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Section 1: Basic Economic Concepts
Basic Terms Economics - the study of scarcity and choice Individual Choice - decisions by individuals about what to do and what not to do. Economy - system that coordinates choices about production with choices about consumption, and distributes goods and services to the people who want them. ● Market Economy - production and consumption are the result of decentralized decisions by many firms and individuals, no central authority telling people what to produce or where to ship it ○ Can change prices ● Command Economy - publicly owned and there is a central authority making production and consumption decisions ○ Lack of incentives ● Property Rights - establish ownership and grant individuals the right to trade goods and services with each other ● Marginal Analysis ○ Marginal Decisions - decisions of what to do with the next opportunity ○ Marginal Benefit - gain from doing something one more time ○ Marginal Cost - cost of doing something one more time ○ If MB>MC, activity should continue ● Resource - anything that can be used to produce something else, can be scarce ○ Land - resources that come from nature ○ Labor - effort of workers ○ Capital - manufactured goods used to make other goods/services ○ Entrepreneurship - efforts of entrepreneurs in organizing resources for production ● Opportunity Cost : value of what you give up when you make a choice ● Positive Economics - branch of economic analysis that describes way economy actually works ● Normative Economics - makes prescriptions about the way economy should work Trade-Offs - occur when you give up something in order to have something else ● Production Possibilities Curve - illustrates the trade-offs facing economy , produces only two goods, shows max quantity of one good that can be produced for each possible quantity of the other good produced ○ Inside - feasible ○ Outside - not feasible
○ On - feasible and productively efficient ○ Straight line - constant OC ○ Curved - increasing OC Efficiency ● Productive Efficiency - produces at a point on its productive possibilities curve ● Allocative Efficiency - produces at point along the curve that makes consumers as well off as possible ● Bowed out shape - reflects increasing opportunity cost ● Economic Growth results in an outward shift when production possibilities are expanded. The economy can now produce more of everything. ○ Increase in resources used to produce good and services (land labor capital entrepreneurship) ○ Technology Comparative Advantage and Trade ● Gains from trade - dividing tasks, people can get more of what they want through trade than they could if they tried to be self-sufficient. ○ Arise from specialization: each person specializes in the task that he/she is good at performing ● Comparative Advantage - if the OC of that production is lower compared to that of others ● Absolute Advantage - if a person can make more of it given a certain amt of time and resources ● Terms of Trade - rate at which one good can be exchanged with another ● Producers with the absolute advantage can produce the largest quantity of the good. It is the producer with the comparative advantage who should specialize in production of the good to achieve mutual gains from trade. ● Calculating OC: ○ What you gain / what you give ● Everyone has a comparative advantage in something
Supply: ● Supply schedule - shows how much of a good or service producers would supply at different prices. ● Quantity Supplied (QS) - the actual amount of good people are willing to sell at some specific price. ● Supply curve - shows the relationship between the quantity supplied and the price. ● Law of supply - the price and QS of a good are positively related. ● Change in supply - change in the QS at any given price represented by shift of curve left or right ● Movement along the supply curve - changes in QS of good because of price change. ● Factors that shift supply curve: ○ Change in input price ■ Input is any good or service that is used to produce another good or service.The quantity of any one good seller is willing to supply at any given price depends on the prices of its other co- produced goods. ■ When the price of input falls, supply increases. ○ Change in the price of similar goods ■ When price of substitute falls, supply shifts right ■ When price of complement rises, supply shifts left ○ Change in technology ○ Change in expectations ■ When the price is expected to fall in the future, supply increases today. ○ Change in number of producers ■ When the number of producers rises, supply shifts right. ● Individual supply curve - relationship between QS and price for an individual producer Equilibrium ● Equilibrium - when no individual would be better off doing something different. ● Equilibrium Price/market-clearing price - when QS = QD ● Equilibrium Quantity - quantity bought and sold at equilibrium price ● Surplus of a good when the QS > QD ○ When the price is above its equilibrium level. ● Shortage - of a good when the QS < QD ○ When the price is below its equilibrium level. ● Market price always moves toward the equilibrium price, the price at which there is neither surplus nor shortage.
