Tran LyMicroeconomics Notes & PracticesAdvent 2014

Chapter 1: Introduction• Microeconomics: Branch of economics that deals with behavior of individual economic units – consumers,

firms, workers, and investors – as well as the markets that these units comprise.• Describe how prices are determined through the government and interaction between consumers, worker,

and firms• Positive analysis: Describing relationships of cause and effect• Normative analysis: Examining questions of what ought to be• Market: collection of buyers and sellers that, through their actual or potential interactions, determine the

price of a product. • Arbitrage: practice of buying at a low price at one location and selling at a higher price in another• Perfectly competitive market: many buyers and sellers; no single agent has a significant impact on price• Nominal price: absolute price of a good; unadjusted for inflation• Real price: price of a good relative to an aggregate measure of price; price adjusted for inflation

CHAPTER 2: The Basis of Supply and Demand

1. Supply and Demand: a. The Supply Curve: Relationship between the quantity of a good that producers are willing to sell and

the price of the good.- Law of supply: The higher the price, the more firms are able and willing to produce and sell.- Upward sloping curve

b. The Demand Curve: Relationship between the quantity of a good that consumers are willing to buy and the price of the good.

- Law of Demand: the lower the price, the more consumers will want to purchase a good.Shifting the Demand Curve: Change in income:

• Normal good: As Income increase, quantity demand for normal good increase, D shifts to the right.• Inferior good: As Income increase, quantity demand for inferior good decrease, D shifts to the left. OR change in price of substitutes or complements: 1. Substitutes: two goods for which an increase in the price of one lead to an increase in the quantity

demanded of the other.2. Complements: two goods for which an increase in the price of one leads to a decrease in the quantity

demanded of the other.

Variables that affect supply:• Price of the goods• Production costs (Land, Labor, Capital,

Wages, Interest charges, Raw materials)• Technology• Information (future expectation, price

increases => supply decreases) • When production cost decrease, output

increase => S shifts right

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OR Taste & preference; Taxes and Subsidies; Information

2. The Market Mechanism:a. Equilibrium: A situation in which each individual is doing his/her best given the decisions of

the other individuals- Equilibrium (or market clearing) price: Price that equates the quantity supplied to the quantity demanded.- Market mechanism: Tendency in a free market for price to change until the market clears.

- Assumptions:1. At any given price, a given quantity will be produced and sold.2. Represents what goes on in a perfectly competitive market: Many sellers and buyers; No barrier of entry;

Homogenous products; Full information =>Firms and Consumers are price takers.* No individual can influence the price with their actions.

3. Changes in market equilibrium:(Graph – Shift of supply and demand curves over time as market conditions change)

- Example 2.1.a. Market for Eggs. The supply curve for eggs shifted right as production costs fell; the demand curve shifted to the left as consumer preferences changed. As a result, the real price of eggs fell sharply and egg consumption rose.

- Example 2.1.b. Market for College Education. The supply curve for a college education shifted right as the costs of equipment, maintenance, and staffing rose. The demand curve shifted to the right as a growing number of high school graduates desired a college education. Both price and enrollments rose sharply.

Surplus: Situation in which the quantity supplied exceeds the quantity demanded (Excess supply: pressure to lower price)

Shortage: Situation in which the quantity demanded exceeds the quantity supplied (Excess demand: pressure to increase price)

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4. Elasticity of Supply and Demand:- Elasticity: Percentage change in one variable resulting from a 1-percent increase in another.- Price Elasticity of Demand: Percentage change in quantity demanded of a good resulting from a 1%

increase in its price.

- The demand is price elastic when ED < -1 or |ED| > 1 - The demand is price inelastic when ED > -1 or |ED| < 1

a. Linear Demand Curve: Demand curve that is a straight line: Q = a – bP

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1. Infinitely Elastic Demand:For a horizontal demand curve, ∆ Q /∆ P is infinite. A tiny change in price leads to an enormous change in demand. Demand is perfectly elastic: ED = −∞

1. Completely Inelastic Demand:For a vertical demand curve, ∆ Q /∆ P is 0. Because the quantity demanded is the same no matter what the price, the elasticity of demand is zero: ED = 0

- EPD depends not only on the

slope of the demand curve but also on the price and quantity.

- The elasticity varies along the curve as price and quantity change. Slope is constant for linear demand curve.

- Near the top, price is high and quantity is small => EP get closed to −∞ (More elastic).

- The |elasticity| becomes smaller as we move down the curve.

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b. Other Demand Elasticities:2. Income Elasticity of demand: Percentage change in the quantity demanded resulting from a 1-percent

increase in income.

EI > 0 => Normal goodEI < 0 => Inferior good

3. Cross-price Elasticity of demand: Percentage change in the quantity demanded of one good resulting from a 1-percent increase in the price of another.

EPoD > 0: substitutes; EPo

D < 0: complements

5. Short-run Vs. Long-run elasticities: Demand:

4. Gasoline: Long-run is more elastic than short-run

- In the short run, an increase in price has only a small effect on the quantity of gasoline demanded. Motorists may drive less, but they will not change the kinds of cars they are driving over night.

- In the long run, because they will shift to smaller and more fuel-efficient cars, i.e. electricity cars, the effect of the price increase

will be larger. Demand, therefore, is MORE elastic in the long run than in the short run.

5. Automobiles => Durable Goods. Durability: Long-run is LESS elastic than short-run.

- If price increases, consumers initially defer buying new cars, thus annual quantity demanded falls sharply.

- In the longer run, old cars wear out and must be replaced; thus annual quantity demanded picks up. Demand, therefore, is less elastic in the long run than in the short run.

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6. Income Elasticities:- For most goods and services – foods, beverages, fuel, entertainment, etc. – income elasticity of demand is

larger in the long run than in the short run.- For a DURABLE good, the short-run income elasticity of demand will be much larger than the long-run

elasticity. Supply:

7. Supply and Durability: If the price increases, there is greater incentive to convert scrap copper into new supply. Secondary supply (supply from scrap) increases sharply. Later, as the stock of scrap decreases, secondary supply decreases. Long-run secondary supply is LESS elastic in the short run.

Supply and Demand: S&D for Coffee: A freeze or drought in Brazil causes the supply curve to shift to the left.

8. Short-run:1. In the short run,

supply is completely inelastic; only a fixed number of coffee beans can be harvested.

- Demand is also relatively inelastic; consumers change their habits slowly.

- As a result => the initial effect = SHARP increase in price.

9. Intermediate run:

Both supply and demand are more elastic; price falls part of the way back.

10. Long-run: Supply is extremely elastic; because new coffee trees will have had time to mature, the effect of the freeze/drought will have disappeared. Price returns to P0.

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6. Understanding and Predicting the effects of changing market condition:- Demand: QD = a – bP- Supply: QS = c + dP- Elasticity: Demand: ED = −b(P*/Q*) Supply: ES = d(P*/Q*)- a = Q* + bP*- Q = a − bP + fI

7. Government Intervention – Price controls:- Taxes and Subsidies- Quality controls: quotas, bans- Price controls:

1. Price ceiling: Maximum legal price for a good or service

- Non-biding => No effect and market stays the same.

- Price ceiling < Equilibrium price => Biding, market price drop.

