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Microeconomics Study Guide

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Economics
Course
ECON-UA 10
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All Professors
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Fall

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1  HEIDI SEO MICROECONOMICS CH. 1 What is Economics? ● Economics - Study of choice under conditions of scarcity ● Scarcity of time and spending power ● Opportunity cost - The cost, or next best choice among alternatives that are mutually exclusive, of what we must forego ○ Explicit costs - Actual dollar amt you must pay when undergoing a choice ○ Implicit costs - Sacrifices for which no money changes hands (ex: Time, Income) ● Scarcity and Social Choice ○ The Four Resources ■ Labor: Time human beings spend producing goods and services ■ Capital: Any long-lasting tool that is itself produced and helps us make other goods and services (lasts at least a year) ● Physical: Machinery, Equipment, Factory Buildings, Computers ● Human: Skills, Knowledge possessed by workers ● Capital Stock: Total amt of capital at a nation’s disposal at any point in time; Physical and Human combined ■ Land: Physical space on which production takes place as well as natural resources found under it or on it (ex: crude oil, iron, coal, or fertile soil) ■ Entrepreneurship: Ability and willingness to combine the other resources into a productive enterprise Resources → Various Other Inputs → Goods & Services ● Microeconomics - individual actors on economics scene (households, business firms, governments) ○ Positive economics: The study of how the economy works ○ Normative economics: The practice of recommending policies to solve economic problems ■ Policy differences among economists arise from ● Positive disagreements about the outcomes of different policies ● Differences in values (how these outcomes are evaluated) ○ Simplifying Assumption: Any assumption that makes a model simpler without affecting any of its important conclusions ○ Critical Assumption: Any assumption that affects the conclusions of a model in an important way ● Algebra ○ y = b + mx ○ m = slope = Change in y / Change in x CH. 2 Scarcity, Choice, and Economic Systems ● Production Possibilities Frontier (PPF): A curve showing all maximum combinations of two goods that can be produced with the resources and technology currently available ○ Points outside frontier: Unattainable ● Law of Increasing Opportunity Cost: The more of something we produce, the greater the opportunity cost of producing even more of it. ● A firm, an industry, or an entire economy is productively inefficient if it could produce more of at least one good without producing less of any other good ○ Recession: Moved the economy from a point inside the PPF to a point on the PPF using idle resources 2  to produce more goods and services without sacrificing anything (increased civilian and military production) ● Economic Growth: More human and physical capital, technological change ○ A technological change or an increase in resources, even when the direct impact is to increase production of just one type of good, allows us to choose greater production of all types of goods ○ High Consumption Low Growth vs. Low Consumption, High Growth ■ In order to produce more goods and services in the future, we must shift resources toward R&D and capital production, and away from producing things we’d enjoy right now. ● Economic System ○ Specialization: A method of production in which each person concentrates on a limited number of activities ○ Exchange: Trading with others to obtain what we desire ■ S & E enable us to enjoy greater production and higher living standards ● Absolute Advantage: The ability to produce a good or service, using fewer resources than other producers use ● Comparative Advantage: The ability to produce a good or service at a lower opportunity cost than other producers (works internationally, maximes total production for G&S) Labor Required for: 1 Fish 1 Cup of Berries Maryanne 1 hour 1 hour Gilligan 3 hours 1 ½ hours Absolute Advantage: Comparative Advantage: Labor Required for: 1 Bushel of Soybeans 1 T-shirt United States ½ hour ¼ hour China 5 hours 1 hour Absolute