● Demand for a good increases → the equilibrium price & quantity of the good rise. Price Quantity Supply ↑ Price ↓ Q ↑ Supply ↓ Price ↑ Q ↓ Demand ↑ Price ↑ Q ↑ Demand ↓ Price ↓ Q ↓ Price Control ● Price controls - legal restrictions on how high or low a market price may go. ● Price ceiling - a maximum price sellers are allowed to charge for a good ○ Reduce in the quantity of goods supplied and increase in the quantity demanded ○ Price ceiling above Equilibrium does nothing ○ Inefficiencies: ■ Often lead to inefficient allocation to consumers ● people who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a relatively low price do get it ■ Wasted Resources: people expend money, effort, and time to cope (Opportunity Cost) with the shortages. ■ Inefficiently low quality: sellers offer low quality goods at the price control price even though buyers would prefer a higher quality at a higher price. ■ Black market - goods are bought and sold illegally because the prices charged are legally prohibited by a price ceiling. ● Price floor - a minimum price buyers are required to pay for a good ○ Increase in the quantity of goods supplied and decrease in the quantity demanded ○ Price floor below Equilibrium does nothing ○ Government deals with unwanted surplus ○ Inefficiencies: ■ Inefficiently Low Quantity: raises the price of a good to consumers, it reduces the quantity of that good demanded; because sellers can’t sell more units of a good than buyers are willing to buy, a price floor reduces the quantity of a good bought and sold below the market equilibrium quantity. ■ Inefficient Allocation of Sales Among Sellers: those who would be willing to sell the goods at the lowest price are not always those who manage to sell it.
● Demand Price - Supply price = Quota Rent = market price of license when licenses are traded ○ Decrease in demand would decrease effect quota has on quantity sold in a market ● Deadweight Loss - value of forgone mutually beneficial transactions ○ Because some mutually beneficial transactions don’t occur ○ Occurs when market is not perfectly competitive ■ Price is greater and quantity is lower than in perfectly competitive market
Section 3 : Behind the Demand Curve: Elasticity & Utility
Income + Substitution Effects ● Substitution Effect - change in quantity demanded as the good that has become cheaper is substituted for the good that’s expensive ○ Comes from a change in price of one good relative to another good ● Income Effect - change in price of a good is the change in quantity of that good demanded that results from change in purchasing power of consumer’s income when price of good changes ○ When prices fall, consumers can afford to buy more of a particular good or service. ○ Comes from a change in purchasing power ■ Which can result from a change in one/more prices or from a change in actual income received ● Normal Goods - income effect usually reinforces substitution effect ● Inferior Goods - income effect and substitution effect work in opposite directions ○ Substitution effect decreases quantity of any good demanded as its [rice increases ○ Income effect of a price increase for inferior good is an increase in the quantity demanded Elasticity ● Elasticity - responsiveness of one variable to changes in another ● Price Elasticity of Demand - compares percent change in quantity demanded to percent change in price ○ % Change in Qty Demanded = (Change in quantity demanded / Initial Quantity Demanded) * 100 ○ % Change in Price = (Change in price / Initial Price) * 100 ○ PED = %Change in Qty Demanded ➗ %Change in Price ○ Price and Qty demanded move in opposite directions due to Law of Demand sloping downwards ■ Positive % Change in Price leads to Negative % Change in Qty Demanded
■ Negative % Change in Price leads to Positive % Change in Qty Demanded ○ USE ABSOLUTE VALUE even though PED is a negative number ○ When PED is large - demand is highly elastic ○ MidPoint method - (Change in X ➗ Average Value of X) * 100 ■ Average Value of X - (Starting Value of X + Final Value of X) / 2 Interpreting PED ● Demand is perfectly inelastic when Qty Demanded does not respond at all to changes in price. ○ When demand is perfectly inelastic, the demand curve is a vertical line. ● Demand is perfectly elastic when any price increase will cause qty demanded to drop to 0 ○ When demand is perfectly elastic, the demand curve is horizontal. ● Demand is elastic when PED> ● Demand is inelastic when PED< ● Demand is unit-elastic when PED= ● Total Revenue = total value if sales of a good or service. ○ Price * quantity ● Effects ○ Price Effect - after a price increase, each unit sold sells at a higher price, which tends to raise revenue ○ Quantity Effect - after a price increase, fewer units are old, which tends to lower revenue ■ If TR does not change when price changes, good is unit-elastic. ■ If Demand for a good is unit elastic, an increase in price does not change TR, quantity and price effect offset each other ■ If Demand for a good is inelastic, higher price increases total revenue, price effect stronger than quantity effect ■ If demand for a good is elastic, increase in price reduces total revenue. Quantity effect stronger than price effect ○ If TR and Price move in same direction, good is inelastic ○ If TR and Price move in opposite directions, good is elastic. ● Upper left segment of demand curve is elastic and bottom right segment is inelastic ● PED Factors ○ S ubstitutes : PED is high when there are similar substitutes. ○ P roportion of Income - PEd is low when cost uses less share of a consumer’s income ○ L uxury or Necessity - PED is low if the good is necessary ○ A ddictive/Habit Forming - PED is low when good is something that is addictive ○ T ime - PED is high when consumers have more time to adjust to a price change
