Econ 201 Microeconomics

What is Economics and why study it? The What

Economics is choice under constraint Scarcity is how to describe economics in one word The Traditional Definition of Economics is:

Economics is a social science concerned with use of scarce resources in the production and distribution of goods and services to satisfy the unlimited human wants.

Positive vs. Normative Economics Positive economics is descriptive; it describes the facts as they are. Positive

Economics is concerned with “what is.” Normative Economics, on the other hand, tells us what the world should be. It is

prescriptive" rather than descriptive. Normative Economics is concerned with what should be."

The Why Economics gives you a different perspective on things A different tool to make decisions Thinking analytically is valued in the real world

The Resources There three types of resources we will deal with

Land (T) Terra Raw materials (gold, petroleum, etc) and real estate

Capital (K) Cost but K Goods that are used in production of other goods.

Roads, machines, infrastructure Labor (L) Labor

The skills and abilities and the time that people are willing to spend in gainful activities

Microeconomics Microeconomics is the branch of economics that is concerned with entities such as

markets, individuals, and firms. Adam Smith (1723-1790)1

Major work – “An Inquiry into the Nature and Causes of the Wealth of Nations” (1776)

Theories/Ideas – ‘the invisible hand’, ‘laissez-faire’, ‘specialization’

1 Information on the tests regarding Important People will deal primarily with Name and Theories/Ideas

Invisible Hand – Leave the market to operate by themselves. Everyone should work for their own best interests.

Laissez-faire – No government supervision Specialization – Good at something? Focus on it and specialize on it.

Macroeconomics Macroeconomics, on the other hand, is concerned with the overall performance of the

economy. John Maynard Keynes (1883-1946)

Major Work – “The General Theory of Employment, Interest and Money” (1936) Theories/Ideas – ‘slumps are due to a lack of demand’, ‘government should interfere’

Government should stimulate the economy is a recession to get it back on track. When the economy strengthens the government should back off.

Friedrich August von Hayek (1899-1992) Major Work – “The Political Order of Free People” (1979) Theories/Ideas – ‘criticized socialism’, ‘Noble Prize winner (1974)’, ‘argument with

Keynes’ See Keynes vs Hayek rap battle "Fear the Boom and Bust" on youtube.com Socialism was considered anything other than free market. Big on laissez-faire, government intervention will make it worse by creating debt.

Scientific Theory in Economics Observation

Study a phenomenon that you will to make predictions about Make Assumptions

Generalizations – Impossible to capture everything so try to capture the ‘spirit’ Build a Model

Mathematical models – lots of graphs and equations Make Predictions Testing

How did the model match up against what actually happened? Failed? Either start from scratch or try to fix what’s wrong

Three Common Fallacies/Pitfalls The Fallacy of Composition

Draw general conclusions from individual circumstances Excellent growing season Lots of crops from many growers Supply exceeded

demand Low profits The “Post Hoc” Fallacy (Post hoc ergo propter hoc)

Because something happened before an event you cannot assume the first event caused the second event.

The “Ceteris Paribus” Fallacy (All else equal) Failure to keep other things constant Moving to city and assuming the higher wages will make you better off. However,

everything is more expensive. Not everything is equal. Changing one thing can change the result

The Three Major Economic Questions What and How much/many to produce? How to produce? For Whom to produce?

Command Economy vs. Market Economy Command Economy – Government the government makes all the important decisions

about production and distribution. Government owns the resources and the means of production and it determines who will consume the outputs of production. Communism

Market Economy – Firms and individuals make the economic decisions. Individuals, firms, and the interaction between the answer the three questions. Capitalism Most “market economies” are in reality a mix between command and market.

Major Components of Market Economies Money

All types of money – currencies, bank notes, checks, etc. Transactions, bartering

A barter system is a market system in which goods or services are traded directly for other goods or services. Relies heavily on “wants”

Specialization Can apply to individuals and countries and everything in between Very important to the market system

Trade Capital and Investment

Markets, Prices, and Market Equilibrium Market – a mechanism which brings “buyers" and “sellers" together. Price – is the exchange value of goods and services at the market in terms of money Market Equilibrium – the balance between all the buyers (the demand) and the sellers

(the supply) in an economic system.

$$$

Individuals How?

