Micro exam
CH1 Microeconomics and life
Economics is the study of how people manage resources.
• resource decisions are made by individuals, groups, firms, governments
• resources - tangible and intangible things: cash, land, time, ideas, technology, experience, relationships
Goods markets - For goods and services
Input markets - For labor, land, capital , entrepreneurial ability
Financial markets - Savings and loans
Institution - Is any long - lived social organization
Traditionally, economics has been divided into two highly related and interdependent fields:
• microeconomics - study of how individuals/firms manage resources
• macroeconomics - study of the economy on a regional, national, international scale
ECONOMIC THEORIES
Classical theory - focuses on an equilibrium condition where supply and demand interact
• suggests if demand and supply are not equal, the market will adjust so equilibrium prevails
• Great Depression contradicted Classical theory that demand will always equal supply
General Theory of Employment, Interest, and Money (Keynesian economics) - markets may not need to be in equilibrium for the economy to operate
Economic problem-solving boils down to asking four main
questions:
1. What are the wants and constraints of those involved? (Scarcity)
2. What are the trade-offs? (Performance and Decision Making)
3. How will others respond? (Incentives)
4. Why isn’t everyone already doing it? (Are resources being allocated in the best way possible?) (Efficiency)
Scarcity
Scarcity - condition of wanting more than we can get with available resources
• scarcity is a fact of life
• people make decisions aimed at getting the things they want, but are constrained by limited resources
Performance and decision making - economic measurements are our performance indicators
• tell us where we are, help us set goals
• Gross Domestic Product (GDP) - usually a measurement of national income (dollar value of all the final goods and services a country has produced domestically for a specific period of time)
• business cycles - short-run output fluctuations
Unemployment rates - measure unemployed workers in the labour force
• tells labour utilization in economy
• labour is significant input into economy’s production capacity
• high unemployment decreases output
• some unemployment inevitable
• Policy-makers are more concerned with unemployment that comes from growth stagnation
• Consumer Price Index (CPI) - overall price level
• Inflation - state of overall price increases as measured by the CPI
• rapid inflation may disrupt the saving–investment process
• businesses may not borrow money to expand because the cost of borrowing rises
• households don’t want to save money because the future value of their money may be lower
• leads to lower economic output and affects long- run economic growth
• policy-makers decide for long-term growth and reducing recession to keep economic output consistent with full employment
• Monetary policy - conducted by Bank of Canada
• controls money supply, sets interest rates
• low interest rates stimulate output/employment but may create higher inflation
• high rates tend to lower inflation, but may lower output/employment
Fiscal policy - conducted by federal government
• uses spending/taxation to raise economic output
• higher government spending/lower taxes will boost economic output but may bring a higher level of inflation and public debt
• lower government spending/higher taxes will keep inflation and public borrowing in check but may lead to lower output and employment
• all decisions in life involve weighing trade-offs vs. benefits
• true cost of something is not what you pay for it, but also the opportunity you lose to d something else
• Opportunity cost - equal to the value of what you have to give up in order to get something
• Marginal decision making - rational people compare the additional benefits of a choice against the additional costs, without considering related benefits and costs of past choices
• Sunk costs - costs that have already been incurred and cannot be recovered
Incentives
• asking how others will respond can prevent bad decisions by predicting undesirable side effects
• trade-off changes affect choices people make
• Incentive - something that causes people to behave in a certain way by changing the trade-offs they face
• positive incentive - makes people more likely to do something
• negative incentive (disincentive) - makes them less likely to do it
Efficiency
Efficiency - resources used in the most productive way to produce goods/services with greatest societal value
• under normal circumstances, individuals and firms will act to provide the things people want
• increasing efficiency - finding ways to better use resources to produce the things that people want
• disruptors of efficiency include:
• innovation
• market failure
• intervention
• goals other than profit
CORRELATION AND CAUSATION
• correlation - if events appear to occur in relation to each other
• positively correlated - events seem to occur at the same time and move in the same direction
• negatively correlated - increase in one event appears related to a decrease in another (move in opposite directions)
• uncorrelated - no consistent variable relationship
• causation - one event brings about the other
• reverse correlation - Distinguishing dependent from independent variables
• model - simplified representation of a complicated situation
• circular flow model - flow of economic transactions in an economy (Shown below)
Good models
• predict cause and effect
• make clear assumptions
• describe real world accurately
Positive and Normative Analysis
• positive statement - statement that makes a factual declaration about how the world actually works
• normative statement - statement that makes a claim about how the world should be
CH2 Specialization and exchange
The production possibilities frontier intro
Generalizing the input-output relationship for a whole country’s economy:
• Output = GDP = Gross Domestic Product = Q = Value of Final Goods Produced
• Q = f (L=labour; K=capital stock;
A= Technological Efficiency)
• The PPF shows output
combinations of X & Y products that
an economy can possibly produce
with the available inputs and
technology:
• ↑Opp. Cost: To get increasingly more
of X, increasingly more of Y is given up
How to do it?
SEE BOTTOM OF PAGE
Productivity determines standard of living
Productivity is the amount of goods and services produced from each hour of a worker’s time:
Labour Productivity = Output(Q)/Labour(L) Effort = Q per hour of L = Q/L.
• An increase in labour productivity makes the worker more valuable, enabling workers higher wages.
Average Productivity of Labour (APL) = Q/L
Marginal Productivity of Labour (MPL) = ∆Q/∆L
• Capital Productivity = Output(Q)/Capital(K) Effort = Q per hour of capital/machine/equipment use = Q/K.
Marginal Productivity of Capital (MPK) = ∆Q/∆K
• A country enjoys a high standard of living when its workers can produce a large quantity of output per hour.
• To boost productivity and living standards, policymakers must encourage:
• workers to be well-educated
• firms to invest in equipment and tools needed for production
• ready access to the best available technology.
• Technological Progress/Efficiency (A) = Total (or Multi) Factor Productivity (TFP)
How can we get the most out of available resources?
By specializing we get to produce and export (sell) more of what we are good at, and import (buy) of what we are not so good at producing.
▪ Allowing specialization has led to increasing wealth within
and among nations.
Specialization and gains from trade
• Specialization: Countries and firms specialize when they put all their resources into making the goods for which they have the lowest opportunity cost.
• When countries and firms specialize they sell the goods they make to then purchase the goods they need (and don’t make).
• This trade always accompanies specialization.
• When countries and firms specialize and trade, there are more goods (often many more goods) made in total than if each country or firm tried to make everything itself.
• The increase in output is called gains from trade
Production Model
• We use a production model to explain why China or India make t-shirts and Canada doesn’t.
• Recall: A model simplifies a complex reality to highlight key ideas and provide insights into how the economy works.
• We will not look at all countries and all things they produce.
• We simplify to two countries and two goods.
• This also allows us to create a graphical model – one that we can draw
on a paper or screen.
• Our model has only two countries: Canada and China.
• Our model has only two goods: x = shirts and y = wheat
• Notice: If we are interested in shirts, y (wheat) can stand in for
“stuff other than shirts”.
Constant opportunity costs and the straight line PPF
The constant trade off of one shirt for two bushels of wheat is simple for our first example, but not necessarily realistic
If everyone is producing wheat, and we take one person and move them to producing shorts, then we lose two wheat and gain one shirt.
This works both ways (If you take one person from shirts and move them to wheat you lose 1 shirt but gain 2 wheat)
This is called opportunity cost
Constant opportunity costs lead to a straight downward sloping line PPF.
