Microeconomics Exam #2

Chapters 5 - ?

Elasticity Changes Along the Demand Curve

left of middle → elastic

middle → unit elastic

right of middle → inelastic

Total Revenue

Price x Quantity

Total Revenue of Elastic Demand

price goes up, quantity demanded goes down, total revenue goes down

price goes down, quantity demanded goes up, total revenue goes up

Total Revenue of Inelastic Demand

price goes up, quantity demanded is the same, total revenue goes up

price goes down, quantity demanded is the same, total revenue goes down

Determinants of Demand Elasticity

1. Availability of Substitutes

2. Importance of Being Unimportant

3. Luxuries vs Necessities

4. Time

Availability of Substitutes (Determinants of Demand Elasticity)

lots of substitutes = more elastic

Importance of Being Unimportant (Determinants of Demand Elasticity)

small portion of our budget, we don’t pay attention to price, more elastic (ex. gum prices)

Luxuries vs Necessities (Determinants of Demand Elasticity)

luxuries are more elastic, necessities are more inelastic

Time (Determinants of Demand Elasticity)

long run, more elastic

Income Elasticity of Demand

a measure of the responsiveness of demand to a change in income

Income Elasticity of Demand Equation

% change in quantity demanded / % change in income

Income Elasticity of Demand for Normal Goods

positive relationship

as income goes up, quantity demanded goes up

as income goes down, quantity demanded goes down

Income Elasticity of Demand for Inferior Goods

negative relationship

as income goes up, quantity demanded goes down

as income goes down, quantity demanded goes up

Cross Price Elasticity of Demand

measure of the responsiveness of the quantity of one good demanded to a change in the price of another good

Cross Price Elasticity of Demand Equation

% change in quantity Y demanded / % change in price of X

Cross Price Elasticity of Demand for Substitutes

% change in quantity Y demanded goes up / % change in price of X goes up

positive relationship

Cross Price Elasticity of Demand for Complements

% change in quantity Y demanded goes down / % change in price of X goes up

negative relationship

Elasticity of Supply

measure of the response of quantity of a good supplied to a change in price of that good

Elasticity of Supply Equation

% change in quantity supplied / % change in price

likely to be positive in output markets

Elasticity of Labor Supply

measure of response of labor supplied to a change in the price of labor

Elasticity of Labor Supply Equation

% change in quantity of labor supplied / % change in wage rate

Excise Tax

per unit tax on a specific good (ex. cigs, gas)

Excise Tax When Elasticity is the Same

price increase (tax) is split evenly among demanders and suppliers

Excise Tax When Elasticity is the not the Same

more inelastic (less elastic) pays more (carries greater burden of tax)

Most Effective Tax

taxes on inelastic goods (ex. cigs, gas, booze)

Utility

happiness/satisfaction

Total Utility

total satisfaction from a specific quantity

Marginal Utility

extra satisfaction from an additional unit

Marginal Utility Equation

change in utility (U) / change in units (Q)

Law of Diminishing Marginal Utility

each additional unit brings less and less happiness

Consumer Behavior

description of how consumers allocate income among different goods and services to maximize their well being

3 Steps of Consumer Behavior

1. Budget Constraint

2. Consumer Preferences

3. Consumer Choice

Budget Constraint

limit imposed on household choices by income, wealth, and product prices

Choice Set/Opportunity Set

set of options that is defined and limited by a budget constraint

Budget Line

all combinations of goods for which the total amount of money spent equals income

how much I can afford based on prices and my income

Budget Equation

P_XX + P_YY = I

Marginal Utility per Dollar Equation

MU / P

Demand Water Paradox

1. things with greatest value of use frequently have little or no value in exchange

2. things with greatest value in exchange frequently have little or no value in use

Why Demand Curve Slopes Downward

partly because of diminishing marginal utility, income effect, and substitution effect

Income Effect

ceteris paribus, price decline makes you better off because you have more income left over

Substitution Effect

price falls and product becomes relatively cheaper, buy this product now instead of the more expensive one

Indifference Curve Assumptions

1. goods yield positive marginal utility (more is better, must be good and not bad)

2. marginal rate of substitution is diminishing (MU_x / MU_y)

3. consumers have the ability to choose

4. consumer choices are consistent with a simple assumption of rationality

Indifference Curve

a set of points, each point represents a combination of goods (x and y), all of which yield the same total utility

a person is “indifferent” between any of the market baskets represented by points on the curve

graph representing market baskets with same level of utility

Consumer Preference

how do people decide what to buy each week/month? how do they compare groups of items (market basket)?

Properties of Indifference Curves

1. higher indifference curve, the more desirable

2. indifference curves cannot cross

3. there is an indifference curve between every possible bundle

4. must slope downward (more is better)

Shape of Indifference Curve

describes how a consumer is willing to substitute one good for another (look at notes from 2/10)

Marginal Rate of Substitution

slope of indifference curve, describes the tradeoff between two goods, how substitute between the two goods, “trade off rate” quantifies the amount of one good a consumer is willing to give up to obtain another good

Marginal Rate of Substitution Equation

change in C / change in T

Trade Off Rate Equation

- (MU_X / MU_Y)

Combine Indifference Curve with Budget Constraint

consumers will choose combination of x and y that maximizes total utility

look for point of tangency between indifference curve and budget line

Point of Tangency

budget line and indifference curve, slopes are equal at this point

slope of indifference curve = slope of budget line

Utility Maximization

reached when the marginal utility per dollar spent on x equals the marginal utility per dollar spent on y