Advantage: Comparative Advantage: ● Traditional Economy: Resources are allocated according to long-lived practices from the past (Low growth, Stagnant) ● Command/Centrally Planned Economy: Resources are allocated according to explicit instructions from a central authority (Unable to satisfy expectations of their populations; North Korea, Cuba) ● The Market Economy: Resources are allocated through individual decision making ○ Market: A group of buyers and sellers with the potential to trade with each other ○ Price: Amount of money that must be paid to a seller to obtain a good or service ○ People forced to consider opportunity cost to society of the goods that they consume; sensible allocation of resources ○ Market Capitalism: Most resources are owned by private citizens, who are mostly free to sell or rent them to others as they wish 3  ○ Socialism: Most resources are owned by the state ● Mixed Economy: A market economy in which the government also plays an important role in allocating resources CH. 3 Supply and Demand ● Supply and Demand: Economic model designed to explain how prices are determined in perfectly competitive markets ● Circular Flow: A simple model that shows how goods, resources, and dollar payments flow between households and firms ● Product markets: Markets in which firms sell goods and services to households ● Resource markets: Markets in which households that own resources sell them to firms ● Perfectly competitive market: Market in which no buyer or seller has the power to influence the price ● Imperfectly competitive market: buyers and sellers can control or influence the price ● Demand ○ Quantity demanded: Number of units that all buyers in a market would choose to buy over a given time period, given the constraints that they face ■ Implies a choice given the Opportunity Cost and constraints ■ Hypothetical ■ Depends on Price ○ Law of Demand: When the price of a good rises and everything else remains the same, the quantity of the good demanded will fall ■ “Everything else remains the same” - ceteris paribus ○ Demand Schedule: A list showing the quantities of a good that consumers would choose to purchase at different prices, with all other variables held constant ○ Demand Curve: A graph of a demand schedule; a curve showing the quantity of a good or service demanded at various prices, with all other variables held constant; slopes downward ○ Movement along the Demand curve / Change in Quantity demanded: Change in the price of a good ○ Shifts of the Demand curve / Change in Demand other than price ■ Income ● Rise in Income: Shifts Demand curve to the right for normal goods ● Rise in Income: Shifts Demand curve to the left for inferior goods ■ Wealth ● Rise in Wealth: Shifts Demand curve to the right for normal goods ● Rise in Wealth: Shifts Demand curve to the left for inferior goods ■ Substitute ● Rise in Price of Substitute: Shifts Demand curve to the right ● RIse in Price of Complement: Shifts Demand curve to the left ■ Population ● Rise in Population: Shifts Demand curve to the right ■ Expected Price ● Expectation of Higher Price: Shifts Demand curve to the right ● Expectation of Lower Price: Shifts Demand curve to the left ■ Tastes ● Good Tastes toward a good: Shifts Demand curve to the right ● Bad Tastes toward a good: Shifts Demand curve to the left ■ Other Shift Variables: Gvmt Subsidies ● Supply ○ Quantity supplied: Number of units of a good that all sellers in the market would choose to sell over some time period, given the constraints that they face 4  ■ Implies a Choice: what firms choose to sell that gives them highest profit given constraints they face ■ Hypothetical ■ Depends on Price ○ The Law of Supply: When the price of a good rises, and everything else remains the same (ceteris paribus), the quantity of the good supplied will rise. ○ Supply Schedule: A list of different quantities supplied at different prices, with all other variables held constant ○ Supply Curve: A graph of a supply schedule, showing the quantity of a good or service supplied at various prices, with all other variables held constant ○ Movement along the Supply curve / Change in Quantity Supplied: Change in price ○ Shift of Supply curve / Change in Supply ■ Input Prices ● Fall in Input Prices: Increase in