Let’s add land and machinery to the model and consider other possibilities
Capital (Machinery and land) and labor produce two goods: Increasing opportunity cost
While constant opportunity costs occur, often the act of moving a worker from wheat to shirt production leads to increasing opportunity costs
To understand increasing opportunity costs, lets add land and machinery to the economy
To focus on workers (labor) we assume there is a fixed amount of land machinery available
Increasing opportunity costs
Consider an economy where almost everyone is producing shirts
The shirt factories are crowded
The fields have few workers
Only those who love and are good at farming are producing wheat
If a farmer decided to leave the farm ato make shirts, they would be able to add very few extra… (Cont’d here)
Absolute and comparative advantages
Goods are produced all over the world. Same goods produced in many countries.
Determinants of “advantage” in producing certain goods:
• raw resources
• labour
• skills of labour pool
• technology
• infrastructure
Absolute Advantage
- The ability to produce the same good using fewer inputs than another producer
Comparative Advantage
- Producing goods at the lowest opportunity cost compared to another producer
Comparative advantage over time
Comparative advantage is always in a state of flux according to market demands, technology, resources and politics
CH3 Markets
Markets
Market: refers to the buyers and sellers who trade a particular good or service.
Competitive market is one in which fully informed, price-taking buyers and sellers easily trade standardized goods or services.
Buyers are also price takers
• full information about the price and features of the good being bought and sold
• No transaction costs - costs incurred by buyer and seller in agreeing to and executing a sale of goods or services
• a buyer or seller who cannot affect the market price is called a price taker
Demand: How much of something people are willing and able to buy under certain circumstances
Quantity demanded: amount of a particular good that buyers in a market will purchase at a given price during a specified period
Law of demand: inverse relationship between price and quantity demanded
ceteris paribus: to isolate the effect of a single change in the economy
Determinants of Demand
1. Consumer preferences
Demand for certain products or services is steered by consumer preferences. As their tastes and needs change, the demand for a product changes in a given market. If consumers do not prefer a specific commodity, its demand in the relevant market will decline.
2. Prices of related goods
• two kinds of related goods:
a) Substitutes - serve similar purposes; consumer
might purchase one in place of the other (opportunity cost of one decreases). If goods are quite similar, we call them close substitutes
b) Complements - goods consumed together; buying one makes consumer more likely to purchase the other
3. Incomes
• bigger paycheque means more disposable income
a) Normal goods - increased income causes more demand; decreased income causes less demand
b) Inferior goods - increased income decreases demand for inferior goods, substituting them with more expensive and appealing goods
4. Expectations
• consumer expectations about the future (especially prices) also affect demand
• expecting prices to fall may postpone purchasing, causing current demand to decrease
5. Number of buyers
• curve represents a particular number of buyers; increase in number of buyers will increase demand; decrease in buyers slows demand
Factors that shift demand
Supply
Supply - how much of a good or service is offered for sale under given circumstances
Quantity supplied - amount of good or service offered for sale at a given price during a specified period
• each producer has different price point to decide viability to supply
• Law of Supply - quantity supplied increases as price increases and vice versa
• decision to produce a good concerns trade-off of producer benefit from selling and cost to produce it
The supply curve
Determinants of supply
Prices of related goods - affects the opportunity cost of production
Technology - produce more efficiently, using fewer resources; lowers costs, increasing the quantity producers will supply at each price
Prices of the inputs - increase production costs; quantity of product producers supply at given price decreases
Expectations - about future prices affect quantity supplied
Number of Sellers - product quantities producers will supply at various prices in market
• number of sellers in market is considered fixed on supply curve
Market equilibrium
Equilibrium: The price at which the quantity demand is equal to the quantity supplied
Reaching equilibrium
Sellers set prices by trial and error or experience.
• incentives naturally drive market toward equilibrium
• surplus - quantity supplied is higher than the demand;
excess quantity supplied; incentive to lower price
• shortage or excess quantity demand - demand higher
than supplied; incentive is to raise prices
• changes in demand or supply curve, or both, changes
market equilibrium
Changes in equilibrium prediction
• when supply/demand move in the same direction, we can predict the direction of the change in quantity but not the direction of the change in price
• when supply/demand move in opposite directions ,the change in price is predictable but the change in quantity is not
• both supply and demand increase, buyers and sellers agree that at any given price the quantity they are willing to exchange is higher
CH4 Elasticity
Non-Profit Sector (Motivation)
Non-profit service providers also think about price elasticity.
• If they offer a subsidized service, how many people will be driven away by a price rise?
• Service providers often need to cover costs while keeping their services affordable.
• They may need to know the response to other factors, like a change in location:
• Elasticity of demand with respect to distance.
Public Sector (Motivation)
Governments also think about price elasticity.
• How much does a price need to increase to cause people to buy less?
• Used when setting taxes for oil, tobacco, alcohol – some health care providers would like a tax on sugar.
• If a tax is levied on income to pay for services, how will workers
and investors react?
• Calculating and sometimes estimating elasticity is important.
• We can categorize goods by sign and size of elasticity, and predict whether a price increase will increase or decrease revenue.
Change → Reaction → How Much Responsive?
• Incessant change since times immemorial in nature and human behaviour.
• Catalyst (in the denominator), such as a price change → Reaction (quantity after the change minus quantity before the change) in the numerator = Change = quantitative
Responsiveness = Elasticity of Reaction caused by the Catalyst.
• Economists view of evolution: Change > 0 and Growth (the rate of change) over time; no growth = Stagnation; Change < 0 → growth rate < 0 = Decline.
• People evolve—change their behaviour in light of what to do next, triggered by catalysts—elasticity is a quantitative measure of their behavioural reaction. Different folks, different strokes.
Demand Price Elasticity
Elasticity = Responsiveness of QD (quantity demand) or QS (quantity supplied) in %.
Elasticity of Demand: measures how responsive the quantity demanded is to a change in price; more responsive equals more elastic.
What is elasticity?
Elasticity is a measure of how much consumers and producers will respond to a change in market conditions.
• Elasticity can apply to demand or supply.
• Elasticity can be used to measure responses to a change in the price of a good (or service), a change in the price of a related product, a change in income.
• Helps decision makers anticipate answer to: How will others respond?
Two Main Elasticities and Two Related Elasticities
• The most commonly used measures of elasticity are the own-price elasticities.
• price elasticity of demand and price elasticity of supply
• These describe how much the quantity demanded or supplied will change when the price of the good changes.
• A related and important price elasticity is
• cross-price elasticity of demand
• This describes how much the quantity demanded will change when the price of a related good changes. The related good might be a substitute or a complement.
• Lastly, but also very important is
• income elasticity of demand
• This describes how much the quantity demanded will change when income changes.
• NOTE: because the own-price elasticity is the most commonly used, if
you see the term ‘elasticity of demand’ or ‘elasticity of supply’, this refers
to the own-price elasticity.
Price elasticity of demand
• The price elasticity of demand measures consumers’ sensitivity to price changes:
• When consumers’ buying decisions are highly influenced by price, we say that demand is more elastic or very elastic.
• A small change in price causes a large change in quantity demanded.
• When consumers’ buying decisions are not influenced much by price, we say that demand is less elastic.
• A small change in price causes a very small or almost no change in quantity demanded.
Elasticity Example: What does it mean?
• What does it mean for the elasticity of demand to be - 1.38?
• Recall: Elasticity describes the size of the change in quantity demanded of a good in response to a price change.
• A measure of -1.38 means that a 1 percent increase in the
price of coffee will cause the number of cups purchased to fall by 1.38 percent.
• Alternatively, a 1 percent decrease in the price of coffee will cause the number of cups purchased to increase by 1.38 percent.
