principles of microeconomics module 1...seamstress 1more bread = ½ sweater 1 more sweater = 2 bread...

PrinciplesofMicroeconomicsModule1.1

Scarcity,LimitedResourcesandOpportunityCosts

WhatisEconomics?

• Economicsisthestudyofhowpeopleandsocietyallocatescarceresources

• Scarceresources:• Forpeople:Time,Moneyect.• Forfirms:FactorsofProductionà Land,LaborandCapital

• Sincewedon’thaveaninfiniteamountofresources– whatdowedowithwhatwehave?

TradeoffsinDecisions

• Peoplefacetradeoffsindecisionsbecauseofscarceresources• Cannotdoeverything,buyeverything,makeeverything• Needtochoosehowtoallocateourtime,ourmoney,ourresources

• Whenyoumakeonechoice– yougiveuptheotheroption

OpportunityCosts

• OpportunityCost:Whatyougiveuptogetsomething• Example:Howmanytimescanyouhitthesnoozebutton?

Benefit Opportunity Cost

Hititonce MoreSleep Feelrushed inthemorning

Hitittwice MoreSleep Feel rushedSkipbreakfast

Hititthreetimes MoreSleep Feel rushedSkipbreakfastSkipthegym

Hititfourtimes MoreSleep Feel rushedSkipbreakfastSkipthegymLateforwork

OpportunityCost

• OpportunityCostsaresubjectivetotheindividualandchangedependingoncircumstances

• WhatifitwasSaturdaymorningandyouhitthesnoozebutton?• Benefitsofmoresleepmayoutweighanycostsifyoudon’thavetowakeup!

• Whatifyouworkintheafternoon?• Youdonothavethesameconstraintsassomeonewhoneedstogotoworkinthemorning!

OpportunityCosts

• OpportunityCostsdrivethedecisionswemakeeveryday• Wefacethemallthetime• Weweighthecostsandbenefitsofeachdecisionsconsciouslyorsubconsciouslyandmakeachoice

• Testyourself:Whatwasarecentdecisionyoumade?Whatdidyougiveupwhenyoumadethatchoice?Whatwastheopportunitycostforyou?


OpportunityCostsandProductionPossibilitiesFrontier

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ProductionPossibilitiesFrontierProductionpossibilitiesfrontier(PPF)representstheopportunitycostsaneconomyfacesintheproductionoftwogoods.

Alleconomieshavescarceresources-- needtodecidehowtoallocatethoseresourcestoproducegoods.

Ifyouproducemoreofonegood– needtoproducelessoftheother(withnochangeinavailableresources)

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PPFExerciseConsideraneconomythatproducestwogoods:Leatherjacketsandleatherboots.

• DrawthePPFcurveforthiseconomy• Aswemovefromonepointtothenext– calculatethechangeinthenumberofbootsproducedandthenumberofjacketsproduced.

• Whatdoesthistellyouabouthowopportunitycostschange?

A B C D E

Boots 0 20 40 60 80

Jackets 100 90 70 40 0

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PPFExerciseA B C D E

Boots 0 20 40 60 80Jackets 100 90 70 40 0ΔBoots +20 +20 +20 +20ΔJackets - 10 - 20 - 30 - 40

AswemovealongthePPFcurve:OpportunityCostchanges

• O.C.RISES asgiveupmoreofthegoodthatisSCARCE

• O.C.isLOWERwhenthegoodisinrelativeABUNDANCE

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PPFExercise

Supposenowthatthereisashortageinrubber.- Whathappensinthebootindustry?- Whathappensinthejacketindustry?

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PPFExerciseWithashortageinrubber,thisaffectstheproductionofbootsrelativelymorethantheproductionofjackets

BiasshiftofPPF

Ifthereisachangeinresources– needtoconsidertheimpactthishasonbothindustries– equalorbias?