supply, Shift right ● Rise in Input Prices: Decrease in supply, Shift left ■ Price of Alternatives ● Alternate goods: Other goods that firms can produce instead of the good in question ● Alternate market: A market other than the one being analyzed in which the same good could be sold ● Rise in Price of Alternative: Decrease in supply, Shift left ● Fall in Price of Alternative: Increase in supply, Shift right ■ Technology ● Technological Advances: Increase in supply, Shift right ■ Number of Firms ● Increase in number of sellers: Increase in supply, Shift right ■ Expected price ● Rise in Expected Price: Decrease in supply, Shift left ● Drop in Expected Price: Increase in supply, Shift right ■ Changes in Weather and Other Natural Events ● Favorable weather: Increase in supply, Shift right ● Unfavorable weather: Decrease in supply, Shift left ■ Other Shift Variables: Gvmt Tax on suppliers ● Equilibrium Price: The market price that, once achieved, remains constant until either the demand curve or supply curve shifts ● Equilibrium Quantity: The market quantity bought and sold per period that, once achieved, remains constant until either the demand curve or supply curve shifts ● Excess Demand: At a given price, the amt by which quantity demanded exceeds quantity supplied; Pressure on price to rise to Equilibrium ● Excess Supply: At a given price, the amt by which quantity supplied exceeds quantity demanded; Pressure on price to fall to Equilibrium ● Rise in Equilibrium Price and Quantity: Increase demand curve, Shift right; Increase in quantity supplied, Move along the curve right ○ Ex: Rise in Income ● Drop in Equilibrium Price and Quantity: Decrease supply curve, Shift left; Decrease in quantity demanded, Move along the curve left ○ Ex: Bad Weather ● The Three-Step Process 1. Characterize the Market: Identify how trading occurs in particular market 2. Find the Equilibrium: Describe conditions necessary for equilibrium in market, and a method for 5  determining that equilibrium a. Ex: Supply and Demand 3. What Happens When Things Change: Explore how events or government policies change market equilibrium CH. 4 Working with Supply and Demand ● Price Ceilings: A government imposed maximum price in the market ○ Excess Demand/Shortage of Supply ■ Increases time and trouble required to buy good ■ Price decreases, but Opportunity Cost rises ○ Quantity Supplied (Short side of the market) prevails ○ Price below Equilibrium Price ○ Black Market: Goods sold illegally at a price above the legal ceiling ○ Ex: Rent Controls in New York City ■ Decrease in quantity of apts supplied, because of lower rents offering low incentives to purchase or maintain apts ● Price Floors: A government imposed minimum price in the market ○ Excess Supply/Surplus of Supply ○ Quantity Demanded (Short side of the market) prevails ○ Price above Equilibrium Price ○ Maintain Price Floor: ■ Governments buy unsold products (excess supply) at a guaranteed price to prevent surplus from driving down the market price ● Taxes ○ Excise Tax on Sellers ■ Ex: Gasoline tax ■ Shifts supply curve upward by tax amt ■ Tax Incidence: The division of a tax payment between buyers and sellers, determined by comparing the new (after tax) and old (pretax) market equilibriums ● Buyers pay more (higher price); Sellers receive less for each unit sold (lower price) ○ Excise Tax on Buyers ■ Shifts demand curve downward by tax amt ■ Tax Incidence: Buyers pay more (higher price); Sellers receive less (lower price) ● Same whether tax is collected from buyers or sellers ● Subsidies: Government payment to buyers or sellers on each unit purchased or sold ○ Subsidy to Buyers ■ Ex: College Education Cost ■ Shifts demand curve upward by subsidy amt ■ Buyers pay less (lower price); Sellers receive more (higher price) ○ Subsidy to Sellers ■ Shifts supply curve downward by subsidy amt ■ Same whether subsidy is paid to buyers or sellers ● Stock Variable: Measures quantity at a moment in time (ex: 15 gallons) ● Flow Variable: Measures a process that takes place over a period of time (ex: 2 gallons/min) ● Housing ○ Supply curve - # of homes in a market that are available for ownership - the housing stock ■ Price does not affect current housing stock (vertical line) ○ Demand curve - Total # of homes