Price Elasticity of Demand is Always Negative!
Notice: The price elasticity of demand is always negative!
Why?
Because price and quantity demanded move in opposite
directions:
• A positive change in price will cause a negative change in the quantity demanded.
• A negative change in price will cause a positive change in the quantity demanded.
Elasticity of Demand – Potential Confusion using Size without Negative Sign
• There are two possible ways the elasticity of demand can be confusing.
1. People sometimes drop the negative sign in general speech (and some textbooks) because it is ALWAYS negative.
1. Because this elasticity is ALWAYS NEGATIVE, we often refer to it based on its absolute value or size. Economists, being either efficient or lazy (you pick), will just drop the sign for the own price elasticity of demand.
• Example a) An economist might report that the elasticity of demand is 0.4. They mean MINUS 0.4. (and they mean own-price elasticity of demand)
• Example b) A demand price elasticity less than 1 refers to its absolute value or SIZE. For example,−0.3 = 0.3 < 1.
Determinants of Price Elasticity of Demand
• Let’s think about what influences your elasticity of demand.
• Consider coffee: How would to quantity increase if price fell from $3 to $1.50?
• Consider socks: How would the quantity increase if price fell from $10 to $5 per pack?
• Our reaction to a price change depends on the good and how we consume it.
• We might increase our consumption of some goods in response to a price drop, but for others, our reaction is small.
• What determines how we react?
Factors that Affect Elasticity (Substitutes and Necessity)
• Availability of Substitutes
• if there are close substitutes available, then we expect the demand for a good to be more elastic than if there are no close substitutes.
• You might switch easily between one juice and another.
• Degree of Necessity
• When a good is a necessity, people will buy it even if prices rise. Necessities tend to be not very elastic. In winter, if the price of home heating falls, your demand does not increase a lot.
• In contrast, if prices rise, people will substitute away from luxuries. That exotic vacation might not be replaced by camping nearby
Factors that Affect Elasticity (Cost Relative to Income)
• Cost relative to income:
• All else equal, if consumers spend a very small share of their incomes on a good, their demand for the good will be less elastic.
• For example, if you buy a box of salt for $2 or $4, you might not even notice the price difference, since you might buy it once a year (or every several years) and it is a small part of your spending.
• Again, that luxury vacation is more price elastic. If there is a sale, you might move your vacation to take advantage of the lower price. Since it is a big purchase, a small change in price matters.
Factors that Affect Elasticity (Adjustment Time and Market Scope)
• Adjustment time
• Goods often have much more elastic demand in the long run than in the short run. Consider your reaction to gasoline prices. In the short-run, you might try to drive a little less. In the long-run, you might move closer to school or work, or get a 2nd hand electric vehicle. (Maybe one of those new bikes.)
• Scope of the market
• The wider the scope of the market, the lower the elasticity of demand.
• The price elasticity of demand for bananas might be high, but the price elasticity of demand for fruit would be lower.
• The price elasticity of demand for a brand of tea might be high, but the price elasticity of demand for tea in general would be lower.
Using Price Elasticity of Demand
• When we make decisions, we often don’t know the exact price elasticity of demand. But we don’t always need to know this.
• If a business can place goods into a broad category of elasticity, that is enough to predict the effect of a price change.
• Elastic demand describes an elasticity greater than 1 in size. This means that the percent change in quantity is larger than the percent change in price.
• This is common for goods with close substitutes, luxuries, and goods whose purchase requires a big part of your income.
• Inelastic demand describes an elasticity smaller than 1 in size. This means that the percent change in quantity is smaller than the percent change in price.
• This is common for goods without close substitutes, necessities, and goods whose cost is small relative to income.
Elasticity – Extreme Cases – Perfectly Elastic
Definition: Perfectly elastic demand occurs when the quantity demanded changes infinitely with any change in price. If the price increases even slightly, the quantity demanded drops to zero; if the price decreases, consumers will purchase an unlimited quantity.
Elasticity Extreme case - Perfectly inelastic
Definition: Perfectly inelastic demand occurs when the quantity demanded remains constant regardless of any change in price. Consumers will buy the same amount no matter how much the price increases or decreases.
Elastic, Inelastic and Unit Elastic
Recall: We divide goods into groups based on elasticity of demand
• Start With a change in price.
• For example, imagine the price of a good falls by 40%.
• If demand is elastic, the quantity demanded increases more than proportionately. In our example, it increases more than 40%.
• If demand is inelastic, the quantity demanded increases less than proportionately. In our example, the quantity demanded increases less than 40%.
• If demand is unit elastic, the quantity demanded increase by the same percentage.
CH5 Efficiency
Equilibrium: The price at which the quantity demanded is equal to the quantity supplied
• Voluntary exchanges create value and can make everyone better off!
• Efficiency is about creating the most value possible.
Overview
• Willingness to Pay (WTP)
• Willingness to Accept (WTA) to Supply/Sell Competitive Market Equilibrium
• Consumer Surplus (CS)
• Producer Surplus (PS)
• Social Welfare/Economic Well-Being
• Economic Efficiency: CS + PS is the greatest possible
Surplus
• Surplus measures the benefit people receive when they buy something for less than they would be willing to pay for it.
• We call this consumer surplus.
• Surplus also measures the benefit firms or sellers receive when they sell something for more than they were willing to accept.
• We call this producer surplus.
• If people are allowed to trade, they will create surplus!
• Efficiency, in the sense of maximizing total surplus, is one of the most powerful features of a competitive market.
• When all assumptions hold for a competitive market, the equilibrium price is special.
• The equilibrium competitive market price maximizes surplus
Willingness to pay
Buyers: Willingness to pay
• When we buy, it is because we want to. We are not forced to go into the market to make a purchase. If we don’t want to pay, we can walk away. We will only buy if the price is below what we are willing to pay.
Example: You go to the grocery store to buy spaghetti sauce.
• One day, the sauce is on sale for $1.00. You like the price, and choose to buy the sauce.
• Another day, the price is $4.00. You choose not to buy. The store cannot make you buy sauce, so you only buy if the price is at or below the
amount you are willing to pay. • The maximum you are willing to pay is often called the reservation price.
Willingness to sell
When we sell, it is because we want to. We only sell if we are offered a price at or above the price we are willing to accept. Willingness to sell is the lowest price a seller will accept.
• Willingness to sell is also called:
• willingness to accept
• reserve price (or reservation price).
• Notice: both buyers and sellers can have a reserve price. For buyers it is a maximum, for sellers, it is a minimum.
Consumer and producer surplus
Evaluating the equilibrium: Market efficiency
Efficiency of Competitive Markets in Equilibrium and Gains from Trade
A free market maximizes the gains (Total Surplus) from trade.
1. Available goods are bought by buyers with the highest willingness to pay.
2. Goods are sold by the sellers with the lowest costs.
3. Between buyers and sellers, there are no unexploited gains from trade or any wasteful trades.
• These three conditions imply that the gains from trade are maximized
Concept: Willingness to pay and the demand curve
Recall: Willingness to pay is the maximum price a buyer is willing to pay in exchange for a good or service.
• If the price is above the buyer’s willingness to pay, then the buyer will not buy the good or service.
• The demand curve shows how much good people will buy at each price.
• If the price is above a buyer’s willingness to pay, then it is above their demand curve.
• We can draw a demand curve using potential buyers willingness to pay at each price
Willingness to pay and opportunity cost
• Each buyer’s willingness to pay is driven by different factors.
Key question: What are the trade-offs?
Buyers:
• Money spent to buy the camera good cannot be used to buy other things.
