Embed Size (px)
Citation preview
Microeconomics 1/24/12 1:46 PM
Economics: Study of choice under conditions of scarcity
Opportunity Cost: what you give up when making a choice
Society
Resources:
o Land (natural resources)
o Labor: time spent on production
o Capital: long-lasting tool that labor uses to produce
goods/services
Physical
Human
o Entrepreneurship:
Resource Allocation
What is produced? .. Opp cost
How to produce? How much of the four resources are used
Who gets it? Distribution?
3 Methods of Resource Allocation
Command – who gets what (communist – central gov.)
Tradition – resources allocated the way they’ve always been
o Adv: Stable, no unemployment, primitive societies
o Disadv: no growth – no change in standard of living
Market – everyone does what they want with what they have
1
Day 2 1/24/12 1:46 PM
Model: abstract representation of reality. ie graphs, functions. Simple as
possible to accomplish purpose
Assumptions
Simplifying – doesn’t affect conclusions that would be reached
(lack of trees on roadmap) makes model simple as can be to get the
gist of it
Critical – affects conclusions of model (open roads on map in
places of construction in reality)
Supply/Demand – model of how prices are determined in many markets
(group of buyers and sellers with potential to trade with each other) (can be
broad or narrow)– movement of prices affects resource allocation
Ex. Market for gasoline
Quantity demanded (QD) – number of gallons buyers in market would
choose to buy given constraints they face
QD = D(Price) – Law of Demand: as price rises, QD down
o D(Income) –gross income, Positive Relationship
Normal good: rise in income increases demand for that
good. House, car, health club membership, food
Inferior good: rise in income decreases demand
o D(Wealth) – net worth. Direct relationship
o D(Substitutes) – similar good – Direct relationship
o D(Complement) – second good bought along with first good
o D(Population) – positive relationship
o D(Expected Price)- price ppl expect in future – Positive
relationship
o D(Preference) – Positive relationship
o Demand Curve – movement along vs shift of curve
change in price of good causes quantity of demand to
change – movement along curve
when anything else other than price of good causes
quantity demanded to change – demand curve shifts
2
P
QD
Increase in income causes curve to shift right, etc.
D2
D1
Supply: QS – Quantity supplied - # of gallons gas suppliers would like
to sell in the US each month given their constraints
QS= S(price) – higher price, more supply – Law of Supply
S(inputs) – labor, resources. Higher, less supply
S(Alternate) – alternative good that producer can easily produce or
at alternative locations. More/higher price of alternative, less supply
of original good
S(Technology) – advancements – improvement shifts right
S(Weather)– etc.
3
S(Expected Price) – POV of producer, higher expectation of price -
less supply
S(# Firms) – more industry, higher supply
S
P
Q
P B A S
Prices go down – QS decreases, QD increases: Excess Supply
excess demand
D
Q
Equilibrium – set of values for endogenous variables that won’t
change unless an exogenous variable changes
o Endogenous – Prices and Quantity; determined inside model
o Exogenous –A given
Excess Supply – less demand than supply - prices decrease
Excess demand – prices increase to get back to equilibrium
Short side rule: difference between QS and QD, the lesser one wins
Comparative Statics – change one or more of exogenous variables and
observe change that it causes in endogenous variables
Price of input goes up - Supply shifts left, equilibrium price
increases and quantity demanded decreases
4
ex. Price of electricity drops ie Demand decreases – shift left. Equilibrium and
quantity demanded decreases
5
Day 3 1/24/12 1:46 PM
Government Intervention – change prices to make economy more fair
Price Floor: When market price is too low and sellers are unhappy
o a minimum price set by Gov. – has to be set above the
equilibrium price, causing an excess supply which would force
the price back dowb.
o Agricultural Price Floors
As technology increases, supply keeps shifting right, the
prices keep decreasing, hurting farmers
o Excess supply is temporary. When it’s more long-lasting, its
called a Surplus – caused by price floors
o How to maintain the price floor
1. Government buys up the surplus to ensure that
the price doesn’t decrease – not best alternative
2. Artificially shift demand curve to the right to
eliminate the surplus – gov. funds advertising on surplus
items such as milk. – TELL CADY. Food stamps to get rid
of extra food
3. Artificially shift supply curve leftward in order to
get equilibrium at price floor price – done by paying
farmers to not grow crops ewg.org
Price Ceilings: maximum allowable price. Only impacts market if
below equilibrium price – when price is too high P2
o If gov. enacts a price ceiling, there’s an excess demand
a long –term excess demand, it’s called a shortage
if scalpers by all tickets – they will try to sell at price P2
Total Revenue of tix before ceiling would be PexQe
When ceiling is enacted, the new price decreases the total revenue
The difference between Pc and P2 x number of tix = scalpers revenue
6
When supply curve keeps shifting left, price keeps rising
So, a price ceiling can reduce the amount of people seeing plays due
to increase in prices demanded by scalpers
Rent Control
Taxes
o Doesn’t matter who gov. taxes (buyers or sellers)
o Ex. Quantity supplied at specific price? Or what must the
minimum price be to supply X quantity.
o Gov collects Tax on sellers:
Ex. $100 tax on airlines ie suppliers will increase ticket
prices by 100, so the supply curve shifts up ie left
But at the new price ($300 from $200), there will be an
excess supply forcing the price to decrease to new
equilibrium ($260)– this price is what buyers will pay to
the airline
Airlines have to pay $100 tax ie they only get what
buyers pay minus $100 - $160
o Tax incidence – who is really paying
Look at what buyers pay and sellers pay before tax.