MU_X / P_X = MU_Y / P_Y

Production

the process by which inputs are combined, transformed, and turned into outputs

Firm

organization to produce a good or service to meet a perceived need or demand

All Firms Must Make…

1. how much output to supply

2. which production technology to use

3. how much of each input to demand

Profit

difference between total revenue and total cost (TR - TC)

Accounting Profit

what can be counted, expenses out (explicit / costs)

Economic Profit

accounting profit but includes opportunity costs, always smaller (implicit / value of next best alternative)

Economic Profit Equation

total revenue - explicit - implicit

Normal Rate of Return for Your Industry

rate of return on capital that is sufficient to keep owners and investors satisfied, opportunity cost

if risk free → than nearly the same as interest rate on risk free government bonds

look at 2/12 notes for example

Short Run for Normal Rate of Return

there is a fixed factor of product, no entry or exit

Long Run for Normal Rate of Return

no fixed factors of production, there can be entry or exit

we need to know (1) sale price of output, (2) production techniques available, (3) input prices/costs

Optimal Method of Production

minimizes costs for a given level of output

Production Technology

quantitative relationship between inputs and outputs, can be labor intensive or capital intensive (machines)

Production Function

expression of relationship between inputs and outputs, Q = f (K, L)

Marginal Product

additional output produced by adding one more unit of a specific input

Marginal Product Equation

change in Q / change in L

Law of Diminishing Returns

additional units or variable inputs are added to fixed outputs → marginal product of variable input declines

Isoquant

same quantity, a graph that shows all combinations of capital and labor that can be used to produce a given amount of output, similar to indifference curves but now same quantity

Marginal Rate of Technical Substitution

change in K / change in L = MP_L / MP_K , slope of isoquant line

ISOCOST

graph that shows all the combinations of capital and labor available for a given total cost, similar to budget line

TC = (P_K x K) + (P_L x L)

To Calculate Costs…

a firm must know the quantity of inputs needed and how much those inputs cost

Decisions Based on Information

D1: the quantity of output to supply

D2: how to produce that output (which technique to use)

D3: the quantity of each input to demand

I1: the price of output

I2: techniques of products available

I3: the price of inputs (note: I2 and I3 determine production costs)

Fixed Costs

any cost that does not depend on the firm’s level of output, these costs are incurred even if the firm is producing nothing, none in the long run

Variable Costs

a cost that depends on the level of production chosen

Total Costs

total fixed costs plus total variable costs (TC = TFC + TVC)

Total Fixed Costs/Overhead

the total of all costs that do not change with output even if output is zero, horizontal graph

Average Fixed Costs

total fixed cost divided by the number of units of output, a per-unit measure of fixed costs, is an asymptote so it never reaches zero (TFC / q)

as output increases, this declines because we are dividing a fixed number by a larger and larger quantity

Spreading Overhead

the process of dividing total fixed costs by more units of output, AFC declines as quantity rises

Total Variable Costs

the total of all costs that vary with output in the short run

(K x P_K) + (L x P_L)

Total Variable Cost Curve

a graph that shows the relationship between total variable cost and level of a firm’s output, expresses the relationship between total variable cost and total output

Slope of Total Variable Cost

change in TVC / change in q

when change in q = 1, change in TVC = MC

Marginal Costs

the increase in total cost the results from producing one more unit of output, reflects changes in variable costs

change in total costs / change in quantity

The Shape of the Marginal Cost Curve in the Short Run

• every firm is constrained by some fixed input that leads to diminishing returns to variable inputs and limits its capacity to produce

• as a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output

• marginal costs ultimately increase with output in the short run because of the point above

Declining Marginal Product

implies that marginal cost will eventually rise with output (look at graphs from 2/17)

Graphing Total Variable Costs and Marginal Costs

• TVC always increases with output

• MC is the cost of producing each additional unit (“smiley face curve”)

• thus, MC curve chows how TVC changes with single unit increases in total output

Average Variable Costs

total variable costs divided by the number of units of output, a per-unit measure of variable costs

Graphing Average Variable Costs and Marginal Costs

• when MC < AC , average cost is declining

• when MC > AC , average cost is increasing

• rising MC intersects AVC at its minimum point

Average Total Costs

total cost divided by the number of units of output, a per-unit measure of total costs (TC / q)

is also AVC + AFC

Graphing ATC

to get ATC, we add AFC and AVC at all levels of output because AFC falls with output, an ever declining amount is added to AVC thus, AVC and ATC get closer together as output increase, but the two lines never meet

The Relationship Between Average Total Cost and Marginal Cost

• if MC < ATC , ATC will decline toward MC

• if MC > ATC , ATC will increase

• MC intersects ATC at its minimum point (same reason as AVC)

Accounting Costs

out of pocket costs, costs as an accountant would define them, “explicit costs”

Economic Costs

costs that include the full opportunity costs of all inputs, “implicit costs”

Perfect Competition

an industry structure in which there are many firms, each small relative to the industry, producing identical products and in which no firm is large enough to have any control over prices, new competitors can freely enter and exit, includes homogenous products, has perfectly elastic demand

Homogenous Products

undifferentiated products that are identical to or indistinguishable from one another

Total Revenue

the total amount that a firm takes in from the sale of its product price per unit times quantity of output the firm decides to product (p x q)

Marginal Revenue

additional revenue that a firm takes in when it increases output by one additional unit

in perfect competition → MR = Price

this curve and demand curve facing a competitive firm are identical

The Profit Maximizing Level of Output

output level where MR = MC for all firms

perfect competition → MP = P → profit maximizing condition is P = MC

Firms Will Produce As Long As…

marginal revenue exceeds marginal cost