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COMPLETE Introductory Microeconomic Analysis Notes (4.0ed this final!)

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Boston College
ECON 1131

Chapter 9 – Supply and Demand in Competitive Labor Markets • Competitive labor markets operate exactly as do competitive product markets, with the roles of supply and demand revered o Individuals are the suppliers, and business firms are the demanders • Regarding the supply of labor: o Individuals experience the cost of supplying labor in terms of the leisure they sacrifice in order to earn income  The labor-leisure tradeoff (the individual’s labor supply curve) depend on substitution and income effects  The supply curve is not necessarily upward sloping because the substitution and income effects pull in opposite directions • The substitution effect of a wage increase favors working harder • The income effect of a wage increase favors taking more leisure o Men and women in the US appear to have very different supply curves  For men, the income effect slightly dominates • Their labor supply curves are downward sloping and highly inelastic  For women, the substitution effect dominates • Their labor supply curves are upward sloping and more elastic o The supply curve to a given occupation is almost certainly upward sloping o The desire for leisure places a substantial value on time • Regarding the demand for labor o For competitive firms, the extra revenue obtained from hiring additional labor is the value of labor’s marginal product which equals the marginal product of the last worker times the price of the product the worker produces  VMP = LP * PL g o Competitive firms maximize profit by hiring the amount of labor at which the market wage equals the VMP L  To Max profit: Set Wage= VMP L o The VMP isLthe firm’s demand curve for labor • Distributional implications of competitive labor markets o Identical workers within the same occupation earn the same wage no matter where they work o Workers in two different occupations earn the same wage so long as they are equally willing and able to work in either occupation o If workers are identical but occupations differ in their required skill or attractiveness then:  Equalizing wage differentials result which reflect the relative desirability of different jobs  The identical workers receive the same total utility, consisting of the wage plus occupation’s characteristics, no matter what job they take o If workers differ and jobs differ, then the overall market for labor separates into a number of individual, non-competiting labor markets with wages determined in each market by the Laws of Supply and Demand  Identical workers are treated equally  Non-identical workers may receive different amounts of economic rent • Economic rent is the difference between the actual wage received and the wage required to keep a worker employed in a particular occupation o Given that wages differ across occupations and that Wage = VMP ,Lthe VMP L suggests three important determinants of wages in competitive markets:  Aworker’s productivity or skill  The number of other workers with the same skill  The market for the good or service that the worker is producing • Federal Minimum Wage o Minimum wage is a price floor  Causes excess supply o Employment effects are quite small o Not effective when trying to fight against poverty because only a minority of individuals working at minimum wage come from poor families o Lost effectiveness because Congress does not adjust the minimum wage very often o Market wages have exceeded the minimum wage in some regions of the country since the mid 1980’s VMP L Wage S’L SL Total W Min Return to land S L MC L W e Total Wages DL Labor Labor With a minimum wage, the supply curve rises from SLto S’Land the wage rises from Weto W Min Chapter 11 – The Firm’s How Problem and The Total Cost of Production • The total cost curve is the basis of all cost relationships – It stresses five attributes of a firm’s total cost of production o Other things equal:Atotal cost curve depicts the other things equal relationship between the firm’s output and its total cost of production  All other variables that affect total cost are held constant o The short run versus the long run: Total cost in the short run naturally divides into fixed cost and variable cost  Fixed cost is associated with the firm’s fixed factors of production and does not vary with output. They are sunk costs  Variable cost is associated with the firm’s variable factors of production and does vary with output  In the long run, total cost and variable cost are equal because fixed costs are zero o Shape of the total cost curve:  The long run: • Bowed inward toward the origin at low levels of output and outward away from the origin at high levels of output • This shape is based off economies of scale at low levels of output (% change in total cost divided by % change in quantity is less than 1) and diseconomies of scale at high levels of output (% change in total cost divided by % change in quantity is greater than 1)  The short run: • The short run total cost cure is the same shape as the long run but has a vertical shift equal to the fixed costs o Economic cost versus tax accounting cost  The total cost curve is the