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KeyTakeaway

• Alleconomicagentsfacetradeoffswhenmakingdecisions

• Whatevertheychoosecomeswithanopportunitycost– whattheycouldotherwisedowiththeirtime,money,resources

• ApplythisconcepttounderstandhowaneconomymakeschoicesbetweentheproductionofgoodsinthePPF

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Comparativeadvantage,specialization,andtrade

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Howcanwesatisfyourneeds/wants?

1.EconomicSelf-sufficiency:Produceallofthegoodsweneed/wanttoconsumeourselves

2.SpecializationandTrade: ProduceonegoodthatwehaveaComparativeAdvantageinandtradewithothersforwhatweneed

GAINSFROMTRADE:WecanCONSUMEMOREwhileworkingthesameamount.

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TradeExerciseTimetoProduceOneUnit Amount ProducedinOneDay

(8hrsofwork)

Bread Sweaters Bread Sweaters

Seamstress 60minutes =1loaf

120minutes =1sweater

Baker 20minutes=1loaf

60minutes=1sweater

Howmuchbreadandsweaterscaneachagentproduceinonedayofwork?

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TradeExercise

• Whoisbetteratproducingbread?• Whoisbetteratproducingsweaters?• Iftheysplittheirtimeevenlybetweenproducingbothgoods,howmuchcantheyconsume(notrade)?

TimetoProduceOneUnit Amount ProducedinOneDay(8hrsofwork)

Bread Sweaters Bread Sweaters

Seamstress 60minutes –1loaf

120minutes –1sweater

(60/60)*8hrs =8loaves

(60/120)* 8hrs=4sweaters

Baker 20minutes–1loaf

60minutes– 1sweater

(60/30)*8hrs=24loaves

(60/60)*8hrs=8sweaters

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EconomicSelf-Sufficiency

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TradeExerciseBasedonopportunitycost:• Seamstress hasaloweropportunitycostinmakingsweaters• Fortheseamstress,ifsheproducesonemoresweater,shegivesupbaking2loavesofbreadinthattime

• Baker hasaloweropportunitycostinbakingbread

• Forthebakerifheproducesonemoreloafofbread,hegivesupmaking3sweatersinthattime

OpportunityCostdeterminesspecialization

Amount ProducedinOneDay OpportunityCostBread Sweaters Bread Sweaters

Seamstress 8loaves 4sweaters ½ Sweater 2Breads

Baker 24loaves 8sweaters 1/3Sweater 3Breads

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TradeExerciseWhathappens ifthebakerandseamstresswanttotrade?

Supposetheagentsagreethat:• Bakerwillspend5hoursonbread,3hoursonsweaters• Seamstresswillspend8hoursonsweaters

Howmuchdotheyproduce?Howmuchwilltheyconsume?Willtheygainfromthetrade?

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TradeExercise

Whatiftheyagreetotrade2sweatersfor5loavesofbread?

Howmuchwilltheyconsume?

AMOUNTPRODUCEDBread Sweaters

Seamstress 0 (60/120)*8hrs=4sweaters

Baker (60/20)*5hrs =15loaves

(60/60)*3hrs=3sweaters

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TradeExercise

Hastheseamstressgainedfromthistrade?Hasthebakergainedfromthistrade?

AMOUNTCONSUMEDBread Sweaters

Seamstress 0 bread+5bread=5bread

4sweaters– 2sweaters=2sweaters

Baker 15bread- 5bread=10bread

3sweaters+2sweaters=5sweaters

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WithTrade

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ComparativeAdvantageAgentwiththeloweropportunitycostinproducingthegoodwill

haveacomparativeadvantageinitsproduction

OpportunityCostsBread Sweaters

Seamstress 1 morebread=½sweater 1moresweater =2breadCOMPARATIVEADVANTAGE

Baker 1morebread=1/3sweaterCOMPARATIVEADVANTAGE

1moresweater =3bread

• Nosingleagentcanhaveacomparativeadvantageinbothgoods.• Aslongastheopportunitycostsbetweentwoagentsdiffer– both

cangainfromtrade.