For Whom?

Firms

Factors Market

$$$

G & S G & S

$$$

L,T,K L,T,K

What? How Much

Profit – represented by π is total revenue minus total cost Three Questions revisited and why government is needed

What? How Much? – Good and Services need some oversight or else crazy ones may grow in size (mercenaries and WMDs)

How? – Firms seek maximum profits which can be problematic. Child labor is a good way to reduce cost and maximize profit but is unscrupulous.

For Whom? – Market may shift causing a 99% vs. the 1% scenario.

Conditions under which the Market System will work by itself Economic agents are rationale

Economic agents know what they want and act accordingly Markets are perfectly competitive

When there is no single buyer/seller that can affect the market price, markets are competitive

Monopolies are the exact opposite of a competitive market There are no negative externalities

A situation in which economic agents who are not part of a specific market are negatively affected by what is happening in this market. Example is living next to an airport. They may not be traveling much or at all but

they have to deal with the noise, planes, etc… Positive externalities are when economic agents are positively affected by a market

they are not a member of. This is rare because most of the time the firm will attempt to internalize the profit.

A metro stop is built near your house Price of your house increases (positive) Taxes go up on house because of its new cost (internalized)

Income distribution is fair and just Perceived as fair Not everyone makes the same amount, but that there are boundaries.

The system is stable and growing

Goods and Services Market

Not the Boom Bust cycle Great Depression

The Role of the Government Economic agents are rationale

Very little control over this Markets are perfectly competitive, and There are no negative externalities

Improve efficiency The reason mergers are carefully monitored

Do not want to give excessive market power to any one player. Income distribution is fair and just

Promote fairness One way is progressive taxation. Progressive taxation is setting a higher tax rate

to those who make more money. Another way is setting minimum wages.

The system is stable and growing Monetary and Fiscal policies

Monetary policies include money supply and interest rates. Fiscal policies include taxation and spending.

Production Possibility Frontier (PPF) Definition of PPF (See Here)

The PPF represents all possible combinations of Goods and Services that can be produced in an economy with a given amount of resources that are fully and efficiency employed

0 1 2 3 4 5 602468

10121416 PPF Example

PPF

Roses (106)

Guns (103)

Properties of PPF Downward sloping

The only way to produce more of one good is to produce less of another. Concave (bowing out)

This captures the Law of Increasing Opportunity Cost.

Opportunity Cost is the value of the best forgone alternative (the alternative given up). Each million of roses produced cost more and more guns.

Assumes full and efficient employment If you are under the PPF curve then there is unemployment and/or inefficient

employment. Represents efficient allocation of resources Efficient, Inefficient, & Unattainable Production

Applications of PPF The PPF can expand outward or shrink down. This is caused by something that

causes an increase in productivity (technology, increased land or work force, investment). This shift does not need to happen evenly between the outputs

Frontier vs. Urban Society

Production of capital goods (goods used to produce more goods) allows for the PPF curve to grow outward (at the cost of immediate product from producing less consumer goods). Think delaying gratification

In a Frontier society, the focus is more on producing the consumer goods, whereas, the Urban society focusing on capital goods.

Public goods and services are goods and services that nobody can be excluded from consuming.

Private goods and services which can be used only by certain individuals.

Demand Schedule Demand Schedule definitions

Demand schedule is defined as the relationship between prices and quantity demanded at a given point of time, ceteris paribus (all else equal)

Demand curve is a graphical representation of [demand schedule definition]. Law of Downward Sloping Demand when the price of a good increases the price of

this good/service decreases, ceteris paribus (all else equal).

5 7 9 11 13 15 17 190

1

2

3

4

5

6 Quantity Demanded

Demand

Quantity Demanded (106)

Price ($)

Affected the Quantity Demanded The factor that will affect the quantity demanded is the price of the good.