total economic cost which is the total opportunity cost of producing the firm’s output  Accounting cost for income tax purposes includes only the operating expenses of the firm  Economic costs are the operating expenses plus the opportunity cost of capital supplied to the firm by the owner  Economic profit = total revenue – Operating Expenses – Economic Costs o Economic efficiency:  The total cost curve is an efficiency frontier  All points on the frontier have one of two interpretations • Q is the maximum output attainable for total cost of TC or • TC is the minimum total cost required to produce the output q • The least-cost production rule that firms must follow to be on their total cost curves o Firms should hire factors of production to equalize the MP FP Fatio across all factors of production o If the ratios between two factors are unequal, firms should substitute towards the factor with the higher ratio  Doing so increases output at no additional cost • Applications of the least-cost production rule o Least-cost production rule explains why firms do not necessarily hire the most productive workers o Firms economize on relatively expensive inputs and make liberal use of relatively cheap inputs SRTC TC o LRTC Fixed Costs q Chapter 13 – Perfect Competition • Review of perfect competition o Market demand curve is the sum of individual consumer demand curves o Short run market supply curve is the sum of the firms’marginal cost curves o The short run equilibrium occurs at the intersection of these two curves o The demand curve for each firm is horizontal, or perfectly elastic, at the equilibrium price o Firms are price takers o Each firm supplies the output at which e = MC STin order to maximize profit • All-or-none profit test that applies to all profit-maximizing firms o Firms can produce the output that maximizes profit or not produce at all o The will choose the profit-maximizing output as long as total revenue exceeds variable costs (TR>VC) o In terms of unit prices, price must exceed average variable cost (P>AVC) o The all-or-none profit test in the short run implies that the total revenue must cover the total cost of production  The point at which TR = TC is the break-even point  The point at which TR = VC is the shut-down point • The firm is indifferent between producing or shutting down at that point o The all-or-none profit test in the long run implies that TR must cover the total cost of production (in per unit terms, P>ACLR  The point at which TR = TC (P =AC )LRs the break-even point o Since total economic cost includes the opportunity cost of capital, break-even production (zero economic profit) implies that the owners of the firm are earning a rate of return on their capital equal to the highest return they can earn elsewhere • Short-run and Long-run average cost concepts o SRTC = FC + SRVC andAC =AFC +STC o The margin of any variable intersects its corresponding average when the average is neither increasing nor decreasing  MC iSTersectsAC andAST at their minimum values  MC iLRersectsAC at iLR minimum value • The output at whichAC acLReves its minimum value is the minimum efficient scale of operation for the firm • Operation of perfectly competitive markets in the long run o Firms can adjust previously fixed factors of production  Short-run total and average costs tend to be greater than are long-run total and average costs because firms are restricted from adjusting their fixed factors of production in the short run  Short run and long run total, average, and marginal costs are the same for a given level of output if the firms choose the same combination of factors of production the short run that they would choose in the long run  Short run total cost is the actual cost of production the firm experiences  Long run total cost is the limit of how low short run total cost can be at each level of output o New firms can enter or existing firms can exit the industry  Amarket situation in which perfectly competitive firms make profits or losses cannot persist in the long run • Profits lead to entry of new firms, which increases industry supply and puts downward pressure on the market price • Losses cause some firms to leave the industry, which decreases industry supply and puts upward pressure on the market price  Entry or exit continues until the firms just break even and e equals the minimumAC lr o The long run market supply curve shows how much output the industry is willing to supply at each possible price once the industry reaches its full long run equilibrium  Occurs when all firms have adjusted previously fixed factors of production  And when entry or exit has driven profits or losses to the break even point o Long run market supply curves may exhibit constant costs, increasing costs, or decreasing costs  Increasing costs (upward sloping) are the most likely o Long run market supply curve is far more elastic than the short run market supply curve • Desirable normative properties for perfect competition o Perfectly competitive product markets are responsive to consumers’desires o The full adjustment of a perfectly competitive market to increase in consumer demand is driven by changes in prices and profits in three stages  Prices rise in the momentary run when output is fixed, and firms earn