• Willingness to pay is the point at which the benefit that a person will get from the camera is equal to the benefit of spending the money on another alternative – in other words,
the opportunity cost.
• At prices above the consumer’s willingness to pay, the opportunity cost of buying the good is too high, so the consumer walks away
Willingness to sell and the supply curve
Sellers willingness to sell - opportunity cost
• The minimum price a seller will accept will depend on their opportunity cost.
• If you are trying to get rid of things, you are willing to sell for very little. The opportunity cost is small or zero.
• If you have an attachment to an item, the opportunity cost includes the emotional cost of not seeing the camera again.
• For manufacturers, the opportunity cost can usually be summarized by the manufacturing cost – the marginal cost of the item.
Willingness to sell - salary negotiations
• When we accept a job, we are agreeing to sell our labour in return for a wage or salary.
• Data show women earn less than men.
• Data also show that men tend to negotiate for higher salaries more than women.
• Women are more likely to either accept or reject the offer given. Do they have a lower willingness to sell?
• Looking at this more closely, we find that male evaluators:
• are more likely to rate women who negotiate, negatively; and
• prefer to work with women who accept the first salary offered.
• How to deal with this data?
• One approach end salary negotiations and offer men and women the same salaries.
Measuring surplus
• Surplus is the difference between the price at which a buyer or seller is willing to trade and the actual price.
• If you are willing to pay $5 for a morning coffee but only need to pay $2, you have a surplus of $3.
• If you are willing to sell the morning coffee for $1 and you sell it for $2, then you have $1 surplus.
• Surplus measures who benefits from transactions and by how much.
• Buyers won’t pay more than their willingness to pay, but they will
pay less.
• If you get something for less than you would have been willing to pay for it, you have a consumer surplus
Consumer surplus - definition
Consumer surplus
For the individual consumer:
• The net benefit a consumer receives from the purchase of a good or service.
• Measured by the difference between the willingness to buy and the actual price.
For the market:
• Sum of the net benefits each consumer receives from the purchase of a good or service.
• Measured by the (often triangular) area above the price and below the demand curve.
Suppose the cameras on eBay sell for $160.
• Recall:
• The birdwatcher was willing to pay $500. Buying the camera at $160 results in a surplus of $500 - $160 = $340 for the birdwatcher.
• The photographer was willing to pay $250. Buying the camera at $160 results in a surplus of $250 - $160 = $90 for the photographer.
• The real estate agent was willing to $200. Buying the camera at $160 results in a surplus of $200 - $160 = $40 for the agent.
• The other buyers were willing to pay $100 and $150. Neither of them would buy the camera.
• The total consumer surplus in this market is: $340 + $90 + $40 + $0 + $0 = $470
Consumer surplus and a price change
• If the price of the camera falls from $160 to $100, then the surplus increases.
• The birdwatcher was willing to pay $500. Buying the camera at $100 results in a surplus from this transaction of $500 - $100 = $400.
• The photographer was willing to pay $250. Buying the camera at $100 resulting in a surplus from this transaction of $250 - $100 = $150.
• The real estate agent was willing to $200. Buying the camera at $100 results in a surplus from this transaction of $200 - $100 = $100.
• The journalist will buy at this price, resulting in a surplus from this transaction of $150 - $100 = $50.
• The teacher will buy at this price. The teacher gets no surplus as the willingness to pay is $100, and the price is $100.
• The total consumer surplus at this lower price is: $400 + $150 + $100 + $50 + $0 = $700
Producer surplus - definition
Producer surplus
For the individual producer (seller):
• The net benefit a producer receives from the sale of a good or service.
• Measured by the difference between the willingness to sell and the actual price.
For the market:
• Sum of the net benefits each producer receives from the sale of a good or service.
• Measured by the (often triangular) area below the price and above the supply curve.
Example: Back to that camera on eBay. If the price is $160, we can calculate the producer surplus for each seller and the market.
1) The comic book collector would sell for any price at or above $50. The resulting surplus of this transaction is $160 - $50 = $110.
2) The sales representative for a big camera company would accept $100. The resulting surplus of this transaction is $160 - $100 = $60.
3) A nature photographer would sell for $200 and not sell for $160. The resulting surplus of this transaction is $0.
4) A small company is selling a camera for $300. No sale, surplus is $0.
5) A teacher is selling for at least $400. You guessed it! Surplus is $0.
• Producer surplus in the market is $110 + $60 + $0 + $0 + $0 = $170
Producer Surplus, A Price Fall
Example: When the price falls from $160 to $100, the producer surplus also falls. If the price is $100, we can calculate the producer surplus for each seller and the market.
1) The comic book collector would sell for any price at or above $50. The surplus from this transaction is $100 - $50 = $50.
2) The sales representative for a big camera company would accept $100. The surplus from this transaction is $100 - $100 = $0.
3) A nature photographer would sell for $200 and will not sell for $160. The surplus from this transaction is $0.
4) A small company is selling a camera for $300. No sale, surplus is $0.
5) A teacher is selling for at least $400. You guessed it! Surplus is $0.
• Surplus in the market is $50 + $0 = $50 (you can keep adding $0, it
doesn’t change the total).
Producer Surplus for a Firm and a Market
• In Figure 4, we see that there is a producer surplus if the willingness to sell is below the price received for a unit of the good.
• For a firm, the willingness to sell is based on the cost of production.
• A firm will sell one unit if the price for that unit at least covers its cost.
• It will sell a second unit if the price for the 2nd unit covers its cost, and so on…
• The supply curve is based on marginal decision-making.
• For a firm, the supply curve is its marginal cost curve.
• As long as price is at least as high as marginal cost, a firm will sell.
• The producer surplus (PS) is therefore the difference between the price and the marginal cost: (PS = price – marginal cost) for each unit sold.
Total surplus
Surplus: People Never Lose from a Voluntary Transaction
• When people trade, both buyers and sellers get a surplus.
• Trade, in essence, creates value that did not exist without it.
• This is an important concept.
• Voluntary transactions, like selling cameras on eBay, do not have a winner or a loser. Both buyer and seller are winners, since they both gain surplus.
• Total surplus can never be less than zero. If either buyer or seller were to get a negative surplus, they simply would not buy or sell!
Surplus: Positive sum game - NOT a zero sum game
Zero sum game
• Situation in which one gains and another loses an equal amount, such that the net value of a transaction is zero.
• Many games, like poker, or monopoly, have a winner and a loser.
• If you win $20 in a poker game, someone else loses that $20.
Positive sum game
• Situation where both parties in the game can win.
• Voluntary transactions result in both buyer and seller being winners, since they both gain surplus.
• In the eBay example, the bird watcher can buy a camera from the comic book collector. The
bird watcher gets $340 surplus and the comic book collector gets $110 surplus. No one loses
anything.
• Market transactions are a positive sum game.
Market equilibrium is efficient
• Market equilibrium is not only the point where buyers are perfectly matched to sellers, but it is also the point where total surplus is maximized.*
• This is the invisible hand of market forces at work!
• If buyers and sellers can transact freely in a competitive market, the price will both clear the market and maximize the sum of consumer and producer surplus.
* We will see exceptions to this result when we consider markets with externalities – in that case a market does not reach an efficient equilibrium without intervention
Deadweight loss
• Deadweight loss is the loss of total surplus when the quantity of a good that is bought or sold is not (usually) below the market equilibrium quantity.
• Deadweight loss is the loss of total surplus due to inefficiency in a market.
• Any action that moves the price away from the equilibrium price creates a deadweight loss.