2. Price floor: Minimum legal price for a good or service. E.g. minimum wage.

- Non-binding, no effect on the market- Price floor > Equilibrium prick

=> Binding market price goes up. (Graph)

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3. Taxation (graph – draw): Specific tax: an absolute amount of tax: t

PC = Price consumers payPS = Price suppliers pay

Without tax specific: PC = PS

With a specific tax: PC = PS + t; QD at Pc = QS at PS

t = wedgeBurden of Taxation

For consumers Pc – PFor suppliers: Ps - P

Ad valoren tax: α%Ps = (1 – α)PC

4. Subsidy (graph – draw): Specific subsidy: an absolute amount of subsidy: sub

PC = Price consumers payPS = Price suppliers pay

Without subsidy specific: PC = PS

With a specific subsidy: PC + sub = PS; QD at Pc = QS at PS

Burden of TaxationFor consumers Pc – PFor suppliers: Ps - P

Ad valoren subsidy: α%Pc(1 + α ) = PS

***TAXATION AND PRICE ELASTICITY***(2 graphs)

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D1 elasticS1 inelasticSuppliers face the largest burden of taxation

D2 inelasticS2 elasticConsumers face the largest burden of taxation

The burden of taxation is heavier on the more inelastic side.***Incidence of an increase in a specific tax

∆ Pc= EsEs−E D

∆ t

If ED = 0; Demand is perfectly inelastic; ∆ Pc=∆tIf ES = 0; Supply is perfectly inelastic; ∆ Pc=0

***Price Elasticity of Demand and Sales:When demand is inelastic, increase P will increase sales.When demand is elastic, increase P will decrease sales.

(Graph)

Application: Illegal Drug Market

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CHAPTER 3: CONSUMER THEORY3 aspects:

- Consumers have rational preference- Individuals face budget constraints- Individuals make choices that yield the highest satisfaction/happiness – utility

1. Consumer Preferences:

Basic Assumptions:Completeness: Any 2 bundles can always be compared Transitivity: Preferences are transitive. If a consumer prefer bundle A to bundle B and bundle B to bundle C,

then the consumer also prefers A to C. Monotonicity – More is better: Increasing the quantity of at least one of the goods in a given bundle is always

preferred. Indifference curves:

- Preferences are expressed over 2 goods or services

- Consumption set: combination of the 2 goods that can be chosen in the absence of any constraint.

- Bundle: list with specific quantities of one or more goods.

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***Shape of an indifference curve:- Downward sloping by monotonicity- 2 indifferences don’t cross

Marginal Rate of Substitution:- Maximum amount of Good 1 that a consumer is willing to give up in order to obtain one additional unit of

Good 2. - Law of diminishing MRS: As X1 increases along a given indifference curve, the absolute value of MRS

decreases. - Convexity: the decline in the MRS reflects a diminishing marginal rate of substitution. When the MRS

diminishes along an indifference curve, the curve is convex.

- MRS = Slope of indifference curve = ∆ X 1∆ X 2

(Graph)

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- Curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction.

- An indifference curve pass through a bundle X is a set of bundles for which the individual is indifferent with X.

- Preference map: Set of indifferent curves.

- Another way to interpret this assumption: Consider a bundle that is a mix of X and Y. Specifically let’s mix ½ of X and ½ of Y. The mixed bundle has 7 of X1 and 7 of X2. The mixed bundle is preferred to X and Y. => Individual prefer mixes to extremes.

Perfect Substitutes and Perfect Complements:

Perfect substitutes: Two goods for which the marginal rate of substitution of one for the other is a constant.MRS = -1Law of diminishing MRS does not apply

Perfect complements: Two goods for which the MRS is zero or infinite, the

indifference curves are shaped as L-shaped right angles

(elaborate more on graph)

Bad: Good for which LESS is preferred rather than more (Graph):

Utility and Utility Functions:Utility: numerical score representing the satisfaction that a consumer gets from a given market basket.Utility function: Formula that assigns a level of utility to individual market baskets.Bundle (X1, X2) => Utility U(X1, X2)Consider 2 bundles: X with U(X1, X2) and Y with U(Y1, Y2). X is preferred to Y if and only if U(X1, X2) > U(Y1, Y2)

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- Ordinal utility function: Generate the ranking of bundles in order of most to least preferred. - Convecting: the concept of utility with indifference curve. Along an indifference curve, utility remains

constant.

2. Budget Constraints:

3.Consumer Choice:- Individuals are maximizing their utility subject to a budget constraint- The maximizing bundle must satisfy two conditions:- Located on the budget line- Give the consumer the most preferred combination of goods and services (highest U)

- Satisfaction is maximized (given the budget constraint) at the point where MRS = MRT(a) Marginal benefit: benefit from the consumption of one additional unit of a good => |MRS|(b) Marginal cost: Cost of one additional unit of a good => |MRT|(c) Satisfaction is maximized when MB = MC.

(Ex: Chapter 3, question 6 and Dr. Pierre’s graph)

At A, |MRS| is larger than |MRT| (MRS is steeper than budget line)

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- Budget constraints: Constraints that consumers face as a result of limited incomes.

- Budget line: All combinations of goods for which the total amount of money spent is equal to income. Describe the combinations of goods that can be purchased given the consumer’s income and the prices of the goods.

- Spending = Income: I = P1X1 + P2X2

- Slope - Marginal Rate of

Transformation: MRT = −P1P 2

Objective: Individuals are maximizing their utility subject to a budget constraintI = 100; P1 = 5; P2 = 10(1) How much income is spent?

More is better. Individuals spend all their incomes. The optimal choice is on the budget line

(2) Optimal choice is found where MRS = MRT (tangency)

Suppose |MRS| = 2 (willing to pay 2 units of good 2 for 1 more unit of good 1). MRT = -P1/P2 = -½, I only have to give up ½ unit of good 2 for 1 more unit of good 1. A is not optimal because I could increase my utility by purchasing 1 more unit of good 1 => Move from A to C.

***Corner Solution: Situation in which the MRS for one good in a chosen bundle is not equal to MRT. When a corner solution arises, the consumer maximizes satisfaction by consuming only one of the two goods.(Graph + Chapter 3 Exercise 14)

Principles for Maximization of Utility(1) Optimal choice sits on the budget line(2) MRS = MRT

|MRS| = benefit of consuming of one more unit of X|MRT| = cost of consuming of one more unit of X = P1/P2

Marginal Utility- Marginal Utility of X1: Additional amount of utility generated from increasing X1 by 1 unit- Marginal Utility of X2: Additional amount of utility generated from increasing X2 by 1 unit- Overall, as consumption of good 1 increases, MU1 decreases. In general, MU1 and MU2 are both decreasing

Principle of diminishing returns

Connecting MRS and MU’sGraph

Examples of Utility Function

(1) Perfect Substitutes:

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Law of diminishing MRS:When |MRS| is high (at A), there are lots of X2 while few of X1. MU2 is small; MU1 is big. When |MRS| is low (at B), there are lots of X1 while few of X2. MU1 is small; MU2 is big.

From A to B, utility increases as X1 increases; utility decreases as X2

MRS = –MU1/MU2

(2) Perfect Complements:

(3) Cobb-Douglass:

•

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Chapter 4: Individual and Market Demand1. Demand Curve:- Relationship between optimal choice X1 and P1 holding all else the same: that is I and P2 are held constant.

Example 1: Perfect complements

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Example 2: Perfect substitutes (Chapter 4 #2)

2. Income and Substitution Effect:A fall in price good 1 has two effects:

(1) Substitution effect: Consumers will tend to buy more of good 1, which has become cheaper and less of good 2 that is now relatively more expensive.

(2) Income effect: Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power.

