ECON 202: Principles of Microeconomics Review Session for Exam 2 Chapters 5, 6, 9 and 10

ECON 202: Principles of Microeconomics

Review Session for Exam 2

Chapters 5, 6, 9 and 10

Review Session for Exam 2 2ECON 202: Princ. of Microeconomics


1. Externalities, Public Goods and Common Resources.

2. Elasticities.

3. Consumer Behavior.

4. Firm’s Production and Costs.


1. Externalities, Public Goods and Common Resources Externality:

A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.

An externality causes a difference between: the private cost of production and the social cost of production,

or the private benefit from consumption and the social benefit from

consumption.

Presence of externality creates a situation of market failure. When the market fails to produce the efficient level of output.


1. Externalities, Public Goods and Common Resources Negative Externality in Production


Private Solution to Externalities Markets can cure market failure if property rights are

clearly assigned. Coase Theorem

If transaction costs are low, private bargaining will result in an efficient solution to the problem of externalities.

In practice, we would also need: All parties have full information about costs and benefits

associated with the externality. Parties make reasonable demands.

1. Externalities, Public Goods and Common Resources


1. Externalities, Public Goods and Common ResourcesGovernment Solution to Externalities In case of negative externalities in production,

government can impose a tax to make producers internalize the externality. Amount of tax = Difference between Social Marginal Cost and

Private Marginal Cost.

In case of positive externalities in consumption, government can impose a subsidy to make consumers internalize the externality. Amount of subsidy = Difference between Social Marginal Benefit

and Private Marginal Benefit.


Goods can be classified according to Rivalry: When one person’s consuming a unit of a good

means no one else can consume it. Excludability: When anyone who does not pay for a

good cannot consume it.

1. Externalities, Public Goods and Common Resources


For a public good, the aggregate demand is found by adding vertically the individual demands.

Consumer have incentives to not reveal their willingness to pay.

Market do not provide the economically efficient quantity of public goods.

Usually governments provide them.


1. Externalities, Public Goods and Common Resources Free use of common resources can conduce to over-

exploitation, since users do not bear all the costs. Tragedy of the commons.


2. Elasticity

Price elasticity of demand How much quantity demanded varies when price

changes. Midpoint formula:

2

2

21

12

21

12

PPPP

QQQQ

price in change Perc.

demanded quantity in change Perc.dmd. elast. Price

Unit-elastic

Elastic Inelastic

-1 0-∞ +∞


2. Elasticity Polar cases: Perfectly inelastic demand.

Quantity demanded is completely unresponsive to price.

Price elasticity of demand is zero.

Perfectly elastic demand. Quantity demanded is

infinitely responsive to price Price elasticity of demand

equals infinity.


2. ElasticityDeterminants of Price Elasticity of Demand Availability of close substitutes.

More substitutes available, more elastic demand. Passage of time.

As more time passes, more elastic the demand. Luxuries vs. Necessities.

Demand curve for a luxury is more elastic than the demand curve for a necessity.

Definition of the market. The more narrowly defined a market, the more elastic the

demand. Share of a good in a consumer’s budget.

The bigger the share in the consumer’s budget, the more elastic.


2. Elasticity

Elasticity Price of Demand and Total Revenue When demand inelastic:

A cut in price increases quantity demanded less than proportionally.

Total revenue decreases. When demand elastic:

A cut in price increase quantity demanded more than proportionally.

Total revenue increases. When demand unit-elastic:

A cut in price increase quantity demanded proportionally. Total revenue does not change.


2. Elasticity

Cross-Price Elasticity of Demand

Complementary goods Substitute goods

0-∞ +∞

2

2

21

12

21

12

otherother

otherother

PP

PP

QQQQ

demand of elasticity price -Cross


2. Elasticity

Income Elasticity of Demand

Inferior good Normal good

0 1-∞ +∞

LuxuryNecessity

2

2

21

12

21

12

IIII

QQQQ

demand of elasticity Income


2. Elasticity

Price elasticity of supply How much quantity supplied varies when price changes. Midpoint formula:

2

2

21

12

21

12

PPPP

QQ

QQSS

SS

price in change Perc.

supplied quantity in change Perc.supply. of elasticity Price

Unit-elastic

Inelastic Elastic

0 1-∞ +∞


2. Elasticity

Price elasticity of supply depends on the availability of inputs and capital to increase production. Inelastic in a short period of time. After some time has passed, supply will become more elastic.