that everyone in the market would like to own, given the constraints that they face, at each price 6  ■ Both current and prospective homeowners face an interest cost of ownership. This cost rises when current home prices rise, and falls when current home prices fall. ○ Mortgage: A loan given to a home-buyer for part of the purchase price of the home ○ Equilibrium Price: Quantity of homes demanded equals Quantity supplied (stock) ○ Changes ■ Change in Demand = Change in Supply ● Housing stock and Housing demand grows at same rate ● Prices remain unchanged ■ Change in Demand > Change in Supply ● Restrictions on new building ● Demand increases ○ Population shifts, Rapid income growth, change in expectations about future prices ● Housing prices rise ○ Capital Gain: The gain to the owner of an asset when it is sold for a price higher than its original purchase price ○ Capital loss: The loss to the owner of an asset when it is sold for a price lower than its original purchase price ○ 1990s - 2006 Housing Bubble: Expectations of prices to rise caused rapidly increasing demand ■ Economic Growth (high employment) ■ Interest rates decreased (ex: mortgage loan interest rates), lessening cost of home ownership ■ Supply shifted right and Demand shifted right (P and Q increase) ■ Government policy ● Subsidies to lower monthly mortgage payments ● Purchased mortgages from banks for fresh cash for more mortgage ■ Financial Innovations ● Adjustable Rate Mortgage (ARM): low interest rate, low monthly payments ● Mortgage lending: Securitization of mortgages into financial assets (mortgage-backed securities) sold to investors ■ Lending Standards ● If housing prices decline, and owner owes more on mortgage than home is worth, owner might default and stop making payments, leading to foreclosure. Home is resold at a distress sale/bargain price ● Lenders made more subprime loans to borrowers who don’t qualify due to low incomes or bad credit histories ■ Speculation: Expected price to rise ○ 2006-2011 Housing Bust: A sudden drop in demand ■ Oil and gasoline prices spiked (hard to pay mortgage payments) ■ Interest rates on large group of ARMs reset to higher levels ■ Defaults increased, especially on subprime mortgages with no down ■ Supply shifted right and Demand shifted left (P decrease, Q increase) ■ Led to recession ■ High unemployment, Declining incomes ■ Making Home Affordable Program (2009): provided incentives for banks and homeowners to renegotiate mortgage agreements and prevent foreclosures ■ Tried to slow and reverse decrease in demand for housing CH.5 Elasticity 7  ● Price Elasticity of Demand: ○ Sensitivity of quantity demanded to price; the percentage change in quantity demanded caused by a one percent change in price (Ratio of Percentage Changes) ○ Percentage change in quantity demanded divided by the percentage change in price ■ The greater the elasticity value, the more sensitive quantity demanded is to price ■ Relative to movement along demand curve from one point to another ■ Midpoint Formula: Change in the variable divided by the average of the old and new values ○ Inelastic Demand: Price elasticity of demand between 0 and 1 ■ Insensitive to price ■ Steep Demand Curve ■ Quantity changes by a smaller percentage than price ○ Elastic Demand: Price elasticity of demand greater than 1 ■ Sensitive to price ■ Flatter Demand Curve ■ Quantity changes by a larger percentage than price ○ Unit Elastic Demand: Price elasticity of demand equal to 1 ■ “in-between” case ■ Quantity demanded changes by same percentage as price ○ Perfectly Inelastic Demand: Price elasticity of demand equal to 0 ■ Price rises, no change in Quantity demanded ■ Vertical Demand Curve ○ Perfectly Elastic Demand: Price elasticity of demand approaching infinity ■ Price stays at one particular value (where demand curve touches the vertical axis); Any quantity might be demanded ■ Price rise would cause quantity demanded to fall to zero ■ Horizontal Demand Curve ■ Change in quantity will always be infinitely larger ○ Straight Line Demand Curves ■ Elasticity of demand varies along downward-sloping straight-line demand curve ■ Demand becomes less elastic as we move downward and rightward ■ For nonlinear demand curves , moving down the curve can cause elasticity