End of Semester
Economics Note
Page 1
In developed countries, most people work for large firms.
A firm's success and ability to grow depend on pricing and production decisions.
Key decisions for firms include choosing product prices and quantities to produce.
These decisions depend on demand and production costs.
A model of interactions between customers and profit-maximizing firms producing differentiated products is developed.
Firms combine inputs to produce output using a production function.
The change in output as more input is added is measured by the marginal product of an input.
Marginal product usually diminishes beyond a certain point.
Cost functions show how total production costs vary with quantity produced.
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Firms use inputs to produce outputs.
The change in output depends on the input.
Decisions cannot be made without knowing the costs.
Change in output as input changes.
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The goal is to create a profit, not just be in business.
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Cost functions show how total production costs vary with quantity produced.
Measuring surplus is important.
Consumer surplus is the difference between willingness to pay and actual payment.
Producer surplus is the difference between the price received and the cost of production.
Total surplus is the sum of consumer surplus and producer surplus.
Deadweight loss is a loss of total surplus relative to a Pareto efficient allocation.
Total surplus is highest when demand equals marginal cost.
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Decisions cannot be made without knowing the costs.
Change in output as input changes.
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Price elasticity of demand measures the degree of responsiveness of consumers to a price change.
It is calculated as the percentage change in quantity demanded divided by the percentage change in price.
If PED > 1, demand is elastic.
If PED < 1, demand is inelastic.
If PED = 1, demand is unit elastic.
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Price elasticity of demand influences the firm's marginal revenue.
MR is positive when demand is elastic and negative when demand is inelastic.
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Price elasticity of demand also influences the firm's markup (profit margin).
The more elastic the demand, the smaller the markup.
The effect of taxes depends on the elasticity of demand.
Governments raise more tax revenue by levying taxes on price-inelastic goods.
Market power affects a firm's profit margin.
Demand is relatively inelastic if there are few close substitutes.
Firms with market power can set prices without losing customers.
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Market power affects a firm's profit margin.
Demand is relatively inelastic if there are few close substitutes.
Firms with market power can set prices without losing customers.
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Market power can lead to market failure and deadweight loss.
Natural monopolies arise when one firm can produce at lower average costs than multiple firms.
Competition policy can be beneficial to consumers when firms collude to keep prices high.
Firms can increase their market power through innovation and advertising.
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Social and strategic interactions play a role in economics.
Social interactions involve multiple parties, and strategic interactions involve awareness of how actions affect others.
Games describe social interactions, including players and feasible strategies.
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Strategy: Action(s) that people can take when engaging in a social interaction.
Game: Describes a social interaction involving players, feasible strategies, information, and payoffs.
Example: Crop choice game with two farmers, Anil and Bala.
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Nash equilibrium: A set of strategies where each player's strategy is the best response to the strategies chosen by everyone else.
Note: There may be more than one Nash equilibrium in a game.
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Another game: Bala and Anil have to choose a pesticide for their crops.
Repeated games: Most real-world applications are repeated games.
Sequential games: Games where players move at different times.
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Better outcomes often arise in repeated interactions due to social norms, reciprocity, and peer punishment.
Behaving selfishly in one period has consequences in future periods, so it may no longer be the dominant strategy.
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Coordination issues: How to resolve conflicts in games.
Options include converting the game into a sequential game, making an agreement, or considering behavioral changes.
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Demand curve: Represents the willingness to pay of buyers and is downward-sloping.
Supply curve: Represents the willingness to accept of sellers and is upward-sloping.
Equilibrium price: At this price, supply equals demand and the market clears.
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Price-taking firms: Cannot influence the market price and maximize profits when marginal cost equals price.
Isoprofit curves: Show the firm's profit at different levels of output.
Profit maximization: Firms choose the point of tangency between the demand curve and the highest isoprofit line.
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Firm's supply curve is the marginal cost curve.
Producing more or less than the profit-maximizing level leads to lower profits.
Firm's supply curve intersects the marginal cost curve at the profit-maximizing point.
Page 24: Profit Maximization and Competitive Equilibrium
Profit maximization for price-taking firms is achieved at the point of tangency between the demand curve and the highest isoprofit line it can reach.
Demand curve for price-taking firms is completely flat.
Profits are maximized when marginal cost (MC) equals price (P).
Producing more at this price will have consequences.
Producing less at this price will also have consequences.
The firm's supply curve is the same as the marginal cost (MC) curve.
Competitive equilibrium occurs when all buyers and sellers are price-takers and supply equals demand.
The area underneath the demand curve and above the price represents consumer surplus.