profits  Firms increase production in the short run in reaction to the higher prices and profits  Production increase even more in the long run as firms lower their production costs by adjusting previously fixed factors and new firms enter the industry o Supply continues to increase until price is driven to minimum average cost in the long run, and all firms are breaking even once again o Perfect competition leads to four desirable efficiency and equity properties that are the standards against which all other market structures are judged  Allocational efficiency: maximizing the net value of consuming and producing each good. The market text is P e MC whSTh is the profit- maximizing supply rule for perfectly competitive firms  Production (technical) efficiency: producing the total output supplied to the market at the least cost, thereby conserving society’s scarce resources • The market test is production at each firms MES, the minimum long run average cost • Perfectly competitive markets achieve production efficiency in the long run as entry or exit drives price to the minimulrC  Equality of opportunity: the absence of barriers to entry or exit and equal access for everyone to all relevant market information  Horizontal equity: the equal treatment of equals which, in product markets, means equal rates of return on investment, adjusted for risk • The market test is the break-even production, or P = AC, which is satisfied in the long run Price equilibrium when P equals MC minimumAC S AC ST Pe df P e R Profit e v e Total Cost n u e D Q e Quantity Q e Market Representative Firm MC ST AC ST AVC ST AFC Chapter 14 – Pure Monopoly • Implications of market power in the context of pure monopoly, when the industry supplying the market consists of a single firm o Afirm possesses market, or monopoly, power if its demand curve is downward sloping o Almost every firm in a market economy possesses market power by this definition o Any firm that has market power is a price setter o It does not have a supply curve like in a perfectly competitive firm  Rather the firm must determine the single price-quantity combination on its demand curve that maximizes profit  The demand curve determines the total revenue frontier for the firm o When a firm’s demand curve is downward sloping, its marginal revenue curve lies below the demand curve o To maximize profit, the firm selects the output at which marginal revenue equals marginal cost and charges the price on the demand curve corresponding to the chose quantity • Efficiency and equity properties of a pure monopoly o The market outcome under pure monopoly is not very satisfactory from society’s point of view o It is characterized byAllocational inefficiency, production (technical) inefficiency, and inequity  Allocational inefficiency – exists because the monopolist produces at the intersection of MR and MC.As a result Price is greater than MC, and the net value from producing and consuming the good is not maximized.All firms that have market power createAllocational inefficiency. • They engage in a contrived scarcity, keeping output below the efficient level to maximize profit  Production (technical) inefficiency – exists if the monopolist does not produce at the MES, the minimum of its long-run average cost curve.  The inequity of pure monopoly takes two forms • Pure monopoly violates the process of equity principle of equality of opportunity because the barriers to entry that create the monopoly keep other investors out of the market • Pure monopoly violates end-results equity because investors with monopoly power can earn higher rates of return on their capital than other investors o Monopoly profits are often invisible are often invisible because the stock market capitalizes the stream of profits into the value of the stock  Once capitalization occurs, purchasing the stock of a profitable company yields only the same return available to investors generally o The monopoly profits earned by one firm overstate economy-wide profits because they ignore the costs borne by unsuccessful entrepreneurs in the competition for maintained profits o The profits earned by the successful firms represent a gross efficiency loss from the point of view of society o Rent-seeking behavior simply wastes resources • Price discrimination o Firms price discriminate on the basis of their customers’demand elasticities, charging higher prices to customers with lower demand elasticities o Successful price discrimination requires to things:  Firms must be able to identify distinct classes who have different demand elasticities  Customers must not be able to resell the output to one another o Services rather than manufactured products • Windfall profit taxes and public utility regulation o Congress levies windfall profit taxes on an industry when it believes firms are earning excessive profits as the result of a blatant exercise of market power o If Congress could really levy a tax on windfall profits these taxes would transfer some profits to the public treasury without changing firms’production decisions o Windfall profits are difficult to define, however, so that these taxes end up taxing something else, either costs of production or output D MR AC MC P=10 AC=5 MC=3 Q=10 TC TC The Total Revenue is the area under the