Buyers pay $60 and sellers sell $40 – the new difference
between each and the original equilibrium
Ex. If buyers are taxed $100
If you want to keep quantity the same, then the
100 is deducted from the original 200$ ie $100
Demand curve shifts down, so there’s an excess
demand which would force the price up until the
new equilibrium ($160)
$160 is how much buyers pay to the airline
without tax. So they really are paying $260
o Tax incidence – what buyers pay - $60
Sellers - $40
o IE. The tax will be split the same way
Subsidies – Gov. pays either buyers or sellers
7
o Ex. Subsidy of $10,000 per student per year given to the
students
o Tuition of $40,000 will attract Q1 students
o If gov. gives $10,000 subsidy, students will be willing to pay
$50,000 - increasing the number of students attending
college
o The demand shifts up
Incidence: look at new equilibrium - $47,000 – what students
pay to the college, they’re really paying $37,000 with the
subsidy
Buyers benefit: Look at what they paid before and after
subsidy: B:40,000 A:37,000 so $3000
Sellers benefit: $7,000
8
Day 4 1/24/12 1:46 PM
Elasticity – compares % change in a variable caused by % change in
another variable
Sensitivity of quantity to changes in price
Steep demand curve – not too sensitive to price, opposite to a flat
curve
Depends on type of good
Price Elasticity of Demand - % change in quantity demanded/% change in
price of the good – absolute value
Price per gallon # of gallons per week demanded
$3 10,000
$3.30 8,000
$3.60 6,000
% change in quantity demanded the normal way = 2000/10,000 = 20%
OR from $3.30 to $3.00 = 2,000/8,000 = 25% - Don’t do this way
Midpoint Rule: when calculating elasticities: % change in quantity
demanded = change in quantity demanded/ Average Quantity demanded
The average stabilizes the quantity from low to high or high to low
% change in price – change in price/ average price
Elasticity of demand = change in quantity = 2,000/9,000 = 22.2%
Change in price = .30/3.15 = 9.5%
ED = 2.34 for going from 3 to 3.30 or vice versa
Estimate for % change in quantity demanded caused by 1%
change in price
Even though line is straight line, the price elasticity changes
along the line - % change in price decreases as % change in
quantity demanded is increasing so Q/P increases
Elasticity is 0 in the middle and greater above, lower below
9
Elasticity Continued 1/24/12 1:46 PM
Categories of Demand
Elastic Demand: Price elasticity is larger than 1 ie % change in
quantity > than % change in price. Price sensitive. Price up by 1%,
Quantity down by more than 1%
Inelastic Demand: Price elasticity is less than 1. Insensitive
Unit elastic Demand: Price elasticity = 1. Ex. Price up by 1%,
Quantity down by 1%
Perfect Elastic Demand: Price elasticity is infinitive – horizontal
line
Perfect Inelastic Demand: Price elasticity = 0: Undefined – Quantity
won’t change even if price does
Determinants of Elasticity
Ease of substitution
Nature of product: Necessity (Inelastic) or Luxury (Elastic)
good ie movies. Ex. Ed for movies = 3.7. 10% rise in price =
37% decrease in quantity demanded
Narrowness of Definition: easier to find substitutes for goods
outside of the narrow market (specific categories) = more elastic.
Ex. Food price increases = less substitutes (inelastic). Fruit
increases = more subs. (elastic)
Time Horizon: Short run (few months) – ED = .25 for gas ie
inelastic. Long Run – changes in lifestyle (yr or longer) – ED = .60 –
still inelastic, but larger. Demand for most goods is more
elastic the longer we wait
Importance in buyer’s budget: Demand is more elastic when
a good is a bigger part of buyer’s budget
Elasticity and Total Expenditure (Total Revenue). Expenditure =
Revenue
Price x Quantity (Area) = Total Expenditure/Revenue
If demand is inelastic, we know total expenditure increases
Demand Inelastic Demean Elastic
IF price up
TE increases TE decreases
TE decreases TE up
10
If price decrease
Mass Transit: Demand is inelastic. A price increase will cause
quantity demand to decrease less than the price rose ie TE/revenue
increases
Microsoft Anti-Trust Case
ED for windows was .5 - inelastic
If Price increases, quantity dropped, Total Revenue increased ie
Total Cost would have decreased and profit would increase
Profit = total revenue – total cost
if elastic and price decrease/quantity increases, TR increases, but
total cost increases too. Profit is dependent on which one increases
more
Ex. War on Drugs
11
Inelastic.
Qi Q1 Q small decrease in quantity demanded
Supply curve shifts left due to more risk in supplying illegal drug
Increase in crime with increase in Price
Ie Total Expenditure increase = crime by drug users increase
& Total Revenue increase = crime by drug suppliers increase
Focus more on demand
shift curve left - TE and TR decrease, so crime by users and
suppliers decrease
Elasticity of demand for oil = .06
Price of oil - $100/barrel
Quantity – 88 million barrels/day
Iran exports – 2.5 million barrels/day… 2.8% of world oil
Straits of Hormuz – 17 million.. 19%
Embargo would cause a 2.8% increase in demand. What price will
adjust the demand and supply back to equilibrium?
Percentage change in Quan. Dem. = 2.8
2.8/percentage change in price = .06
% change in P = 46.7% ie A 46.7% increase in price will get the
market back to equilibrium ie price of oil would be $146
same thing: 19/x = .06.
12
X = 316.7% increase in oil price. New price would be $416.7
13
Consumer Theory 1/24/12 1:46 PM
Giffen: found Law of Demand to work backwards
Person 1: won’t spend more than $25. Goes out 10 times if $15
Person 2: will go out twice at meals of $30, 3x if $25, 5 times if $15
Market Demand (1+2): 2 meals at $30, 3 at $25, 15 at 15$
“As-If” Theory: people’s behavior conceptualized on point of what they
would do
Indifference Curve Approach: Assumptions about consumer preferences:
1. Rational Preference
Comparability: consumer is able to choose between 2 goods
Transitivity: consumer is able to use transitive property in
choosing goods
2. More is better (non-satiation):
Q of movies
B
region depends on consumer preference
7 Q of rest. meals
A is preferred to B and B to C, so A to C
Purple Line – indifference Curve: Change in one will cause what kind
of change in the other?
If on same curve – they are indifferent to each other
Marginal Rate of Substitution (MRS)
MRS = change in quantity of movies/ change in quantity of
restaurant meals - slope of the line =
MRS gets smaller as you move rightward along the curve – willingness to
trade one for the other decreases – too much of one, not enough of other
14
A point on indiff curve – willing to trade the amount X of one for one of the
other
Any point above indiff curve will be preferred to any point on the curve. Each
point is indifferent to one another.Any point to the right of the curve is
preferred, Left is dis-preferred
Indifference Map: combination of various indifference curves. Higher
ones are preferred by consumers – they have higher utility (how
well off consumer is). Curves cannot cross each other
Budget Constraint
Assume: $300/mo to spend on movies and Rest.
