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ECN 212
Microeconomic Principles
Final Exam Guide
Economics is about (^) deciding how to use limited resources to satisfy unlimited needs (always want more) (^) how people make decisions (^) study of how people interact with one another Scarcity: the limited nature of society’s resources Resources: land, labor, capital, time, entrepreneurship Macroeconomics: study of economy-wide phenomena including inflation, unemployment, economic growth (^) studies the forces and trends that affect the economy as a whole Microeconomics: the study of how households and firms make decisions and how they interact in specific markets (more focused on individual’s decisions) (^) branch of economics that most closely relates to our everyday lives (^) how people make decisions what they buy, how much they work, how they trade (^) how people interact with each other how buyers and sellers determine price and quantity of a good or service -- candy break -- Basic Concepts: (^) Rational Behavior o (^) Rational people ▪ systematically and purposefully do the best they can to achieve their objectives ▪ only take action if benefits > costs (^) Thinking on the margin (rational people) o (^) To change behavior a little bit (up/down) based on your self interest o (^) e.g. driving on the freeway o (^) marginal change: describe a small incremental adjustment to an existing plan of action (one thing at a time; make minimal changes in behavior to
see if benefits go up/down) o (^) make decisions by comparing marginal benefits and marginal costs (marginal benefit < / = / > marginal cost) (^) Trade offs o (^) What you have to give up in order to get something else o (^) E.g. tradeoffs (choices) for attending class (^) Opportunity Costs : o (^) Making decisions requires comparing the costs and benefits of alternative choices o (^) of any item is whatever must be given up to obtain it
o (^) Movement along the demand curve (^) Shift (Change) in Demand Curve o (^) Positive Change: at same price quantity demanded is higher o (^) Negative Change: at same price quantity is lower 1 / 25 / 24 Demand cont… What changes demand? (^) Changes in Income: depending on the type of good, the demand will shift up(+)/ down(-) o (^) Normal good: a good for which demand increases when income increases (e.g. house, car, better food) ▪ As income goes up, demand increases o (^) Inferior good: good for which demand decreases when income increases (e.g. Ramen noodles, night out at McDonald’s) ▪ As income goes up, demand decreases (^) Changes in Population (# of buyers): different generations, migration of new populations o (^) As the population increases (decreases), the demand will shift up (down) directly proportional; positive change (+) (e.g. baby boomers increased demand for nursing homes) (^) Changes in Tastes: as tastes change, demand shifts o (^) E.g. organic oranges demand more (shift right) positive change (+) coke & lots of calories are bad (shift left) negative change (-) (^) Changes in Expectations: as the expectations change so does the demand (prep for what you expect will happen) o (^) E.g. fruit; rumor Chile will break with US buy more (shift right) (+) iPhone; rumor that Apple will release new iPhone buy less (left) (-) (^) Changes in Prices of Related Goods: not price of good o (^) Substitute goods: goods that are similar for the consumer (e.g. types of cereal; coke and pepsi; BMW and Mercedes) ▪ when price of substitute good B decreases, demand of good A decreases (e.g. burger king price goes down McDonald’s demand goes down; movement along curve for BK, does not affect BK demand) *good A price directly related to good B demand o (^) Complement goods: things that go well together (e.g. burgers/hot dogs and buns, printer and ink)