demand curve to the quantity when MR=MC. In this example it is $100 because MR=MC at 10 and the price on the demand curve is TR $10. The total cost is the AC*q or in this case, $50. The profit is the difference between TR and TC or Profit Chapter 15 – Softening Competition: From Collusion to Effectively Competitive Markets • Cooperative behavior as the ultimate means of softening competition among firms, using the industry cartel as an example o Acartel has the effect of turning a market into a pure monopoly o The cartel establishes the monopoly price and restricts output in order to maintain that price by setting production quotas for each firm o Firms have a strong incentive to cheat, which they can easily do by lowering the price just below the cartel price o The firms are trapped in a game known as the Prisoners’Dilemma  The dilemma is that each firm cheats, even though they all know that the best solution is for everyone not to cheat and to maintain the cartel o The incentive to cheat results from mistrust  Cheating is the best strategy for each firm if the other firms cheat or if they do not cheat • Since each firm is unsure what the others will do, they all cheat o Cheating is easier to prevent the more similar the firms are, the quicker the cartel can detect the cheating, and the more severe the punishment is for cheating o Cartels and other forms of cooperative behavior are illegal in the United States • Effectively competitive markets o Monopolistic competition differs from perfect competition in only one important respect  The firms are able to differentiate their products from one another primarily by: • Horizontal (geographic) differentiation • Vertical (quality) differentiation • Varying product characteristics • Advertising and sales promotions o Horizontal differentiation (the location decision) can soften the price competition by giving firms market power o Product differentiation is often the only way that firms in the effectively competitive sector of the economy can hope to capture customers and maintain profits o Firms operating under conditions of monopolistic competition are not entirely successful in softening competition  Profits tend toward zero in the long run because of the absence of barriers to entry or exit  Therefore, monopolistic competition satisfies the equity principles of equality of opportunity and horizontal equity • Equity results from the competitive aspect of the market structure • However, monopolistic competition fails to achieve either Allocational efficiency or production efficiency • Price exceeds marginal cost and the output of each firm is less than the MES o The inefficiencies may be unimportant for two reasons  The inefficiencies are likely to be small in most markets because the firms’ demand curves are often fairly elastic in the long run which means that price is close to marginal cost and output is near the MES  Consumers like the choice among products that product differentiation brings • They may prefer monopolistic competition to perfect competition, which has standardized products o The market system may not produce the correct amount of product differentiation  Firms have an incentive to produce too much product differentiation because of a business-stealing effect • Some of a firm’s profits come at the expense of other firms’profits so that a firm overestimates the value to society of introducing a new product  Firms also have an incentive to produce too little product differentiation because they cannot capture the consumer surplus arising from a new product • The profit from introducing a new product could be negative, whereas the consumer surplus is positive See Figure 15-3 on page 388 to review monopolistic competition Chapter 16 – Oligopoly • Two attributes of oligopoly that work against generalizing about any aspect of market behavior o The actions of a few large firms dominate the industry o The firms engage in repeated strategic interactions over a long period of time • Market behavior is predictable when industries contain a large number of firms because of a law of statistics known as the Law of Large Numbers o This law says that the average behavior of a large group of firms is highly predictable even if the behavior of each firm is not o This law does not apply to an oligopoly in which a few firms dominate the industry  In that case, individual differences among firms and the overall market environment in which the industry operates matter in determining market outcomes • Large firms competing in an oligopoly engage in repeated strategic interactions over a long period of time, continually adjusting their decisions once they see how the other firms have reacted to them o Almost any market outcome is possible in such a strategic environment, from the competitive marginal cost price and zero economic profits to the pure monopoly price and maintained profits • Uncertainties surrounding the question of how significant corporations set their prices o Prices in the highly concentrated industries are stickier than those in the effectively competitive sector of the economy o The large corporations behave as if they have engaged in a tacit collusion to avoid price competition in favor of non-price
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