Price of rest: $20
P of movie: $10
Budget Line. Slope = -2 . change in quantity of movies/change in
Q of Rest. AND –Price of Rest/ P of
movies: Price Ratio
Qr
Income falls from $300 to $200. Everything else same
Budget line shifts leftward parallel to original line
15
Income remains the same. Price of Rest falls from $20 to $15.
Movies the same
Line rotates outward due to being able to buy more meals
Budget: $300 best possible point on budget line?
movie: $10
restaurant: $20
- not on budget line, unaffordable
-middle one is best point. Tangent to budget line. i.e
MRS = price ratio
other line hits twice along budget line. First point MRS is larger than price
ratio and altogether, the indiff. Curve is below the middle one ie worse off
If MRS =3 & PR = 2 then Willing to trade 3 movies for meal but able to trade
2 for one meal – trading 2 movies for meal means you can be better off
Second Point – MRS less than price ratio.
If MRS = 1 and PR = 2 then willing to trade 1 meal for 1 movie, but able to
trade 1 meal for 2 movies. – trading 1 meal for 2 movies mean you can be
better off
If income increases, budget line shift to the right and need new indiff curve
to maximize their possessions ie quantity of both can increase thus are
normal goods
OR income can increase and the quantity of one can decrease ie an inferior
good
Deriving the Demand Curve
16
Qm Pr
30 20 -indv. demand curve for R, M
10
5
7 1415 30 Qr 7 14 Qr
Giffen good: good that violates law of demand b/c it’s inferior & income
effect dominates substitution effect
Q other goods Price of potatoes decreases, rotates out to the right
Quantity of potatoes decreases
Q2 Q1 Q potatoes
Income and Substitution Effects of a Price Change
Supposed price of X decreases – Subs and Income effects on demand
17
If price of X decrease: substitution increases toward X - Law of Demand
Like income increases: If good X is normal: increase
in demand for good X – Law of Demand
OR if good X is inferior: quantity demanded decreases –
violates law of demand – has to dominate substitution effect
Giffen Good Occurs:
Good is very inferior
Income effect of a price change must be very large ie beer example
– already buying a lot of the good
Price decrease caused person to change purchasing preferences
Studies
Devotion of time spent in either French or Econ
QF slope= PE/PF ie hours required to get a point – ability
assume PE/PF = 1. Trade of one point for the other
100
40 100 QE
MRS: willing to trade X amount of point in one subject for more in the other
subj; If it = Price ratio, then best off
Assume: addition of outside variable to affect price of econ point
(amount of hours for studying) to go down then it rotates out
18
QF
100
40 100 QE
PE decreased: substitution effect – Q demanded for E would increase
Income effect: if normal good – QD.E would increase
if inferior – QD.E would decrease in
favor for more QD,F
19
If Giffen good: so inferior, then QD.E decreases and QD,F increases
20
Cost 1/24/12 1:46 PM
Firm’s goals: maximize total profit (π)
Total profit = Total revenue – Total cost
Basic Principles of Cost
Cost relates to a decision: ex. increase/decrease output level.
Changing aspects of how things run
Cost is opportunity cost:
Cost is measured in dollars
Cost is a flow variable (for firms): process that takes place over
a period of time – ex. cost per year/month, profit, revenue
o –not a stock variable: quantity that can be measured in a
moment of time – wealth
“Sunk” cost are irrelevant and not considered: cost that has
already been paid or must be paid in future regardless of your
decision. Ex. nonrefundable ticket – can’t go to concert
Categories of Cost
Explicit: opportunity cost where money is exchanged – money paid out
Implicit: cost where money is not paid out
Explicit Implicit
Labor Costs – benefits, taxes Depreciation – value of capital that
is lost
Raw materials Forgone interest
Rent payments Foregone rent
Interest payments Foregone salary of owner
21
Accounting Cost: explicit cost + depreciation
Economic Cost (cost, opp. cost): Explicit + Implicit (all of them)
Fixed Cost: cost of all fixed inputs; Sunk costs – irrelevant for other
decisions
Variable Cost: cost of all variable inputs
2 inputs: affect Fixed and Variable Cost
Fixed Input: cannot be varied as output changes ex. space for nyu
growth
Variable Input: can be varied as output changes ex. more
teachers
Short Run: “ “ with at least one input being fixed – can’t be varied
Long Run: time horizon long enough to make all inputs variable inputs
22
1/24/12 1:46 PM
$
ATC – avg. total cost (fixed costs)
AVC
Q
And LRATC is always less than or equal to ATC in short run
Long Run Costs
Q per day Long Run Total Cost
0
1
2
3
Quantity per day Long Run Total Cost Long Run Avg. Ttl
Cost. LRTC/Q
0 $0 -
1 $400 400
2 $600 300
3 $720 240
4 $900 225
5 $1200 240
23
o
ATC
ATC
30
2 4
Short run costs
marginal cost below average cost at A – pulls avg down
Short run Total Cost (TC) is always greater than Long Run Total Cost
except at 2 where they’re equal ie the inputs at that level are the
best and there are no other options in the long run to reduce the
cost.
Takes longer for ATC curve to hit minimum because it’s declining
When it rises above average – it pulls avg up
If we start at A and want to move 2 units to 4 units in the short run
24
LRATC
In the long run, you move to C to $225
$
0 1K 18K Q
2 reasons for economies of sale: where 1K is
1. Increased opportunities for specialization
2. Spreading cost of lumpy inputs - input that a fixed amount of it
suffices for a wide range iof output – bad
Diseconomies of scale: more output produces – high cost in long run
Reasons for diseconomies
1. Difficulty monitoring production
2.Beauracratic decision making – larger the firm – more
management democracy ie more ppl have to petition
Constant Returns to Scale – between 1K and 18K
Assume: No artificial barriers to entry ie Number of entrants and
that all potential firms in an industry are identical
MES: minimum efficient scale = lowest output level at which LRATC
hits bottom
25
If a flat bottom, the first point is the MES
1000
$ LRATC (typical firm)
30K is the max output
ie only 3 firms can survive -
each could achieve LRATC of
1K
2K
1K
*Natural Oligopoly – few # of firms
6K 10K (MES) 30K Q
*Suppose 5 identical firms instead of 3 thus each producing 6,000
-each has LRATC of $2K
-If one firm cuts it price lower than 2K then it moves down the curve
toward A ie cost per unit decreases
-The other 4 firms would have higher costs per unit thus have to
lower their price to the price the first one did. End up at point B, but
make less.
