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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.