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

•   MP_L = (Δ Total Output)/(Δ Labor)

•   MP_C = (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