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Midterm 2 Comprehensive Notes

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University of Alberta

February 11, 2014 1. The Consumer’s objective 2. Consumer equilibrium 3. Individual demand 4. Market demand 5. Consumers’ surplus The Consumer’s Problem o The consumer wants to maximize her/his happiness subject to his/her level of income. o Our choices for our happiness is restricted by our level of income. o Maximize utility o U = U (q , 1 ,2… q ) n Subject to… o I = p 1 1 p q2 2. + p q n n o And: The consumer must spend all of her/his income Proof (sort of) Consider a consumer who only buys two goods, A and B Claim: consumer equilibrium occurs where MU /P = MA /A B B  MU /AMU = B /P A B  MU /A =AMU /P B B Here; MU /PA= A/a < 5/1 = MU /P B B (this consumer could do better) o Suppose we ask consumer to buy one less unit of A. o Consumer’s utility falls by 8 o Their happiness falls by 8 units, however they now have four dollars to buy more units of B. o Consumer buys 4 units of B o Her/his utility increases by (4)(5) o Gain in utility = 20 o NET gain in utility = 20- 8  = 12 This proves that at the initial portion is not a consumer equilibrium The position (MU /A > AU /P ) BannBt be an equilibrium MU /A =Autility gained by the last dollar spent on good A MU /B =Butility gained by the last dollar spent on good B If MU AP Chinese food > Mexican food o Larry prefers: Chinese food > Mexican food > Italian food o Curly prefers: Mexican food > Italian food > Chinese food o Italian food > Chinese food o Chinese food > Mexican food o By transitivity ▯ Italian food > Mexican food (this is not true!) Preferences are not transitive. C: C > M > R M: M> R>C R: R>C>M Horizontally Summing TO drive a market demand, we horizontally sum individual demands. Price Individual A Individual B Individual C Market 20 15 7 17 39 40 8 2 14 24 60 3 0 10 13 Add up price and ind. a, ind. B and ind. C ** Write this under all summation information [ private good]. This method/graph only works with private goods. o Rival or non-rival goods o Exclusive and non-exclusive goods o Air in room vs. pencil in your hand. Someone else can’t use it. o Rival AND exclusive good = private good (ex: hot dog, pen) o Rival AND non-exclusive = open access good (ex: fish in the ocean) o Exclusive but not rival = club goods (a big swimming pool with only a couple people  not having an impact on anyone else’s consumption) o Non-exclusive and non-rival = a public good (ex: national defense) different than a publicly provided good such as education. The demand curve shows us two things 1) it shows what quantity consumers will buy given a price. And 2) it shows what price consumers are willing to pay for a given quantity. The value of the willingness to pay represents the consumer’s evaluation of the benefits associated with the consumption of the last unit. So, it represents the Marginal Benefits of consumption. In a consumer equilibrium the consumer consumes up to the point where Marginal Benefits = Price. Consumers’ Surplus The difference between what a consumer is willing to pay and what the consumer has to pay. Ex: discrete good = laptop. You can’t buy half a laptop. P Q 9 1 7 2 6 3 5 4 3 5 P = $5 CS = ? CS = (9-5) + (7-5) + (6-5) + (5-5) Consumer surplus must be non-negative (CANNOT BE NEGATIVE) (CS > or equal to 0) CS = 4 + 2 + 1 + 0 CS = $7 CS = (WTP –1P )1+ (WTP – 2 ) 2 …. (WTP = willingness to pay) Continuous Good Graph* P = 32 – 4Q P = 8 CS = ? We need to find a value for the Consumer Surplus. 8 = 32 – 4Q Q = 6 CS = ½ b x h CS = ½ (6) (32 – 8) CS = $72 Willing to spend 72 dollars MORE Application: The Disneyland Dilemma Consider an amusement park. The management of the park is trying to choose a price strategy. Three options 1) Charge P per ride 2) Charge P per ride and an admission fee 3) Charge only an admission fee Tag- A-Bag o Garbage disposal o Concern we have in Edmonton – we’re running out of places to put this garbage o Voluntary program o Charge a flat fee o Want to charge a per bag of garbage fee 1) Legal organization of Firms 2) Methods of corporate Finance 3) Reading: Chapters 7, 8, 9 Voting Benefits: Get what you want socially acceptable Costs Time Information Financial Environment of Business The Legal Organization of a Firm 1) Sole Proprietorship o Business is owned by a single person o Advantages:  Easy to form, easy to dissolve  All decision making power resides with the sole owner  Only taxed once. Business profits are part o the owner’s income  income taxes. That is not going to happen if you set your business up as a corporation. o Disadvantages:  Owner has unlimited liability. Business assets and personal assets can be taken if it fails. You could lose everything. 2) Partnership o Business owned by two or more people o Advantages:  Easy to form  Only taxed once  Spreads risk  Allows specialization o Disadvantage  Each partner has unlimited liability 3) Corporation o A legal entity that may conduct business in its own name just like an individual. o Advantages:  Each shareholder has limited liability  Corporations are well positioned to raise large sums of money  Shareholders enjoy limited liability o Disadvantages  Subject to double taxation. The profits of a corporation are subject to corporate taxation. The after tax profits that are distributed to shareholders are income and are subject to income tax.  Corporations are subject to a Principal Agent Problem. Shareholders are the principals and managers are the agents. o Principal Agent Problem:  Shareholders  Maximize Profits.  Managers  Maximize their happiness  These two goals are not always consistent. Methods of Corporate Finance 1) Bonds (Debt financing) o A legal claim against the corporation o It represents debt o The return is paid whether the corporation makes profits or not. o Bondholders are not owners, they are creditors o Bonds have a maturity date 2) Stocks (Equity Financing) o Ownership in the corporation o Shareholders have a right to a portion of the profits, called dividends. o They are not assured of a fixed rate of return o Two types of shares: - Common shares ▯ shareholders vote for the board of directors - Preferred shares ▯ shareholders do not vote but get preferential treatment in regards to dividends. Example: Volume High Low (the Close Change (100s) (highest lowest price it possible traded at in price) that business day Northgate 1435 1.54 1.40 1.40 -0.11 What influences the demand for a stock? 1. Price of the stock Current price Perceived future price [Bear Market: downward trends in stock prices] [Bull Market: upward trend in stock prices] 2. Stability of the Company 3. Its products 4. Ethical issues 5. Information about the accuracy of its records 6. Dividends and earnings 7. Certification from an external auditor 8. The interest rates on corporate and government bonds March 4, 2014 1)
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