Microeconomics Review ECO105.pdf

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Paul Cohen

Microeconomics Review 1.1 – 1.4 • The problem of scarcity exists because all human wants cannot be satisfied with limited time, money, and energy. Scarcity exists everywhere. • Opportunity cost is the cost sis the best alternative given up. Could be equal to, less than, or greater than monetary costs. • Voluntary trade is not a zero-sum game. Both traders gain. Mutually beneficial gains from trade are caused by differences in comparative advantage. • Opportunity cost = Give Up/Get 2.1 – 2.5 2.1 • Preferences describe your wants and their intensities • The term demand describes consumers’ willingness and ability to pay for a particular product/service. 2.2 • The diamond-water paradox illustrates the idea that what consumers are willing to pay for a particular good depends on the marginal benefit. The paradox is resolved by distinguishing marginal value from total value. You would die w/o any water, so you would be willing to pay everything you can for the first drink. But when water is abundant and cheap, and you are not dying of thirst, the marginal benefit is low, even though the total benefit of all water consumed is high. Diamonds are desirable because they are relatively scarce. • Willingness to pay depends on marginal benefit. 2.3 & 2.4 • The law of demand says that if the price of a product/service rises, the quantity demanded decreases, and vice versa. Quantity demanded is the amount you actually plan to buy at a given price. • Market demand shows the sum of demands of all individuals willing and able to buy a particular product/service. Changes  in  Demand   The  demand  for  a  product/service   Decreases  if:   Increases  if:   Preferences  decrease   Preferences  increase   Price  of  a  substitute  falls   Price  of  a  substitute  rises   Price  of  a  complement  rises   Price  of  a  complement  falls   Income  decreases  (NORMAL  GOOD)   Income  increases  (NORMAL  GOOD)   Income  increase  (INFERIOR  GOOD)   Income  decreases  (INFERIOR  GOOD)   Expected  future  price  falls   Expected  future  price  rises   Number  of  customers  decreases   Number  of  customers  increases     Ex:  If  Ham  and  cheese  are  complements,  then  when  the  price  of  ham  falls  the   demand  for  cheese  will  increase.       2.5 %  𝐶ℎ𝑎𝑛𝑔𝑒  𝑖𝑛  𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦  𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑃𝑟𝑖𝑐𝑒  𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦  𝑜𝑓  𝐷𝑒𝑚𝑎𝑛𝑑 =   %  𝐶ℎ𝑎𝑛𝑔𝑒  𝑖𝑛  𝑃𝑟𝑖𝑐𝑒 𝑇𝑜𝑡𝑎𝑙  𝑅𝑒𝑣𝑒𝑛𝑢𝑒 =  𝑃𝑟𝑖𝑐𝑒  𝑥  𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 • If the demand for good/service is inelastic , the price elasticity of demand is <1. When the price is raised, the percentage decrease in quantity demanded is less than the percentage rise in price, so total revenue (P x Q) increases. • Price Elasticity of Demand is influenced by substitutes, time to adjust, and proportion of income spent on a product/service. 3.1 – 3.5 3.1 • Businesses must pay higher prices to obtain more labour because workers are supplying time, and the marginal cost of their time increases as more hours are supplied. • For smart supply decision, the marginal cost is the opportunity cost of time, thus the marginal cost increases as you provide more, and the marginal benefit is measured in $ (wages you earn). • Since marginal cost of your time increases, you give up the least valuable time first. 3.2 Sunk costs are those costs that cannot be recovered. Sunk costs are not part of additional opportunity costs and have no influence on smart choices! Ex: You are considering selling you used car and buying a new car. Which of the following would be a sunk cost? ▯ The sale price of the used car ▯ The cost of the new car þ The insurance you paid for the used car ▯ The trade-in value of the used car 3.3 - 3.5 • The Law of Supply states that if the price of a product rises, the quantity supplied of the product also increases since this creates incentives for production to increase by providing the higher profits. Individuals and businesses devote more of their time or resources to producing or supplying because of the quest for profits. 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙  𝑂𝑝𝑝𝑜𝑟𝑢𝑛𝑡𝑖𝑦  𝐶𝑜𝑠𝑡 =   𝑋  𝐺𝑖𝑣𝑒𝑛  𝑈𝑝 𝑀𝑜𝑟𝑒  𝑌 𝑉𝑎𝑙𝑢𝑒  𝑜𝑓  𝑋  𝐺𝑖𝑣𝑒𝑛  𝑈𝑝 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙  𝑂𝑝𝑝𝑜𝑟𝑢𝑛𝑖𝑡𝑦  𝐶𝑜𝑠𝑡 =   𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒  𝑖𝑛  𝑌 • Supply increases with improvement in technology, a fall in the price of an input, a fall in the price of a related product/service, a fall in expected future price, and increase in number of businesses, and vice versa. 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦  𝑜𝑓  𝑆𝑢𝑝𝑝𝑙𝑦 =   𝐶ℎ𝑎𝑛𝑔𝑒  𝑖𝑛  𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦  𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 %  𝐶ℎ𝑎𝑛𝑔𝑒  𝑖𝑛  𝑃𝑟𝑖𝑐𝑒 • If the percentage change in quantity supplied is less than the percentage change in price, elasticity of supply is less than 1 and is called inelastic. Quantity supplied is relatively unresponsive to a change in price. • Elasticity of Supply of a product/service is influenced by: availability of additional inputs, and the time production takes. • Knowledge of the price elasticity of supply for an item allows accurate projections of future outputs and prices, helping businesses avoid disappointed customers. 