Economics.docx

Economics Study Notes #1 DEMAND, SUPPLY, EQUILIBRIUM Demand refers to the buying behavior of a household Basically, microeconomists want to try to explain three things: Why people buy what they buy How much they're willing to pay How much they want to buy Buying Decisions-Demand: Income, Subs., Comp., Expectations, # of consumers, Tastes/Preferences (ISCENT) Buying Decisions-Supply: Subsidies, Resource Price, Other goods producer makes, Tech, Tax, Expectations, # of suppliers (SROTTEN) All buyers will try to maximize their utility, that is, make themselves as happy as possible, by spending what money they have in the best way possible. Budget Constraint  -  The outermost boundary of possible purchase combinations that a person can make, given how much money they have and the price of the goods. Budget Line – A curve showing various combinations of two products a consumer can produce with a specific money income. Price changes and income changes shift budget line. Ceteris Paribus – all else equal Diminishing Returns  -  Concept that the marginal utility derived from acquiring successive identical goods decreases with increasing quantities of goods. 4381500422275Expected Value (EV)  -  How much a buyer thinks that a good or investment will be worth after a time lapse, based on the probabilities of different possible outcomes. Usually refers to stocks and other uncertain investments. Giffen Good  -  Theoretical case in which an increase in the price of a good causes an increase in quantity demanded. Firm  -  Unit of sellers in microeconomics. Because it is seen as one selling unit in microeconomics, a firm will make coordinated efforts to maximize its profit through sales of its goods and services. The combined actions and preferences of all firms in a market will determine the appearance and behavior of the supply curve. Income Effect  -  Describes the effects of changes in prices on consumption. An increase in price causes a buyer to feel poorer, lowering the quantity demanded, and vice versa. Although the buyer's actual income hasn't changed, the change in price makes the buyer feel as if it has. 19050-66675Indifference Curve  -  Different combinations of goods and services that give a consumer equal utility or happiness. (usually convex as people don’t like extremes) (two indifference curves never cross) Inferior Good  -  A good for which quantity demanded decreases with increases in income. (opp: Normal Good) Market Economy  -  An economy in which the prices and distribution of goods and services are determined by the interaction of large numbers of buyers and sellers who have no significant individual impact on prices or quantities. Market-clearing Price  -  equilibrium price. Natural Monopoly  -  A monopoly that exists because the average cost curve is downward-sloping, making it difficult for new firms to enter the market. Normal Good  -  A normal good is a good for which an increase in income causes an increase in demand, and vice versa. (opp: Inferior Good) Optimization  -  To maximize utility by making the most effective use of available resources, whether they be money, goods, or other factors. Price Ceiling  -  Maximum price set by the govt. Set below market price; causes a shortage. Price Floor  -  Minimum price set by the govt. Set above market price; causes a surplus. Risk-averse  -  Refers to a buyer who is unwilling to invest in an investment with wide variation in possible payoffs. Someone who is risk-averse might even refuse to invest in something with a positive expected value if the variation in possible outcomes is too great. Risk-loving  -  Refers to a buyer who is willing to invest in an investment with wide variation in possible payoffs, in the hopes of getting a large return. In extreme cases, a risk lover might even invest in something with a negative expected value. Risk-neutral  -  Refers to a buyer who does not care about variation in possible payoffs. A risk-neutral buyer will invest in any investment with a positive expected return, regardless of how risky it is. Substitution Effect  -  Describes the effects of changes in relative prices on consumption. An increase in price of one good causes a buyer to buy more of the other good. Total Revenue  -  All of the income a firm makes; P x Q Utility  -  An approximate measure for levels of "happiness." #2 ELASTICITY Price Elasticity of demand – Measures how responsive consumers are to changes in the price of a product. Value stated in absolute terms. The value of the line of the slope and the value of elasticity are not the same. %?# / %?$ Price Elasticity of Demand Type of Demand Degree of Inclination Substitutes Available Degree of Necessity Proportion of Income Time needed to find Alternatives Ed < 1 Perfectly Inelastic Vertical None Critical - - Relatively Inelastic Steep Few Necessary Low Short Ed = 1 Unit Elasticity 45 deg. - - - - Ed > 1 Relatively Elastic Flat Many Luxurious High Long Perfectly Elastic Horizontal Infinite - - - Effect on Total Revenue (TR) Price Elasticity of Demand Price Increase Price Decrease Relationship between Price and TR Ed < 1 increases decreases Direct Ed = 1 no change no change Independent Ed > 1 decreases increases Indirect Cross Price Elasticity of demand – Measures the response of the quantity of one good demanded to a change in the price of another good. %?