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Economics 120 Economics 120 CRAM SESSION CRAM SESSION Instructors: Paul and Ashwin

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Economics 120 CRAM SESSION. Instructors: Paul and Ashwin. Review of Major Concepts from 1 st Midterm. Opportunity Cost PPC Curve Demand and Supply Curve. Opportunity Cost. - PowerPoint PPT Presentation

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Page 1: Economics 120 CRAM SESSION

Economics 120Economics 120CRAM SESSIONCRAM SESSION

Instructors: Paul and Ashwin

Page 2: Economics 120 CRAM SESSION

Review of Major Concepts from Review of Major Concepts from 11stst Midterm Midterm

Opportunity CostOpportunity Cost PPC CurvePPC Curve Demand and Supply Curve Demand and Supply Curve

Page 3: Economics 120 CRAM SESSION

Opportunity Cost Opportunity Cost

Definition: The cost of using resources for a certain Definition: The cost of using resources for a certain purpose, measured by the benefit given up by purpose, measured by the benefit given up by not using them in their best alternative use.not using them in their best alternative use.

““The foregone benefits by the next best The foregone benefits by the next best alternative”alternative”

Example: Suzie has two options work at job that Example: Suzie has two options work at job that pays $6/hour for 8 hours or run her own business pays $6/hour for 8 hours or run her own business which pays $100/day. What is the opportunity which pays $100/day. What is the opportunity cost of running her own business????cost of running her own business????

Page 4: Economics 120 CRAM SESSION

Production Possibility CurveProduction Possibility Curve

The negatively sloped boundary shows the combinations that are just attainable when all of society’s resources are efficiently employed.

Page 5: Economics 120 CRAM SESSION

Basic Overview of Supply and Basic Overview of Supply and DemandDemand

Quantity Demand: total amount of any particular good or service that consumers wish to purchase in some time period.

Quantity Supply: total amount of any particular good or service that suppliers wish to supply in some time period.

Demand

Supply

Price

Quantity

Pe

Qe

Page 6: Economics 120 CRAM SESSION

Four Laws of Demand and Four Laws of Demand and SupplySupply

1.1. An increase in demand causes an An increase in demand causes an increase in both the equilibrium increase in both the equilibrium price and the equilibrium quantity price and the equilibrium quantity exchanged.exchanged.

2.2. A decrease in demand causes a A decrease in demand causes a decrease in both the equilibrium decrease in both the equilibrium price and quantity exchanged.price and quantity exchanged.

Page 7: Economics 120 CRAM SESSION

Four Laws of Demand and Four Laws of Demand and Supply Continued…..Supply Continued…..

3. An increase in supply causes an 3. An increase in supply causes an increase in both the equilibrium increase in both the equilibrium price and the equilibrium quantity price and the equilibrium quantity exchanged.exchanged.

4. A decrease in supply causes a 4. A decrease in supply causes a decrease in both the equilibrium decrease in both the equilibrium price and quantity exchanged.price and quantity exchanged.

Page 8: Economics 120 CRAM SESSION

Elasticity of Demand/SupplyElasticity of Demand/Supply

The price elasticity of demand is the The price elasticity of demand is the measure of responsiveness of measure of responsiveness of quantity of a product demanded to a quantity of a product demanded to a change in that product’s price.change in that product’s price.

= Percentage change in quantity = Percentage change in quantity demanded demanded

Percentage change in pricePercentage change in price

Page 9: Economics 120 CRAM SESSION

Elasticity of Demand/SupplyElasticity of Demand/Supply

Inelastic Demand: a situation in which, for a given Inelastic Demand: a situation in which, for a given percentage change in price, there is a smaller percentage change in price, there is a smaller percentage change in quantity demanded; percentage change in quantity demanded; elasticity is less than one. elasticity is less than one.

Ex: Pace Maker, certain drugs…Ex: Pace Maker, certain drugs…

Elastic Demand: the situation in which for a given Elastic Demand: the situation in which for a given percentage change in price there is a greater percentage change in price there is a greater percentage change in quantity demanded. percentage change in quantity demanded.