to rise, fall, or remain constant, depending on the shape of the curve ● Elasticity and Total Revenue ○ TR = P x Q ○ Inelastic Demand ■ 1% rise in price → less than 1% fall in quantity demanded ■ The greater amt sellers get on each unit outweighs the impact of the drop in quantity ● Total Revenue will rise for sellers / Total spending will rise for buyers ■ Drop in price → TR will fall ○ Elastic Demand ■ 1% rise in price → more than 1% fall in quantity demanded ■ Sellers get more on each unit, but that is outweighed by the drop in the quantity they sell ● Total Revenue will fall for sellers ■ Drop in price → TR will rise ○ Unit-Elastic Demand ■ 1% change in price → 1% change in quantity ■ TR remains unchanged ● Determinants of Elasticity ○ Availability of Substitutes: Elastic Demand ○ Necessities: Less Elastic Demand 8  ○ Luxuries: More Elastic Demand ○ Importance in Buyers’ Budgets: Spending on a good makes up a larger proportion of families’ budgets → More Elastic Demand ○ Time Horizon: How much time we wait after price change ■ Short-run elasticity: Elasticity measured just a short time after a price change ● Adjustments after rise in price of gas: Use public transit more often, Arrange a car pool, Check tire pressure more often, Drive more slowly on the highway, Eliminate unnecessary trips, If there are two cars, use the more fuel-efficient one ■ Long-run elasticity: Elasticity measured a year or more after a price change ● More elastic than short-run ● Adjustments after rise in price of gas: Buy a more fuel-efficient car, Move closer to your job, Switch to a job closer to home, Move to a city where less driving is required ■ Ex: Elasticity and Mass Transit ● Inelastic for both Short (0.2-0.5) and Long Run (0.5-0.9) ● Rise in fares would likely raise mass-transit revenue for a city ($2.50 to $3.00 up 20%) ● Price Elasticity of Supply: Percentage change in quantity supplied by a 1% change in price ○ Percentage change in quantity supplied divided by the percentage change in price ● Determinants of Supply Elasticity ○ Alternatives to producing the good: Easier to find, More Elastic Supply ○ Narrowness of the market: More Elastic Supply ○ Time Horizon: Long-Run Supply Elasticities > Short-Run Supply Elasticities ● Other Elasticities ○ Income Elasticity of Demand: Percentage change in quantity demanded caused by a 1% change in income; Sensitivity of quantity demanded to changes in buyers’ income ■ Percentage change in quantity demanded / Percentage change in Income ■ Income Elasticity tells us relative shift in Demand curve - Percentage increase in quantity demanded at a given price ■ Income Elasticity is positive for normal goods, Negative for inferior goods ○ Cross-Price Elasticity of Demand: Percentage change in quantity demanded of one good caused by a 1% change in price of another good ■ % change in quantity demanded of X / % Change in Price of Z ■ Ceteris Paribus on Demand ■ Positive Cross-Price Elasticity: Two goods are substitutes ● Rise in price of one good increases demand for other good ■ Negative Cross-Price Elasticity: Two goods are complements ● Rise in price of one good decreases demand for other good ● Applications of Elasticity ○ The War on Drugs ■ Demand: Price inelastic ■ Decreasing Supply: Shift Supply Leftward ● Rise in price will increase revenue for sellers and expenditure of buyers ● Restricting supply will increase drug usage ■ Decreasing Demand: Shift Supply Leftward; Stiffer penalties on drug users ● Fall in price will decrease revenue for sellers and expenditure of buyers ○ Forecasting Price in an Oil Crisis ■ Decrease in Oil Supply with Elastic Demand ● Price Increases by Small amount ● Oil-consuming nations would be better cushioned from supply disruptions 9  ■ Decrease in Oil Supply with Inelastic Demand ● Price Increases by Large amount ■ If more cost-effective alternative energy sources become available → Short-run price elasticity of demand for oil will be greater in the future than it is today ● Availability of substitutes increases price elasticity of demand ○ Spikes in Food Prices ■ Supply and Demand are both inelastic (Incomes grown in China and India) ● Food = necessities ● When a good makes up a relatively small percentage of household budgets, demand is less elastic ■ Bad