Download Economics 310 Handout 1 Professor Tom K

Economics 310
Handout 1
Professor Tom K. Lee
Section I: Review of basic economic concepts
Part 1: Prices, concepts of demand and demand elasticities
(1.5, 2.1, 2.5, 4.1, 4.4, 4.5)
Absolute price is the exchange rate of goods and services for
money.
Relative price is the exchange rate of goods and services for goods
and services.
Market price is the price determined by the actions of all the
buyers and sellers of a market.
Demand price of a product is the maximum amount a consumer is
willing to pay for the last unit of a product.
Two views of a demand curve: positive vs normative views
Consumer surplus is difference between the maximum amount that a
consumer is willing to pay for the quantity demanded and the
actual payment of the purchase.
The First Law of Demand states that as the market price of a
product increases the quantity demanded of the product
decreases.
Own-price demand elasticity is the percentage change in the
quantity demanded of a product per percentage change in the
market price of the product.
The Second Law of Demand states that the own price demand
elasticity is higher in the long run than in the short run.
Change in demand vs change in quantity demanded
Determinants of demand: Income
Prices of substitutes & complements
Advertising
Preferences
Interest rate
Gov't taxes, subsidies & regulation
Expectations
Number of buyers in the market
Income demand elasticity is the percentage change in the
quantity demanded of a product per percentage change in
income.
Cross-price demand elasticity is the percentage change in the
quantity demanded of a product per percentage change in the
price of another product.
Market demand is horizontal summation of buyers' demand curves.
Part 2: Concepts of supply and supply elasticities
(10.1, 17.5)
Supply price of a product is the minimum that one has to pay to
induce a seller to produce and supply the last unit of a
product.
Two views of a supply curve: positive vs normative views
Economics 310
Handout 2
Professor Tom K. Lee
Producer surplus is the difference between the actual amount a
seller receives and the minimum that a seller is willing to
accept for the quantity supplied.
Economic rent is producer surplus with supply price being zero.
The First Law of Supply states that as the market price of a
product increases the quantity supplied of the product
increases.
Supply elasticity is the percentage change in quantity supplied of
a product per percentage change in the market price of the
product.
The Second Law of Supply states that the supply elasticity is
higher in the long run than in the short run.
Change in supply vs change in quantity supplied
Determinants of supply: Technology
Input prices
Joint product prices
Interest rate
Gov't taxes, subsidies & regulation
Expectations
Number of sellers in the market
Market supply is horizontal summation of sellers' supply curves.
Part 3: Partial equilibrium analysis and applications
(2.2-2.4, 10.2, 10.5, 18.1, 18.2)
Equilibrium price is that price where quantity demanded equals
quantity supplied.
Equilibrium price and quantity determination
The Law of Supply and Demand states that, whenever the market price
deviates from the equilibrium price, there are market forces
that would bring the market price back to the equilibrium price
so that transactions take place at the equilibrium price.
The equivalence of excise tax on production vs consumption
Price ceiling is the maximum price that a market is allowed to
operate at.
Price floor is the minimum price that a market is allowed to
operate at.
Agricultural price support
Agricultural target price & deficiency payment
International trade and tariff
Pricing of exhaustible resources
Economics 310
Handout 3
Professor Tom K. Lee
Section II: Consumer theory and applications
Part 4: Consumer theory
(3.1-3.3)
A consumer budget line is the combinations of products that the
expenditures on these products will exhaust a consumer's
income.
An indifference curve is the combinations of products that give a
consumer the same level of satisfaction.
Marginal utility is the incremental amount of satisfaction due to
the last unit of a product consumed.
Marginal Rate of Substitution is the compensation of the
consumption of one product in sacrifice of the consumption of
another product while holding a consumer's satisfaction level
constant.
The Law of Diminishing Marginal Rate of Substitution states that
the marginal rate of substitution gets less and less as we gain
more and more of a product while holding utility constant.
Utility maximization subject to a consumer budget constraint
Optimality condition for consumption choice: incremental
satisfaction from the last dollar spent on each product should
be the same across all products.
The Composite-good Convention
Part 5: The decomposition of price effect into income effect and
substitution effect
(3.4, 4.2-4.3, 4.6)
An income-consumption curve is the combinations of products that
are utility maximizing at different levels of income while
holding all prices constant.