Ex: blue ink penEx: blue ink pen

These same concepts can be applied to supply These same concepts can be applied to supply curves.curves.

Page 10: Economics 120 CRAM SESSION

Chapter 7Chapter 7

Producers in the Short RunProducers in the Short Run

Page 11: Economics 120 CRAM SESSION

Goals of the FirmGoals of the Firm

1) To maximize profits1) To maximize profits

2) Every firm is a single, consistent, 2) Every firm is a single, consistent, decision-making unitdecision-making unit

Page 12: Economics 120 CRAM SESSION

Profit – Maximizing OutputProfit – Maximizing Output

∏ ∏ = TR – TC= TR – TC

= (P x Q) – (C x Q)= (P x Q) – (C x Q)

= Q (P – C)= Q (P – C)

- therefore a firm’s profits are - therefore a firm’s profits are effected by both revenue and costeffected by both revenue and cost

Page 13: Economics 120 CRAM SESSION

Costs and ProfitsCosts and Profits

Costs: economics – “opportunity Costs: economics – “opportunity cost:” the benefit foregone by not cost:” the benefit foregone by not using an input a certain wayusing an input a certain way

Types of CostTypes of Cost:: 1) inputs – costs you can place a 1) inputs – costs you can place a

dollar value on. eg) rentdollar value on. eg) rent 2) imputed – costs you cannot place 2) imputed – costs you cannot place

a dollar value on. eg) goodwill a dollar value on. eg) goodwill

Page 14: Economics 120 CRAM SESSION

Types of Imputed CostsTypes of Imputed Costs

3 categories:3 categories: 1) the “useful economic life” of long 1) the “useful economic life” of long

lived capital assets. eg) buildinglived capital assets. eg) building 2) Cost of employing capital in the 2) Cost of employing capital in the

firm eg) machinaryfirm eg) machinary 3) cost of risk3) cost of risk #1 and 2 are use depreciation#1 and 2 are use depreciation

Page 15: Economics 120 CRAM SESSION

Economic vs. Accounting Economic vs. Accounting ProfitProfit

Economic profit takes into account Economic profit takes into account implicit costs implicit costs (costs that we cannot put an actual dollar value on)(costs that we cannot put an actual dollar value on)

Economic profit takes into account opportunity cost Economic profit takes into account opportunity cost and the cost of riskand the cost of risk

Therefore: Therefore: economic profits < accounting profitseconomic profits < accounting profits If economic profit is positive, the owners capital is If economic profit is positive, the owners capital is

earning more than it could in its next best alternative earning more than it could in its next best alternative useuse

Zero accounting profit does not mean zero Zero accounting profit does not mean zero accounting profit. i.e. the company is not making any accounting profit. i.e. the company is not making any moneymoney

Page 16: Economics 120 CRAM SESSION

Production FunctionProduction Function

A production function describes the A production function describes the relationship between the inputs that relationship between the inputs that a firm uses and its outputsa firm uses and its outputs

Q = f ( L, K )Q = f ( L, K )

where Q = outputwhere Q = output

K = capitalK = capital

L = labourL = labour

Page 17: Economics 120 CRAM SESSION

Time Horizons for Decision Time Horizons for Decision MakingMaking

Short Run - In terms of time it is the Short Run - In terms of time it is the length of time over which some of length of time over which some of the firms factors of production are the firms factors of production are fixedfixed

Long Run – factors of production are Long Run – factors of production are variable, technology is fixedvariable, technology is fixed

Very Long Run – length of time over Very Long Run – length of time over which all factors are variablewhich all factors are variable

Page 18: Economics 120 CRAM SESSION

Short Run ProductionShort Run Production

Total Product (TP): amount of output produced Total Product (TP): amount of output produced during a given period of timeduring a given period of time

Average Product (AP): TP / # of units of variable Average Product (AP): TP / # of units of variable factor used to produce it. Labour is the most factor used to produce it. Labour is the most commoncommon

Therefore: AP = TP / LTherefore: AP = TP / L Marginal Product (MP): change in total product Marginal Product (MP): change in total product

resulting from the use of one more variable resulting from the use of one more variable factor;factor;