4.1 – 4.4 4.1 • A market is a process between buyers and sellers. It is not a place. • For markets to work and voluntary exchanges to happen, governments must define and protect property rights and enforce contracts, or agreements, between buyers and sellers. • Voluntary exchange that occurs in the market is the result of cooperation between the buyer and seller. • For the buyers, MB ≥ Price or Marginal Opportunity Cost. • For the seller, P ≥ Estimated Marginal Opportunity Cost. 4.2 • When the market price is too high, there is a surplus, and quantity demanded is less than the quantity supplied. The surplus creates pressure for prices to fall, and vice versa. • 4.3 • Market-clearing price is the first name for the market price that equalizes Q and Q . Balances the forces of competition between D S consumers and businesses, with the forces of cooperation between consumers and businesses. • Equilibrium price exactly balances the forces of competition and cooperation to coordinate the smart choices for consumers and businesses. At the equilibrium price, there is no tendency for change. • Price signals in markets create incentives, and coordinate the smart choices of consumers and businesses. 4.4 • Here is an illustration of what could happen in a market. • Consider the effect that the following event will have on the market for jeans: The income of consumer’s increases. The demand increases, the market-clearing price rises, and the quantity supplied increases. 5.1 – 5.5 5.1 – 5.3 • Price ceilings are set below the market-clearing price. Quantity adjustment occurs when prices can’t adjust. • Ex: Most of the employment impact of minimum wages will come from businesses hiring fewer low-wage workers in the future. • Price floors are set above the market-clearing price. Quantity adjustment occurs when prices can’t adjust. • Rent controls result in shortages of rental housing. There is no incentive the build more rental housing, and an incentive for owners of rental apartment buildings to convert these into condominiums. The quantity will adjust to the quantity supplied. Rent controls have unintended and undesirable consequences: create housing shortages, giving landlords the upper hand over tenants. 5.4 • The outcomes of well-functioning markets are efficient, but not always equitable. Government may smartly choose policies that create more equitable outcomes, even though the trade-off is less efficiency. 5.5 • Positive statement – About what is • Normative statement – About what should be 6.1 – 6.3 • Obvious/explicit costs are costs a business pays directly. This includes depreciation, which is a tax rule for spreading cost over lifetime of long-lasting equipment. • Implicit costs are hidden opportunity costs of what business owner could earn elsewhere with time and money invested. • Normal profits are compensation for business owner’s time and money; the sum of hidden opportunity costs what business owner must earn to do as well as best alternative use of time and money. 𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐  𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔  𝑃𝑟𝑜𝑓𝑖𝑡𝑠 − 𝐻𝑖𝑑𝑑𝑒𝑛  𝑂𝑝𝑝𝑜𝑟𝑢𝑛𝑖𝑡𝑦  𝐶𝑜𝑠𝑡𝑠 𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐  𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝑂𝑏𝑣𝑖𝑜𝑢𝑠  𝑂𝑝𝑝𝑜𝑟𝑢𝑛𝑖𝑡𝑦  𝐶𝑜𝑠𝑡𝑠 + 𝑁𝑜𝑟𝑚𝑎𝑙  𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔  𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝑂𝑏𝑣𝑖𝑜𝑢𝑠  𝐶𝑜𝑠𝑡𝑠 𝐻𝑖𝑑𝑑𝑒𝑛  𝑂𝑝𝑝𝑜𝑟𝑢𝑛𝑖𝑡𝑦  𝐶𝑜𝑠𝑡𝑠 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔  𝑃𝑟𝑜𝑓𝑖𝑡𝑠 − 𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐  𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝐻𝑖𝑑𝑑𝑒𝑛  𝑂𝑝𝑜𝑟𝑢𝑛𝑖𝑡𝑦  𝐶𝑜𝑠𝑡𝑠 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝑂𝑏𝑣𝑖𝑜𝑢𝑠  𝐶𝑜𝑠𝑡𝑠 −  𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐  𝑃𝑟𝑜𝑓𝑖𝑡 • Smart business decisions depend on economic profits . • When businesses pursue economic profits, the unintended consequence is that markets produce the products/services consumers want. • A business owner should leave an industry when economic profits are negative, when additional benefits are less than additional opportunity costs, and when revenues are less than all opportunity costs. • Businesses expand and enter an industry with economic profits, pushing quantity sold up and prices down, until prices are just enough to cover all opportunity costs of production and economic profits are zero. 7.1 – 7.4 Market Structure and Pricing Power Market Monopoloy Oligopoly Monopolistic Extreme Structure Competition Competition Characteristic Pricing Power Price Maker Price Maker Price Maker Price Taker (10) (5-9) (1-4) (0) Product No closer Differentiated Differentiated Many perfect Substitutes substitutes substitutes substitutes substitutes Number of 1 Few Many Many, many Sellers Barriers to High Medium None None Entry Elasticity of Low/Inelastic Low/Inelastic High/Elastic High/Elastic Demand • Market structure depends on the nature and degree of competition in the industry • Economies of scale occur when average costs fall as the scale of production increase. This occurs when there are high fixed or sunk costs. • Economies of scale can lead to a monopoly because when the business increases output, it can lower the cost per unit, and charge a lower price, driving smaller firms out of business. • With natural monopolies , one business can supply the entire market at a lower cost than can two or more businesses. There are high fixed costs. The marginal cost of delivering is quite low. As quantity of output increase, average total costs fall. They create a challenge for policy makers because there are gains related to the low-cost efficiencies of a monopoly. 7.4 • Businesses’ quest for economic profits and the market power of monopoly generate actions – cutting costs, improving quality, innovating, advertising, etc. When competitors respond, prices are driven towards levels f extreme competition. The process of creative destruction unintentional improves productivity and living standards for all. Competitor’s actions also result in business cycles. 8.1 – 8.4 8.1 • Marginal revenue is the additional revenue from selling one more unit. • Marginal revenue is less than the price for
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