• Normal good:

Change in food from A to D: Substitution effect X1D

– X1A

> 0Change in food from D to B: Income effect X1

B – X1

D > 0 (normal good)

Change in food from A to B: Total effect: X1B

– X1A

> 0 Remarks: Substitution effect < 0 when price increasesSubstitution effect > 0 when price decreasesIf income effect < 0 when price increase (less income, less purchasing power): normal good

Consumer is initially at A on budget line RS. When price of food falls, consumer moves from A to B; consumption of food increase from F1 to F2.Imaginary budget line RT

• Substitution effect: F1E

(move from A to D)Changes the relative prices food and clothing but keeps real income constant.

• Income effect: EF2

(move from D to B)Keeps relative prices constant but increases purchasing power.

• Total effect:

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• Inferior Good:

• Giffen Good: Good whose demand curve slopes upward because the (negative) income effect is larger than the substitution effect.

The consumer is initially at A on the budget line RS. Price of food decrease, consumers move to B.

• Substitution effect: F1E(move from A to D)• Income effect: F2E(move from D to B)

In this case, food is an inferior good because the income effect is negative. However, because substitution effect > income effect, the decrease in price leads to increase in quantity demanded.

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Exercise 1: Perfect complements X1 and X2

Exercise 2: Perfect substitutes X1 and X2

• When food is an inferior good, and when the income effect is large enough to dominate the substitution effect, the demand curve will be upward sloping.

• The consumer is initially at A.• After price of food falls,

consumer moves to B to consume less food.

• Income effect EF2 > Substitution effect F1E, the decrease in price of food leads to lower quantity demanded.

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Chapter 6: Production

(1) Production Decisions of a Firm:

Typically, focus on 2 types of inputs: labor (L) and capital (K); focus on a single output q.

1. Production Technology: A practical way of describing how inputs can be transformed into outputs.2. Cost Constraints: Firms must take into account the prices of labor, capital, and other inputs.3. Input choices: Given its production technology and prices, the firm must choose how much of each input

to use in producing its output. Production function: relationship between output q and input L, K: q = f (K, L)Short-run vs. Long-run:

- Short-run: fixed input, K is fixed: q = f (K fixed, L)- Long-run: all inputs are variable and adjustable

(1) Short-run:- q = f (K fixed, L)- Properties of the short-run production function: Marginal product of labor (MPL) – Amount of output that is

produced from the addition of an extra unit of labor

InputsRaw materials,

land, labor, physical capital

FIRM(use technology)

Outputs

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(2) Long-run: Both K and L are variables: q = f (K, L) - Isoquant: All combinations of L and K that allows to produce a specific level of output. - Assumption: more inputs => more outputs

Slope = MPL = ∆ q∆ L

Average product of labor: APL = qL

Law of diminishing marginal product:MPL decreases eventually as L increases; MPL usually increases as L increases for low values of L. Law of diminishing marginal returns: Principle that as the use of an input increases with other inputs fixed, the resulting additions to output will eventually decrease.

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Example of Isoquants:

1. Perfect substitutes: K & L are perfect substitutes in the production process.MRTS = -1; q = K + L

2. Fixed proportions (Perfect complements): K & L are used in fixed proportion in the production process; q = min (K, L)

Isoquant map: graph combining a number of isoquants, used to describe a production function.

Input increases as move from q1 to q2.

Slope of Isoquant = MRTS (marginal rate of technical substitution): Amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant.

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3. Typical Isoquant: Cobb-Douglass production function:

(2) Returns to Scale:- Rate at which output increases as inputs are increased proportionately

(1) Increasing returns to scale: when all inputs double, q more than doubles.(2) Constant returns to scale: when all inputs double, q doubles.(3) Decreasing returns to scale: when all inputs double, q less than doubles.

Chapter 7: Cost of Production

• Economic Cost vs. Accounting Cost:(1) Economic cost: Cost to a firm of utilizing economic resources in production(2) Accounting cost: Actual expenses plus depreciation charges for capital equipment

- Opportunity cost: value of the best forgone alternative- Sunk cost: expenditure that can’t be recovered- Costs:

• FC – Fixed cost: cost that doesn’t depend on the level of output q• VC – Variable cost: cost that increases a q increases• TC – Total cost = FC + VC• MC – Marginal cost: cost to produce an additional unit of the output q

• AFC = FCq

• AVC = V C

q

• ATC = T Cq

- Economically efficient: When a firm minimizes its cost of production- Technologically efficient: When a firm can’t produce a given level of output using fewer inputs

Cobb-Douglassq = ALaKb

MRTS = −ab

KL

A: technology; the larger A the better firm is at transferring inputs into outputs.

MRTS = ∆ K∆ L

Along an isoquant ∆ q = 0

MRTS = −MPLMPK

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• Short-run Cost:- Short-run cost minimization: what is the least costly way to produce a given level of output q?- In the short run, economically efficient and technology efficient are equivalent.

• Cost in the Long Run:- The isocost line: graph showing all possible combinations of labor and capital that can be purchased for a

given total cost.- C = wL + rK

MC crosses ATC at minimum value of ATC

MC crosses AVC at minimum value of AVC

In the typical case, to be economically efficient in the long run means:• The input choice is technologically

efficient *on the isoquant• Slope of isocost = Slope of

isoquant or MRTS = −w

rB is not economically efficient

because MRTS ≠ −w

r

Suppose |MRTS| = 2, 1 unit of L can replace 2 units of K to produce q.Slope of isocost = 1, 1 unit of L cost only 1unit K.

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Cobb-Douglass: q = K1/2Q1/2; a = ½; b = ½ Suppose w = 10, r = 20Slope of isocost line = -1/2 A is economically efficient:

At A, MRTS = -1/2 = −ab

KL

K = ½LNow, suppose w increases to w = 20Slope of new isocost line = -1B is economically efficient

K = L Substitute into production function: q = K1/2Q1/2

L = √2q

K = q

√2

So C(q) = wL + rK = 10√2q + 20q

√2; C(q) = 20√2q

Slope of cost function = Marginal costMC = 20√2ATC = 20√2

Constant return of scale whenever a + b = 1Cost Function for Perfect Substitutes (MRTS is not diminishing):

- w > r: only employ K; L = 0; K = q; C(q) = rK = rq- w < r: only employ L; L = q; K = 0; C(q) = wL = wK- w = r: All technological efficient choices are economically efficient; any L and K as long as q = L + K

C(q) = wL + rK = wq or rq

Economies and Diseconomies of Scale- Economies of scale: situation in which output can be doubled for less than a doubling of cost- Diseconomies of scale: situation in which a doubling of output requires more than doubling of cost - No economies of scale: constant LRAC because of constant return to scale

Relationship between Short-Run and Long-Run Cost

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LR cost is always lower than SR cost

Chapter 8: Profit Maximization and Competitive Supply

• Perfect Competition:- A competitive firm is a price-taker: can’t influence the price; Product

homogeneity; Free entry (or exit)- A firm faces a perfectly elastic demand curve at the market price: P = MR

The LAC is the envelope of the SRAC SAC1, SAC2, and SAC3.With economies and diseconomies of scale, the minimum points of the SRAC do not lie on the LAC.

- Profit: π(q) = Revenue – Cost

- Rule of profit maximization: MR = MC

- A perfectly competitive firm maximizes profit when P = MC

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Short-run Profit Maximization by a Competitive Firm:

In the SR, assume that FC is sunk. Firm choose q* where P = SRMC If the firm stays open, it produces q*If the firm shuts down, it still has to pay the fixed cost, but produce q = 0. Firm stays open in the short run as long as P ≥ AVC.