Consumer and Producer Surplus ● Willingness to Pay - max price at which he or she would buy that good ● Individual Consumer Surplus - net gain to an individual buyer from purchase of a good. ○ WTP - Price ● Total COnsumer Surplus - sum of individual consumer surpluses of all buters of a good in a market ○ = Area below demand curve but above price ● Producer Surplus - net gain to individual seller from selling a good ● Total Producer Surplus - sum of individual producer surpluses of all sellers of a good in a market ○ Bounded by supply curve, price line and vertical axis ○ Area above supply curve but below price ○ Fall in price results in reduction in producer surplus equal to the sum of the shaded areas - decrease in the area above supply curve but below price. ○ Increase in supply lowers equil. price and causes consumer surplus to increase ○ Decrease in demand decreases equil. Price and causes producer surplus to decrease. Taxes + DWL + Efficiency ● Total surplus = total net gain to consumers and producers from trading in a market. ○ Sum of producer and consumer surplus ● A market is efficient if, once market has established gains from trade, there is no way to make some people better off w/out making others worse off ● Anything that prevents the sale of a unit that would have occurred in market equilibrium reduces total surplus ● How to Maintain Efficiency: ○ Reallocation of Consumption among Consumers ■ Reduces consumer surplus. ■ Reallocating good among consumers always means taking good away from person who values it more to one who values it less
○ Reallocation of Sales among Sellers ■ Reduces producer surplus. ■ Any consumer who sells good at an equilibrium price has a lower cost than any other consumer who keeps the good. Increases total cost. ○ Changes in the Quantity Traded ■ Prevent transaction that would have occurred in market equilibrium ■ Reduces total surplus ● An Efficient Market : ○ Allocates consumption of the good to potential buyers who most vale it, as indicated by higher willingness to pay ○ Allocates sales to potential sellers who most value the right to sell the good, as indicated by lower cost ○ Ensures every consumer who makes a purchases values the good more than every seller who makes a sale, so that all transactions are mutually beneficial ○ Ensures every potential buyer who doesn't make a purchase values the good less than every potential seller who doesn't make a sale, so that no mutually beneficial transactions are missed. ● Progressive Tax - a tax that rises more than in proportion to income ○ High-income taxpayers pay a larger percentage of their income ● Regressive Tax - a tax that rises less in proportion to income ○ High-income taxpayers pay a smaller percentage of their income ● Proportional Tax - rises in proportion to income ● Excise Tax - a tax on sales of a particular good or service ○ Post-tax supply shifts up by the amount of the tax compared to the pre-tax supply curve ○ Drives a wedge between price paid by consumers and the price received by producers ■ Consumers pay more and producers receive less ■ Generally increases equilibrium price and decreases equilibrium quantity ■ Tax imposed on Consumers - demand shifts downwards ■ Tax imposed on producers - supply shifts upward ● Incidence of a tax - measure of who pays it ○ Depends on PES and PED ○ When an Excise Tax is paid mainly by consumers: ■ When PED is low and PES is high ■ PED>PES ○ When an Excise Tax is paid mainly by producers: ■ When PED is high and PES is low ■ PES>PED
Utility Maximization ● Utility of a consumer = measure of personal satisfaction ● Marginal Utility = additional utility generated by consuming one more unit of the good or service. ● Principle of diminishing marginal utility = consumption of another unit yields less additional utility than the previous unit. ○ MU curve slopes downwards ○ TU= add up previous marginal utilities ● Budget Constraint = limits consumer’s spending to no more than his/her income ○ Defines consumer’s consumption possibilities ■ Set of all affordable consumption bundles
■ A consumer who spends all of his/her income will choose a consumption bundle on the budget line ■ MUx/Px = MUy/Py ■ A consumer chooses the consumption bundle that maximizes total utility = the optimal consumption bundle. ● We use marginal analysis to find the optimal consumption bundle by analyzing how to allocate the marginal dollar. ○ MU spent on each good (MU of a good divided by price) = same.