# of X / %?$ of Y. If Exy is positive, they must be substitute goods. If Exy is negative, they must be complementary goods. If Exy is 0 or undefined, the two goods are independent. Income Elasticity of demand – Measures the responsiveness of demand to changes in income. %?# / %?income. If Ei is positive, it is a normal good. If Ei is negative, it is an inferior good. Price Elasticity of Supply – Measures the response of quantity of a good supplied to a change in price of that good. %?# / %?$. Time is the only determinant of Es. During the market period, prices are perfectly inelastic. In the Short Run, all variable inputs can be changed, and in the Long Run, all inputs (including fixed inputs) can be changed. Total Revenue Test – Use this test to determine the type of demand. Keeping in mind TR = P x Q, if P and TR move in the same direction, it must be inelastic. If they move in opposite directions, it must be elastic. This test cannot be used to determine Ed. #3 COSTS OF PRODUCTION Production – The process by which inputs are combined, transformed, and turned into outputs. Explicit Cost – Monetary cost of production Implicit Cost – Opportunity cost of production Economic Cost – Cost of production taking into account the opportunity cost. Explicit Cost – Implicit Cost Accounting Profit – monetary profit Economic (Pure) Profit – Profit taking into account the opportunity cost. Accounting Profit – Implicit Cost 424815024765 Fixed Cost – Costs that does not change with quantity of output and cannot be removed in the short run. (eg: rent) Variable Cost – Costs that vary with the quantity of output. (eg: staff, capital) Marginal Cost – Increase in total cost resulting from producing one more unit of output. ? Total Cost / ? Quantity 3514725169545 Average Fixed Costs are downward sloping. 77152519685 Marginal Cost intersects ATC and AVC at their minimum points. 357822577470Average Total Cost = AFC + AVC 40957511430 #4 PURE COMPETITION Pure Competition Spectrum Pure Competition Monopolistic Competition Oligopoly Pure Monopoly Number of Firms Many Many Few One Entry into Market Very easy Easy Difficult Impossible/barred Control of Price None Some If colluding: lots If not: limited Considerable Non-Price Competition None Lots Some Maintaining PR Pure Competitions have many firms that produce identical products. No firm in a purely competitive market has enough influence on the market to control prices. New competitors can freely enter and exit from a purely competitive market. In a perfectly competitive market, individual firms are price-takers. Since buyers and sellers have no significant influence on the much larger market, they have to accept the market price and make their decisions accordingly. Price is determined by the interaction of market supply and demand. 273367543180Each firm faces a perfectly elastic demand curve. In perfect competition, MR = P. Therefore, D = MR. As a result, because MR = MC maximizes profit, a firm in a purely competitive market will operate where MC = D. Profit can be found by TR – TC, or (MR * Q) – (ATC * Q). 45720016510 466725662305Operating Profit (or loss) equals TR – TVC. If operating profit is positive, a firm should stay in operation in order to offset Fixed Costs. If operating profit is negative, a firm should shut down immediately. Blue = Losses Green = Operational Profit 337185019050An economy of scale refers to an increase in a firm’s scale of production which leads to lower average costs per unit produced. After a certain point, a minimum efficient point or scale will be reached. After this, diseconomies of scale will lead to higher average costs per unit produced. This can be seen on a Long Run ATC Curve: The long-run industry supply curve (LRIS) traces output over time as the industry expands. In a decreasing cost industry, the LRIS slopes down. In an increasing cost industry, the LRIS is slopes up. 3000375336556667533655 Allocative Efficiency – When no change is possible without making some members of society worse off, allocative efficiency is reached. P = Min. ATC Productive Efficiency – P = MC. In a purely competitive market, operating at productive efficiency also means operating at allocative efficiency. #5 PURE MONOPOLY Market failure occurs when resources are misallocated, or allocated inefficiently. Imperfect competition is an industry in which single firms have some control over price and competition. This industry is undergoing a market failure. In all imperfectly competitive industries, output is lower and price is higher than it would be under perfect competition. The equilibrium condition P = MC does not hold, and the system does not produce the most efficient product mix. Pure monopolies usually require severe barriers to entry: Govt. directive, Exclusive Patents, Large Economies of Scale, and Ownership of a scarce F of P. In a monopoly, the firm is the industry and the demand curve is downward. 352425780415For a monopolist, an increase in output involves not just producing more and selling it, but also reducing the price of its output to sell it. At every level of output, a monopolist’s MR is below demand. As a result, there is a loss of efficiency. The green rectangle shows profit, while the yellow triangle shows loss of efficiency. 