• In the previous two examples, a deadweight loss occurred both when
• the price was held above the equilibrium price of $200,
• the price was held below the $200 equilibrium price.
Missing markets
• In the two examples we just saw,
• the price change is the indirect cause of deadweight loss,
• the direct cause is the reduction in the quantity of cameras traded.
• The non-equilibrium price causes fewer transactions to take place, and the surplus those transactions would have created are lost.
• In the case of a missing market, there are no transactions because the market doesn’t exist.
• Before the invention of eBay, millions of sales that did not take place because buyers and sellers weren’t aware of each other was a large loss of surplus.
• When a market does not exist, then all of its potential surplus is a deadweight loss.
CH6 Government intervention
Why intervene?
There are strong reasons not to intervene:
• In our discussion of markets, we saw that markets gravitate toward equilibrium.
• When markets work well, prices adjust until consumer demand = producer supply.
• Subsequently, we saw that equilibrium price and quantity also maximize surplus.
• But, when huge price hikes make food unaffordable, or rents rise and a large number of citizens are unhoused, or technology demands highly educated workers, governments are called upon to act.
Three Reasons to Intervene
1. Correcting market failures
2. Changing the distribution of surplus
3. Encouraging or discouraging consumption
Correcting market failures
• A market failure is a situation where the equilibrium in the market is not efficient.
• The market might not be competitive – only one large supplier
• In this case the price charged will be inefficiently high.
• The good or service being exchanged might impose costs on people who are not part of the transaction.
• Bystander costs:
• The cost is not captured in the price paid.
• The price is too low and too much is bought – like the gas in our cars.
• When there are market failures, government intervention can/may increase total surplus.
Changing the distribution of surplus
• Efficient markets maximize total surplus, but the distribution of surplus might seem unfair to many.
Example:
• An efficient job market might leave people with wages too low to live on.
• Governments could and do set a minimum wage.
• A minimum wage will lift workers’ incomes, changing the distribution of surplus:
• Employers’ surplus is smaller.
• Workers’ surplus (those who still have a job) is bigger.
Distribution of Surplus: The Theory of Distribution—Distributive Justice
• An adequate economic theory must answer basic questions of human economic action:
• First, for whom shall I provide? All persons sharing in the final distribution of production—distributive justice: By what principles do we distribute our wealth?
Proportional to a person’s significance (productivity?, humanness?, personhood?...)?
• A person’s total consumption equals one’s own income or wealth plus or minus any gifts or other “transfer payments” received or given.
• Second, what shall I provide? – The theory of utility ranks products.
• Third, how shall I provide it? –
1. The theory of production.
2. The theory of justice in exchange, which economists call equilibrium, explains how the sale of each product provides the compensation of its producers: labour compensation for the workers and property compensation for the property owners.
Western theories of justice
• Plato (c. 427 – 348 BC), justice is a virtue establishing rational order, with each part performing its appropriate role and not interfering with the proper functioning of other parts.
• Aristotle (384-322 BC) justice consists in what is lawful and fair, with fairness involving equitable distributions and the correction of what is inequitable.
• Augustine (354–430 CE), the cardinal virtue of justice requires that we try to give all people their due;
• Aquinas (c.1225 - 1274), justice is that rational mean between opposite sorts of injustice, involving proportional distributions and reciprocal transactions.
• Hobbes (1588–1679) believed justice is an artificial virtue, necessary for civil society, a function of the voluntary agreements of the social contract.
• Hume (1711-1776), justice essentially serves public utility by protecting property (broadly understood).
• Kant (1724–1804), it is a virtue whereby we respect others’ freedom, autonomy, and dignity by not interfering with their voluntary actions, so long as those do not violate others’ rights;
• Mill (1806–1873) said justice is a collective name for the most important social utilities, which are conducive to fostering and protecting human liberty.
• Rawls (1921–2002) analyzed justice in terms of maximum equal liberty regarding basic rights and duties for all members of society, with socio-economic inequalities requiring moral justification in terms of equal opportunity and beneficial results for all; and various post-Rawlsian philosophers develop alternative conceptions.
Competitive Market Equilibrium & Justice in Exchange
• Justice In Exchange and Distributive Justice: Distributive justice requires that common goods be distributed according to the prevailing social norms, which might take account of the dignity or need of persons.
• A key condition of equilibrium in modern economic theory for the continuation of the economic system depends on market prices covering the costs of production. If a business person failed to cover business costs under normal competitive conditions, the business will suffer a loss, regardless of owner’s need or social dignity. This does not directly involve the just price of goods or services.
Equilibrium: Equality between each product's value and the total income of its producers is necessary for economic equilibrium.
• This equilibrium Aristotle (384-322 BC) in his Ethics called “justice in exchange,” or “commutative justice” and the equilibrium price, “just price” as interpreted by Albert the Great (teacher of St. Aquinas) of the University of Cologne, Germany, in 1250 CE
Theory of Personal Distribution & Justice
• Aristotle noted in his Ethics that every human community necessarily has a principle for distributing its common goods, which he called its “distributive justice.”
• In each case, the goods are distributed in (geometric) proportion to the relative importance or merit of the persons involved:
•“All men agree that what is just in distribution must be according to merit in some sense, though they do not all specify the same sort of merit.”.
• St. Augustine of Hippo (354–430 CE) - A theory of personal distribution: Every human person, by virtue of natural interdependence with other persons, also has a principle for distributing the use of one’s wealth between oneself and other persons: the degree of one’s love for other persons relative to oneself.
• Persons ought to be treated as ends and not merely as means.
• Every human does, as a matter of fact, always act with some person(s) as the ultimate end or purpose of action.
A Moral Imperative: Personal & Social Distribution
• The entire history of economic theory thus far may be divided into just three
periods: the Scholastic (1250–1776), the Classical (1776–1871), and the Neoclassical
(1871–c. 2019).
• Recall the difference between “positive” theory, which describes things as they are, and
“normative” theory, which prescribes how they ought to be.
• Prescriptive or “Normative” Scholastic Economics: The descriptive or positive economic theory of the Scholastics was distinct from—but integrated with—their prescriptive or normative economics. The fact of scarcity squarely at the center of moral decisions making.
• Love properly means willing some good to some person. We can love our fellow human beings: benevolence, or goodwill, which can be extended to everyone in the world; and beneficence, or doing good, which we cannot.
• A theory of personal distribution: A person, being interdependent with other persons, has a principle for distributing the use of one’s wealth between oneself and other persons: the degree of one’s love for other persons relative to oneself. We give our wealth without compensation to
Political Economy & Distribution
• Domestic economy: Similar moral imperative to love others as yourself applies to decisions at every social level, from the personal to the political; but the practical limits on distribution imposed by the fact of scarcity also apply — The approximate equality of wealth and income that can be practiced in a group the size of a household cannot be extended to a whole nation or the world.
• Yet, there is wide acceptance of specialized methods of distribution at the domestic level:
• For example, the endowment of charitable foundations by personal gifts and bequests and the incorporation of charitable distribution into the ordinary functions of guilds and business partnerships.
• Political economy questions:
• Right to ownership and use of property: What right do humans have to appropriate inanimate objects and animals for their own use? To human slavery?
• Should most or all property be privately owned or held in common?
• Who should have responsibility for alleviating cases of extreme need?
• Should restrictions be imposed on economic activity, such as freedom of foreign and domestic trade or allowable wages and prices? and
• How should the government's own finances be conducted?
Final Distribution & Government
• Private vs. communal ownership : From this view it follows that a political commonwealth obviously does require some “common wealth”: common goods administered by government to promote the general common good.