Normal(superior) goods are goods where an increase in income would
increase the demand for the goods.
Inferior goods are goods where an increase in income would decrease
the demand for the goods.
A price-consumption curve is the combinations of utility maximizing
product choices at different price levels of a product while
holding all other prices and income constant.
Price effect is the change in the optimal consumption point as the
price of a product changes while holding all other prices and
income constant
Substitution effect is the change in the optimal consumption point
as the price of a product changes while holding all other prices
and satisfaction level constant.
Income effect is the change in the optimal consumption point as the
income changes while holding all prices at the new price levels.
Price effect = Substitution effect + Income effect
Ordinary goods are goods that satisfy the First Law of Demand.
Economics 310
Handout 4
Professor Tom K. Lee
Giffen goods are goods that violate the First Law of Demand.
Own price demand elasticity and the price-consumption curve
Part 6: Applications of the decomposition of price effect
(5.1)
Excise tax vs lump sum tax
Excise subsidy vs lump sum subsidy
Tax-plus-rebate program
Part 7: Intertemporal consumer theory
(5.5)
An intertemporal budget line is the combinations of consumption
today and consumption tomorrow such that the present value of
consumption equals to the present value income.
An intertemporal indifference curve is the combinations of
consumption today and consumption tomorrow that give a consumer
the same level of satisfaction.
Effect of an interest rate change and savings behavior
Ricardian Equivalence Theorem states that under perfect competition
government budget deficit due to a tax cut has no effect on
intertemporal consumption choices but increases savings.
Section III: Producer theory and applications
Part 8: Producer theory with one input and applications
(1.6, 7.1-7.2, 8.1-8.3, 8.9, 20.5)
Total product, average product and marginal product curve.
The Law of Diminishing Marginal Product states that there exists
a level of input beyond which additional unit of input would
yield a lower marginal product.
Three stages of production
Equalizing marginal product: the case of education
Opportunity cost is the best feasible alternative foregone.
Total cost, total fixed cost, total variable cost and marginal cost
Average cost, average fixed cost and average variable cost
Equalizing marginal cost: the case of pollution abatement
Part 9: Producer theory with two inputs and applications
(7.3-7.4, 8.4-8.6)
An Isoquant is the combinations of inputs that yield the same level
of output.
Marginal Rate of Technical Substitution is the amount of an input
that must be increased in order to maintain a given output level
when the amount of one of the other inputs is reduced.
Economics 310
Handout 5
Professor Tom K. Lee
The Law of Diminishing Marginal Rate of Technical Substitution
states that as we use more and more of an input the marginal
rate of technical substitution of that input decreases.
Decreasing, constant and increasing returns to scale.
An isocost line is the combinations of inputs that have the same
production cost.
Cost minimization subject to an output constraint
Output maximization subject to a cost constraint
Optimality condition for input choices for output-constrained cost
minimization: incremental cost due to the last unit of output
through an increase in an input should be the same across all
inputs.
Optimality condition for input choices for cost-constrained output
maximization: incremental output due to the last dollar spent on
an input should be the same across all inputs.
Effect of input price increases on average(marginal) cost curves
Input choice restriction raises cost of production.
Short-run vs long-run average(marginal) cost curves
Section IV: Profit maximization and perfect competition
Part 10: Short-run vs long-run profit maximization of
a competitive firm
(9.1-9.6)
Perfect competition model: many small price-taking buyers
many small price-taking sellers
no transaction cost (free entry & exit)
perfect information
homogeneous private good
no externality
Short run profit maximization conditions of a competitive firm:
-price equals short-run marginal cost
-short-run marginal cost is increasing
-price is no less than minimum average variable cost
The short-run supply curve
Shut-down decision
Long-run profit maximization conditions of a competitive firm:
-price equals long-run marginal cost
-long-run marginal cost is increasing
-price is no less than minimum long-run average cost
The long-run supply curve
Economics 310
Handout 6
Professor Tom K. Lee
Part 11: Competitive industry equilibrium
(9.7)
Zero profit equilibrium conditions of a competitive industry
-price equals long-run marginal cost
-long-run marginal cost is increasing
-price equal minimum long-run average cost
Efficiency of zero profit equilibrium of a competitive industry
Why do firms exist? -to reduce transaction costs
-economies of scale (and scope)
-diversification of risk
Why do corporations exist? -separation of ownership & management
-limited liability
Section V: The spectrum of market structures
Part 12: Monopoly and market power
(11.1-11.5, 15.1-15.3)
Sources of monopoly power -essential input
-economies of scale
-gov't regulation
-entry barrier
Natural monopoly is a one seller situation where for all relevant
levels of demand the average cost curve is declining.