Gets too high and no one will buy it. Demand Curve Shifts

Factors Income

Win the lottery buy more luxury goods Market size

Economy is good more people willing to spend Price of related goods

Complementary goods (coffee & cream, cars & tires, milk & cornflakes)

If the price of one complementary good (milk) increases, it will affect the quantity demanded of the other good (cornflakes) This does not change the curve!!! Only your location on it. Symbiotic relationship

Substitute goods (Coke & Pepsi) If the price of one competing good increases people will consume less of it

and consume more of the cheaper alternative. Tastes and Preferences New inventions

Think of the demand for CD players after the iPod caught on Expectations

Think snow storm predicted so everyone stocks up on milk so the demand of milk increases

Special factors Most important special factor is the weather

Demand for sandals in the winter is low but in the summer is high.

5 10 15 20 25 30 350

1

2

3

4

5

6

Original

Shifted

Supply Schedule Definitions

Supply schedule is the difference between prices and quantity supplied at a given time, ceteris paribus (all else equal).

The supply curve is the graphical representation of [supply schedule definition] Supply Curve

0 2 4 6 8 10 12 14 16 18 200

1

2

3

4

5

6

Supply

Supply

Quantity Supplied

Price ($)

Shifts along the Curve vs. Shifts of the Curve. The only factor that cause movements along the supply curve are caused by a change

in price. Factors that Affect the Supply Curve

Production costs If something becomes more expensive to produce then it shifts to the left

increasing the price of the quantity supplied Drought causes bad harvest price of crop in question increase

Prices of related goods Products produced by the same technologies (soccer balls & basketballs)

Company that makes basketballs and soccer balls may shift production from one to the other due to March Madness, World Cup, etc...

Related to Tastes and Preferences Special Factors

Weather once again Great harvest of coffee beans will flood the market and cause a shift to the

right on the graph. Meaning that the price will be lower for a given quantity. Inventions

New invention replaces the old Expectations

Expecting a hike in gas prices, people will stock up on gas beforehand Expecting large amount of purchases (new game releases), then company will

produce more anticipating this.

Supply and Demand Market equilibrium

Equilibrium price is the one at which Demand and Supply are in balance, that is, the quantity offered for sale is equal to the amount that people wish to buy. This price is also known as the "market-clearing price"

Excess Supply vs. Excess Demand When you are above the equilibrium price the difference between the 2 curves at a

given price is called surplus. The consumers want less then what firms wish to produce at that price.

Conversely if you are beneath the equilibrium point, the difference between the 2 curves at a given price is called shortage. Consumers wish to buy more than firms are willing to produce at that price

Some Applications Price ceiling is the maximum price that a producer can legally charge. A price ceiling

only makes sense if it is imposed below the market equilibrium This will generate a shortage

Price floor… will only make sense if it is imposed above the equilibrium price Minimum wage This will generate a surplus

Price Elasticity of Demand The Elasticity of Demand (Ed) is the absolute value of the percentage change in the

quantity demanded divided by the percentage change in prices. This captures the sensitivity of quantity of demand to the change in prices

Ed=| percentagechange∈quantitypercantage change∈ price |=|% ∆ Q

% ∆ P | % ∆ Q=∆ Q

Qm The change in quantity (ΔQ) divided by the average quantity(Qm)

% ∆ P=∆ PPm

The change in price (ΔP) divided by the average price (Pm)

Total Revenue is the market-clearing price (equilibrium price) times the equilibrium quantity. TR=P ¿×Q¿

Price Discrimination is the practice of charging different customers different prices for the same good or service. This is possible because different customers have different sensitivity to price

changes Elastic, Inelastic, Unitary Elastic Demand

A product is ELASTIC (or sensitive) if the Ed > 1 If the price changes it greatly changes the quantity

A product is INELASTIC if the Ed < 1 A change in price effects the quantity on to a smaller degree

Unitary elastic demand when the Ed = 1 Elasticity is NOT slope generally, however there are two exceptions (extreme cases)

Perfectly inelastic Perfectly inelastic means that the quantity demanded does not change regardless

of any price change. Think medication This will be represented by a perfectly vertical quantity demanded curve.