• Private ownership usually has the triple advantage of greater social peace, productivity, and order.
• Purpose of government: People form a group for the purpose of living well together, a thing which the individual person living alone could not attain, and good life is virtuous life. The primary concern here is with establishing and maintaining social order.
• Whether or not the government provides such goods itself, it must ensure that there are places of learning, military defense, law courts, markets, places of worship, and the various productive occupations.
• Care for the needy : The ownership of wealth does not necessarily coincide with its use:
that is the whole point of making decisions about its final distribution. And human
arrangements of private property do not supersede the fact that every human being
requires property to live.
• The fact of scarcity as the reason for placing the general responsibility for the poor, except
in emergencies, primarily on individual persons in their various intermediating social relationships rather than the government.
The Political Philosophy of Redistributing Income
Consider three philosophies (moving on from Scholastics to Neo-Classical economic analysis):
• Utilitarianism
• Liberalism
• Libertarianism
Utilitarianism
• Utility: A measure of happiness or satisfaction.
• Utilitarianism: Utilitarianism argues that govt should choose policies to maximize society’s total utility.
• Founders: Jeremy Bentham, John Stuart Mill.
• Because of diminishing marginal utility,
• Redistributing income from rich to poor, which
• Increases utility of the poor more than it reduces utility of the rich.
• Yet, utilitarians do not advocate equalizing incomes – would reduce the total income of everyone due to incentive effects and efficiency losses.
Liberalism
• Liberalism: Liberalism argues that govt should choosevpolicies deemed to be just by an impartial observervbehind a “veil of ignorance”.
• Founder: John Rawls
• Maximin criterion: Govt should aim to maximize the
well-being of society’s worst-off person. • Calls for more redistribution than utilitarianism (though
still not complete equalization of incomes).
• Income redistribution is a form of social insurance, a govt policy aimed at protecting people against the risk of adverse events.
Libertarianism
• Libertarianism: Libertarians argues that govt should punish crimes and enforce voluntary agreements but not redistribute income.
• Advocate: Robert Nozick
• Instead of focusing on outcomes, libertarians focus on the process.
• Govt should enforce individual rights, should try to equalize opportunities.
• If the income distribution is achieved fairly, govt should not interfere, even if unequal. • From the review of redistribution of income philosophies, arguably one common takeaway is:
• Most people believe govt should provide a “safety net”.
Encouraging or Discouraging Consumption
In general, among the post-Rawlsian, the rights- based alternatives, such as the libertarian, the socialistic, the communitarian, the globalist, and the feminist, there is an attempt to interpret justice as requiring respect for the dignity of all persons as
free and equal, rational moral agents. The progressive development of this Kantian idea is becoming increasingly prominent in Western theories of justice.
• Around the world, many people judge certain products to be good or bad based on culture, religion, health or other values.
• Taxes discourage people from consuming bad products without banning them.
• Examples: tobacco and alcohol
• Sometimes, reducing or increasing consumption increases total surplus:
• If your consumption affects others, and that is not captured in the price, then consumption will not be efficient without intervention.
• Subsidies encourage people to consume more of the good products or services.
• Examples: Education and vaccinations provide public benefits and receive public funding (i.e., tax revenues collected from taxpayers).
Four Real-World Interventions
• Let’s consider four real world interventions:
1. A maximum price on tortillas in Mexico.
2. A minimum price for milk in Canada.
3. Tax on high-fat or high-calorie foods.
4. A subsidy on tortilla.
Positive vs. normative analysis
Positive analysis is about facts: Does the policy actually accomplish the original goal?
Normative analysis is a matter of values and opinions: Do you think the policy is a good idea?
Price controls
• Price controls fall into two categories:
• A price ceiling is a maximum legal price at which a good can be sold.
• A price ceiling only affects the market if it is below the equilibrium price.
• If a price ceiling is above the equilibrium price, the market will be able to reach equilibrium.
• A price floor is a minimum price at which a good can be sold.
• A price floor only affects the market if it is above the equilibrium price.
• If a price floor is below the equilibrium price, the market will be able to reach equilibrium
Examples:
PRICE CEILING
• Historically Mexico has set a price ceiling for tortillas, intending to guarantee that people could afford them.
• Consider the case where milk tortilla prices would rise to $0.50 per kilogram, with an equilibrium quantity of 50 million kilograms.
• A price ceiling of $0.25 would prevent the market from reaching this high equilibrium price.
• Quantity supplied would decrease.
• Quantity demand would increase.
• This would create a shortage of tortillas.
PRICE CEILING AND SHORTAGES
• In this example, with the price ceiling, people want to buy three times as many tortillas as suppliers will sell.
• Does this help consumers? Yes and no.
• Some consumers could buy some tortillas at a low price of $0.25 a kilograms.
• Some consumers would not be able to buy any tortillas due to the shortage.
• What about producers?
• producer surplus would fall due to the lower price.
• Overall, total surplus falls – there is a deadweight loss – because a lower quantity is exchanged than would occur in equilibrium
PRICE CONTROLS - WELFARE EFFECTS
• We can’t predict whether a price ceiling will help or hurt consumers without examining the conditions of the particular market.
• If area 1 is larger than area 2, there is an overall loss because the loss from lack of supply is greater than the benefit of the lower price.
• If area 2 is larger than area 1, then consumers gain more from the lower price than is the loss from the lower quantity supply.
• We can be certain producers lose surplus.
• If there is no market failure, then there is always a deadweight loss.
• Is it worthwhile? That is a normative question.
• We can calculate the deadweight loss, governments and people decide if it is worth paying?
CH7 Consumer behavior
Utility and Decision Making
Consumer Choices: Economists ask about consumer wants and constraints, prompting reflection on personal wants and constraints.
Maximizing Utility: Consumers face choices that maximize utility while considering constraints like time and money.
The Concept of Utility
Definition: Utility measures satisfaction derived from goods, services, and experiences.
Subjectivity: Utility is subjective and varies between individuals, making it difficult to measure directly.
Independence from Price: Utility is not dependent on price but on the satisfaction derived from consumption.
Utility Function
Numerical Representation: Utility is represented as a numerical value reflecting the ranking of various bundles of goods.
Relationship to Bundles: The utility function relates utility measures to all possible bundles of goods.
Indifference Curves: Graphically represent consumer preferences and the trade-offs between different goods.
Preferences: Graphical Indifference Curves
Ranking of Goods: Consumers rank goods based on the satisfaction they provide.
Indifference Curves: Show bundles providing equal utility, with key properties:
Higher curves represent higher utility.
Curves cannot cross or be thick.
They slope downward, indicating trade-offs.
Marginal Utility
Definition: Marginal utility is the additional satisfaction from consuming one more unit of a good.
Diminishing Marginal Utility: Each additional unit consumed yields less additional satisfaction.
Example: The first scoop of ice cream provides high utility, but subsequent scoops provide less.
Preference Maps
Graphical Representation: Illustrate consumer preferences over two goods.
Indifference Curves: Show the consumer's willingness to substitute between goods.
Utility Maximization
Goal: Consumers aim to maximize utility within their budget constraints.
Rationality Assumption: Rational utility maximization is assumed in economic analysis.
Complexity: Discusses the complexity of utility maximization, including trade-offs between immediate satisfaction and long-term benefits.
Budget Constraint
Definition: Represents the maximum spending capacity of a consumer.
Graphical Representation: A line showing all possible combinations of goods that can be purchased within a fixed budget.
Slope Interpretation: The slope indicates the trade-off between different goods.