Those that don’t want to lower price have to increase price – disadv.
It’ll keep going until 2 firms go bankrupt leaving 3 firms to survive
OR firms will merge
26
*Only one would survive
2K *Natural monopoly
1K
15K 30K
Many firms - cost per unit would decrease if small
number of firms
*Perfect competition/monopolistic competition
100 30K
variety of small and big firms – no
adv/disadv ex. clothing stores
*Hybrid
100 15K 30K
27
Profit 1/24/12 1:46 PM
Theory of Firm
Goal: maximize profit = Revenue – Cost
Accounting Profit: Total revenue – Explicit Costs
Economic Profit: Total revenue – All Costs
Costs per day
Explicit Implicit
$200 Wages $50 forgone interest
$50 raw materials $100 foregone salary to owner
(owner puts in own time)
$100 interest payments
$400 Rent
Total $750 Total $150
Suppose TR = $1000
Account Profit (pi) = 1000 – 750 = $250
Economic Profit = 1000 – 900 = $100
Or Suppose TR = $850
Acct = 850 – 750 = $100
Economic = 850 - 900 = $-50
Sacrificing $150 for staying in business
Profit Maximizing Output Level
Total Revenue & Total Cost (Always use economic def) Approach
Q/day Price on
each unit
TR/day TC/day Profit/day
0 >$1000 0 $200 -200
1 1000 1000 800 200
2 800 1600 1100 500
3 700 2100 1450 650
4 600 2400 1850 550
5 400 2000 2350 -350
28
short term b/c there’s a fixed cause of $200 at output of 0
2500
2000
distance b/t curves is profit – greatest
diff is max. profit
1500
1000
500
0 1 2 3 4 5
*3 – profit maximizing output
*4 – Revenue maximizing output level
Marginal Cost and Marginal Revenue Approach
MR = change in TR/change in Q
MC = change in TC/change in Q
Q MR MC
0 1000 600
1 600 300
2 500 350
3 300 400
4 -400 500
5
29
*Don’t want to move from 3 to 4 or 4 to 5 because MR decreases
*If MR>MC – firms should increase output
*If MR<MC – firm should not increase output – that’s the profit max.
output level
1000
800
600
400
200
0 1 2 3 4 5 Q
*plot in between Q
*when MR curve lies above MC curve – that change increases output
30
when MR is below MC curve – don’t increase output
The profit maximum output level is the closest Q (output) to the
crossing point of MR and MC
0 100 500
Red is profit max. output level – after 500 units, MC is higher
increasing after 100 units is still good bc MR curve is higher than
MC curve
31
MC curve must cross MR curve and cross MR curve from below
120 is max TR and 100 is max profit
*up to 120, as Q increases, TR rises so MR>0
*after 120 – as Q increases, TR falls and MR<0
100 120 Q
100 120
*crosses at 120 b/c MR is going from positive to negative
32
MC and MR should cross where max profit is greatest on top graph
loss *short run b/c TC doesn’t start at 0
minimizing loss
*profit max. output at 100
100
*no output level where they can earn profit b/c TC>TR
*increase output up to 100 in minimize loss.
*lowest possible loss is 100
*loss minimizing output at 100
100 (Q*)
Firm A & B at Q* in short run – both suffering loss
TR TC Profit TVC TFC Profit if
shut down
Firm A $5K $6K -1K 4K 2K -2K
Firm B $5K $6K -1K 5.5K .5K -.5K
33
*Firm A should stay open. Compare Profit to “profit if shut
down” and produce Q*
*Firm B should shut down and produce 0
TVC – operating costs
Shut down Rule (SR): As long as TR > TVC at Q* then firm can
stay open, vice versa
TR has to cover operating costs
Firms can vary on variable and fixed costs – affecting their ability to
stay open or shut down
34
1/24/12 1:46 PM
Long Run Losses – there are no costs to pay, everything can be reduced to
0
Exit Rule – if TR>TC at Q*, stay in industry. If TR<TC at Q*, exit industry
Marginal Analysis – additional variables that compares additional marginal
revenue to marginal costs
Franklin National Bank – ‘74
Output (Q) = $ lent out
Cost – interest paid on deposits + other marketing costs to attract
deposits
Revenue – interest earned on loans made
1974 – prime rate on loans from banks was 10% - to larger corps
Sources Cost per dollar to
bank
Total dollars from
source
Checking Acct. 2.25 cents $ 2 billion
Savings Accts 4 cents $ 1 billion
Federal Funds Market 10 cents $1.7 billion
Average costs per dollar = 5.43 cents
- they lowered prime rate to 8% so a MR of 8 cents
in reality costing them MC of 10cents/dollar from FFM to attract
more dollars
35
Perfect Competition 1/24/12 1:46 PM
Markets
Output market: goods/services that business firms produce & households
buy
Resource market: trading of resources; business firms buy from
households
Asset market: things of value that aren’t goods/services nor resources –
real estate, stocks/bonds, foreign exchange – not in the given year
Output markets:
Vary in size, forms of advertising, profit margins
Market structure: environment in which trading takes place
Perfect Competition
Reasons for study: point of reference, successful perfect
competitive markets, most markets come close enough
Assumptions:
o Many buyers and sellers – each indv. has little impact on
market ex. colleges
o Standardized product across markets ex. wheat
o Easy entry and exiting – low barriers
o Easily obtained information about product, cost, and cost from
other sellers
o
o *firms are price takers – take market price as a given (top
two above)
36
Q qe q
market demand curve demand curve for firm
Marginal Revenue for firm: same as demand curve. MR = P for a
perfectly competitive firm
Marginal Cost: profit maximizing output level is where MC and MR
cross –
37
$
6
5
q1 q2 q
*upward sloping part of MC curve is firm’s supply curve
*As price increases, quantity increases
For market graph – add all firms quantities at Price X1, X2, etc. to
get market supply curve
Price dependent on demand curve – equilibrium price of market will
determine firms’ pricing
Profit
$
ATC
5 d=MR
Q* - where MR crosses MC
q* q
firm producing at q* - 5$ for each unit sold.