The Short-Run Supply Curve for Competitive Firm

In the SR, competitive firm maximizes profit by choosing output q* where MC = P (or MR).The profit is rectangle ABCD.Any change in output will lead to lower profit.

Here, economic profit > 0 because P > SRAC at q*.

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Market supply is MORE ELASTIC than individual firm supply (flatter).

Market Supply Curve in Short-Run

Supply of a competitive firm describes the relationship between price and profit-maximizing output. In the SR, firm chooses its output so that P = MC as long as P ≥ AVC.The short-run supply curve is above AVC where MR crosses AVC.

Market supply is more elastic than individual firm supply (flatter)

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Short-Run Equilibrium

Example: QD = 100 – P; FC = 100, MC = 2q, C = 100 + q2; n = 4

• VC = C – FC = (q2 + 100) – 100 = q2

AVC = q 2q

= q

MC is always > AVC (2q > q) => P shut-down = 0MC is the supply curve: S curve: P = 2qP = MC = 2q => q = ½ P• Market Supply Curve:

QS = n(P/2) = 4(P/2) = 2P

• Equilibrium:QS = QD 2P = 100 – P P* = 100/3; Q* = 200/3

A price P* so that QD = QS at P*The number of firms is fixed to nQ* = nq*SR:

• Find a supply curve• Find a market supply curve• Find the equilibrium

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Long-Run Profit Maximization

Long-Run Equilibrium

Equilibrium: A price P* so that QD = QS at P*. Firms can freely enter and exit the industry. At P1 = $40, profit > 0 => entry the market (number of firms n increases). Short-run supply curve shifts to the right => Decrease market price to P2 = $30. At P2, profit = 0. Example: MC = 2qC(q) = 100 + q2 => ATC = 100/q + qP = 100 – Q => Q = 100 – P

In Long-Run Equilibrium: profit = 0 so P = ATCProfit maximization: P = MC

• MC = ATC: 2q* = 100/q* + q* • q* = 100/q*• q* = 10 P* = MC at q* => P* = 2q* = 2(10) = 20Q* = 100 – P* = 100 – 20 = 80n* = Q*/q* = 80/10 = 8 firms

If the firm stays in business, it produces at q2 where P = LRMC

Firm wants to exit the industry when P = LRAC

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MODEL FOR LONG-RUN EQUILIBRIUM (analysis from Professor St. Pierre & example from Midterm 2)

In (b), the long-run supply curve in a constant-cost industry is a horizontal line (SL). When demand increases, initially causing a price rise (move from A to C), the firm initially increases its output from q 1 to q2, shown in (a) => Profit > 0. This leads to entry of new firms, causing a shift to the right in industry supply. Because input prices are unaffected by the increased output of the industry, entry occurs until the original price is obtained (at point B in (b)). Analysis:

• Initial equilibrium: q1, Q1, P1, n1

Demand curve shifts right to D2

• New Short-run equilibrium: q2, Q1* (between Q1 and Q2), P2, n1

• New Long-Run equilibrium: Because P2 > AC at q2, number of firms n1 increases to n2.SR supply shifts right to S2.New LR equilibrium: P1 (original price), Q2, q1, n2

Long-Run Market Supply - The LR Market supply is perfectly elastic for constant cost industries => The minimum ATC is independent

of the scale of the industry (Q). - The LR Market supply is upward sloping for increasing cost industries (ATC increases as Q increases). - The LR Market supply is downward sloping for decreasing cost industries (ATC decreases as Q decreases).

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Chapter 9: The Analysis of Competitive Market

Why deviation from competitive output creates loss of welfare? At perfectly competitive market output Qo: P* = MC (Supply curve). Willingness to pay for last unit purchased equals to marginal cost of last unit sold. That is when total surplus is maximized. It is exactly what happens in competitive market: Consumers purchase the good up until willingness to pay = P*; Suppliers produce the last unit when P* = MC. Price P is what ensures MC = willingness to pay for the last unit purchased.

Deviation from competitive output – Example: Incidence of a tax:

Subsidy Case (graph + welfare analysis)

• Consumer Surplus: sum of differences between willingness to pay & prices for all units consumed.

• Producer Surplus: sum of differences between price and MC for all units supplied.

• Total Surplus: TS = CS + PSEfficient output: when TS is maximized (allocate efficiency)

Pb is the price (including tax) paid by buyers, Ps is the price that sellers receive, less the tax: Pb – Ps = t

• Consumer surplus loses A + B• Producer surplus loses D + C• The government earns A + D in

revenue• Deadweight loss is B + C

Ps – Pb = s (subsidy)

Demand is often more price elastic in the long run than in the short run because it takes time for people to change their consumption habits and/or because the demand for a good might be linked to the stock of another good that changes slowly.

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Chapter 10:

- Market Power: Ability of a seller or buyer to affect the price of a good (below marginal cost or above marginal value of a good)

1. Monopoly: Market with only one seller- Average revenue = Demand Curve (downward sloping; Marginal revenue decreases as Q increases)- Marginal Revenue = Double the slope of Demand Curve

D: P = a – bQMR = a – 2bQ

- Profit maximization: MR = MC

Q* is the profit maximized output level (MR = MC). If the firm produces smaller output => lose some profit because extra revenue can be earned. If the firm produces more output would reduce profit because the additional cost would exceed additional revenue.

- Market power measure: Markup over marginal cost as a percentage of price P−MC

P=−1

EdMarket power is inversely related to price elasticity of demand faced by firm. As |Ed| get closer to 1 (more elastic), market power increases. With perfect competition, firm has no market power as demand is perfectly inelastic −∞ thus P = MC

Compute Price: P = MC

1+(1

Ed)

Exercise #3: A monopolist firms faces a demand Ed = -2. Constant MC = $20 per unit. If MC increases by 25%, would the price charged also rise by 25%?

Since P = MC

1+(1

Ed) : P = MC / (1 – ½) = MC/0.5 = 2MC = 2($20) = $40

If MC increases by 25%, P will also increase 25% (directly proportional relationship according to the formula)

Exercise #7: A profit-maximizing monopolist is producing Q = 800; P = $40If Ed = -2; (40 – MC)/40 = ½ => 40 – MC = 20 => MC = $20 per unit. Percentage markup = 0.5; or 50% of the price.

Suppose AC = $15, FC = $2000. Find the firm’s profit:TR = 800($40) = $32,000

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TC = AC*Q = 800($15) = $12,000Profit = TR – TC = $20,000

***Shift in Demand:- A monopolistic market has NO supply curve. There is no one-to-one relationship between price and the

quantity produced. - An increase in the demand for a monopolist’s product doesn’t always result in a higher price (Price

elasticity of demand => Market power). An increase in the supply facing a monopsonist doesn’t always result in a lower price.

• Monopoly case:

Case a: Demand curve shifts from D1 to D2. But the new marginal revenue curve intersect MC at the same point => Same output, but lower price. Case b: Demand curve shifts from D1 to D2; demand becomes more elastic. The new marginal revenue curve intersects MC at a higher level of output. But because demand is now more elastic, price remains the same.

• Monopsony case:ME1 intersects with MV curve at Q1, result in price P (where Q1 intersects AE1).Suppose Supply curve shifts from AE1 to AE2. Therefore Marginal expenditure curve also shifts from ME1 to ME2, which intersects MV at a new output. This new level of output results in the same price (Q2 intersects with AE2).