Maximizing Utility Within Constraints
Optimal Bundle: Consumers maximize utility by choosing the optimal bundle of goods within their budget.
Tangency Condition: The optimal bundle occurs where the highest indifference curve is tangent to the budget line.
Changes in Income and Prices
Income Increase: Allows consumers to purchase more goods, shifting the budget constraint outward.
Price Changes: Affect purchasing power and consumption choices through income and substitution effects.
Income and Substitution Effects
Income Effect: Describes changes in consumption due to increased effective wealth from lower prices.
Substitution Effect: Describes changes in consumption due to changes in relative prices.
Deriving Demand Curves
Demand Curve Derivation: Demand curves can be derived from consumer behavior in response to price changes.
Illustration: Changes in price affect the quantity demanded.
Utility and Society
Social Dimensions: Utility extends beyond individual consumption to include social and emotional factors.
Altruism and Reciprocity: Concepts illustrate how utility can be derived from social interactions and helping others.
Key Concepts
Utility: A measure of satisfaction or pleasure derived from consuming goods and services.
Marginal Utility: The additional satisfaction gained from consuming one more unit of a good or service.
Diminishing Marginal Utility: The principle that each additional unit consumed yields less additional satisfaction than the previous unit.
Budget Constraint: Represents the maximum amount of money available for spending on goods and services, illustrated by a budget line.
Indifference Curves: Graphical representations of consumer preferences, showing combinations of goods that provide equal utility.
Optimal Consumption Bundle: The combination of goods that maximizes utility within the constraints of the budget.
Rational Utility Maximization: The assumption that consumers make choices to maximize their utility based on preferences and constraints.
Income Effect: The change in consumption resulting from a change in purchasing power due to price changes.
Substitution Effect: The change in consumption resulting from a change in the relative price of goods.
Demand Curve: A graphical representation of the relationship between the price of a good and the quantity demanded.
Revealed Preference: The concept that consumer choices reveal their preferences and the utility derived from different goods.
Altruism: The motivation to help others without expecting anything in return, contributing to overall utility.
Reciprocity: The motivation to respond to another's action with a similar action, influencing consumer behavior.
Consumer Choice Theory: The study of how individuals make decisions to allocate their resources among various goods and services.
Social Dimensions of Utility: The understanding that utility can be influenced by social interactions, norms, and perceptions.
CH12 Costs of production
What Are You Paying For in a Prescription?
Example of Lipitor: Lipitor, a cholesterol-lowering drug produced by Pfizer, generated a staggering $160 billion in total revenue over its 23 years of market presence, illustrating the financial impact of successful pharmaceuticals.
Market Context: With 2.4 million Canadians suffering from cardiovascular disease, Lipitor's sales represented a significant portion of Pfizer's overall revenue, highlighting the drug's importance in the healthcare market.
Cost vs. Price Analysis: The manufacturing costs of Lipitor are a small fraction of its retail price, primarily due to substantial investments in research and development (R&D), which averaged $879.3 million in 2018. This disparity underscores the financial risks pharmaceutical companies face in developing new drugs.
Fixed Costs: R&D costs are classified as fixed costs, as they are incurred regardless of the number of drugs sold. In contrast, variable costs, such as raw materials and labor, fluctuate based on production levels.
The Building Blocks of Business: Revenues, Costs, and Profits
Profit Definition: Profit (π) is defined as the difference between total revenue and total cost, serving as a critical measure of a firm's financial health.
Revenue Calculation: Total revenue is calculated as the product of the quantity sold and the price per unit. For instance, if Pfizer sells 5 billion Lipitor pills at $2.70 each, the total revenue amounts to $13.5 billion.
Example Calculation: This example illustrates how revenue generation is fundamental to a firm's operations and profitability.
Total Costs
Total Costs Formula: Total costs are calculated as the sum of fixed costs and variable costs, providing a comprehensive view of a firm's financial obligations.
Fixed Costs: These are costs that remain constant regardless of production levels, such as salaries, rent, and R&D expenses. (DONT CHANGE)
Variable Costs: These costs vary with production levels, including expenses for raw materials, labor, and utilities. (CHANGE)
Explicit and Implicit Costs
Explicit Costs: These are direct monetary payments made by a firm, such as rent, wages, and materials, which are easily identifiable in financial statements.
Implicit Costs: These represent the opportunity costs of using resources in a particular way, such as the potential income lost from using owned property instead of renting it out.
Economic and Accounting Profit
Accounting Profit: This is calculated as total revenue minus explicit costs, reflecting the profit reported in financial statements.
Economic Profit: This is calculated as total revenue minus all opportunity costs (both explicit and implicit), providing a more comprehensive view of a firm's profitability.
Example: A firm may report a positive accounting profit while experiencing a negative economic profit if implicit costs are significant, highlighting the importance of considering all costs in decision-making.
Production Function
Definition: The production function describes the relationship between inputs (such as labor and capital) and outputs (goods and services), illustrating how resources are transformed into products.
Marginal Product: This refers to the additional output produced by adding one more unit of input, which is crucial for understanding production efficiency.
Diminishing Marginal Product: This principle states that as more units of an input are added, the additional output produced will eventually decrease, impacting production strategies.
Costs of Production
Short Run vs. Long Run: In the short run, some inputs are fixed, while in the long run, all inputs can be varied. This distinction is vital for strategic planning and resource allocation.
Economies of Scale: These are cost advantages that firms experience as they increase production, leading to lower average costs.
Diseconomies of Scale: These occur when a firm becomes too large, resulting in increased per-unit costs, which can negatively impact profitability.
Average and Marginal Costs
Average Costs: These are calculated by dividing total costs by the quantity of output, providing insight into cost efficiency.
Marginal Cost: This is the cost of producing one additional unit of output, calculated as the change in total cost divided by the change in quantity, which is essential for optimizing production levels.
Summary of Key Concepts
Total Revenue: The total amount received from sales of goods and services.
Total Cost: The total amount paid for inputs used in production.
Profit: The difference between total revenue and total cost.
Fixed Costs: Costs that do not change with production levels.
Variable Costs: Costs that vary with production levels.
Explicit Costs: Direct monetary costs incurred by a firm.
Implicit Costs: Opportunity costs associated with resource allocation.
Economic Profit: Total revenue minus all opportunity costs.
Accounting Profit: Total revenue minus explicit costs.
Production Function: The relationship between inputs and outputs in production.
Marginal Product: The increase in output from an additional unit of input.
Diminishing Marginal Product: The decrease in additional output from increased input.
Economies of Scale: Lower average costs associated with increased production.
Diseconomies of Scale: Higher average costs associated with increased production.
CH13 Perfect competition
Price Takers:
Individual buyers and sellers cannot influence market prices.
Firms accept the prevailing market price for goods and services.
Buyers and sellers base transactions on the market-determined price, making them "price takers."
Standardized Goods:
Products are identical and interchangeable.
Buyers have no reason to prefer one seller over another if prices are the same.
Commodities like lumber, oil, and agricultural products often serve as examples of standardized goods.
Free Entry and Exit:
No significant barriers exist for firms to enter or exit the market.
New firms enter when they anticipate profits; existing firms exit if unable to cover costs.
Examples:
Low investment industries (e.g., plantain roasting) allow easy entry.
High investment industries (e.g., oil production) face barriers to entry.
Revenue and Cost Concepts
Revenue Metrics:
Marginal Revenue (MR): Revenue from selling one additional unit; MR = Price (P).
Total Revenue (TR): TR = P × Quantity (Q).
Average Revenue (AR): AR = TR / Q = P.
Cost Structure:
Fixed Costs: Independent of production levels (e.g., equipment rental).