weather ● Leftward shift in Supply ● Huge price increase ● Quantity demanded falls ● Poor have greater burden ● Farm output shrinks → Higher incomes and bigger budgets cut back less → Lowest incomes cut back even lesser CH. 6 Consumer Choice ● Budget Constraint: Which combinations of goods and services the consumer can afford with a limited budget, at given prices; indicates trade-off consumers are able to make between one good and another ○ Budget line - Graphical representation of budget constraint ○ Prices of goods and consumer’s income assumed CONSTANT ● Relative Price: Price of one good relative to the price of another ○ P of x / P of y = Relative Price of Good X, Opportunity cost of one more unit of good X, Absolute Value of the slope of the consumer’s budget line ● Changes in Income ○ Increase in income shifts budget line rightward with no change in slope ● Changes in Price ○ Decrease in price of X rotates budget line outward (vertical intercept higher and slope steeper) ○ Decrease in price of Y rotates budget line outward (horizontal intercept higher and slope flatter) ● Preferences ○ Assumptions: People have preferences. Preferences are logically consistent or transitive (rational preferences). More is better. ○ Consumer always chooses point on budget line rather than a point below it. ● Marginal Utility Approach ○ Anything that makes consumer better off raises utility ○ Anything that makes consumer worse off decreases utility ○ Marginal Utility: Change in utility an individual enjoys from consuming an additional unit of a good ■ Law of Diminishing Marginal Utility: The marginal utility of anything diminishes with every increase in amt ■ Marginal Utility over Price = Gain in utility consumer gets for each dollar spent on the last good (Decreases with more consumption) ○ Utility-maximizing consumer will choose point on the budget line where marginal utility per dollar is same for both goods ■ MU of x / Price of x = MU of y / Price of y ■ There is no further gain from reallocating spending in either direction. ○ Change in Income ■ Increase in Income → Increase in Quantity Demanded (Normal Good) 10  ■ Increase in Income → Decrease in Quantity Demanded (Inferior Good) ○ Change in Price ■ Fall in the price of a good rotates budget line outward (horiz/vert) ● Obeys Law of Demand ● Upward sloping demand curve - Occurs when fall in price causes increase in quantity demanded (inferior good) ● Substitution Effect: The consumer substitutes toward the good whose relative price has decreased ○ Always moves quantity demanded in opposite direction to price change (Law of Demand) ● Income Effect: The price decline of one good increases his total purchasing power over both goods ○ Drop in price increases total purchasing power ○ Rise in price decreases total purchasing power ○ Normal: Increase in income = Increase in demand for normal goods ○ Inferior: Increase in income = Decrease in demand for inferior goods ● Normal Goods ○ Price of a normal good falls ■ Substitution Effect: Increases quantity demanded ■ Income Effect: Increases purchasing power, Increases quantity demanded ○ Price of a normal good rises ■ Substitution Effect: Decreases quantity demanded ■ Income Effect: Decreases quantity demanded ● Inferior Goods ○ Price of an inferior good falls ■ Substitution Effect: Increases quantity demanded ■ Income Effect: Increases purchasing power, Decreases quantity demanded ○ Price of an inferior good rises ■ Substitution Effect: Decreases quantity demanded ■ Income Effect: Decreases purchasing power, Increases quantity demanded ○ Substitution Effect always dominates for inferior goods, because so many other variety of goods and services, fall in price of an inferior good does little to purchasing power ● Market Demand Curve: found by horizontally summing individual demand curves of every consumer in the market (Add Quantity Demanded) ● Possibilities of Consumer Theory (maximizing personal satisfaction based on rational, logically consistent preferences) ○ Saving: Sacrificing consumption of all goods now to increase further consumption ○ Borrowing: Buying consumption of all good now in order to pay later ○ Uncertainty ○ Imperfect Information ● Behavioral Economics (irrational preferences, decisions against own interests) ○ Salience: Extent to which it “jumps out at them” (ex: M&M colors) ○ Preference for defaults: Rational preferences overpower the default choice or sometimes default choice overpowers ○ Decision-making environment: Strong influence of environment on decisions ○ Self-Binding: Preferences to bind themselves to narrower choices for long-run good CH. 6 APPENDIX ● Indifference Curve - Represents all combos of 2 goods that make the consumer equally well off ○ Marginal Rate of Substitution (MRSy,x) of good y for good x - Along any segment of an indifference curve is the max rate at which a consumer would willingly trade units of y for units of x ○ The MRS at any point on the indifference curve is equal to the (absolute value of) the slope of the curve at that point. When measured at a point, the MRSy,x tells us the max rate at which a consumer would willingly trade good y for a tiny bit more of good x. 11  ● Indifference Map - Set of indifference curves that describe Max’s preferences (“More is better”); Any point on a higher indifference curve is preferred to any point on a lower one ○ Higher indifference curves provide greater utility for a consumer than lower indifference curves ● Optimal combination of goods for a consumer is the point on the budget line where an indifference curve is tangent to the budget line ○ Optimal combination of two goods x and y is that combo on the budget line for which MRSy,x = Px/Py ● Changes in Income ○ A rise in income, with no change in prices, leads to a new quantity demanded for each good. Whether a particular good is normal (quantity demanded increases) or inferior (quantity demanded decreases) depends on the individual’s preferences, as represented by his indifference map ● Changes in Price ○ Drop in price rotates budget line rightward, pivoting on vertical intercept CH. 7 PRODUCTION AND COST ● Profit = Total Revenue - Total Cost ● Long Run = All variable inputs can change in quantity over time ● Short Run = At least one of firm’s inputs that are fixed cannot change over time ● Production in the Short Run ○ Total product = Max quantity of output produced from combo of inputs ■ Capital and Labor (inputs) = Total Product (output) ○ Marginal Product of Labor (MPL) = Change in total product divided by change in number of workers employed ■ MPL = Change in Q / Change in L ■ Tells us the rise in output produced when one more worker is hired ■ Increasing Marginal Returns to Labor = MPL rises as more labor hired, because more workers allow production to become more specialized ■ Diminishing Marginal Returns to Labor = MPL decreases as more labor hired ● Rise in output is smaller and smaller with each successive worker, because additional gains from specialization will be harder to achieve and each worker will have less of the fixed input with which to work ● Applies not just to labor but to any variable input ■ Law of Diminishing (Marginal) Returns = As we continue to add more of any one input (holding the other inputs constant), its marginal product will eventually decline ● Costs ○ Total cost = The cost of producing Q is opportunity cost in order to produce output ○ Sunk cost= One that already has been paid, or must be paid, regardless of any future action being considered ■ Sunk costs shouldn’t be considered when making decisions ■ Future payment can be sunk, if an unavoidable commitment to pay it already has been made ○ Explicit cost ■ Rent paid out ■ Interest on loans ■ Managers’ salaries ■ Hourly workers’ wages ■ Cost of raw materials ○ Implicit cost ■ Opportunity cost of Owner’s land and buildings (Rent forgone) ■ Opportunity cost of Owner’s money (Investment income forgone) ■ Opportunity cost of Owner’s time (Labor income forgone) ○ Least-Cost Rule = Business firm will produce any given output level using least-cost combo of inputs 12  available to it ○ Cost in the Short Run ■ Fixed Costs = Rent, Interest, Overhead ■ Variable Costs = Rise as Q increases, Wages of hourly employees, Cost of raw materials ■ Total Cost (TC) = TFC + TVC ■ Average Fixed Cost (AFC) = TFC / Q ■ Average Variable Cost (AVC) = TVC / Q ■ Average Total Cost (ATC) = TC / Q ● U-Shape of ATC curve results from AVC and AFC ● At low levels of Q, AVC and AFC are falling, so ATC curve slopes downward ● At higher levels