Firm economic profit is greater than 0
Cost per unit
Revenue per unit
38
Distance between them is profit per unit
Total profit = profit per unit times q*
Loss - economic profit less than 0
MC ATC
AVC
q*
cost per unit (where ATC crosses MC) is above 5$
loss per unit
Total loss = loss per unit time q *
AVC
39
continued 1/24/12 1:46 PM
Shut down rule at q*
Shut down if P (TR/q) < TVC/q (AVC)
When looking at loss graph – firm should stay open (look at loss graph)
Firm suffering loss – and should shut down
ATC
$ MC AVC
d=MR
5
q* q
shut down because MC>MR and AVC is greater than 5$ (Price)
MC AVC
Ps
*Ps – shut down price
if above shut down price – stay open
when it drops below shut down price – doesn’t produce anymore
the black portion is the firm’s supply curve – usually stops at AVC curve
40
Adjustment to the Long Run
S1 $5 d=MR
ATC
3 profit
$5
$3
D
Q q* q
MARKET FIRM
In Long run , profit >0 attracts entry
S1 will move right as more firms come in ie the equilibrium price will
start to decrease
The demand curve on the firm’s graph will drop, so the profit will
start decreasing
Price will fall until Profit = 0 or where MC = MR
D=MR will drop to $3 where it crosses the ATC curve & q* will
decrease - so the supply curve will keep shifting right until
equilibrium price is $3
*If economic loss – firms will exit, supply curve shifts left until profit
= 0
41
In the long run, firms must also be at the minimum of their LRATC
curve
$
MC ATC LRATC
$3 d=MR
MC ATC
$1.5 d=MR2
q* q
-when q* increases – movement along LRATC curve to increase profit
but all firms will do this – more entry – so at lowest possible
price/unit (1.50) firms are open at 0 profit
Long Run equilibrium of firm in perfect competition
42
MC
ATC LRATC
P d=MR
q*
profit max.: MR = MC
perfect competition: MR = P
Economic profit = 0: Price = ATC and Price = LRATC
Long run – economic profit usually = 0 due to easy entry
Comparative Statics
S MC
P2 ATC
L
P2
P1 P1
D2
D
Q1 Q2 Q q* q2
q
MARKET FIRM
If tastes change in favor of good – Demand shifts right in short run and
Price rises to P2
A = initial long run equilibrium
B = new Short run equilibrium
43
In Long run – supply will shift right and Price (d=MR) will shift down
until it reaches original P1. New long run equilibrium = A
Price are market signals – price tells firms to produce more and
new firms to enter and produce more
-Start at P1 (where demand curve crosses supply curve)
-Demand curve shifts right and price rises
-Supply curve shifts right to a new point c back to P1
-Long Run supply curve is horizontal line across P1, connecting A
and C – Constant Cost industry – entry doesn’t cause input prices to
rise
Increasing Cost Industry – entry causes input prices to rise & exit
causes input prices to fall. Ex. Corn
44
Monopoly 1/24/12 1:46 PM
Monopoly:
Market with a single seller of a good with no close substitutes
Barriers to entry: keep others out
o Economies of Scale: cost per unit would be higher with
more firms - natural monopoly – single firm will naturally
dominate ex. cable
o Legal Barriers:
Gov. Declaration – only one firm legal
Gov. production – Gov. produces the
good/service itself ex. post office, MTA
Gov. Franchise – Gov. establishes rights for
single company to operate ex. cable
Patents/Copyrights
Zoning – how many sellers allowed in range of distance
ex. theaters
o Network Externalities: additional members in the network
imply greater benefits for each user of the network ex. social
networks
o Predatory Behaviors: threatening of other firms to exit the
market
Single Price – charges same price on each unit of the product vs
Price Discriminating Monopoly: charges different prices to different
customers
Single Price
Demand curve facing monopoly - same for market and firm
P Q TR MR
$100 0 0 100
$100 1 100 80
$90 2 180 60
$80 3 240 40
$70 4 280
45
*MR does not equal Price like in Perfectly Competitive markets
MR increases less than Price because price has to be lowered each
time
P
Q1
0 to Q1 – Profit because MR > MC - where they cross is output level
Produces at Q1 where MC crosses MR
Price to charge at Q1 units is where Q1 cross Demand Curve
Total Profit – - Q1 times profit per unit
Revenue per unit = P1
Cost per unit = where ATC curve crosses Q1
Profit per unit – dist between cost per unit and where demand cross
Q1
*make to sure to know how to do monopoly suffering loss in which it
stays open and one that shuts down - need to know AVC curve
Price setter
Monopoly has no supply curve – there’s only one price that monopolies
charge – Profit maximizing price
46
Monopoly VS Perfect Competition
Perfect Competition:
$
12 12
10 10
80 100 8000 10000
typical firm Market (100 firms)
Perfectly Competitive Market taken over by Monopoly
$ S
MC to produce another unit is
$10
15
10
D
6000 8000 Q
*Supply curve is the MC in a Monopoly
*MR lies below Demand curve in Monopoly
*Monopoly charges higher price than perfectly competitive markets
& produces less ie charging now $15 and producing 6000 units
*Monopoly Power – firms have power to raise prices and serve market
poorly – producing less
Monopoly Myths
Monopolies have unlimited power to raise the price (only constraint
is public outrage)
47
o Monopoly only goes up to Profit Maximizing Price – raising
price decreases profit because firm is selling less
Monopoly can pass any cost increases such as taxes onto
consumers
o Fixed cost (fixed tax) – doesn’t vary with level of output –
Won’t raise price above P1 because neither Demand,
MR, MC are affected
ATC is affected – curve shifts up – lowers profit per unit
but will continue to charge at P1
Fixed costs are not passed along to consumers
o Variable Costs (tax per unit) – ex. tax of $1 per unit –
shifts MC by $1 which causes output to decrease and
Price to increase
Monopoly can only pass some of the variable cost
increase onto consumers
P2 rises above P1 less than MC increases
*all above is in respect to single price monopoly
Price Discrimination – deals with more than one price –
- charging different customers different prices for reasons other
than differences in cost. Based on differences in willingness to pay.