The effect of a tax:

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A tax on output can have different effect on a monopolist than on a competitive firm. MR = MC + tExercise #4: Average Revenue Curve, or Demand: P = 120 – 0.02 QCost Function: C = 60Q + 25,000

• Level of production, price, and total profit:Demand: P = 120 – 0.02QMarginal Revenue: MR = 120 – 0.04QMC = 60Profit maximization: MR = MC => 120 – 0.04Q = 60 => Q = 1500P = 120 – 0.02(1500) = 90Profit = TR – TC = (90)(1500) – [(60)(1500) + 25,000] = 20,000 cents => $200• Levy a tax of 14 cents per unit: Demand: P* + t = 120 – 0.02Q (P* is the price received by suppliers)

Marginal Revenue: MR = 120 – 0.04Q – t (t = 14 = lost revenue per unit)Profit maximization: MR = MC => 120 – 0.04Q – 14 = 60 => Q = 1150Price: P* = 120 – 0.02Q – t = 83Profit: TR – TC = (83)(1150) – [(60)(1150) + 25,000] = 1450 or $14.50

OR A DIFFERENT WAY TO SOLVE THIS USING MR = MC + tMR = 120 – 0.04QMC + t = 60 + 14 = 74MR = MC => 120 – 0.04Q = 74 => Q = 1150Demand: P* + t = 120 – 0.02Q (P* is the price received by suppliers) Price: P* = 120 – 0.02Q – t = 83It does not matter who sends the tax payment to the government. The burden of the tax is shared by consumers and the monopolist in exactly the same way.

- Sources of monopoly power:(a) The elasticity of market demand(b) Number of firms in the market(c) Interaction among firms

2. Social Costs of Monopoly Power:

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- Rent Seeking: spending of resources in any socially unproductive activities in order to acquire, maintain, or exercise monopoly power (market power). Firms can invest as much as monopoly profit into rent seeking activities.

- Property rights (patents): monopoly right => create monopoly power. Bring innovation and promotes research and development that otherwise would not take place => Increase social welfare.

- Price regulations: most often used for natural monopolies, such as local utility companies.- Natural monopoly: Firm that produces the entire output of market at a cost lower than what it would be if

there were several firms. If a firm is a natural monopoly, it is more efficient to let it serve the entire market rather than have several firms compete.

- Regulating the price of a natural monopoly:A firm is a natural monopoly because it has economies of scale (declining average and marginal costs) over its entire output range. If price were regulated to be Pc (competitive price; MC cross D) the firm would lose money and go out of business. Setting the price at Pr yields the largest possible output consistent with the firm’s remaining in business; excess profit is zero.

When moving from a competitive price and output (Pc and Qc) to a monopoly price and quantity (Pm and Qm):

a. Consumer lose A + B b. DWL = B + C

***Important note:PS: Above MC and below monopoly priceCS: above monopoly price and below demand curveDWL: between 2 quantity; below demand curve and above MC

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3. Monopsony: Market with one buyer- Monopsony power: Buyer’s ability to affect the price of a good. - Marginal value: Additional benefit derived from purchasing one more unit of a good. - Average expenditure = Supply Curve- Marginal Expenditure: Double the slop of supply curve- Profit maximization: Output @ ME = MV; Price @ MV (Demand curve) intersects AE (Supply curve).

- Sources of monopsony power:a. Elasticity of market supplyb. Number of buyersc. Interaction among buyers

4. Social Costs of Monopsony Power:MONOPOLY vs. MONOPSONY

a. Monopoly: Produce where MR = MCAR (Demand) > MR so P > MC

b. Monopsony:Produce where ME = MVAE (Supply) < ME so P < MV

When moving from a competitive price and output (Pc and Qc) to a monopsony price and quantity (Pm and Qm):

c. Increase in consumer surplus A – Bd. Producer surplus falls by A + Ce. DWL = B + C

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 Chapter 18: Negative Externality and Public Goodsa. Negative Externalities:

- Externality: action by either a producer or a consumer which affects other producers or consumers, but is not directly accounted for in the market priceExample: A firm emits noxious fumes that affect residents of a community. The noxious fumes impose costs on the residents, and the residents have no control over the quantity of the fumes. Costs may include health problems, foul-smelling air, reduce property values and house price. The firm do not have to pay to emit the fumes => this external cost is not reflected in the price of their products => Negative Externality.

- Externality Missing market: Others are not compensated- Marginal external cost – MEC: increase in cost imposed externally as one or more firms increase output by

one unit.- Marginal social cost: MSC = MEC + MC

Welfare AnalysisEquilibrium Output: Q1 Efficient Output: Q*

CS A + B + F + G APS C + D + E B + C + D + F

Externality Cost(between MSC and MC)

D + E + F + G + H F + D

TS A + B + C - H A + B + CDWL = H; The market produces too much => Market failure; Missing market for pollution- A monopolist who produces under the presence of either positive or negative externality do not always lead

to greater misallocation of resourcesa. Negative externality: a competitive market produces too much output (the cost was underestimated)

compared to the socially optimal account. A monopolist restricts output => produce closer to optimal point.

b. Positive externality: a competitive market produces too little output. A monopolist further restricts output => produce even less goods => Greater misallocation of resources.

b. Positive Externality:- Marginal social benefit – MSB = MEB + MB- Example: Money spent on R&D. If a firm designs a new product, and if that design can be patented => earn

a large profit. But if the new design can be imitated by other firms, those firms can appropriate some of the developing firm’s profit => Little reward for R&D.

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c. Ways of correcting Market Failure:- Targeting the emission:

a. Tax emissionsb. Regulate emissions (standards)

- Target the market for paper: Tax the market for paperThe optimal tax is set to the value of MEC (NOT marginal private cost) at Qefficient

Exercise #6QD = 160,000 – 2000P => P = 80 – 0.0005QD

QS = 40,000 + 2000P => P = (QS – 40,000)/2,000 = 0.0005QS – 20MEC = 0.0006QS

- Produced under competitive conditions:Equilibrium price: QD = QS => 160,000 – 2000P = 40,000 + 2000PP = $30 Q = 100,000

- Socially efficient price and output:MSC = MEC + MC = 0.0006QS + 0.0005QS – 20 = 0.00011QS – 20Set this equal to Demand: 0.00011Q – 20 = 80 – 0.0005QQ = 62,500P = $48,75

- The optimal tax is set to the value of MEC at Qoptimal

t = MEC at Q = 62,500t = 0.0006(62,500) = $37.5Pc = 80 – 0.0005(62500) = $48.75Ps = 0.0005(62500) – 20 = $11.25(Difference of t = $37.5)

The market should face the real cost: P represents MSC. To obtain efficiency, the price needs to reflect MSC.Exercise #7Demand: P = 100 – Q MC = 10 + Q MEC = Q Competitive conditions:

Set P = MC (supply curve):100 – Q = 10 + Q Q = 45P = $55

Positive externality:MSB > MB (Demand curve)The difference is MEBA self-interested homeowner invest in q1 in repairs @ MC = D (MB)Efficient level of repair is q* (higher) @ MSB = MC.

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Socially efficient price and output:MSC = MEC + MC = 10 + 2QSet this equals to Demand: 100 – Q = 10 + 2QQ = 30P = $70

The optimal tax is set to the value of MC at Q optimal:t = MEC = Q = 30 Pc = 100 – 30 = $70Ps = 10 + Q = $40

Monopolistic conditions:MR = 100 – 2Q (double the slope of Demand curve)Profit maximization: MR = MC => 100 – 2Q = 10 + QQ = 30P = $70This coincides with the socially efficient level.

Tax for monopoly would be 0 because the monopolist is already producing at the socially efficient output in this case.