MP = ∆ TP / ∆ LMP = ∆ TP / ∆ L ∆ ∆ TP / ∆ LTP / ∆ L

Page 19: Economics 120 CRAM SESSION

Law of Diminishing ReturnsLaw of Diminishing Returns

States that if you keep increasing States that if you keep increasing your variable factors, eventually MP your variable factors, eventually MP will declinewill decline

Page 20: Economics 120 CRAM SESSION

Costs in the Short RunCosts in the Short Run

TC = TFC + TVCTC = TFC + TVC ATC = AFC + AVCATC = AFC + AVC MC = ∆ TC / ∆ QMC = ∆ TC / ∆ Q

= ∆ TFC / ∆ Q + ∆ TVC / ∆ Q= ∆ TFC / ∆ Q + ∆ TVC / ∆ Q

Because fixed costs do not vary with Because fixed costs do not vary with outputoutput

MC = ∆ TVC / ∆ QMC = ∆ TVC / ∆ Q

Page 21: Economics 120 CRAM SESSION

Chapter 8Chapter 8

Long Run Production Long Run Production

Page 22: Economics 120 CRAM SESSION

Chapter 8Chapter 8Producers in the long Run…. Producers in the long Run….

In the short run, the only way to produce a In the short run, the only way to produce a given level of output is to adjust the input given level of output is to adjust the input of variable factors. of variable factors.

In the long run “ALL INPUTS ARE In the long run “ALL INPUTS ARE VARIABLE,” and there are numerous ways VARIABLE,” and there are numerous ways to produce any given output. to produce any given output.

We need to produce goods without We need to produce goods without wasting society’s scare resources and wasting society’s scare resources and produce the chosen output at least cost. produce the chosen output at least cost.

Page 23: Economics 120 CRAM SESSION

What does Economically What does Economically Efficient mean?Efficient mean?

Economic Efficiency is achieved by a Economic Efficiency is achieved by a firm choosing from among the many firm choosing from among the many technically efficient options and technically efficient options and finding the one that produces a given finding the one that produces a given level of output at the lowest possible level of output at the lowest possible cost.cost.

Page 24: Economics 120 CRAM SESSION

Cost Minimization Cost Minimization

Firms in the long run should select the Firms in the long run should select the economically efficient method of production, economically efficient method of production, which is the method that produces its output which is the method that produces its output at the lowest possible cost. at the lowest possible cost.

Cost Minimization: an implication of profit Cost Minimization: an implication of profit maximization that firms choose the maximization that firms choose the production method that produces any given production method that produces any given level of output at the lowest possible cost.level of output at the lowest possible cost.

Page 25: Economics 120 CRAM SESSION

Principle of Substitution Principle of Substitution

Implies that a firm ‘s method of Implies that a firm ‘s method of production will change if the relative production will change if the relative prices of factors change. Relatively prices of factors change. Relatively more of the cheaper factor and more of the cheaper factor and relatively less of the more expensive relatively less of the more expensive factor will be used.factor will be used.

MPMPK K = MP= MPLL

P P K K = P = P LL

Page 26: Economics 120 CRAM SESSION

Long Run Cost CurvesLong Run Cost Curves

The long run average cost (LRAC) curve is the The long run average cost (LRAC) curve is the boundary between cost levels that are boundary between cost levels that are attainable (with given technology and factor attainable (with given technology and factor prices) and those that are unattainable. prices) and those that are unattainable.

For Low rates of output, it makes little sense to For Low rates of output, it makes little sense to use a lot of capital because of high fixed cost.use a lot of capital because of high fixed cost.

For higher rates of output, fixed cost of larger For higher rates of output, fixed cost of larger amounts of capital can be spread (averaged) amounts of capital can be spread (averaged) over more units, and lower labour costs per unit.over more units, and lower labour costs per unit.

Page 27: Economics 120 CRAM SESSION

SRATC and LRACSRATC and LRAC

Page 28: Economics 120 CRAM SESSION

Increasing and DecreasingIncreasing and Decreasing “Returns to Scale” “Returns to Scale”

If the change in the output is If the change in the output is proportionally less than the change proportionally less than the change in the use of all the inputs, we have in the use of all the inputs, we have decreasing returns to scale.decreasing returns to scale.