3. Consumer Behavior

Utility and Consumer Decision Making Basic idea of the model:

Consumers buy the affordable combination of goods that makes them as well of as possible.

In economic terms: Given the income and prices, consumers will choose a bundle of

goods that maximizes their utility.

Law of diminishing marginal utility. The more you consume of a good, the less utility you receive

from the last unit consumed.


3. Consumer Behavior How consumers make decisions

Consumers spend progressively their money available in the goods which give the highest utility per dollar spent.

Suppose slice of pizza cost $2, cup of coke cost $1 and total income is $10.

(1)Slices

of Pizza

(2)Marginal Utility

( MUPIZZA )

(3)Marginal Utility

per Dollar(4)

Cupsof Coke

(5)Marginal Utility

( MUCOKE )

(6)Marginal Utility

per Dollar

1 20 10 1 20 20

2 16 8 2 15 15

3 10 5 3 10 10

4 6 3 4 5 5

5 2 1 5 3 3

6 3 -- 6 1 --

Pizza

Pizza

P

MU

Coke

Coke

P

MU


3. Consumer Behavior Optimal consumption satisfy two conditions:

All money is spent. Marginal utility per dollar is equal across goods.

When second condition is not satisfied, we can increase utility by: Consuming less of the good with lower utility per dollar, and Consuming more of the good with higher utility per dollar.

Sometimes, marginal utility per dollar is never equal across goods. Choose the combination with the smallest difference between

MU per dollar across goods.


3. Consumer Behavior What happens when the price of one of the good changes? Substitution effect:

Change in quantity demanded keeping constant the consumer purchasing power.

Income effect: Change in quantity demanded that results from the change

consumer purchasing power.

D

Giffen good D





Other factors affecting consumer’s decision Social recognition

Consumer can receive utility from consume goods that them appear knowledgeable and fashionable.

Buying decision depends partially in good’s characteristics and partially in how many other people are buying the product.

Celebrity Endorsement Consumers can believe that public figures are particularly

knowledgeable about products. Consumers feel more fashionable and closer to famous people if

the use the same product they do.


3. Consumer BehaviorOther factors affecting consumer’s decision (cont.) Network Externalities

For some products, its usefulness increases with the number of consumers that use it. (network externality)

Network externalities can create considerable switching costs. Fairness

Evidence that people like to be treated fairly and usually try to treat others fairly.

Ultimatum and dictator game. Businesses consider this concern and keep prices low in some

demand spikes. Consumers will avoid a firm if they believe firm acts unfairly. By clearing excess of demand, firms can also make disappear the

popularity of their products.


3. Consumer BehaviorBehavioral Economics

The study of situations in which people make choices that do not appear to be economically rational.

Ignoring Nonmonetary Opportunity Costs If you own something you could sell, using it involves an

opportunity cost. (ticket example) Behavioral economist believe that inconsistency is caused by

endowment effect. Tendency of people to value more something when they own it than

when they don’t.

Failing to Ignore Sunk Costs A sunk cost is a cost that has already been paid and cannot be

recovered, and it should be ignored in any later decision.



Behavioral Economics (cont.) Being Unrealistic About Future

People over-value current consumption and under-value future consumption.

People have long-run goals, but day to day decisions are not consistent with those goals.

Some economist argue that these are cases of inconsistent preferences over time.


4. Firm’s Production and Costs

Technology are the processes a firm uses to turn input into output of goods and services.

Technological change is a change in the ability of a firm to produce a given level of output with a given quantity of inputs.

Short-run is the period of time when at least one input is fixed. Usually, the capital is the fixed input.

Long-run is the period of time when a firm can vary all its inputs. Size of physical plants or technology used can be changed.



In the short run, having at least an input fixed imposes to the firm costs that can not avoid: fixed cost.

Also, the inputs that the firm can vary impose a cost that depends on their use: variable cost.

Variable Cost + Fixed Cost = Total Cost Relevant measure of costs is the Economic Cost, which

include: Explicit costs (Accounting costs): Costs paid in money. Implicit costs: Opportunity costs



Production function is the relationship between the inputs used and the output produced.

