AP Micro Unit 2
• AP Microeconomics
• Section 9; Module 46
• Explaining the Law of Demand
• The demand curve has a negative slope
– There are two major reasons as to why the demand curve has a negative slope
• 1. Substitution effect
– The substitution effect is the economic understanding that as prices rise — or income decreases — consumers will replace more expensive items with less costly alternatives.
– When a good absorbs only a small share of the typical consumer’s income, often times the substitution effect is the sole explanation of why the market’s demand curves slopes downward
• 2. Income effect
– The change in the quantity of that good demanded that results in a change in the consumer’s purchasing power when the price of a good changes
• Real income (income adjusted to reflect its true purchasing power)
• Nominal income (Income that is not adjusted)
• Two major issues
– For the majority of goods and services, the income effect is not important and has no major impact on individual consumption
• Income effect usually only comes into play in the housing market or in any other budget category that consumes much of a family’s spending
– When it matters at all, the income effect usually reinforces the substitution effect
• The vast majority of goods are normal goods, meaning their demand decreases as income falls
• Two inconsistencies
• 1. Giffen Goods
– Good that absorbs a large share of consumer’s budgets and is also an inferior good
– When price of this good increases, so does demand
– Named for Sir Robert Giffen who believed he saw an upward sloping demand curve in potatoes in Ireland
– Has never been validated in any real situation
• Veblen goods
– Named for Thorstein Veblen
– Goods that are members of commodities where people’s preference for buying them increases as price increases
• Luxury goods
• Conspicuous consumption
– Buying goods to impress others
– Defining and Measuring Elasticity
• As discussed before, quantity demanded changes because of changes in price
– The question now becomes, by how much will the quantity demanded change when price changes?
• Price elasticity of demand
– The ratio of the percent change in the quantity demanded to the percent change in the price as we move along the demand curve (using absolute value)
• The price elasticity of demand formula
• How elastic is elastic?
• Perfectly inelastic
– Where price elasticity of demand is zero (Vertical line)
– These are goods where people pay no attention to the price of a good and quantity demanded does not change when price changes
• Perfectly elastic
– Where a tiny price increase will cause the quantity demanded to drop to zero
– Price elasticity is infinite (Horizontal line)
– When price elasticity of demand is greater than one, demand is elastic
– This means that a small change in price causes a dramatic change in the quantity demanded
• When price elasticity of demand is less than one, demand is inelastic
– This means that a large change in price causes a small change in the quantity demanded
• When price elasticity of demand is exactly one, demand is unit-elastic
– It is a unitary or proportional change
• Estimating Elasticities
• Price isn’t the only thing that can effect demand
– Changes in income
– Changes in population
– Changes in the prices of other goods
• Economists use careful statistical analysis to separate the influence of these other factors, holding other things equal
• Elasticity Changes Along Straight-Line Curves
• Elasticity is not the same as slope.
• Slope measures the steepness or flatness of a line in terms of the measurement units for price and quantity.
• Elasticity measures the relative response of quantity to changes in price.
• Elasticity changes along straight line supply and demand curves–slope does not.
– AP Microeconomics
• Section 9; Module 47
• Influences on the Price Elasticity of Demand
– Necessities versus Luxuries
• Price elasticity of demand tends to be low (inelastic) for a necessity and high (elastic) for luxuries
– Availability of Close Substitutes
• Price elasticity of demand tends to be higher if there are close substitutes available
– Proportion of Income Spent
• Goods tend to be inelastic if the good takes up a small portion of income and elastic if they take up a large portion
– Length of Time period (Time Horizon)
• Elasticity increases as long as time increases
– Long-run price elasticity is higher than short run elasticity
• Revenue Test
• Relationship Between Price Elasticity of Demand and Revenue
• Total Revenue is defined as the total value of sales of a good or service
– Total revenue = Price x Quantity sold
If demand is elastic:
• Total revenue decreases.
If demand is inelastic:
• Total revenue increases.
• AP Microeconomics
• Section 9; Module 48
• Income elasticity of demand
• The percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in the consumer’s income
– Used to determine if a good is a normal good or an inferior good
• Computing the Income Elasticity of Demand
• Example: American consumer income falls by 2% and quantity of flights to Europe declines by 8%.