Section 4: Production, Costs, and Perfect Competition
Defining Profit ● Total Revenue - Total Cost ● Explicit Costs - cost that involves actually laying out money
● Diminishing Returns to Input - when increase in qty of input, holding all other levels fixed, leads to decline in MP of input Firm Costs ● Fixed Costs : Cost that does not depend on qty of output produced ○ Cost of fixed input ● Variable Costs : cost that depends on qty of output produced ○ Cost of variable input ● Total Costs : FC + VC ○ Total cost curve : total cost vs qty of output ● Marginal Cost : Change in TC / Change in Qty ○ Slope of total cost curve ● ATC = TC/Q ○ U-shaped ATC falls at low levels of output and rises at higher levels ■ Spreading Effect - larger output → greater output across which FC is spread, leading to lower AFC ■ Diminishing Return Effect - larger output → greater variable input required to produce additional units, leading to higher AVC ● AFC = FC/Q ● AVC = VC/Q
● Minimum-Cost Output - qty of output at which ATC is lowest - if corresponds to bottom of U-SHaped ATC ○ Minimum-cost output : atc = mc ○ If output less than Minimum-Cost Output: MC<ATC and ATC is falling ○ If output more than minimum-cost output: MC>ATC and ATC is rising ● MC curve intersects AVC and ATC curve at lowest point ● A realistic marginal cost curve has a swoosh shape (U shape). MC often falls as firm increases output ○ Hiring additional workers allows greater specialization and leads to increasing returns ○ Diminishing returns to workers set in and MC rises ● Average Product - TP / QTy of input ○ Mp curve intersects AP curve at max point ● Average Product Curve - Average Product vs. Qty of input Long-Run Costs and Economies of Scale ● In the long run → a firm’s fixed cost becomes a variable it can choose. ○ long-run average total cost curve, or LRATC, - output vs ATC when fixed cost has been chosen to minimize average total cost for each level of output ■ If there are many possible choices of fixed cost, the long-run average total cost curve will have smooth U shape ● A company that has to increase output suddenly to meet demand surge will find that ATC rises sharply in short-run because
Section 5: Perfect Competition
● Price-Taking Firm → firm whose actions have no effect on market price ● Demand curve horizontal line at market price ○ Demand curve of MARKET downward sloping but demand curve of FIRM horizontal ● Many Firms - none of whom have a large market share ○ Market Share - fraction of total industry output accounted for by that firm’s output ● Standardized product → commodity → consumers regard products of different firms as the same good ● Free entry and exit ○ Perfectly competitive firm has small market share because it is easy for competing firms to enter the industry ● Price-taking firm optimal output rule : Price = MC ○ ALLOCATIVELY EFFICIENT ■ Exact amount of product is being produced to meet society’s desires ○ PRODUCTIVE EFFICIENCY ■ Lowest possible cost using fewest possible resources ● MR=D=AR=P ● A firm may produce positive Accounting profit even if economic profit is zero or negative. Firm’s decision should be based on Economic Profit
○ Whether market p ○ Price is more or less than Minimum ATC ● If TR>TC → profitable ● If TR = TC → breaks even ● If TR<TC → loss OR ● Profit/Q = TR/Q - TC/Q ● If P>ATC = profitable ● If P=ATC → breaks even ● If P<ATc → loss ● If P<AVC - shutdown point ● If p>=AVC - continue production Long Run equilibrium
- P=MR , price takers
- P = MC, allocatively efficient q
- P = min ATC , productively efficient
- Normal profit
- Homogenous products Graphing Perfect Competition ● Profit = TR-TC = (TR/Q - TC/Q)Q ● Profit = (P-ATC)Q ● Break-Even = zero profit ● P>Minimum ATC → profitable. Entry into industry in long run ● P=Minimum ATC → Break Even ● P<Minimum ATC → loss. Exit from industry in the long run. ● P>Minimum AVC → stay open ● P=Minimum AVC → indifferent ● P<Minimum AVC → shut down ○ Shut down price = min. AVC ○ Short RUn = MC curve is short run individual supply curve ● Whenever price falls in between min. ATC and min. AVC → better off producing in short run ● In the long run, firms will exit an industry if Price is constantly less than break-even price at minimum ATC ● PROFIT → FIRM ENTRY → SUPPLY INCREASE → PRICE DECREASE → PROFIT DECREASE UNTIL PROFIT = 0 ● LOSS → FIRM EXIT → SUPPLY DECREASE → PRICE INCREASE → PROFIT INCREASE UNTIL PROFIT = 0 ● Profit = (p-atc)Q Long-Run Outcomes in Perfect Competition* ● Industry Supply Curve → price vs. total output of industry as a whole ● Short-Run Industry Supply Curve → how qty supplied depends on market price given fixed number of firms