203835060960 355727040640The only exception is a natural monopoly in which an industry realizes such large economies of scale in producing its product that single-firm production of that good or service is most efficient. For example (see right), with one firm producing 500,000 units, average cost is $1 per unit. With five firms each producing 100,000 units, average cost is $5 per unit. X-Inefficiency – inefficiency due to lack of competition/motivation causing operation at a point above the LRATC. Fair Return Price – no economic profit is made. P = ATC Socially Optimal Price – operation at allocative efficiency. P = MC #6 MONOPOLISTIC COMPETITION In a monopolistically competitive industry, there are many firms and no barriers to entry. However, there is a limited control on prices through product differentiation. Supporters of product differentiation claim that differentiated products and advertising gives the market system its vitality and are the basis of its power. Critics argue that product differentiation amounts to nothing more than waste and inefficiency as large sums of money are spent to create minute, meaningless, and possibly nonexistent differences among products. They also claim that advertising raises the cost of production and serves as a barrier to entry. In the Short-Run, MC = MB: 45720022225 320992547625 The firm’s D must end up tangent to ATC for profits to equal zero. This is the condition for long-run equilibrium in a monopolistically competitive industry. Since economic profit ends up becoming zero, a monopolistically competitive industry is efficient. On the other hand, P is above MC and ATC is not at its minimum. #7 OLIGOPOLY An oligopoly is a form of industry characterized by a few dominant firms. Products may be homogeneous or differentiated. The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others. A group of firms that gets together to make joint decisions on P and Q is called a cartel. Collusion occurs when price- and quantity-fixing agreements are explicit. Tacit collusion occurs when firms end up fixing price without a specific agreement, or when agreements are implicit. 367665067945 The kinked demand model is a model of oligopoly in which the demand curve facing each individual firm has a “kink” in it. The kink follows from the assumption that competitive firms will follow if a single firm cuts price but will not follow if a single firm raises price. In game theory, firms are assumed to anticipate rival reactions in a complex series of strategic moves and reactive countermoves among rival firms. 2791460101600 The dominant strategy is the strategy that is best no matter what the opposition does. Therefore, A will advertise regardless of B’s decision. 39916106985When uncertainty and risk are introduced, the game changes. A maximin strategy is a strategy chosen to maximize the minimum gain that can be earned. Therefore, C will choose the top strategy (safe option). On the other hand, if C only lost $1 for bottom left (little risk) and C anticipates D to choose the right strategy, C will likely choose the bottom strategy. #8 RESOURCE MARKETS Derived Demand – Demand for resources (inputs) that is dependent on the demand for the outputs those resources can be used to produce. In other words, inputs are demanded by a firm if, and only if, households demand the good or service produced by that firm. Diminishing Returns – A firm that decides to increase output will eventually encounter diminishing returns. Productivity – The amount of output produced per unit of that input. Output / Input Marginal Product of Labor (MPL) – Additional output per one additional unit of labor. Marginal Revenue Product (MRP) – Additional revenue a firm earns by employing one additional unit of input. MPL x P Substitution Effect – The tendency of firms to substitute away from a factor whose price has risen and toward a factor whose price has fallen. Output Effect – States that as output changes, demand for a factor changes in the same direction. Capital, Land, and Labor are complementary due to the output effect. 3028950158750 MRP = D in a firm with 1 variable input. If productivity increases, MRP will increase, and therefore D will shift rightward. The Least Cost Rule states that the marginal product of the last dollar spent on labor must be equal to the marginal product of the last dollar spent on capital, which must be equal to the marginal product of the last dollar spent on land, and so forth. If unions increase product demand, wage rates increase and QL increases. If exclusive selection is made, supply decreases, increasing wage rates. But QL also decreases, so if you are left out of the union, you lose your job. In inclusive unions, a higher wage rate can be secured, but again, at the cost of QL. Therefore, some people are left out. 22860062865 In a bilateral monopoly model, unions and businesses clash over the wage rate, leading to bargaining. In a competitive industry, the market would operate where S and D = MRP intersect. This inefficiency is explained through a similar Monopsony Model. Supply of total land is perfectly inelastic. Elasticity of Resource Demand can be found by %?# / %?$.