Pure monopoly model -many small price-taking buyers
-one price-setting seller
-no substitutes and no entry
-homogeneous private good
-perfect information
-no externality
Total revenue, average revenue and marginal revenue curves
A monopolist never operates in the inelastic region of a demand
curve.
A monopolist has no supply curve.
Short-run profit maximizing conditions of a monopoly:
-marginal revenue equals marginal cost
-change in marginal cost exceeds change in marginal revenue
-price is no less than average variable cost
Social cost of a monopoly –Harberger triangle (DWL)
-rent-seeking cost
-dynamic cost
Economics 310
Handout 7
Professor Tom K. Lee
Part 13: Price discrimination
(12.1-12.3, 12.5)
Conditions of price discrimination
-market power
-ability to separate consumer groups
-no resale
1st degree price discrimination is the charging of different prices
for different units of a product to each consumer.
2nd degree price discrimination is the charging of different prices
for different blocks of units of a product to each consumer.
3rd degree price discrimination is the charging of different prices
to different consumers(possibly in different markets).
The inverse demand elasticity rule: a monopolist will charge a
higher price in a market with a lower demand elasticity.
Uniform pricing is the charging of the same price to different
consumers.
Welfare comparison of 3rd degree price discrimination vs uniform
pricing
Two-part tariffs is a form of pricing charging buyers an entry fee
plus a per unit price.
All-or-nothing contract is a form of pricing where a buyer can buy
a fixed quantity of a product at a fixed price per unit or
nothing.
Part 14: Peak load pricing
(12.4)
Peak-load pricing is the pricing of a service when the demand of
the service varies over time, with the peak users charged the
marginal cost and the marginal capacity cost while the off-peak
users are charged only the marginal cost.
Reverse-peak problem arises from implementing peak-load pricing
when the peak users are charged the marginal cost plus a high
marginal capacity cost but the off-peak users are only charged
the marginal cost and the demand for peak users and off-peak
users differ so little that peak users end up consuming less
than the off-peak users.
Solution to reverse peak problem: vertical summation of demands
Part 15: Monopolistic competition
(13.1)
Monopolistic competition model
-many small price-taking buyers
-many small price-setting sellers
-product differentiation
-no transaction cost(free entry & exit)
-perfect information
-no externality
Economics 310
Handout 8
Professor Tom K. Lee
Profit maximization conditions of a monopolistic competitive firm:
-marginal revenue equals marginal cost
-change in marginal cost exceeds change in marginal revenue
-there exists an output such that demand price is no less than
average variable cost
Zero profit equilibrium of a monopolistic competitive industry:
-marginal revenue equals marginal cost
-change in marginal cost exceeds change in marginal revenue
-price equals average cost
Inefficiency of monopolistic competition
Excess Capacity Hypothesis states that at the zero profit
equilibrium of a monopolistic competitive industry, average cost
is not at the minimum average cost, that is further increase in
output will lower average cost.
Part 16: Models of oligopoly and game theory
(13.2-13.4, 14.1-14.5)
Dominant-firm price-leadership model and residual demand
Cartels as multiplant monopoly
Oligopoly: Cournot(quantity) vs Bertrand(price) rivalry
Game theory -number of players
-information sets of players
-preferences of players
-strategy sets of players
-equilibrium concepts, e.g. Nash equilibrium
Prisoners' dilemma game has unique Pareto-dominated Nash
equilibrium.
Battle-of-sexes game has two nonequivalent Nash equilibria.
Repeated games and reputation
An isoprofit curve of a firm is the combinations of outputs of
firms that give a firm the same level of profit.
A best response function is the profit maximizing output choices of
a firm at various output levels of the other firms.
Cournot-Nash duopoly equilibrium: incentive compatibility
individual rationality
Instability of cartels
Information asymmetry: adverse selection and moral hazard
Section VI: The study of input market and intermediate good market
Part 17: The demand and supply of labor
(16.1, 16.6, 17.1, 17.2)
The value marginal product of an input is the competitive price
of a product times the marginal product of the input.