Always helps firm – can harm or benefit consumers
3 requirements
Downward sloping demand curve facing firm – demand is
sensitive to price
Prevent Resale – no one will buy at the higher prices – easier for
services
Identify different groups’ willingness to pay
48
Assumption: Constant MC
$
175 increase in profit from charging $175 to those willing to pay it
150
100
increase in profit from charging $100 to those unwilling to pay $150
50 MC
D
MR
80 100 160 Q
found 80 ppl who are willing to pay $175 per unit as compared to the single
price monopoly at $150
*increase in profit = (175-150) x 80
found 60 ppl who are willing to only pay $100 – profit is $50
20 ppl willing to pay 150 -
Perfect Price Discrimination
-each customer is charged the highest price they’d be willing to pay
ex. used cars
each rectangle is an additional unit charging above $150 - the additional
profit
150
50 MC
D
MR
100 200
intersection of MC and D
Additional Revenue
49
additional profit in second triangle by selling more than 100 but less
than $150
Demand curve becomes MR
ex. tuition – FAFSA
50
Oligopoly 1/24/12 1:46 PM
Requirements
1. few firms that dominate the market (2+)
2. strategic interaction among firms – one firm anticipates reactions
of others firms when making decisions
How oligopolies arise
Barriers to Entry
Economies of Scale (natural oligopoly) ex wireless phones –
work at MES
Legal Barriers
o Gov. franchise
o Patents/Copyrights
o Zoning
Network Externalities
Predatory Behavior
Reputation
Game Theory
Prisoner’s Dilemma
A & B criminals: committed murder but arrested for dealing heroin
Each criminal offered deal – confess/not confess
A”S PAYOFFS - - B’s Actions
confess Don’t confess
confess 15 yrs 3 months
Don’t confess 30 yrs 5 yrs
A’s actions ^
51
o Dominant strategy: best strategy regardless of what other
player does
Strictly Dominant Strategy – always gives you better
outcome no matter what other player chooses
o Weakly Dominant Strategy: at least as good no matter
what the other player choose and by at least one
choice by the other player, it’s better
Ex. game show
o
52
1/24/12 1:46 PM
Delta’s Strategies
High Price Low Price American’s
strategies
American strictly dominant strategy is to choose low price no matter what
Delta does
Delta has the same strict dominant strategy
If Delta changes 3 million to 1 million under low price, then delta doesn’t
have a dominant strategy – their strategy depends on what American does -
but same outcome – both choose low price
can predict outcome as long as you know dominant strategy of one player
Cooperation
53
High Price Amer : 2milD:2 million
A: -1 millionD: 3 million - - 1
Low Price A: 3 millionD: -1 million
Amer: .5 millD: .5 mill
Explicit Collusion (price fixing) – companies agree to charge
prize that benefits all firms. Ex. OPEC - cartel
o Extreme case: cartel – work to max total profit by having
each cartel produce certain amt. – pretend their monopoly
Assume: no fixed costs and constant marginal costs
$
20
18
D facing cartel
15 MR MC = ATC
100 150 Q
Total Profit = red square
o Suppose Quota A = 50 and Quota B = 50
o Each sells 50 units making $5 profit per unit
Profit A & B = $250 .. 50 x 5
o Problems with explicit collusion:
Illegal in most cases
Tendency for cheating: when it’s hardest to
detect – more members
Suppose B sticks to agreement but A cheats,
increasing its own output to 100 so total market
output it 150. The profit max falls to $18. Total
cartel profit = 3 x 150 = $450 - -profit dec.
Player A profit = $3 x 100 = $300
Player B profit = 3 x 50 = $150
Tacit Collusion – implicit understanding of prices
o Price leadership – all oligopolists implicitly agree that one
firm is the leader – implicit power – can raise the price and
other firms will follow. Ex. airlines ie American Airlines
Incentive to cheat – not raise prices to make more
profit. Price leaders can enact policies
54
Tit for Tat: If leader raises price and others don’t,
then the price will be lowered back down
Punitive Reaction – Leader raises prices, some
don’t so leader lowers price below original price
(price war)
Delta
Safety Ads No Safety
Safety A:Low profits
D:Low
A: Very high
D: Very low
No Safety A: Very low
D: Very high
A: Medium
D: Medium
Amer
American and Delta dominant strategy is to run safety ad, but
they’re both collusive at no safety ads
George’s Actions
Call to check Don’t call Show up
Hire No job 0 No job 0 Job +1
Don’t Hire No job 0 No job 0 Possible job, poss
no job/humiliation
1/2
55
Dominant strategy is to show up
56
Labor Markets 1/24/12 1:46 PM
Households provide resources to firms for resource payments in return
(wages, rent)
(Perfectly) Competitive Labor Markets
Many buyers and sellers - - *Households and firms are wage takers
Standardized labor
Easy entry and exit
Easily obtained information
Labor Supply: Quantity of labor supplied = number of qualified people who
would like to work in a labor market given their constraints
Short Run: not enough time to become qualified (so # of qualified ppl is
fixed)
Ex. US market for truckers
wage rate Ls
#workers
Shifts to the right:
Number of qualified ppl increases
Increase in % of people who want to become truckers
Population growth
Decrease in wages in alternate labor markets (housing market)
57
Labor Demand
W
20 B
A
10
Ld
L2 L1 # workers
*lower wage rate – higher demand for labor
Movements along curve:
-Output Effect: when W increases – MC shifts up (because variable input
changes) – Q decreases - need less labor ie Ld decreases
Substitution Effect: W increases and labor is more expensive relative to
other inputs- firms shift to alternative inputs – use less of this type of labor
Shifts:
Change in technology
Substitutable – new technology that replaces worker – shift L
58
Complementary – makes labor more productive – shift R
Price of substitute input increases – shifts R - increasing demand
Price of complementary input increases – shifts L
Price of product increases - shift R – want more Q, need more labor
W US market for attorneys
Ls
W2 excess supply
W1
W3
Ld
L1 # attorneys
W2: Excess supply causes Wage rate to decrease - Labor supply decreases
and labor demand increases
W3: Excess demand causes wage rate to increase – supply increase and
demand decreases
Comparative Statics
W Ls1
W2
W1
59
Ld2
Ld1
L1 L2 L3 L
Society becomes more litigious - Labor demand curve shifts right
A: initial equilibrium – long run equilibrium
B: new short run equilibrium
Labor supply will shift right as wage rate increases – causes wage
rate to decrease to W3 – between W1 and W2
- Long run labor supply curve through A & C – increasing cost
industry
W2 is market signal to increase labor supply
60
1/24/12 1:46 PM
W LS
$80
$50
Ld2
Ld1
1 1.3 #attorneys (mil)
A: initial short run and long run equilibrium
Demand shifts right
B: new SR equilibrium after Ld2 shift – those already qualified enter
Supply shifts Right until wage rate decreases ‘til no more entrants
C: new long run equilibrium at $60
Why Wages Differ?