Perfectly elastic Perfectly elastic means that any change in prices will change the quantity demand

infinitely. This will be represented as a perfectly horizontal quantity demand curve.

A list of something? Necessary vs. Luxury

Necessities are things we cannot live without. Inelastic Demand

Luxuries are wants not needs Share in Budget

The larger the budget share the more elastic the demand. Milk becomes a dollar more expensive no response… Price triples then

there will be a response. Substitutes

The more substitutes available the more elastic

Prices rise at one store, demand shifts to a competitor at a lower price. Time

As time passes the demand becomes more responsive Gas prices go up but the response is not immediately felt till you go back

to the pump.

Bumper Harvest Paradox Brazil produces 70% of the world’s coffee. Had an incredible year of weather, producing

a huge harvest. They ended up losing money.

Elasticity of Supply Elasticity of Supply is the percentage change between quantity supplied and percentage

change in price.

ES=|%∆ QS

%∆ P |

----------------------------END OF MIDTERM 1 MATERIAL----------------------------

Utility Definitions

Utility is a scientific concept used in Economics to explain how rational consumer divide their resources between different goods and sources that bring them satisfaction In one word it is “satisfaction”

Rational Consumers are: Non-satiated

Always prefer more than less Given a choice between one of a good or two of the same good, they take

the two of a good. Transitive

Likes good A more than good B, and likes good B more than good C, therefore they like A more than C Chocolate > Cereal > Fruit

Complete That when you offer the consumer a bunch of choices the consumer is able to

compare. (?) Cardinal or Ordinal Utility

Cardinal Utility means measureable utility Ordinal Utility (more important of the two) means able to order/rank the satisfaction

You don’t have to be able to know how much you like something; you just need to be able to know if you like it more or less than something else.

Total vs. Marginal Definition

Total Utility is the total satisfaction that we derive from the choices that we make Total Utility = Σ Marginal Utility

Marginal (= additional) Utility is the additional satisfaction that we derive from consumer one more unit of a good or service, ceteris paribus. This is how much satisfaction you get from each individual unit

Law of Diminishing Marginal Utility After some point each additional unit of a good/service that we consume will

bring us less and less satisfaction (becoming jaded). Thirsty so you drink a bottle of water (+ 10 Happiness). Still a little thirsty so

you drink another bottle (+ 7 Happiness). Prices reflect Marginal Utility not Total Utility.

This explains why water (a necessity of life) is less expensive than diamonds (a want).

Applications Consumer Surplus and Producer Surplus

Consumer Surplus is the difference between how much we value a product and how much we pay for it. The bigger the consumer surplus the happier the consumers are

Producer Surplus is the additional value that producers get above what they are willing to sell for.

The sum of Consumer Surplus and Producer Surplus is defined as Welfare

Production Theory Firm is a business organization devoted to managing the process of production and

supply Three major types of Business Organizations

Individual Proprietorships Partnerships Corporations

Scale small medium Large

# of Firms 72% of all US firms 8% 20%

Sales 5% in the US 15% 80%

Liability Full / Unlimited Full / Unlimited Limited

Ownership Owner Owners Shareholders

Control Owner Owners Board of Directors

Individual Proprietorship Think lunch trucks

Partnerships Partners are responsible for each other (one disappears, the other inherits all the

debts) This is why they are not popular and people prefer Individual Proprietorship

Corporations Owned by shareholders who appoint a Board of Directors to run the corporation. Due to the limited liability if the company fail is does not affect the shareholders as much as if it was a Individual Proprietorship or Partnerships. Major downside is taxes (35%)

Production Function specifies the maximum output that a company can produce with a given amount of resources and technologies.

Production Relationships Total Product (Output)

Total amount produced Marginal Product of an Input

The additional output produced by one more unit of the input, ceteris paribus.

Marginal Product = ∆ Q

∆ input=MP

Change in output divided by the change in input In the graph below the reason for the increase in productivity before the Law of

Diminishing Marginal Productivity is due to specialization. Firms, in the graph below, will never be located before the local maximum or

after the marginal productivity crosses zero. Average Product of an Input

The output per unit of input employed, ceteris paribus.