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KeyTakeaway• Tradeandspecializationmakeeveryonebetteroffbecause– consumemorewithoutworkingmore

• Tradecanbebeneficialevenwhenoneeconomicagentismuchbetteratproducingbothgoods

• Todeterminewhichgoodsaneconomicagentwillproduce– needtounderstandcomparativeadvantage(or)opportunitycostinproducingeachgood

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PrinciplesofMicroeconomicsModule1.4(A)

EconomicSystems

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EconomicSystems

• Economicsystemsaresystemsof• Production• ResourceAllocation• Exchange• Distributionofgoodsandservices

1. Whattoproduce?2. Howmuchtoproduce?3. Whoreceivestheoutput?

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PropertyRightsandEconomicSystems

• Propertyrightsareanimportantcomponentofeconomicsystems• Becauseaneconomyistryingtoanswerthepreviousthreequestions-à whoownswhatinfluencesthetypeofsystemwehave

• PropertyRights– determinewhoownsaresourceandwhodecideshowitisused.

• Individuals• Associations• Government

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• PropertyRights– determinewhoownsaresourceandwhodecideshowitisused.


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• PropertyRights determinewhoownsaresourceandwhodecideshowitisused.


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FourComponentsofPropertyRights

1. Therighttousethegood2. Therighttoearnincomefromthegood3. Therighttotransferthegoodtoothers4. Therighttoenforcepropertyrights

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EconomicSystems

Allocation

OWNERSHIP

Planned Private

Planned SocialistPlannedEconomy

CommandCapitalism

Private MarketSocialism Capitalism

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Market-basedEconomy

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PrinciplesofMicroeconomicsModule1.4(B)

MarginalAnalysis

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• Inthisvideowewilldiscussmarginalanalysisandhowchangesinincentiveswillchangedecisionsoffirmsandconsumers

MarginalAnalysis• Marginalanalysis:examinationoftheassociatedcostsandpotentialbenefits ofspecificbusinessactivitiesorfinancialdecisions.

• Goal:todetermineifthecostsassociatedwiththechangeinactivitywillresultinabenefitthatissufficientenoughtooffsetthem.

• Insteadoffocusingonbusinessoutputasawhole,theimpactonthecostofproducinganindividualunitismostoftenobservedasapointofcomparison.

MarginalAnalysis• Marginalanalysis:examinationoftheassociatedcostsandpotentialbenefitsofspecificbusinessactivitiesorfinancialdecisions.

• Goal:todetermineifthecosts associatedwiththechangeinactivitywillresultinabenefitthatissufficientenoughtooffsetthem.

• Insteadoffocusingonbusinessoutputasawhole,theimpactonthecostofproducinganindividualunitismostoftenobservedasapointofcomparison.

MarginalAnalysis• Marginalanalysis:examinationoftheassociatedcostsandpotentialbenefitsofspecificbusinessactivitiesorfinancialdecisions.

• Goal:todetermineifthecostsassociatedwiththechangeinactivitywillresultinabenefitthatissufficientenoughtooffsetthem.

• Insteadoffocusingonbusinessoutputasawhole,theimpactonthecostofproducinganindividualunitismostoftenobservedasthebestpointofcomparison.

ExampleofMarginalAnalysis• Amanufacturerwishestoexpanditsproduction• A marginalanalysisofthecostsandbenefitsisnecessary.