– Answer: 4
• It is a normal good and is income-elastic
• Example: Consumer income falls by 5% and consumers increase consumption of Spam by 4%.
– Answer: -.80
• This good is an inferior good
• Cross-price elasticity of demand
• Defined as the ratio of the percent change in the quantity demanded of one good to the percent change in the price of another
– Used to determine if a good is a compliment or substitute
• Computing the Cross-Price Elasticity of Demand
• Examples
– Suppose that when the price of a burger falls by 10 percent, the quantity of pizza demanded decreases by 5 percent.
• Example: The price of Nike shoes increases 2% and quantity demanded for Converse shoes increases 4%.
– Answer: 2
• The goods are substitutes
• Example: The price of gasoline increases 20% and quantity demanded for large SUVs decreases by 5%.
– Answer: -.25
• The goods are complements
• THE PRICE ELASTICITY OF SUPPLY
• Price elasticity of supply
– A measure of the extent to which the quantity supplied of a good changes when the price of the good changes.
– To determine the price elasticity of supply, we compare the percentage change in the quantity supplied with the percentage change in price.
• Two extreme cases
• Perfectly inelastic supply
– Where price elasticity of supply is zero (Vertical line)
– Any increase or decrease in price will leave the quantity supplied unchanged
• Perfectly elastic supply
– Price elasticity of supply is infinite (Horizontal line)
– Quantity supplied is zero below some price and infinite above that price
– Factors that impact the price elasticity of supply
• The availability of inputs
– Price elasticity tends to be large when inputs are readily available and can be shifted into and out of production at a relatively low cost
– Price elasticity tends to be small when inputs are available at a relatively fixed quantity or can be shifted into and out of production at a relatively high cost
• Time
– Price elasticity of supply tends to grow larger as producers have more time to respond to a price change
• Long-run price elasticity of supply is greater than short-run price elasticity
• AP Microeconomics
• Section 9; Module 49
• Simplified Introduction to Consumer and Producer Surplus
• In this unit, we will measure a variety of economic benefits
– Consumer surplus
• Benefits consumers receive from being able to purchase a good
– Producer surplus
• Benefits producers receive from being able to sell a good
• By understanding producer and consumer surplus, you can then determine how much benefit exists because of the existence of a market as well as changes in consumer and producer welfare
• In order to calculate the producer and consumer surpluses, all you need are the supply and demand curves of a good
• Consumer surplus and the demand curve
• As discussed before, there are many factors that go into the consumer’s decision to purchase a good
– Willingness to pay
• A consumer’s maximum price at which he or she would buy that good
• Demand curve for used textbooks
• Individual Consumer Surplus is the difference between the price paid and the consumer’s willingness to pay.
– This difference is the NET GAIN from trading in a competitive marketplace for goods.
– This is represented graphically as the area above the price paid for the good and below the demand curve.
• Total Consumer Surplus is the sum of the individual consumer surpluses of all the buyers in a given market
• Changing price changes consumer surplus
– When price falls, consumer surplus will increase
– When price increases, consumer surplus will decrease
• Consumer Surplus
• Producer Surplus and the Supply Curve
• Cost
– Cost is the lowest price at which a person is willing to sell a good
• Individual producer surplus is the net gain to an individual seller from selling a good
– It is equal to the difference between price received and the seller’s cost
• Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good in a market
• AP Microeconomics
• Section 9; Module 50
•
Consumer Surplus, Producer Surplus and Efficiency
• The gains from trade
– Total Surplus
• It is the sum of consumer and producer surplus
• This illustrates another core principle of economics:
– There are gains from trade.
• The Efficiency of Markets
– A market is efficient if there is no way to make some people better off without making other people worse off
– Once a market is in equilibrium there is no way to increase gains from trade
• An efficient market performs four important functions
– It allocates consumption of the good to the potential buyers who most value it, as indicated by the fact they have the highest willingness to pay
– It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have the lowest cost.
– It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial
– It ensures that 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.
There are three caveats
• Although the market may be efficient it isn’t necessarily fair
• Markets sometimes fail
• Even when the market equilibrium maximizes total surplus, this does not mean that it results in the best outcome for every individual consumer and producer.