Solutions to “Secondhand” Smoke:a. A bill is proposed that would lower tar and nicotine levels in all cigarettes. Some smokers might actually smoke more in an effort to maintain a constant level of consumption of nicotine, although the total amount of tar and nicotine released into the air would probably be reduced. The smoker is worse off because he or she will spend more on cigarettes and consume less tar and nicotine. Nonsmokers would be better off because less tar and nicotine would be in the air. It is difficult to know whether society as a whole would be better or worse off. b.A tax is levied on each pack of cigarettes. Producers will pay some of the tax and consumers (i.e., smokers) will also pay a portion. Thus the price of cigarettes will increase, and smokers will smoke fewer cigarettes. The extent of the effect of the tax depends on the elasticity of demand for cigarettes. Nonsmokers would be better off because there is less smoking but smokers are worse off, so it is unclear whether society as a whole benefits. Also, some smokers might substitute cigars or pipes for cigarettes, which might actually be worse for nonsmokers. c. A tax is levied on each pack of cigarettes sold. It does not matter upon whom the tax is levied, it will be shared between consumers and producers in exactly the same proportions as in part b, so the effects will be the same as in part b. d. Smokers would be required to carry government-issued smoking permits at all times.Smoking permits effectively transfer property rights to clean air from smokers to nonsmokers.A major issue with this program would be the high cost of enforcing the permits. The price ofthe permit would induce some smokers to quit smoking, but it would not raise the marginal cost of smoking. Therefore smokers who bought permits would continue to smoke about the same amount. Again, smokers would be worse off and nonsmokers better off, so it is unclear whether society benefits as a whole.

d. Public Goods:- Public good: Nonexclusive and non-rival good:

1. Non-rival: when the marginal cost of providing the good to an additional consumer is 0.Ex: Highway without congestion, TV signal => can be exclusive

2. Non-exclusive: when people can’t be excluded from consuming a goodEx: Lake, ocean => but fishing is rival

- Example of public goods: national defense- Private good: Exclusive and rival- Market failure: free riders – Consumer or producer who does not pay for a nonexclusive good in the

expectation that others will. Problem: it’s difficult to exclude people from consuming a nonexclusive commodity. E.g.: Public TV, security in a mall

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- An externality occurs when an action by a consumer or producer affects other consumers and/or producers, but is not accounted for in the market price. Since users benefit from the information they glean from Wikipedia but don’t have to pay for it, there are positive externalities. There may also be negative externalities to the extent that the information provided by Wikipedia makes it easier for students to plagiarize when writing research papers. This imposes a cost on instructors who must check student work for such behavior.

Example: Three stores – Demand for security:Store 1: P = 80 – 10QStore 2: P = 40 – 5QStore 3: P = 40 – 5QMC = $60/hour (Constant => horizontal MC curve)

a. Market outcome (equilibrium):80 – 10Q = 60Q = 2

b. Efficient provision of security: Add all willingness to pay:P = 160 – 2Q = 60Q = 5

Exercise #10: Three groups in a community: Demand curves for public TV in hours of programing T are:W1 = $200 – TW2 = $240 – 2TW3 = $320 – 2TMC = $200/hour

(a) Efficient number of hours of public TV:Add all willingness to pay: W = $760 – 5TSet this equal to MC = $200 T = 112 hours

(b) How much public TV Would a competitive private market provide:Assume TV is not a public good, and it costs $200 to produce each hour for each group. Group 1: W1 = 200 – T = 200 => T = 0Group 2: W2 = 240 – 2T = 200 => T = 20 Group 3: W3 = 320 – 2T = 200 => T = 60Total number of hours demanded are 80 hours.

Chapter 16: General Equilibrium and Economic Efficiencya. General Equilibrium Analysis:

- Partial equilibrium: focusing on one market, all else the same, independent of effects from other markets. Ignoring feedback effects can lead to inaccurate forecasts of the full effect of changes in one market.

- General equilibrium: Looking at simultaneous equilibrium in all relevant markets, taking feedbacks effects into account.

- A partial equilibrium analysis will stop at the initial shift whereas a general equilibrium analysis will continue on and on, incorporating possible shifts in demand in related markets and ensuing feedback effects on the first market.Example 1: Good 1 and Good 2 are substitutesQD1 = 10 – 2P1 + P2 QD2 = 10 – 2P2 + P1

QS1 = 5QS2 = 5

a. Partial Equilibrium: Analysis of market for good 1: Suppose P1 = P2 = $5 Q1 = 5; P1 = $5

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Suppose QS1 increase to 10QD1 = 10 – 2P1 + 5 = 15 – 2P1 = 10P1 = $2.5

b. General Equilibrium Analysis:Initial equilibrium: P1 = 5; Q1 = 5; P2 = 5; Q2 = 5Suppose QS1 increase to 10Final equilibrium:10 – 2P1 + P2 = 1010 – 2P2 + P1 = 5P1 = 5/3P2 = 10/3

Exercise #1: Gold and Silver are subtitutesPg = 975 – Qg + 0.5Ps; Qg = 75Ps = 600 – Qs + 0.5Pg; Qs = 300

a. Equilibrium prices: Pg = 975 – 75 + 0.5Ps = 900 + 0.5PsPs = 600 – 300 + 0.5Pg = 300 + 0.5PgPs = 300 + 0.5(900 + 0.5Ps) = 750 + 0.25Ps => 0.75Ps = 750; Ps = $1,000Similarly, Pg = $1400

b. Qg = 150:Plug in new numbers:Pg’ = $1300Ps’ = $950

b. Efficiency in Exchange:- Exchange economy: no production take place; individuals own endowments; two or more consumers trade

two goods among themselves- Pareto efficient allocation: allocation of goods in which no one can be made better off unless someone else

is made worse off- Contract curve: Curve showing all efficient allocations of goods between two consumers, or of two inputs

between two production functions

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- Pareto efficient implies MRSA = MRSB

Starting at A, any trade that moved the allocation outside the shaded area would make the consumers worse off. At B, the trade is mutually beneficial, but not yet efficient (because UJ and UK did not intersect)Even if a trade from an inefficient allocation makes both people better off, the new allocation is NOT necessarily efficient.At C, the two indifference curves intersect => MRS of two people are identical => Pareto efficient. D is also Pareto efficient. This allocation would leave Karen no worse off (the point is on the initial indifference curve) but would make James much better off (his indifference curve shifts right).

Pareto Efficient allocations are not all equally desirable from a social point of view. Society also cares about equity (whether the allocation is fair).

c. Trade in a Competitive Market:- Consumers are price takers- Market prices of the two goods determine the terms of exchange among consumers. - Income = Market value of endowment

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A is initial allocation. Price line PP’ represents the ratio of pricesCompetitive market will lead to an equilibrium at C, the point of tangency of both indifference curves and the price line. Example:Jen’s MRS of orange juice for coffee is 1 (willing to trade 1 coffee for 1 orange juice)Drew’s MRS of orange juice for coffee is 3 (willing to trade 3 coffee for 1 orange juice)Porange = $2; Pcoffee = $3 => possible to trade 2/3 coffee for 1 orange juiceSince both are willing to trade more than what they have to pay, there is an excess demand for orange juice and excess supply of coffee. Thus, price of coffee will decrease, price of orange juice will increase.