Average Product = Q

input=AP

The output divided by the input

0 1 2 3 4 5 6 7 8-200

0

200

400

600

800

1000

1200

1400

MPAP

Input

Outputper Unitof Input

Law of Diminishing Returns Ceteris paribus, after some point adding more units of an input will add less and less

additional output Also known as the Law of Diminishing Marginal Productivity

Returns to Scale Production is subject to increasingly returns to scale when doubling all inputs results

in more than double output Production is subject to decreasing returns to scale when doubling all inputs results in

less than double outputs Production is subject to constant returns to scale when input doubles results in outputs

doubles Time and Production

Short-run vs. Long-run Short-run is a period in which the firm can only change variable costs. Long-run is a period in which the firm can vary all costs, both fixed and variable.

Production and Technology Product Innovation

New technology becomes available Think the Industrial Revolution

Process Innovation Existing services or goods become better

Faster computers, smaller cell phones Economic vs. Accounting: Costs & Profits

Economic costs (EC) ≠ Accounting costs (AC) EC = AC + OC

Opportunity cost (OC) is the value of the best forgone alternative (best thing you have give up)

Economic costs will always be higher than accounting costs Having a Profit (π) of 0 can be considered good if it is based off of the economic

costs. This is because there was no better alternative then what you chose. Profit (π) = TR – TC = (P)(Q)-EC

Costs Total Cost (Graph)

the total monetary spending of a company on inputs needed to produce a given number of outputs Total cost is the sum of the fixed costs and the variable costs

TC = FC + VC and ΔTC = ΔVC (because FC is constant) Total cost, as seen in graph below, initially rises with a decreasing slope but

after a certain point rises with an increasing slope. Fixed Costs (Graph)

Costs that do not change with output (sunk or overhead) Rent of the building for example

Variable Costs (Graph) Directly related to output. The more you produce the higher the variable cost.

The price of ingredients for a pizza place Marginal Cost (Graph)

The minimum cost that a firm has to make to produce one more unit of output.

MC=∆ TC∆Q

=∆ TC=∆ VC

The shape initially has a negative slop but after a certain point it will switch to a positive slope. This shape is a reflection of the graphical representation of Market Production

An increase in Market productivity will result in a decrease in Marginal Cost, and vice versa.

Average Cost (Graph) Average Cost is simply the cost per unit of output.

AC=TCQ

= FC+VCQ

= FCQ

+VCQ

=AFC+ AVC

The Average cost is the sum of the average Fixed cost and the average Variable cost

Graph Analysis In the short run we distinguish between the fixed and variable costs; however, in

the long run all costs are variable. The variable cost will be the total cost but offset by the fixed cost. Both total and

variable costs have an “S” shape. (Explained in total cost) Because the MC = ΔTC = ΔVC, it is the SLOPE of TC and VC.

Marginal, Variable, and Average Variable costs are always the same for the first unit.

The MC will intersect the AFC and AVC at their respective minimums. When MC is below average is pulls it down, when it is above it raises it.

0 1 2 3 4 5 6 7 80

50

100

150

200

250

300

350

400

450

500

FCVCTC

Quantity

Costs

0 1 2 3 4 5 6 7 80

20

40

60

80

100

120

ACAFCAVCMC

Quantity

Cost

Perfectly Competitive Markets Characterizations

Large number of profit maximizing firms Profit (π) = TR - TC

Producing identical products Price takers (relatively small firms)

This means that they cannot affect the price of goods. Entry and exit are easy (free)

Small firms so start-ups are relatively cheap

Milk 1 Firm

Profit Maximization The demand faced by a Perfectly competitive firm is perfectly elastic Marginal Revenue is the additional revenue that the firm will generate by selling one

more unit of its product Profit (π) = TR – TC

TR = P*Q* & TC = FC + VC ΔTC = MC & ΔTR = MR = P

Profits will be maximized when the slope of the TC curve is equal to the slope of the TR curve.

Profit maximization P=MC!!

d

q

TC = FC + VC