Imaginary World:
All labor markets are perfectively competitive (many buyers and
sellers, standardized labor, easy entry and exit, easy info)
Except for wage differences, all jobs are equally attractive to all
workers
All workers equally qualified to do any job
All above imply persistent wage difference are impossible
Ls2 Ls
61
50 80
30
50
Ld
Nurses Engineers
Nurses would rather be an engineer for higher wage rate
causes Labor Supply for nurses to shift left and LS for engineers to shift Right
continue until at an equal amount - $50 ie real world wage difference has a
violation of the assumptions
Real World Violation of the Assumptions of Imaginary World
Not all jobs are equally attractive
o Non-monetary job charac. – people like or dislike job for
characteristic other than money ex. danger
o Different Human capital requirements
o Compensating wage differential – differences in wages that
compensates people for non-monetary and diff human capital
requirements ex. Neurosurgeon paid more than general
surgeon
Not all people can become equally qualified for all jobs: differences
in characteristics from job to job
Not all people have equal abilities to be productive at their job ex.
some bring in more revenue
o Economics of Superstars: some making 10 fold of others in
same profession. How changes in technology combined with
differences in ability lead to soaring incomes at the very top
62
Minimum Wage
Federal minimum wage: $7.25
o Exceptions: disabled, employee that earns tips – can earn less
State minimum: higher than federal
Objections to minimum wage
Not well targeted – demographics vary
Creates winners and losers
W W Ls1 Ls2
7.25
4 4
3
LD
L2 L1 L
unskilled, covered unskilled, uncovered min.w
24
20
Ld2
Ld1
skilled – earn higher than min w
At 7.25 minimum wage in unskilled/covered, there’s an excess supply. LD
decreases
Those who lost their jobs go to unskilled/uncovered so labor supply shifts
right but wage drops
Demand for skilled labor increases
63
There is a better alternative
o Earned Income Tax Credit – if income is low, gov. gives tax
credit
64
65
66
67
68
69
70
Capital and Financial Markets 1/24/12 1:46 PM
present costs vs future revenue
Present Value (PV) of future payment is that amount of money
today that has the same value as that future payment – indifference
Assume:
Can borrow and lend at the same interest rate
No uncertainty – no risk
What is PV of $11,000 to be received in one year from today
Suppose interest rate (r) = 10%
Can either receive 10K now or borrow 10K
PV of $Y in one year = $Y/1+r ex. 11K/ 1 +.1 = 10K
If Y/1+r is put in bank for one year, will have (y/1+r) times (1+r) = $Y
PV of $Y in two years = Y/1+r^2
*PV of $Y in T years = $Y/(1+r)^t
*PV of future payment is lower if 1. $Y is lower & 2. R is higher & 3. T is
larger
Decision to invest in physical capital
Assume: Machine costs 100K
It lasts for 3 years
It provides net additional revenue of $35K (paid at the end of year)
71
R = 10%
PV of net additional revenue = 35K/(1.1) + 35K/(1+1.1)^2 + 35K/(1.1)^3 =
31,818 + 28,926 + 26,296 = 87,040
Do not buy b/c PV of future revenue (87K) < 100K
Suppose r = 2%
PV = 35K/1.02 + 35K/(1.02)^2 + 35K/ (1.02)^3 = 34,314 + 33,641 + 32,
981 = 100,936
Buy machine b/c PV of future revenue > current cost
Critical Interest Rate: interest rate that makes one indifferent about
purchasing a given physical capital
r
10
investment curve
300K
r = interest rate in economy
at r = 10%, all investments with critical interest rate >10% will be done
if lower than 10% - not made -
72
1/24/12 1:46 PM
Present Value and Financial Assets (IOU)
73
Financial Assets
Bond – promise of money in future
Stock – share of ownership of corp. – profits in future
Primary Market - sold to original buyer
Household/ - - - Financial Asset - - - original lender/
Corporation/ buyer of asset $
Gov. Agency $ financial asset
somebody else
Secondary Market – changing financial assets hand after hand
(somebody else) – where bonds and stocks exchanged
Provides liquidity – feasibility of getting cash
Price – price of selling additional assets in primary market
depend on prices in secondary market (high prices better)
Bond – “Corporation” promises to pay bearer X amount on “date
Bearer should pay PV of bond today
Suppose r = 10%
o PV in a year = 10K/1.1 = 9,090 – you shouldn’t pay
more
Suppose r = 5%
o PV in yr = 10K/1.5 = 9,524
Inverse relationship between interest rates and bond prices
Coupon Bond: “Corporation” promises to pay X amount on
“date” and coupon payments below
74
o Each coupon had different dates with X amount of $
o Assume r = 10%. PV in a year = 500/1.1 + 500/(1.1)^2
+ 500/(1.1)^3 + 10K = 8,757
Stock and The Stock Market
Share of Stock: share of ownership (control over board of
directors – every share owned is a vote & % of future
profits) in a corporation
Future profits
o Dividends – paid out to shareholders
o Retained earnings – corporations holds onto profits
(reinvests) – if successful, earnings invested leading to
higher profits leading to higher share prices and
shareholders experience capital gain (buy asset at low
price and sell at higher price)
o PV of $Y per year forever = $Y/interest rate
o Ex. Apple - $35 in profit per share per year
Suppose r = 6%. PV = $35/.06 = $583
Where stock comes from
o Ex. 2 people A&B – each gets half of the profits initially
o so they issue new shares of stock with more people –
profits decreases per each person
o profits increase in future and each will gain profits,
more than original
o *Companies issue new shares of stock if it is
advantageous for the company in the future
How Stock Prices are determined
o Supply & Demand
Markey for apple shares
$ per S
75
share
600
560
520
D
932 # of shares
Supply curve - # of shares in existence = # of shares held
Demand curve = # of shares ppl want to hold
IF $600 then demand (how much they want to hold) is less than 932
but actually are holding 932 million - people start selling shares –
decreasing price and increasing demand for shares
IF $520 – Demand is above how much is actually being held,
increasing price
76
Intersection – satisfaction between how much ppl want and how
much they hold
*stock prices change because demand curve shifts. The supply curve
cannot shift
P S
620
77
$560
D2
D
932 # of shares
IF demand increases – shift right. Price increases
78
79
1/24/12 1:46 PM
Predicting Stock Prices
Fundamental Analysis: using basic logic –
o Interest rates – if it decreases, then PV increases
o Business cycle:
o Industry and Company Specifics
Technical Analysis: look at patterns in changing of stock prices.