- The allocation in a competitive equilibrium is Pareto efficient- If everyone trades in the competitive marketplace, all mutually beneficial trades will be completed and the

resulting equilibrium allocation will be Pareto efficient. MRSA = MRSB = MRT = P1/P2

d. Equity and Efficiency:- The Utility Possibilities Frontier: Curve showing all efficient allocations of resources measured in terms of

the utility levels of two individuals

(1) Any point on the frontier are Pareto efficient

(2) Any point below the frontier are inefficient

(3) From H to F: James gains utility while Karen doesn’t lose anything

(4) From H to E: Karen gains utility while James doesn’t lose anything

(5) L is not attainable (not enough of both goods)

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e. Social Welfare Functions:- Measure describing the well-being of society as a whole in terms of the utilities of individual members

FIRST WELFARE THEOREM:Every competitive equilibrium allocation is Pareto efficientSECOND WELFARE THEOREM:Any Pareto efficient point/allocation can be sustained as a competitive equilibrium if the endowment can be redistributed (refer to Utility Possibilities Frontier)

- If individual preferences are convex, then every Pareto efficient allocation (every point on the contract curve) is a competitive equilibrium for some initial allocation of goods.

f. Efficiency in Production:- Results about efficiency also extend to economies where production is possible

3 notions of Efficiency:a. Input Efficiency:

- The output of good 1 and good 2 is allocated on the Production Possibilities Frontier- Every producer’s marginal rate of technical substitution (MRTS) of labor for capital is equal in the

production of both goods

- Technical efficient: MRTS = w/r b. Output efficiency:

- The combination of outputs that best matches the preferences of individuals - MRS = MRT (= Px/Py) for all consumers

c. Exchange efficiency: - The outputs are traded until MRS’s are equalized for everyone: MRS = Px/Py

g. Market Failure: When the market equilibrium is not Pareto efficient:- Market power (Monopoly, monopsony)

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Missing market:- Incomplete information- Externality- Public goods

PRACTICE MIDTERM EXAM 3Question 1:• The First Welfare Theorem: Every competitive equilibrium is Pareto efficient. • The endowment: A: C =2 W =1; B C = 3 W = 2; MRS = -W/C

Point e is not Pareto efficient because MRSA is not equal to MRSB

• The allocation that is the competitive equilibrium is:- Consume all the goods in the endowment (not 1)- MRSA = MRSB (not 2)

• 3 => Point W At W, MRSA = MRSB = -3/5 (= Price ratio). Price ratio is Pc/Pw = 3/5

Question 2: Q = 50,000 – P => P = 50,000 - QMC = $1000/ozMEC = 1,000 + Q

(1) Competitive equilibrium quantity and price: Set P = MC50,000 – Q = 1,000Q = 49,000ozP = $1,000

(2) Efficient production level:

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MSC = MC + MEC = 2000 + Q50,000 – Q = 2000 + QQ* = 24,000ozP* = $26,000

(3) Dead Weight Loss: between MSC and MC, between two quantities: (49,000 – 24,000)(51,000 – 1,000)/2 = 25,0002

(4) Specific tax on gold:t = MEC = 1000 + Q* = 1000 + 24,000 = $25,000 per ozPc = $26,000Ps = $1,000

Question 3:1. Define:

- Non-rivalry: when the marginal cost of producing a good to an additional consumer is 0- Non-exclusivity: when it is impossible to exclude people from consuming one good

2. Competitive markets fail to provide the efficient quantity of a public good:The positive externality presents in the provision of a public good. When individuals demand a public good, they look at their willingness to pay and compare it with the price of the public good. No one has the incentive to consider the impact of their decision on the well-being of others. But when someone decides to purchase a public good, everybody else benefit => Positive externality. Therefore, if a public good were provided via markets, there would be under provision of it. In some cases, market completely fails to provide a public good so it’s best for the government to provide it. Example: national defense.

Question 4:a. Rent seeking: when firms invest resources into unproductive activities to acquire, maintain, or

bargain to gain monopoly power. E.g.: Lobbying, bribing, anti-competitive practices, etc. Rent seeking makes monopoly power even less efficient than what the DWL suggests, because firms can invest as much as monopoly profit into rent seeking efforts.

b. Partial equilibrium: focusing on one market, all else the same, independent of effects from other markets. Ignoring feedback effects can lead to inaccurate forecasts of the full effect of changes in one market.

General equilibrium: Looking at simultaneous equilibrium in all relevant markets, taking feedbacks effects into account.

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A partial equilibrium analysis will stop at the initial shift whereas a general equilibrium analysis will continue on and on, incorporating possible shifts in demand in related markets and ensuing feedback effects on the first market.c. Monopoly power is a market failure because monopolists create dead weight loss by setting the

price above marginal cost (price does not reflect the true cost). The output is too low compared to optimal point, which corresponds to output inefficiency. Other considerations can be mentions such as rent seeking, and/or the presence of other market failure (negative externality can make monopoly power less damaging, while positive externality make monopoly power more damaging).

Edgeworth Box – Special Cases:

Case 1: A has perfect complement utility, B has convex preference (convex indifference curve):

Case 2: Both have perfect substitutes preferences (but with difference MRS)

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zxzzxxz Note that if both of the agents have the same MRS in this case, ALL POINTS in the Edgeworth box are Pareto efficient (same indifference curves).

Final Examination: 6 questionsDemand/supply with government intervention. Income/substitution effect. Analysis of competitive markets in both short-run and long-run. Monopoly power. Externality. Relating to efficiency concepts...

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Useful Assignments:Midterm 2: Long-run and Short-run equilibriumQuestion 2: LRMC = q, Supply curve: P = 10a. QD = 100 – P

P = 100 – Q = 10 => Q* = 90P = LRMC => q* = 10n* = 9 firmsP = 10

b. Increase in government spending: QD = 300 – P QD = 100 – PP = LRMC = q => P = q In the short-run, number of firms remain fixed; n* = 9

Market supply curve: QS = n*(P) = 9PSR equilibrium: 300 – P = 9P => P** = 30Q** = 300 – 30 = 270q** = 270/9 = 30

c. New long-run equilibrium:In the long-run, since profit > 0, there are more firms entering the market. QD = 300 – P = 300 – 10 = 290q*** goes back to q* = 10 P = 10n* = Q/q = 29 firms

d. If the increase in government spending was temporary, then new long-run equilibrium would go back to old long-run equilibrium in part a.

Practice Final Exam Question 1:a. Externality:

- Action by some producers or consumers that affect other producers or consumers, but are not accounted for in their market price.

- Positive externality: Education, Research and Development- Negative externality: Smoking in public, pollution from paper mills

b. Market for paper:QD = 160,000 – 2000P => P = 80 – 0.0005QD QS = 40,000 + 2000P => P = 0.0005QS – 20 MEC = 0.0006QS

Unregulated equilibrium price:QD = QS => 160,000 – 2000P = 40,000 + 2000PP = $30Q = 100,000Graph:

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c. Efficient output level:MSC = MC + MEC = 0.0005QS – 20 + 0.0006QS+ = 0.0011QS – 20 Efficient output level: 80 – 0.0005Q = 0.0011Q – 20 Q* = 62500P* = $48.75

d. Part b and part c have different results because there is external marginal cost that the equilibrium price and output did not take into account. The market for paper produces negative externality (polluting the environment), but the external cost was not included in the private cost. Thus marginal cost is underestimated, and firm produces too much output compared to efficient output level. There is a deadweight loss in equilibrium.Deadweight loss: Compute based on the graph = 1125000

e. Tax should be set equal to MEC at Q* to maximize welfare:t = 0.0006(Q*) = 0.0006(62500) = $37.5

Question 2:(1) q = 10K1/2L1/2; r = 50, w = 18; L = 9, K = 25 for an output of q = 150:

q = 10(25)1/2(9)1/2 = 150 => technologically efficient

MRTS = -25/9 = -2.78; -w/r = -18/25 => not economically efficient(2) q = 2K + L; r = 40, w = 25; L = 50, K = 5 for an output of q = 60:

q = 2(5) + 50 = 60 => technologically efficientMRTS = -1/2 (draw graph); -w/r = -25 /40 is not equal to -1/2 => not economically efficient

(3) q = 10K; r = 50, w = 5; K = 5, L = 0, output of q = 50: both technologically and economically efficientQuestion 3: x1 is a Giffen good. An increase in price of good 1 will leads to an increase in consumption of good 1. X2 is a normal good because one can’t consume all inferior goods (violate the more the better).