of Q, rising AVC overcomes falling AFC, ATC curve slopes upward ■ Marginal Cost = Change in Total Cost / Change in Total Q ● When MPL rises, MC falls ● When MPL falls, MC rises ● MC curve is U-shaped making AVC curve U-shaped as well which in turn is based on increasing and then diminishing marginal returns to labor ● MC curve crosses both AVC and ATC curve at their respective minimum points ● Production and Cost in the Long Run ○ All inputs and all costs are variable ○ Long Run Total Cost (LRTC) = Cost of producing each Q when all inputs are variable and least-cost input mix is chosen ○ Long Run Average Total Cost (LRATC) = LRTC / Q ■ LRATC curve combines portions of each ATC curve in the LR; For each output level, firm will always choose to operate on the ATC curve with the lowest possible cost ○ Economies of scale = LRATC decreases as output increases; The more output produced, the lower the cost per unit; Total costs increase by smaller proportion than output ■ Gains from specialization ■ Spreading costs of lumpy inputs (Q can’t be increased gradually as output increases, but must be instead adjusted in large jumps ○ Diseconomies of scale = LRATC increases as output increases ; LRTC rises more than in proportion to output, LRATC curve slopes upward ○ Constant returns to scale = LRATC is unchanged as output increases ○ Minimum Efficient Scale (MES) = Lowest output level at which firm’s LRATC curve hits bottom CH. 8 HOW FIRMS MAKE DECISIONS: PROFIT MAXIMIZATION ● Accounting Profit = Total Revenue - Accounting Costs [ONLY EXPLICIT COSTS] ● Economic Profit = Total Revenue - All costs of production [EXPLICIT AND IMPLICIT] ● Demand curve facing firm = Customers willing to purchase from a particular firm; Shows us max price firm can charge to sell any given amt of output ● Total Revenue and Elasticity ○ Elasticity > 1= Lowering the price by a given percentage causes Q sold to rise by larger percentage; Total Revenue rises ○ Elasticity < 1 = Lowering the price by given percentage causes Q sold to rise by smaller percentage; Total Revenue falls ● The Cost Constraint ○ Firm has given production technology, which determines different combos of inputs the firm can use to produce its output ○ Firm must pay prices for each of the inputs that it uses (Price-taker) ● The Profit-Maximizing Output Level ○ Firm’s Profit = TR - TC at each output level 13  ○ Firm chooses output level where profit is greatest ○ Marginal Revenue = Tells how much revenue rises per unit increase in output ■ MR = Change in TR / Change in Q ■ Downward sloping demand curve = Each increase in output causes a revenue gain, from selling additional output at the new price, and a revenue loss from having to lower price on all previous units of output ■ Marginal Revenue is less than the price of the last unit of output ○ Using MR and MC to Maximize Profits ■ Increase in output will always raise profit as long as MR > MC ■ Increase in output will always lower profit as long as MR < MC ■ Profit-Maximizing output level, firm should increase output whenever MR > MC but not increase output when MR < MC ● MC = MR ○ Using TR and TC Approach ■ Profit-Maximizing output level, firm should produce Q where vertical distance between TR and TC curve is greatest and TR curve lies above TC curve ○ Marginal Approach to Profit = Firm should take any action that adds more to its revenue than to its costs ● Short Run and the Shutdown Rule ○ Let Q* be the output level at which MR = MC. Then in the short run: ■ If TR > TVC at Q*, the firm should keep producing ■ If TR < TVC at Q*, the firm should shut down ■ If TR = TVC at Q*, the firm should be indifferent between shutting down and producing ● Long Run and the Exit Decision ○ Firm should exit the industry in the LR when at its best possible output level it would suffer a loss ○ Exit = Permanent cessation of production when a firm leaves an industry CH. 9 PERFECT COMPETITION ● Market structure = All characteristics of a market that influence the behavior of buyers and sellers when they come together to trade ● Perfect Competition = Market structure with four characteristics ○ Large numbers of buyers and sellers, and each buys or sells tiny fraction of total Q in market ○ Sel
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