The average revenue product of an input is the average revenue
of a product times the average product of an input.
Economics 310
Handout 9
Professor Tom K. Lee
Profit maximizing input choice conditions for a competitive firm:
-input price equals value marginal product of the input
-value marginal product of the input is declining
-maximum average revenue product is no less than input price
The marginal revenue product of an input is the marginal revenue of
a product times the marginal product of an input.
Profit maximizing input choice conditions for a monopolist:
-input price equals marginal revenue product of the input
-marginal revenue product is declining
-average revenue product is no less than input price
Income-leisure tradeoff and backward bending labor supply curve
Part 18: Other forms of market structure of the labor market
(16.7, 17.6)
Monopsony is a one price setting buyer but many price taking
sellers market.
Monopsonist has no demand curve.
Labor union as -workers' welfare maximizer
-union due maximizer
-membership maximizer
Part 19: The market for intermediate goods and transfer pricing
Transfer pricing is the pricing of an intermediate good by
one division of a firm to another division of the firm.
Transfer pricing with no intermediate good market
Transfer pricing with a competitive intermediate good market
Section VII: General equilibrium analysis
Part 20: General equilibrium of an exchange economy
(19.1, 6.1-6.3)
Exchange economy & Edgeworth exchange box
Consumption contract curve is the combinations of consumption
points where the marginal rates of substitution of the two
consumers are equal.
Pareto optimality is the condition where one cannot increase the
well being of one individual in an economy without hurting the
well being of another individual in the economy.
Offer curve is the combinations of utility maximizing consumption
choices at various price levels for a given endowment point.
The First Fundamental Welfare Theorem states that every general
competitive equilibrium is Pareto efficient.
The Second Fundamental Welfare Theorem states that every Pareto
efficient outcome can be achieved by income redistribution
followed by a competitive market process.
Pure monopoly vs discriminating monopoly in an exchange economy
Economics 310
Handout 10
Professor Tom K. Lee
Part 21: General equilibrium of a production economy
(19.2-19.5, 19.7)
Edgeworth production box
Production contract curve is the combinations of input choices
where the marginal rates of technical substitution for the two
products are equal.
Production possibility frontier is the combinations of products
that an economy can produce when it uses all its resources
efficiently.
Marginal rate of transformation is the reduction in the output of
one product when there is an increase in output of another
product while using all resources efficiently.
Gains from international trade:
-the case of differences in technology
-the case of differences in taste
Efficiency conditions for general competitive equilibrium
-equality of marginal rate of technical substitution across
products
-equality of marginal rate of substitution across consumers
-marginal rate of transformation equals relative prices
General equilibrium with product market monopoly
General equilibrium with input market monopoly
Section VIII: Miscellaneous topics of economics
Part 22: Public goods and demand revelation
(20.1-20.2)
Pure public goods -nonrivalry in consumption
-nonexclusion
Excludable public goods e.g. membership social clubs
The free-rider problem occurs in the provision of a pure public
good where each consumer has an incentive not to buy the pure
public good in hope that the other consumers would buy it so as
to free ride on their consumption of the pure public good, but
then no consumer would buy the pure public good leading to
underprovision of the pure public good.
Vertical summation of the demand curves for a pure public good
Demand-revelation mechanism is the process through which truthful
information on the demand of a public good would be voluntarily
revealed by the consumers.
Groves-Ledyard mechanism is an example of demand revelation
mechanisms where each buyer's contribution to the payment of
a public good is dependent only on the information supplied
by the other buyers on their demand for the public good.
Economics 310
Handout 11
Professor Tom K. Lee
Part 23: Externality, common property and Coase Theorem
(20.3-20.4)
Externality is the situation where the act of consumption or
production of one individual affects the well being of another
individual.
Positive externality and excise subsidy
Negative externality and excise tax
Tax vs quota in negative externality
Marketable pollution license
Property rights -rights of ownership
-right to use
The common-property problem arises when property rights are
allocated on a first-come first-serve basis, leading to
excessive usage of the resource.
The Coase Theorem states that if property rights are well defined
and enforced, and there are no transaction costs, then no matter
how property rights are allocated the outcome would be
efficient.