Question 4: QD = 100 – 0.05P; QS = 19.95P a. Equilibrium:

QD = QS => 100 – 0.05P = 19.95PP = $5Q = 99.75 (thousands units)ED = -0.05(5/99.75) = about 0ES = 19.95(5/99.75) = 1Demand is almost perfectly inelasticSupply is unit elastic. It makes sense because this is the market for cigarettes. We would expect demand to be very inelastic (addiction).

b. t = 1:∆Pc = (Es)/(Es – Ed) = 1/1 = 1

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Consumer will approximately bear the entire burden of the tax. Thus Pc = 6; Ps = 5 Pc = Ps + t = Ps + 1 100 – 0.05Pc = 19.95Ps = 19.95(Pc – 1)100 – 0.05Pc = 19.95Pc – 19.95 Pc = $5.9975 = approximately $6Ps = approximately $5

c. The assumptions were correct or not:(i) Tax will generate additional government revenue: yes(ii) Tax will reduce smoking in the population: maybe not, depend on the long run and short

run. It is hard to give up smoking in the short run. (iii) Free up income for individuals: incorrect. Almost the entire burden of tax falls on

consumers (because of their perfectly inelastic demand for cigarettes. Producers pays barely any tax, so they will keep producing!).

Question 5:a. Monopoly is a market failure because firm has market power to manipulate price. Firms can set

price above marginal cost (does not reflect the true cost of production), and produce too little compared to competitive equilibrium output. Monopoly violates the output efficiency, thus is a market failure. Graph (Show MC, MSC, Demand curve and DWL).

b. Yes. Monopoly can spend as much as their entire profit on rent seeking to acquire, remain, or exercise their market power. Rent seeking makes monopoly even more inefficient. The loss of welfare could correspond to DWL and profit in the worse case scenario.

Question 6: Bad weather => increase in the price of staple foods.

a. Long-run equilibrium for a perfectly competitive market firm: Initially, firm produces q1 at price P1, market produces Q1, and there is fixed number of firms n1.

b. Bad weather affect equilibrium in the short-run: Bad weathers increase cost and reduce output of firms. MC and AC both shifts up. This leads to a shift to the left of Market Supply curve. Short-run new equilibrium: output produced by firms decreases to q2, market output decreases to Q2, Price increases to P2 (due to decrease in quantity supplied), and there are still n1 firms.

c. Bad weather repeats itself. At q2, profit is negative because price increase is less than the cost increases. Thus firms exit => number of firms decrease to n2. Market supply shifts left to S3, thus push price even higher to P3. The remaining firms break even again and produces at q3 = q1. Note: the entire increase in cost is reflected in the overall price increase (P3 – P1).

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Practice Midterm 1 - Question 3:Cobb-Douglass with a = 1, b = 2I = $12P1 = $0.5; P2 = $1

a. Optimal choice: Spending = IncomeThus, I = P1X1 + P2X2 0.5X1 + X2 = 12MRS = (-a/b)(X2/X1) = -1/2 (X2/X1) MRT = MRS

-P1/P2 = -1/2(X2/X1) -1/2 = -1/2 (X2/X1) => X1 = X2 Substitute into function => optimal choice: (8, 8)

b. New optimal choice => do everything again!c. Effect of new information: Want to consume more chickens over soda. The preference changes shift

demand for chicken to the right and demand for soda to the left.Exercises Chapter 2:#6. Long-run elasticities differ from short-run elasticities. For durable goods, long-run demand for goods is more inelastic than short-run (example: TV, cars)For most other goods (food, services, beverages), long-run demand for goods is more elastic than in short-run.

#7. a. Elasticity of demand is NOT the same as the slope of the demand curve. It also depends on the prices of

the goods. Elasticity of demand is the percentage change in quantity demanded divided by the percentage change in the price of the product.

b. The cross-price elasticity is positive for substitutes and negative for complements.c. Supply of apartments is more inelastic than in the short run. In the short run, it is difficult to change

supply of apartments in response to a change in price. In the long run, more apartments can be built if price increases.

#9. Price ceiling might not benefit all students. For those students who get an apartment, students may find this benefit. However, students who can’t find an apartment, the cost of finding one will increases. The rent for other places might also increase (live outside of the college town). Impose subsidy or price ceiling with lead to excess demand and shortage of supply => higher price of alternative products/options.

#7. ED = -0.4; ES = 0.5 a. QD = a – bP

QS = c + dPP* = $5-b(P/Q) = -b(5/15.75)= -0.4b = 1.26 a = 15.75 + (1.26)(5) = 22.05 QD = 22.05 – 1.26PSimilarly, QS = 7.875 + 1.575P

b. Change in price: ∆P = 5 – 2 = 3; ∆ Q = 15.75 – 23.5 = -7.75 Average price: (5 + 2)/2 = 3.50Average quantity: (23.5+15.75)/2 = 19.625

ED = PQ

∆ Q∆ P

= -0.46

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Chapter 3:

#6. The MRS describes the rate at which the consumer is willing to trade off one good for another to maintain the same level of satisfaction. The ratio of prices describes the trade-off that the consumeris able to make between the same two goods in the market. The tangency of the indifference curve with the budget line represents the point at which the trade-offs are equal and consumer satisfactionis maximized. If the MRS between two goods is not equal to the ratio of prices, then the consumer could trade one good for another at market prices to obtain higher levels of satisfaction. For example, if the slope of the budget line (the ratio of the prices) is −4, the consumer can trade 4 units of Y(the good on the vertical axis) for one unit of X (the good on the horizontal axis). If the MRS at the current bundle is 6, then the consumer is willing to trade 6 units of Y for one unit of X. Since the two slopes are not equal the consumer is not maximizing her satisfaction. The consumer is willing to trade 6but only has to trade 4, so she should make the trade. This trading continues until the highest level of satisfaction is achieved. As trades are made, the MRS will change and eventually become equal to the price ratio.

Chapter 4:#2. An individual can’t consume both inferior goods. No, the goods cannot both be inferior; at least one must be a normal good. Here’s why. If an individual consumes only food and clothing, then any increase in income must be spent on either food or clothing or both (recall, we assume there are no savings and more of any good is preferred to less, even if the good is an inferior good). If food is an inferior good, then as income increases, consumption of food falls. With constant prices, the extra income not spent on food must be spent on clothing. Therefore as income increases, more is spent on clothing, i.e., clothing is a normal good.

Explain the term “marginal rate of technical substitution.” What does a MRTS 4 mean? MRTS is the amount by which the quantity of one input can be reduced when the other input is increased by one unit, while maintaining the same level of output. If the MRTS is 4 then one inputcan be reduced by 4 units as the other is increased by one unit, and output will remain the same.

5. What is the difference between a production function and an isoquant?A production function describes the maximum output that can be achieved with any given combination of inputs. An isoquant identifies all of the different combinations of inputs that can be used to produce one particular level of output.

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