▪ when price of good A goes down, demand for good B goes up (e.g. price of printers decreases, demand for ink increases) *good A price inversely proportional to good B demand) (e.g. decrease in demand shift of whole demand curve left movement upward and left along demand curve rise in prices) 1 / 27 / 24 *in class number chosen: 3 Supply: function that shows the quantity supplied at different prices (^) Quantity supplied: quantity that sellers are willing and able to sell at a particular price (^) Horizontal Reading: at a price of $P1 per car, suppliers are willing to sell Qs million of cars (^) Vertical Reading: to produce Qs1 cars, suppliers must be paid at least $P (^) Law of Supply: at the price of a good or service goes up (down) the quantity supplied for that good or service goes up (down) directly related (increase in price = increase in quantity supplied) o (^) *Note: supply curve (function) Si does not change as the price changes, only the quantity supplied changes! o (^) Movement along supply curve o (^) e.g. Starbucks Supply Schedule (& Curve) Y: Price of lattes ($) X: Quantity of lattes supplied (starbucks) (Peet’s) Qs^ = quantity supplied (market) 0.00 0 0 0 1.00 3 2 5 2.00 6 4 10 3.00 9 6 15 4.00 12 8 20 5.00 15 10 25 6.00 18 12 30 o (^) add another supplier (3rd^ column) o (^) Market Supply vs. Individual Supply ▪ Quantity supplied in market is sum of quantities supplied by all sellers at each price
(^) Negative change : if a tax is imposed by the government on the seller, the sellers will be willing to sell less of their products at the same prices (inversely related) (^) Subsidy: form of financial aid or support extended to an institution, business, or individual (^) Positive change: if a subsidy is offered by the gov’t to the seller, the sellers will be willing to sell more of their products at the same price (directly related) o (^) Entry or exit of producers ▪ When there are more sellers producing a good, the supply of the good increases positive change: when Samsung followed Apple with the production of smart phones, the supply for smart phones went up o (^) Changes in opportunity costs ▪ Opportunity cost: value of the next highest valued alternative or the forgone cost ▪ e.g. producers might decide to produce one product over another (wheat vs. soybean, LX vs. LS cars, iPads vs. iPhones) ▪ negative change:
- a farmer can grow either soybeans or wheat
- the farmer is currently growing soybeans
- the price of wheat increases (now want to produce wheat, less soybeans)
- the farmer’s opportunity cost of growing soybean increases o (^) Expectations ▪ Change behavior today because expect something tomorrow ▪ Events in the middle east lead to expectations of higher oil prices ▪ In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price ▪ e.g.
- A rightward shift of a supply curve is called a A. increase in supply
- Lead is an important input in the production of crystal. If the price of lead decreases, then we would expect the supply of C. crystal to increase
- Suppose there is a decrease in the price of corn. If corn is an input into the production of ethanol, we would want expect the supply curve for ethanol to A. shift rightward (more supply) 2 / 1 / 24 Equilibrium
Market equilibrium is reached when quantity demanded = quantity supplied (^) Equilibrium price: price that equates quantity supplied with quantity demanded (^) Equilibrium quantity: the quantity supplied and demanded at the equilibrium price Dis-Equilibrium: (^) Surplus: (excess supply) when quantity supplied > quantity demanded (Qs > Qd) o (^) Above equilibrium o (^) e.g. Sales in stores o (^) e.g. If P=$5, Qd = 9 lattes, Qs = 25 lattes ➔ surplus = Qs – Qd = 16 lattes o (^) facing a surplus, sellers try to increase sales by cutting prices causes Qd to rise and Qs to fall (^) Shortage: (excess demand) when quantity demanded > quantity supplied (Qd > Qs) o (^) Below equilibrium; more people than product o (^) Prices start going up, more people willing and able to buy equilibrium (movement along quantity demanded and quantity supplied curves) o (^) Facing a shortage, sellers raise the price, causing Qd to fall and Qs to rise Changes in Equilibrium (^) When the demand curve and/or the supply curve shifts, so does the market equilibrium o (^) e.g. Market of Books ▪ PE1+^ QE1 =^ A ▪ Positive shift in demand curve shortage raise prices movement along D & S until new equilibrium (B) is reached ▪ PE2+^ QE2 = B ▪ Positive shift in supply curve surplus lower prices movement along D & S until new equilibrium (C) is reached ▪ PE3+^ QE3 = C (^) Three Steps to Analyzing Changes in Equilibrium