• Equity and Efficiency
– There is often a trade-off between equity and efficiency:
• Policies that promote equity often come at the cost of decreased efficiency and policies that promote efficiency often result in decreased equity
• Equity and efficiency are at the core of most debates about taxation
– Economists classify taxes according to how they vary with the income of individuals
• Progressive Tax: rises more than in proportion to income (federal income tax)
• Regressive Tax: rises less than in proportion to income (sales tax and excise taxes)
• Proportional Tax: rises in proportion to income (flat tax or per capita tax)
• Effects of Taxes on Total Surplus
– To understand the economics of taxes it is helpful to look an excise tax
• A tax charged on each unit of a good or service that is sold
• Effect of an excise tax on quantities and prices
– An excise tax drives a wedge between the price paid by consumers and the price received by producers
– It leads to inefficiency by distorting incentives and creating missed opportunities for mutually beneficial transactions
• Price elasticities and tax incidence (tax burden)
– The incidence of an excise tax depends on the price elasticity of supply and price elasticity of demand
– When an excise tax is paid mainly by consumers:
• The price elasticity of demand is low and the price elasticity of supply is high
– When an excise tax is paid mainly by producers:
• The price elasticity of demand is high and the price elasticity of supply is low
• The Benefits and Cost of Taxation
– The revenue from an excise tax
• The revenue collected by an excise tax is equal to the area of a rectangle with the height of the tax wedge between the supply price and demand price and the width of the quantity sold under the tax
• The cost of taxation
– Prevents mutually beneficial transactions from occurring.
• The value of the forgone mutually beneficial transactions is called the deadweight loss.
– In considering the total amount of inefficiency caused by the tax we must also take into account administrative costs
• Administrative costs of a tax are the resources used by government to collect the tax and by taxpayers to pay (or to evade) it, over and above the amount collected.
• AP Microeconomics
• Section 9; Module 51
• Utility
• When analyzing consumer behavior, we’re looking into how people pursue their wants and needs and the subjective feelings that motivate purchases
– How do we measure subjective feelings?
– Utility
• Measure of personal satisfaction
• A concept we use to understand behavior but don’t expect to measure in practice
• How do we measure utility?
– For the sake of simplicity, it is useful to suppose that we can measure utility in hypothetical units called utils.
– Utility function
• Shows the relationship between a consumer’s utility and the combination of goods and services, the consumption bundle, he or she consumes
• Marginal utility
– The change in total utility from consuming one additional unit of that good or service
• Definition of 'Law Of Diminishing Marginal Utility‘
A law of economics stating that as a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product.
Budgets and Optimal Consumption
• The principle of diminishing marginal utility explains why most people eventually reach a limit
• Budget constraint
– Limits the cost of a consumer’s consumption bundle to no more than the consumer’s income
• Consumption possibilities
– The set of all consumption bundles that are affordable, given the consumer’s income and prevailing prices
• Budget line
– Shows the consumption bundles available to a consumer who spends all of his or her income
• Compute the total utility of each consumption bundle. Determine the optimal consumption bundle.
• Marginal Utility per dollar
– How much additional utility one gets from spending an additional dollar on a good
• Marginal utility of one unit of the good/Price of one unit of the good
– Optimal Consumption Rule
– In order to maximize utility, a consumer must equate the marginal utility per dollar spent on each good or service in the consumption bundle
• AP Microeconomics
• Section 10; Module 52
• Understanding Profit
• The primary goal of most firms is to maximize profit
• Profit = Total Revenue – Total Cost
• Explicit versus Implicit Costs
• Explicit Cost
– Cost that requires the outlaying of money
• Implicit Cost
– Does not require the outlaying of money
– It is measured by the value, in dollar terms, of the benefits that are forgone
• Accounting Profit versus Economic Profit
• Accounting Profit
– Total revenue minus explicit cost and depreciation
• Depreciation means reduction in value
• Economic Profit
– Total revenue minus the opportunity cost of its resources
– Implicit cost of capital
• Opportunity cost of the capital used by a business
– The income the owner could have realized from that capital if it had been used in its next best alternative way
• Normal Profit
• Economic profit
– Total revenue is higher than the sum of implicit and explicit costs
• Loss (Negative economic profit)
– Total revenue is lower than the sum of implicit and explicit costs
• Normal profit
– Economic profit equal to zero
– Minimum level of profit needed for a company to remain competitive in the market.