The area below the price and above the supply curve represents producer surplus.
In equilibrium, all gains from trade are exploited and there is no deadweight loss.
Equilibrium allocation is Pareto efficient under certain assumptions.
Caveats of competitive equilibrium:
Allocation may not be Pareto efficient if assumptions do not hold.
The distribution of total surplus depends on the elasticities of demand and supply.
The share of total surplus is inversely related to elasticity.
Finding price-takers in real life is not common.
Page 25: Changes in Demand
The entire demand curve can shift due to exogenous shocks.
Exogenous shocks are factors that are held constant but can change.
Examples of exogenous shocks include income, prices of related goods, and tastes and preferences.
The impact of a change in price on demand depends on the relationship between the price and demand for complements or substitutes.
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No new information.
Page 27: Changes in Supply
The entire supply curve can shift due to exogenous shocks.
Exogenous shocks are factors that are held constant but can change.
Examples of exogenous shocks include costs of production, technology/productivity, and entry into or exit from markets.
The impact of a change in price on supply depends on various factors.
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No new information.
Page 29: Taxes and Welfare
Taxes are used by governments to raise revenue.
Sales taxes are taxes on supply and shift the supply curve upwards.
Taxes create a wedge between demand and supply, leading to various effects.
Taxes increase the price paid by buyers.
Taxes reduce the price received by sellers.
Taxes reduce the quantity sold.
The impact of taxes on economic surplus:
Consumer surplus and producer surplus are both lower.
Government revenue is created through the transfer of surplus from consumers and producers.
The total surplus after taxes may be lower compared to the pre-tax outcome.
The fall in total surplus due to taxes is positively related to the elasticity of demand.
More elastic demand leads to a greater change in quantity demanded and a larger deadweight loss.
Tax incidence, or who bears the tax burden, depends on the relative elasticity of consumers and producers.
The less elastic group bears more of the tax burden.
Taxes can still raise welfare if the tax revenue is used to provide beneficial goods/services.
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No new information.
Page 31: Perfect Competition
Perfect competition has specific characteristics:
The goods or services being exchanged are identical.
There is a very large number of potential buyers and sellers.
Buyers and sellers act independently of one another.
Price information is easily available to buyers and sellers.
Characteristics of perfect competition:
All transactions take place at a single price (Law of One Price).
The market clears at this price (supply equals demand).
Buyers and sellers are all price-takers.
All potential gains from trade are realized.
Perfect competition may not hold completely in reality but can be a good approximation.
Real-world examples of perfect competition are hard to find.
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No new information.
Page 33: Market Equilibration
An exogenous shift in supply or demand requires a change in price for the market to reach a new equilibrium.
In disequilibrium, buyers and sellers on the short side of the market can realize rents by transacting at different prices, making them price-makers.
This process continues until a new competitive equilibrium is reached, known as market equilibration through rent-seeking.
An economic rent is a payment or benefit received that is superior to the next best alternative.
Lab experiments show market dynamics and the role of buyers and sellers in determining prices.
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No new information.
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No new information. Elasticity of supply and demand:
Supply is more elastic in the long run as more firms enter production or exit if firms are running at a loss.
Prices reflect scarcity, so if a good becomes scarcer and more costly to produce, the supply will fall and prices will tend to rise.
Peak oil is not evident as high prices stimulate further exploration.
Market dynamics and fluctuations:
Short-run fluctuations reflect short-run scarcity.
Demand is inelastic in the short run due to limited substitution possibilities.
Supply is inelastic in the short run because oil wells are expensive to drill and their capacity is fixed.
OPEC plays a role in controlling supply.
Negative supply shock:
The percentage increase in price is much larger than the percentage decrease in quantity.
Non-clearing markets:
Sometimes markets do not clear and goods may be rationed.
The potential for rents may create a secondary market, such as ticket scalpers.
Markets with controlled prices:
Rent ceiling is an example of price control.
Price controls create rents, which may lead to trade on a secondary market.
Economic rents:
Stationary economic rents arise in equilibrium and are persistent, such as consumer/producer surplus from bargaining or monopoly.
Dynamic economic rents occur in disequilibrium and are eliminated via a rent-seeking process, such as disequilibrium price-setting with a fixed number of firms in the short run.
Some types of economic rents help economies function well, such as employment rents and innovation rents.
Summary:
Economic rents play a role in market equilibration, inducing rent-seeking behavior to clear the market.
The value of assets is uncertain and can be resold, leading to positive feedback processes and potential bubbles.
Not all markets clear, and there may be rationing, price controls, and