Which buyers consume the good? (^) The buyers who value the good most highly are the ones who consume it every buyer whose WTP (willingness to pay) is >/= to equilibrium price will buy Which sellers produce the good? (^) The sellers with the lowest cost produce the good every seller whose cost is </= to equilibrium price will produce the good Does Equilibrium Q maximize PS and CS? (^) At Q =20, cost of producing the marginal unit is $ value to consumers of the marginal unit is only $ we can reduce the waste by reducing Q (^) This is true at any Q greater than 15 Does Equilibrium Q Maximize PS and CS? (^) At Q =10, cost of producing the marginal unit is $ value to consumers of the marginal unit is only $ CS + PS can increase by increasing Q (^) This is true at any Q less than 15 Does Equilibrium Q Maximize Total Surplus? (^) The market equilibrium quantity maximizes total surplus : At any other quantity, can increase total surplus by moving toward the market equilibrium quantity Elasticity Review for Elasticity: (^) Percentage Change: measure of how much a variable (P) changes in % end value P – start value P * 100 start value P o (^) e.g. What is the % change of P if it moves from A (15) to B (10) (15 – 10) / 15 * 100 from B to A (10 – 15) / 10 * o (^) A to B is different from B to A (changes depending on where you start) (B-A)/A * 100 =/= (A-B)/B * 100 2 / 8 / 24 Elasticity cont…
Midpoint Method (Average): end value P – start value P * 100 Midpoint Price Elasticity of Demand (^) How much quantity demanded (or supplied) changes when price changes? How price sensitive are buyers? (^) e.g. if the price of a cruise goes up, quantity demanded changes a lot (won’t buy) more Elastic (flatter curve) (^) e.g. if the price for a drug like insulin goes up, quantity demanded changes little (still need to buy life-saving drug) more Inelastic (steeper curve) (^) By law of demand along a D curve, P and Q move in opposite directions (inverse) price elasticity is negative (use absolute value of solution for class) (^) How responsive the quantity demanded (Qd) is to a change in price (P) can be calculated by the ratio of the % change in Qd over the % change in P (^) Note: percentage change = end value – start value * 100 Midpoint (^) We do not use the standard method to calculate percentage changes; we use the absolute value of the calculation (^) Unitary : percent change in Qd = percent change in P (^) The variety of demand curves o (^) The price elasticity of demand is closely related to the slope of the demand curve o (^) Rule of Thumb: the flatter the curve, the bigger the elasticity; the steeper the curve, the smaller the elasticity o (^) Five different classifications of D curves:
- “ Perfectly Inelastic Demand ”: P falls 10%, Q changes 0% (one extreme case) D curve: vertical Consumer’s price sensitivity: none Elasticity: 0
- “ Inelastic^ Demand ”: P^ falls 10%,^ Q rises^ less than^ 10% D curve: relatively steep Consumer’s price sensitivity: relatively low Elasticity: < 1
o (^) Elasticity is a measure of how much buyers and sellers respond to changes in market conditions o (^) When studying how some event or policy affects a market elasticity provides information on the magnitude of the effect on the market o (^) Demand is said to be price elastic if buyers respond substantially to changes in the price of the good o (^) Demand is elastic if the price elasticity of demand is greater than 1 o (^) Which is not a determinant of the price of elasticity of demand for a good? steepness / flatness of the supply curve for good o (^) Which is likely to have the most price elastic demand? diamond earrings (luxury) 2 / 10 / 24 Elasticity cont… Price Elasticity and Total Revenue Total Revenue: the firm’s total sales of a product (^) selling