If the change in the output is If the change in the output is proportionally more than the change proportionally more than the change in the use of all the inputs, we have in the use of all the inputs, we have increasing returns to scale.increasing returns to scale.

Page 29: Economics 120 CRAM SESSION

Example of Returns to ScaleExample of Returns to ScaleSituation Situation 11

InputsInputs OutputsOutputs or or constant constant returns to returns to ScaleScale

BEFOREBEFORE 22 33

AFTERAFTER 44 99

Situation Situation 22

BEFOREBEFORE 55 1010

AFTERAFTER 1010 2020

Page 30: Economics 120 CRAM SESSION

MESMES

Any output level that can be produced Any output level that can be produced at the lowest LRAC is characterized as at the lowest LRAC is characterized as an efficient scale of output.an efficient scale of output.

The smallest of these flow rates of The smallest of these flow rates of output at which the firm attains output at which the firm attains minimum LRAC is called the firm’s minimum LRAC is called the firm’s Minimum Efficient Scale (MES) of Minimum Efficient Scale (MES) of output.output.

Page 31: Economics 120 CRAM SESSION

Chapter 9Chapter 9

Perfect CompetitionPerfect Competition

Page 32: Economics 120 CRAM SESSION

Perfect Competition Perfect Competition

Basic AssumptionsBasic Assumptions1. Homogeneous (i.e. identical) products.1. Homogeneous (i.e. identical) products.

2. Buyers know prices charged by each firm.2. Buyers know prices charged by each firm.

3. MES is small relative to market size.3. MES is small relative to market size.

4. Freedom of entry and exit in long-run.4. Freedom of entry and exit in long-run.

Page 33: Economics 120 CRAM SESSION

Important FormulasImportant Formulas

Total Revenue = price x quantityTotal Revenue = price x quantity

Average revenue (AR) = TR/Q Average revenue (AR) = TR/Q

Marginal revenue (MR) = Marginal revenue (MR) = ΔΔTR/TR/ΔΔQQ

We maximize profits where MR = MCWe maximize profits where MR = MC

In the short run we shut down where Price < Average In the short run we shut down where Price < Average Variable Cost……..Variable Cost……..

If Price is equal to AVC we can either shut down or notIf Price is equal to AVC we can either shut down or not

Page 34: Economics 120 CRAM SESSION

Firm and Industry GraphsFirm and Industry Graphs

Page 35: Economics 120 CRAM SESSION

Short Run AssumptionsShort Run Assumptions

1. Firms are price-takers & maximize 1. Firms are price-takers & maximize profitsprofits

2. Number of firms and plant size is given.2. Number of firms and plant size is given.

3. Input prices are given3. Input prices are given

4. Price equates QD and QS4. Price equates QD and QS

Page 36: Economics 120 CRAM SESSION

Long Run Perfectly Competitive Long Run Perfectly Competitive FirmFirm

Page 37: Economics 120 CRAM SESSION

Assumptions in the Long Run in Assumptions in the Long Run in a Perfectly Competitive a Perfectly Competitive

Industry Industry 1. 1. Firms are price-takers & maximize Firms are price-takers & maximize

profitsprofits.. 2. 2. Firms choose plant size & entry or exit.Firms choose plant size & entry or exit.

Implications of Assumptions 1 - 2Implications of Assumptions 1 - 2 Economic profits are zero.Economic profits are zero. Each firm operates at MES. Each firm operates at MES. P = min LRAC.P = min LRAC.

