Principle of microeconomics / James R. Kearl. – Lexington : D.C. Heath, 1993. – 637 p. 36 Навчальне видання Methodological Instructions for practical training on Microeconomics for foreign students of the Department of Economics and Management Відповідальний за випуск Редактор: О.В. Прокопенко М.В. Буката Комп’ютерне верстання О.В. Дудкіна, Н.М. Костюченко Підписано до друку 1.11.2010, поз. Формат 60×84/16. Ум. друк. арк. 2,09. Обл..-вид. арк. 2,05. Тираж 30 пр. Зам. № Собівартість видання грн. к. Видавець і виготовлювач Сумський державний університет, вул. Римського-Корсакова, 2, м. Суми, 40007 Свідоцтво суб’єкта видавничої справи ДК № 3062 від 17.12.2007. 37