price of the firm’s product * quantity sold ( R = P * Q ) (^) Important because, if you have a business total revenue will determine how much money you make by selling your product (^) As price increases, 2 effects on revenue: o (^) Higher P more revenue on each unit you sell o (^) But you sell fewer units (lower Q), due to law of demand Elastic Demand (^) % Change in Qd > % Change in P elastic (^) Revenue at Point E1 is P1Q (^) Price goes up Revenue at Point E2 is P2Q (^) Revenue at point E1 > E2 Revenue goes down Unitary Demand (^) % Change in Qd = % Change in P unit elastic (^) Revenue at Point E1 is P1Q (^) Price goes up Revenue at Point E2 is P2Q (^) Revenue at point E1 = E2 Revenue does not change Inelastic Demand (^) % Change in Qd < % Change in P inelastic (^) Revenue at Point E1 is P1Q (^) Price goes up Revenue at Point E2 is P2Q (^) Revenue at point E1 > E2 Revenue goes up
e.g. (^) Design websites for local businesses, charge $200 per website, currently sell 12 websites per month o (^) Costs are rising consider rising price to $250 (law of demand says that you wont sell as many websites if you raise your price); how many fewer websites? How much will your revenue fall, or might it increase? o (^) R1 = 200 * 12 = $2400 /mo o (^) R2 = 250 * 8 = $2000 /mo o (^) Revenue falls, elastic (^) Pharmacies raise the price of insulin by 10%. Does insulin’s total revenue rise or fall? o (^) Insulin: necessity inelastic price & revenue are directly proportional rise in price revenue rises (^) As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies’ total revenue rise or fall? o (^) Luxury elastic price and revenue are inversely related price falls revenue rises Other Elasticities (^) Income Elasticity of Demand: measure response of Qd to a change in consumer income (normal vs. inferior goods) o (^) For normal goods (directly related income & Qd), income elasticity > 0 o (^) For inferior goods (inversely related income & Qd), income elasticity < 0 (^) Cross-Price Elasticity of Demand: measures response of demand for one good to changes in price of another good o (^) For substitutes (e.g. cereal types, Price of A increases, Qd of B increases), cross-price elasticity > 0 o (^) For complements (e.g. racket & ball, P of A increases, Qd of B decreases), cross-price elasticity < 0 e.g.
Consumer Choice Budget Constraint: as the consumption of one good moves up, consumption of the other moves down CPC + FPF = B** (How much spend on clothes + how much spend on food) B = Budget C = Quantity of Clothes F = Quantity of Food P C = Price of Clothes P F = Price of Food (^) Shows the possible combinations of different goods he/she can buy given his/her income and the prices of the goods (^) e.g. John’s income is $1200, Price: P F = $4 per Food, P C = $1 per Cloth A. If John spends all his income on food, how many Food does he buy? 1200 = FPF 1200 = F($4) F = 300 foods If John spends all his income on Clothes, how many Clothes does he buy? 1200 = CPc 1200 = C($1) C = 1200 clothes If John buys 100 Food, how many Clothes can he buy? 1200 = C($1) + (100)($4) C = 3 clothes Plot each of the bundles from parts A-C on a graph that measures Food on the x-axis and Clothes on the y-axis. Connect the dots B. If his income falls to $ 800 = FPF 1200 = F($4) F = 200 foods C. Keep^ income^ at^ $1200, the^ price^ of^ Clothes rises^ to^ Pc =^ $2^ per^ clothes Preferences: What the consumer wants (^) Indifference curve: shows consumption bundles that give the consumer the same level of satisfaction
- Downward Sloping
- Higher^ indifference^ curves^ are^ preferred^ to^ lower^ ones
- Cannot^ cross
- Bowed inward