3. 3. Input prices Input prices (let (let nn = number of firms) = number of firms) ……don’t depend on don’t depend on nn ( (constant cost industryconstant cost industry))

LR industry supply curve is horizontal.LR industry supply curve is horizontal. 4. 4. Price equates QD and QSPrice equates QD and QS

Page 38: Economics 120 CRAM SESSION

Chapter 10Chapter 10

MonopolyMonopoly

Page 39: Economics 120 CRAM SESSION

Market StructureMarket Structure

OutputOutput All firms seek to produce and sell a All firms seek to produce and sell a

quantity of output at which quantity of output at which MR = MCMR = MC in in order to maximize profitsorder to maximize profits

PricePrice Monopoly seller will try to charge the Monopoly seller will try to charge the

maximum buyers are willing to pay. B/C maximum buyers are willing to pay. B/C monopolist is sole producer, its demand monopolist is sole producer, its demand curve is the market demand curve. curve is the market demand curve. Monopolist charges the price where Monopolist charges the price where equilibrium hits the demand curveequilibrium hits the demand curve

Page 40: Economics 120 CRAM SESSION

Market StructureMarket Structure

Remember: Remember: Monopolist faces a negatively sloped Monopolist faces a negatively sloped

demand curvedemand curve it charges the highest possible priceit charges the highest possible price The monopolists MR is less than the The monopolists MR is less than the

price at which it sells outputprice at which it sells output Therefore the monopolists MR curve Therefore the monopolists MR curve

is below its demand curveis below its demand curve

Page 41: Economics 120 CRAM SESSION

Marginal Revenue – Monopoly Marginal Revenue – Monopoly vs. Perfect Competitionvs. Perfect Competition

In perfect competition; if firm In perfect competition; if firm increases quantity it increases increases quantity it increases revenuerevenue

gain = price x additional quantitygain = price x additional quantity

- For a monopoly, additional revenue - For a monopoly, additional revenue is equal to: new (lower) price x is equal to: new (lower) price x quantity – “spoilage”quantity – “spoilage”

Page 42: Economics 120 CRAM SESSION

Profit – Maximizing OutputProfit – Maximizing Output

Profit maximizing quantity for a Profit maximizing quantity for a monopoly is where monopoly is where MR = MCMR = MC

This only determines our quantityThis only determines our quantity Price is equal to where it hits the Price is equal to where it hits the

demand curvedemand curve Price is always greater than MCPrice is always greater than MC

Page 43: Economics 120 CRAM SESSION

Monopolies and Supply Monopolies and Supply CurvesCurves

There is no such thing as a There is no such thing as a supply curve for a monopolysupply curve for a monopoly

Once the monopoly determines its Once the monopoly determines its optimal quantity (where MR = MC), optimal quantity (where MR = MC), monopoly uses knowledge of the monopoly uses knowledge of the demand curve to determine the price demand curve to determine the price that it will charge that it will charge

Page 44: Economics 120 CRAM SESSION

Entry BarriersEntry Barriers

Unlike perfectly competitive markets, there Unlike perfectly competitive markets, there are entry barriers in a monopolistic marketare entry barriers in a monopolistic market

2 classes of barriers2 classes of barriers 1) Natural Barriers: arise from economies of 1) Natural Barriers: arise from economies of

scale. There is always a huge initial cost scale. There is always a huge initial cost involved. Eg) electrical powerinvolved. Eg) electrical power

2) Created Barriers: eg) Microsoft. Company 2) Created Barriers: eg) Microsoft. Company that either owns a patent to a certain that either owns a patent to a certain technology or has a lot of “brand loyalty”technology or has a lot of “brand loyalty”

Page 45: Economics 120 CRAM SESSION

Price DiscriminationPrice Discrimination

Occurs when producer charges different prices for Occurs when producer charges different prices for different units of the same product sold for reasons different units of the same product sold for reasons not related to cost differencesnot related to cost differences

Eg) senior’s discounts for movie ticketsEg) senior’s discounts for movie tickets Price discrimination is possible when:Price discrimination is possible when: 1) Firms have market power; i.e. not price takers1) Firms have market power; i.e. not price takers 2) Consumers different valuations can actually be 2) Consumers different valuations can actually be

identifiedidentified 3) No arbitrage opportunities exists (the process of 3) No arbitrage opportunities exists (the process of

purchasing a product at a lower price and re-selling purchasing a product at a lower price and re-selling it for a higher oneit for a higher one

When a firm uses price discrimination it is trying to When a firm uses price discrimination it is trying to capture consumer surpluscapture consumer surplus

Page 46: Economics 120 CRAM SESSION

CartelsCartels

When firms get together and act as a When firms get together and act as a monopoly by controlling and reducing monopoly by controlling and reducing supply in order to raise prices and supply in order to raise prices and increase profits eg) OPECincrease profits eg) OPEC