Marginal Product of Labor is the increase in production by hiring one additional worker. After certain number of workers, increments in production will be

every time smaller. (law of diminishing returns)

Average Product of Labor is the quantity produced divided by the amount of workers hired.



QUANTITY OF WORKERS

QUANTITY OF

PIZZA OVENS

QUANTITY OF PIZZAS

PER WEEK

MARGINAL PRODUCT OF

LABOR

AVERAGE PRODUCT OF

LABOR

0 2 0 — —

1 2 200 200 200

2 2 450 250 225

3 2 550 100 183.3

4 2 600 50 150

5 2 625 25 125

6 2 640 15 106.7


4. Firm’s Production and Costs With information from production function, we can also

obtain the costs the firm faces.

QUANTITY OF WORKERS

QUANTITY OF

PIZZA OVENS

QUANTITY OF PIZZAS

PER WEEK

COST OF PIZZA OVENS (FIXED COST)

COST OF WORKERS

(VARIABLE COST)

TOTAL COST OF PIZZAS

0 2 0 $800 $0 $800

1 2 200 800 650 1,450

2 2 450 800 1,300 2,100

3 2 550 800 1,950 2,750

4 2 600 800 2,600 3,400

5 2 625 800 3,250 4,050

6 2 640 800 3,900 4,700



Marginal Cost is the change in a firm’s total cost from producing one more unit of a good or service.

When production changes by many units after increasing an input, marginal cost can be estimated as:

In the short-run: If marginal product of labor increase, marginal cost decreases. If marginal product of labor decreases, marginal cost increases.

Produced Quantity in Change

Cost Total in Change Cost Marginal



Average Total Cost = Total Cost / Quantity Total Cost = Fixed Cost + Variable Cost Average Total Cost = Average Fixed Cost +

Average Variable Cost

Average Fixed Cost = Fixed Cost / Quantity Average Variable Cost = Variable Cost / Quantity




Marginal Cost (MC), Average Total Cost (ATC) and Average Variable Cost (AVC) are U-shaped

Marginal Cost (MC) intercepts ATC and AVC at minimum point. When MC is higher than ATC, ATC increases. When MC is lower than ATC, ATC decreases. When MC is higher than AVC, AVC increases. When MC is lower than AVC, AVC decreases.

As output increases, Average Fixed Cost turns smaller. As output increases, difference between Average Total

Cost (ATC) and Average Variable Cost (AVC) shrinks.


Cost in the long-run When in the long-run a firm can decrease average cost

by increasing production, this firm experiences economies of scale.

Level of output where economies of scale are exhausted: minimum efficient scale.

If long-run average cost remain unchanged as production increases, the firm experiences constant returns to scale.

If long-run average cost increases as production increases, the firm experiences diseconomies of scale.



Problems

According to some recent reports, the livestock sector generates more greenhouse gas emissions than transport, which contributes to global warming. As a consequence, the agricultural sector has been affected by a substantial reduction in crop yields.Suppose the effect of the externality from the livestock to the agricultural sector can be measured as $120 per head of cattle.Find the DWL and the efficient number of heads. How would the government intervene this market to reach the efficient level of production?

Marginal Benefit

Private Marginal Cost

Marginal Cost and Marginal Benefit

Millions of Heads

$1,000

100

Livestock market

$1,060

$940

90

$1,120

$880

80 120110


Problems


Problems


Problems


Problems


Problems

Ernest can spend all his money in buying fish and coconuts. The store charges one dollar for a coconut and 2 dollars for a fish. After spending all his money, with his current consumption, Ernest is obtaining 60 units of marginal utility per dollar from fish and 80 units of marginal utility per dollar from coconuts.

Is he optimizing his utility? If not, which good should he increase consumption?

Now the price of fish goes down to $1.5 and Ernest has his income reduced. Suppose that Ernest is again spending all his money and consuming the original combination of goods.

Is he optimizing his utility? If not, which good should he increase consumption?


Problems

ECON 202: Principles of Microeconomics


Chapters 5, 6, 9 and 10

Documents

ECON 202: Principles of Microeconomics Review Session for Exam 2 Chapters 5, 6, 9 and 10