(^) Marginal Rate of Substitution : Slope of indifference curve; rate at which a consumer is willing to trade one good for another (^) Perfect Substitutes: two goods with straight-line indifference curves, constant MRS (not very bowed) o (^) e.g. nickels and dimes consumer is always willing to trade 2 nickels for 1 dime (^) Perfect Complement: two goods with right-angle indifference curves (very bowed) o (^) e.g. left shoes, right shoes (7 left, 5 right is just as good as 5 left, 7 right) (^) Optimization: the point on the budget constraint that touches the highest possible indifference curve 2 / 15 / 24 Consumer Choice cont… Optimization: What the consumer chooses (^) At the optimum equilibrium: MRS = PF/PC (Slope of indifference curve = slope of budget constraint) (^) e.g. A is the optimum, consumer buying 600 clothes and 150 food with $ What is the price of Clothes goes up from $1 to $1? Budget constraint pivots inward and a new optimum is achieved in B quantity demanded for Clothes goes down as its price goes up (^) As price of a good goes down, quantity demanded goes up (^) Need price to change to determine change in demand of a good (^) The Effects of an Increase in Income o (^) Increase in income, shifts the budget constraint outward (does not change the shape of the curve) o (^) If normal good, buy more of that good o (^) e.g. Inferior vs. Normal Goods ▪ An increase in income increases the quantity demanded of^ normal goods and reduces the quantity demanded of inferior goods ▪ Suppose food is a normal good but clothes are an inferior good ▪ Use^ a^ diagram^ to^ show^ the^ effects^ of^ an^ increase^ in^ income^ on John’s optimal bundle of Food and Clothes o (^) e.g. PF=$4, PC=$ PF falls to $2 budget constraint rotates outward buys more food, fewer clothes (^) A fall in the price of Food has 2 effects on John’s optimal consumption of both goods: o (^) Income Effect: A fall in PF boosts the purchasing power of income, allows him to buy more clothes and more food (feel richer, going to spend more than usual)
o (^) Why MPL is important: ▪ When hire extra worker costs rise by the wage we pay the worker output rises by MPL ▪ Comparing them helps us decide whether we should hire one more worker (rational people think at the margin) Total Revenue, Total Cost, Profit (^) Goal: Maximize profit Profit = Total Revenue – Total Cost o (^) Total revenue: amount a firm receives from the sale of its outputs o (^) Total cost: market value of the inputs a firm uses in production Profit/Loss = (P * Q) – (Capital Costs + Labor Costs) = (Total Revenue) – (Total Cost) (^) e.g. 2 / 29 / 24 Costs Explicit vs. Implicit (^) Explicit costs require an outlay of money o (^) e.g. paying wages to workers (^) Implicit costs do not require a cash outlay o (^) The opportunity cost of the owner’s time (^) Matter for firms’ decisions (^) e.g. need $100,000 to start our business; interest rate is 5% o (^) borrow $100, explicit cost = $5,000 interest on loan o (^) borrow $60,000 use $40,000 of your savings explicit cost = $3,000 (5%) interest on the loan
implicit cost = $2,000 (5%) foregone interest you could have earned on your $40, o (^) in both cases, total (exp+imp) costs are $5, Economic vs. Accounting Profit (^) Accounting Profit (AP) : = Total Revenue – Explicit Costs (^) Economic Profit (EP): = Total Revenue – (Explicit Plus Implicit Costs) (^) Economic profit will never exceed accounting profit (^) e.g. the rent on office space has just increased by $500/month o (^) you rent your office space: ▪ Explicit costs increase by $500/mo ▪ AP & EP each fall by $500/mo o (^) you own your office space ▪ Explicit costs do not change AP does not change ▪ Implicit costs increase $500/mo EP falls by $500/mo Fixed & Variable Costs (^) Total Cost (TC) : FC + VC (^) Fixed Costs (FC) do not vary with the quantity of output purchased (^) Variable Costs (VC) vary with the quantity produced Average Total Cost (ATC) is the cost per unit (^) ATC = TC / Q Q = quantity of output (^) ATC = AFC + AVC o (^) AVC = ATC - AFC o (^) VC = (ATC-AFC)Q or = (AVC)*Q *AFC: average fixed cost (^) Generally u-shaped curve *AVC: average variable cost (^) As Q rises: o (^) Initially, falling AFC pulls ATC down o (^) Eventually, rising AVC pulls ATC up o (^) Efficient Scale: quantity that minimizes ATC Marginal Cost (^) Marginal Cost (MC) is the increase in Total Cost (TC) from producing one more unit of output (Q): MC = ∆TC / ∆ Q (^) e.g. I: AVC II: ATC III: MC o (^) TFC @ output Y ▪ AFC = C-E