Normally the firm would set D = MC (=S)Normally the firm would set D = MC (=S) With a cartel, they reduce supply to With a cartel, they reduce supply to

where MR = MC (like a monopoly) and where MR = MC (like a monopoly) and charge the price where it hits the charge the price where it hits the demand curvedemand curve

Page 47: Economics 120 CRAM SESSION

Problems That Cartels FaceProblems That Cartels Face

Whenever quantity is reduced and price Whenever quantity is reduced and price rises there is always an incentive for forms rises there is always an incentive for forms to take advantage of the higher prices and to take advantage of the higher prices and produce more quantity since no one is produce more quantity since no one is policing how much they are producingpolicing how much they are producing

If enough firms decide to cheat and produce If enough firms decide to cheat and produce more quantity, eventually price will fall to more quantity, eventually price will fall to where it originally was where the firms were where it originally was where the firms were in competition against each otherin competition against each other

Page 48: Economics 120 CRAM SESSION

Chapter 11Chapter 11

Imperfect Competition and Imperfect Competition and Strategic BehaviourStrategic Behaviour

Page 49: Economics 120 CRAM SESSION

OligopolyOligopoly

Has characteristics somewhere between a perfectly Has characteristics somewhere between a perfectly competitive firm and a monopolycompetitive firm and a monopoly

Firms in an oligopoly market have “identical products” Firms in an oligopoly market have “identical products” but have barriers to entry and a few number of sellersbut have barriers to entry and a few number of sellers

Eg) toothpaste – Crest, Colgate, AquafreshEg) toothpaste – Crest, Colgate, Aquafresh Each firm faces a negatively sloped demand curve that Each firm faces a negatively sloped demand curve that

is highly elastic b/c other firms have close substitutesis highly elastic b/c other firms have close substitutes Freedom of entry and exitFreedom of entry and exit Output is determined where MR = MC and price is Output is determined where MR = MC and price is

determined where it hits the demand curve (same as determined where it hits the demand curve (same as monopoly)monopoly)

Page 50: Economics 120 CRAM SESSION

Predictions of TheoryPredictions of Theory

b/c there is an ease of entry with b/c there is an ease of entry with oligopolies, short run profits provide oligopolies, short run profits provide an incentive for new firms to enter an incentive for new firms to enter the industry the industry

As new firms enter, each firms As new firms enter, each firms demand curve shifts to the left until demand curve shifts to the left until profits are eliminatedprofits are eliminated

Page 51: Economics 120 CRAM SESSION

Oligopoly CharacteristicsOligopoly Characteristics

Oligopolistic firms will make profits as a Oligopolistic firms will make profits as a group if they cooperate, or collude.group if they cooperate, or collude.

However an individual firm can make more However an individual firm can make more profits if it cheats when other firms are co-profits if it cheats when other firms are co-operating. operating.

If firms compete with rival firms this If firms compete with rival firms this results in benefits to customers. Results in results in benefits to customers. Results in competition which results in better competition which results in better products and cheaper prices.products and cheaper prices.

However if they collude rival firms benefit However if they collude rival firms benefit at the cost of customers.at the cost of customers.

Page 52: Economics 120 CRAM SESSION

Game TheoryGame Theory

Game theory is used to study Game theory is used to study decision making in situations where a decision making in situations where a number of players compete. number of players compete.

Page 53: Economics 120 CRAM SESSION

Prisoner’s DilemmaPrisoner’s Dilemma

Two people, call them A and B, have Two people, call them A and B, have jointly committed a crime.jointly committed a crime.

Police arrest both. Police think they Police arrest both. Police think they have committed the crime, but lack have committed the crime, but lack proofproof

Payoff Matrix:Payoff Matrix:

Page 54: Economics 120 CRAM SESSION

Prisoner's Dilemma Game Prisoner's Dilemma Game Theory Theory

Page 55: Economics 120 CRAM SESSION

Game Theory With no Game Theory With no Dominant StrategyDominant Strategy

Page 56: Economics 120 CRAM SESSION