Variable Costs: Change with production levels (e.g., raw materials).
Profit Maximization:
A firm maximizes profit by producing where MR = Marginal Cost (MC).
If MC < MR: Increase production.
If MC > MR: Reduce production.
Short-Run Decision-Making
Production Decisions:
Operate if the market price covers at least Average Variable Costs (AVC).
Shut down temporarily if Price (P) < AVC to avoid losses greater than fixed costs.
Short-Run Supply Curve:
The portion of the Marginal Cost (MC) curve above the AVC represents the short-run supply curve.
Long-Run Decision-Making
Exit and Entry:
Firms exit the market if P < Average Total Cost (ATC).
Firms enter the market if P > ATC.
Long-Run Supply Curve:
In perfectly competitive markets, the long-run supply curve is typically horizontal (perfectly elastic).
Firms operate where P = Minimum ATC, earning zero economic profit.
Adjustments to Market Changes:
Price increases attract new firms, increasing supply and driving prices back to equilibrium.
Price decreases cause firms to exit, reducing supply until P = ATC.
Key Examples and Graphical Insights
Revenue Table for Plantains (Example):
Shows TR, AR, and MR at constant prices. MR remains equal to P, simplifying calculations.
Cost and Profit Table:
Tracks total costs, revenues, and profits for different production levels.
Highlights how rising marginal costs reduce profits as production increases.
Graphs:
Illustrate relationships between MC, ATC, AVC, and price.
Show optimal production points where MR = MC.
Market Responses to Changes
Demand Increase:
Short Run: Higher prices and profits encourage production increases.
Long Run: Entry of new firms shifts supply right, reducing prices back to equilibrium.
Demand Decrease:
Firms reduce output or exit the market if prices fall below ATC.
Temporary shut-downs occur if P < AVC, avoiding further losses.
Efficiency and Long-Run Dynamics
Efficient Scale:
Firms operate at the lowest point of their ATC curve in the long run.
Production aligns with P = MC = ATC, minimizing costs and maximizing efficiency.
Zero Economic Profit:
In the long run, firms earn zero economic profit, reflecting competitive equilibrium.
Accounting profits still exist but are equal to opportunity costs.
Variations in Long-Run Supply Curves
Perfectly Elastic Supply:
Identical firms with the same cost structures ensure a horizontal long-run supply curve.
Upward-Sloping Supply:
Differences in firm efficiency or increasing input costs may cause the supply curve to slope upward.
The least efficient firms set the market price.
CH14 Monopoly
Characteristics of a Monopoly
Market Power: Ability to set prices above marginal cost due to no competition.
Sources of Monopoly Power:
Scarce Resources: Unique or hard-to-access inputs.
Economies of Scale: Cost advantages favor large-scale production (e.g., utilities).
Government Intervention: Patents, copyrights, or regulated monopolies.
Aggressive Tactics: Predatory pricing or exclusive deals.
Monopoly Behavior
Profit Maximization:
Produce where Marginal Revenue (MR) = Marginal Cost (MC).
Set price based on demand for this quantity.
Demand Curve:
Downward sloping: To sell more, the monopolist must lower the price.
Revenue Metrics:
Total Revenue (TR) = Price × Quantity.
Average Revenue (AR) = TR / Q.
MR decreases faster than AR due to price reductions for all units sold.
Social Welfare Impacts
Deadweight Loss:
Monopolies restrict output and raise prices compared to competitive markets.
Results in lost consumer and producer surplus.
Corruption and Inefficiency:
Monopolies in critical goods (e.g., wheat, electricity) harm societal efficiency.
Elasticity and Pricing:
Monopolists exploit inelastic demand to set higher prices (e.g., pharmaceuticals).
Price Discrimination
Definition: Charging different prices for the same product based on willingness to pay.
Types:
First-Degree (Perfect): Charge each consumer their maximum willingness to pay.
Second-Degree: Price varies with quantity or product version.
Third-Degree: Different prices for different consumer groups (e.g., student discounts).
Benefits:
Increases firm profit by reducing consumer surplus.
May enhance efficiency by covering fixed costs or increasing output.
Challenges:
Preventing arbitrage and identifying willingness to pay.
Public Policy Responses
Antitrust Laws:
Prevent monopolistic practices and break up dominant firms.
Examples: Sherman Act, Clayton Act (U.S.).
Price Regulation:
Set price caps to mimic competitive outcomes.
Risks: Incorrect pricing may deter investment or cause losses.
Public Ownership:
Government operates monopolies to serve public interest (e.g., Canada Post).
Challenges: Efficiency loss due to lack of profit motive.
Market Restructuring:
Vertical or horizontal splits to foster competition (e.g., electricity generation in New Zealand).
Natural Monopolies
Definition: A single firm can supply the market at a lower cost than multiple firms due to economies of scale.
Policy Options:
Regulate prices to balance efficiency and accessibility.
Public ownership to ensure fair pricing and service coverage.
CH18 Externalities
Introduction to Externalities
Externality: A cost or benefit impacting bystanders not involved in a transaction.
Negative Externality: External costs (e.g., pollution, traffic congestion).
Positive Externality: External benefits (e.g., education, vaccinations).
Social Cost: Private cost + External cost.
Social Benefit: Private benefit + External benefit.
Inefficiency:
Markets with externalities fail to maximize total surplus.
Negative externalities result in overproduction.
Positive externalities result in underproduction.
Key Concepts and Examples
Negative Externalities:
Examples:
Pollution from factories.
Traffic congestion increasing air pollution.
Effects:
Social costs exceed private costs.
Overproduction leads to deadweight loss (DWL).
Private equilibrium quantity exceeds efficient equilibrium.
Positive Externalities:
Examples:
Home improvements raising neighborhood property values.
Vaccinations reducing disease spread.
Effects:
Social benefits exceed private benefits.
Underproduction results in DWL.
Private equilibrium quantity is below efficient equilibrium.
Private Solutions
Coase Theorem:
Private bargaining can resolve externalities if transaction costs are low and property rights are clearly defined.
Limitations:
High transaction costs.
Difficulty in enforcing agreements.
Examples:
Polluters compensating affected parties.
Neighbors paying for shared benefits (e.g., landscaping).
Government Interventions
Taxes and Subsidies:
Pigouvian Tax:
Counteracts negative externalities by increasing private costs to reflect social costs.
Example: Carbon tax to reduce emissions.
Pigouvian Subsidy:
Counteracts positive externalities by increasing private benefits to reflect social benefits.
Example: Subsidies for education or renewable energy.
Quotas and Tradable Allowances:
Quotas:
Set a maximum limit on production or consumption.
Example: Emission caps.
Tradable Permits:
Allow firms to buy and sell quotas.
Example: Cap-and-trade systems for pollution.
Command-and-Control:
Direct regulation of quantities or processes.
Example: Mandatory installation of catalytic converters in vehicles.
Evaluating Policies
Taxes vs Tradable Permits:
Taxes generate revenue but require precise calibration.
Permits ensure efficient allocation but require a market for trading.
Subsidies:
Improve efficiency but depend on funding sources.
Risks: Over-subsidization or unfair distribution of benefits.
Command-and-Control:
Simpler but less flexible than market-based approaches.
Network Effects and Externalities
Positive Network Effects:
Increased participation enhances value (e.g., social media).
Negative Network Effects:
Over-participation reduces value (e.g., internet congestion).
Climate Change and Externalities
Carbon Pricing:
Taxes or tradable permits address greenhouse gas emissions.
Challenges include political opposition and equitable distribution of costs.