• AP Microeconomics
• Section 10; Module 53
• Maximizing Profit
• Businesses need to discover the quantity of output needed to maximize profit
• Principle of marginal analysis
– Every activity should continue until marginal benefit equals marginal cost
• Marginal revenue
– The change in total revenue generated by an additional unit of output
• MR= ΔTR/ΔQ
• Optimal output rule
– Profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost (MR=MC)
• Marginal cost curve
– Shows how the cost of producing one more unit depends on the quantity that has already been produced
• Marginal revenue curve
– Shows how the marginal revenue varies as output varies
• AP Microeconomics
• Section 10; Module 54
• The Production Function
• Production Function
– The relationship between the quantity of inputs a firm uses and the quantity of output it produces
• Inputs and Output
• Fixed Input
– An input whose quantity is fixed for a period of time and cannot be varied
• Variable input
– An input whose quantity the firm can vary at any time
• Long run
– Time period in which all inputs can be varied
• Short run
– Time period in which at least one input is fixed
• Total Product Curve
– Shows how the quantity of output depends on the quantity of the variable input, for a given quantity of the fixed input
• Marginal Product of an Input
– The additional quantity of output produced by using one more unit of that input
• MPL = (Δ Total Output)/(Δ Labor)
• MPC = (Δ Total Output)/(Δ Capital)
• Diminishing returns to an input
– When an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input
• AP Microeconomics
• Section 10; Module 55
• Fixed costs (FC) are costs whose total does not vary with changes in output.
– These are the payments to the fixed inputs in the production function.
– Also called “overhead”
• Variable costs (VC) are costs that change with the level of output.
– These are the payments to the variable inputs in the production function.
• Total cost (TC) is the sum of total fixed and total variable costs at each level of output.
TC = FC + VC
• Total Costs
• Total Costs Graphed
• Marginal Cost
• Marginal Cost (MC) is the additional cost of producing one more unit of output.
MC = ΔTC/ΔQ
MC = ΔTC/ΔQ = Δ(VC + FC)/ΔQ = ΔVC/ΔQ
• Average Cost
• Average Total Cost (ATC) is the total cost divided by the level of output (it is also called average cost, unit cost, or per unit cost).
– ATC = TC/Q
– Since TC = TFC + TVC, ATC= AFC + AVC
• AFC= Average fixed cost
• AVC= Average variable cost
• Minimum Average Total Cost (Minimum-cost output)
– Quantity of output at which average total cost is lowest
• It corresponds to the bottom of the U-shaped average total cost curve
• The relationship between MC and ATC
• The MC curve intersects the U-shaped ATC and AVC at their respective minimum points.
• At output less than the minimum cost output, marginal cost is LESS THAN average total cost and average total cost is falling
• At output greater than the minimum cost output, marginal cost is GREATER THAN average total cost and average total cost is rising
• AP Microeconomics
• Section 10; Module 56
• Long-Run Costs
• In the long run, a firm’s fixed cost becomes a variable it can choose
– Firms chose their fixed cost in the long run based on the level of output it expects to produce
• Economies of Scale
• The shape of the LRATC is determined by scale
– Scale is the size of the firm’s operations
• Economies of scale
– When long-run average total cost declines as output increases
– Refers to the cost advantages companies experience when production becomes efficient, as costs can be spread over a larger amount of goods.
• Increasing returns to scale
– When output increases more than in proportion to an increase in all inputs.
• For example, with increasing returns to scale, doubling all inputs would cause output to more than double
• Diseconomies of scale
– When long-run average total cost increases as output increases
• Decreasing returns to scale
– Exist when output increases less than in proportion to an increase in all inputs
• Constant returns to scale
– Output increases directly in proportion to an increase in all inputs
– Sunk costs
• A sunk cost is a cost that has already been incurred and is non-recoverable
– Sunk costs should be ignored in a decision about future actions