Meta-analysis on previous stock prices from computer data to
predict if stock will inc/dec
Efficient Markets Hypothesis
All publicly available information relevant to a stock’s value is
already built into the stock’s price at every moment in time - - ex.
Demand increases because everyone saw good value in new
product. Those who already hold stock profit the most.
*Patterns can disappear if everyone “figures” out trend.
80
Economic Efficiency 1/24/12 1:46 PM
Economic efficiency means we are not wasting opportunities to
make people better off
Pureto Improvement (PI) – any change or action taken in
economy that makes at least one person better off and
harms no one ex buying lunch
Economic efficiency requires tg=gat akk P.I. are exploited
*Every pureto imp. must be a potential im=oureto
Potential pureto improvement (PPO)
o Any change or actions for which the gains to the
gamers and greter after than the loses to the losers
o Every PPI can become a pureto with an apporopriate
side payment
Ex. 100 K in gains to gamer –
Economic Efficiency requires that every potential pureto
improvement be exploited
o Gains greater than losses
Economic efficiency of a market
Reinterpret demand curve
100
99
D
0 1 2 3
Either: start with price and see how many units purchased OR look
at units and see what maximum price people are willing to pay
81
Ex. Value of first unit = $100 -
$100
$99
$40 D
0 1 2 3
*$40 –market price. Willing to pay 100, but only have to pay 40
Consumer surplus – difference between value of good and what you
pay for it ie = $60
Area under demand curve = market consumer surplus
Area - .5bh = CS
82
1/24/12 1:46 PM
Producer Surplus: benefits on supplier side; on a unit is the dollars
received beyond the minimum necessary to produce that unit
P
S
16
12
10
1 2 3 4 Q
Supply curve: how much a supplier needs to produce X amt of units
Market Price $16. Ex. 1 unit would produce for $10, but market price
is $16 so surplus is $6 – area of rect.
Blue triangle: Market producer surplus aka 1/2 bh or 1/2x4x6
P S
100
D
83
2K Q
Consumer surplus – red triangle
Producer surplus – orange triange
CS + PS = Total benefits
Competitive markets are efficient
150
100
40
1K 2K
Efficient quantity: every pareto improvement taking place - 2K
consumer willing to pay $150 and supplier willing to supply at $40
As long as price is between $40 and $150 then both are better off – pareto
improvement
As long as demand curve lies above supply curve – efficient
2K is efficient quantity – can’t produce extra unit and have a gain
for both consumer and producer
Under perfect competition, market will eventually get to equilibrium
Economic efficiency mean total benefits are maximized
84
Price Ceiling – Inefficient market
S
P
100
60
D
900 2K Q
-$60 is price ceiling, 900 units will be bought and sold
-Producer surplus = green triangle – above supply curve below
market price. Worse off
-Consumer surplus – area under demand curve, above market price –
blue area - can only buy 900 units. Better off when getting surplus
on units they’re buying, but not buying the units they used to buy
Putting a restriction on market reduces total benefits
Price ceilings can never be a potential pareto improvement
Red triangle – welfare loss or dead weight loss – Total benefits we
don’t enjoy due to some policy
Monopoly Market takes over perfectively competitive market
85
MC becomes supply curve
140
100
MR D
800 2K
Sets the price at $140, consumer willing to pay but monopoly not
exploiting price by charging a lot less – have to keep the price the
same for everyone – loses revenue when price decreases
Efficient if monopoly can price discriminate
-dead weight loss – green triangle – all the benefits we could get but
not getting b/c monopoly refusing to lower it’s price
Governments Role in Economic Efficiency
Legal Infrastructure:
o Types of Law
Contract Law: specifies what contracts are legal/illegal
and law enforces contract – penalized. Need this to
make deals efficient
Tort Law: establishes reasonable standards of
reliability, if product produced causes harm to someone
else – if company is responsible
Property Law: establishes procedures to determine
ownership of properties and what you can do with the
property
Criminal Law: prevents transactions that harm others
ex. getting jumped
Dealing with market failure: market is inefficient despite
legal infrastructure – needs Gov. intervention
o Monopoly power – firms raise price, dec output – inefficient
86
o Externality: byproduct of a good/service that affects 3rd
parties (other than buyer/seller) ex. buying gas that affects
env aka other people – Negative Ex. – overproduce
o
Pos Ext: benefits others
o Public good – won’t exist if just left up to market
Ex. National defense -
87