COSTS BENEFITS

Additionalmanufacturingequipment Estimatedincreaseinsalesattributedtotheadditionalproduction

Additional employeesforincreasedoutput

Larger orNewFacilities

Additionalmaterialsforproduction

ExampleofMarginalAnalysis• Iftheincreaseinincome>theincreaseincost,theexpansionmaybeawiseinvestment

COSTS BENEFITS

Additionalmanufacturingequipment Estimatedincreaseinsalesattributedtotheadditionalproduction

Additional employeesforincreasedoutput

Larger orNewFacilities

Additionalmaterialsforproduction

Incentives

• Peoplefacetrade-offsintheeverydecisionsthattheymake• Weighthecosts/benefitsassociatedwiththeirchoices• Choosewhatfitstheirneeds/wantsbest

• Incentiveschangecosts/benefitsofadecision• Becausetheyalterthecostsorbenefitsofdoingsomething– theymaychangethechoiceapersonmakes

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ExamplesofIncentivesandDisincentives

INCENTIVES DISINCENTIVES

Retailstoresales:Buy-one get-onesales

Taxesoncigarettes,alcohol ect.

Attendance policiesinclass Calorie reportsatfast-food restaurants

Taxsubsidy fornewgreentechnology Pollution tax

KeyTakeaways

• Marginalanalysisisusedfrequentlybyfirmstoweighthebenefitsanddrawbacksofbusinessdecisions

• Peopledothistoo!Theyweighthecostsandbenefitsofvariousdecisionsandmakeachoice

• Incentives/disincentiveschangethecostsorbenefitsofachoice,thereforemayalterthedecisionsomeonemakes


SupplyandDemandintheMarketforGoodsandServices

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Whatarecompetitivemarkets?CompetitiveMarkets:

• Bringtogetherthedecentralizeddecisionsofbuyersandsellers• DecentralizedDecisionsofBuyers:

• Drivethemtotrytogetthelowestpossiblepriceforthegoodstheywant

• DecentralizedDecisionsofSellers:• Drivethemtotrytogetthehighestpossiblepriceforthegoodstheyareselling

Whenthesedecisionscometogether– competitivemarketsyield:

• Bestpossiblepricefortheproduct• Producedatthelowestpossiblecost• Mostefficientallocationofresources

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Whatarecompetitivemarkets?FundamentalAssumptionsofSupply+DemandModel:

1.OperatingunderPerfectCompetition• Lotsofbuyersandsellers• Goodssoldareidentical• Nocosttoenteringorleavingthemarket

2.Equalaccesstoinformation3.Externalitiesdonotexist

Nosingleeconomicagentcanunilaterallyexertanypricecontrol

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WhatisDemand?• Demandcomesfromthebuyerofagood/service• Eachbuyeristryingtogetthelowestpricepossibleforthegood/servicethattheywant

• LawofDemand:Aspriceofagooddeclines,peoplewanttobuymoreofit

Qdemanded

Price

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FactorsthatShiftDemand

• ChangeinIncome• NormalGoods• InferiorGoods

• ChangeinTastesandPreferences• ChangeinPriceofRelatedGoods• ChangeinNumberofBuyers• ChangeinFutureExpectations

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WhatisSupply?• Supplycomesfromthesellerofagood/service• Eachselleristryingtogetthehighestpricepossibleforthegood/servicethattheyproduce

• LawofSupply:Aspriceofagoodincreases,peoplewanttosellmoreofit

Qdemanded

Price

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FactorsthatShiftSupply

• ChangeinPriceofInputs• ChangeinProductionTechnology• ChangeinNumberofSellers• ChangeinFutureExpectations

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KeyTakeaway• Demandisdeterminedbythebuyersofagood.Buyeralwayswanttogetthelowestpricetheycan!Hence,demandisdownwardsloping

• Supplyisdeterminedbythesellersofthegood.Sellersalwayswanttogetthehighestpricetheycan!Hence,supplyisupwardsloping

• Certainfactorsaffecteachofthecurvesandcausethemtoshift.Theshiftscomefromanunderlyingchangetothe“willingnesstobuy”or“willingnesstosell”.

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SupplyandDemandintheMarketforGoodsandServices

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MarketEquilibrium

Supply

Demand

Quantity

Price

P*

Q*

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MarketEquilibrium

Supply

Demand

Quantity

Price

P*

Qd Qs

P

SURPLUS

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MarketEquilibrium

Supply

Demand

Quantity

Price

P*

Qd Qs

P

SHORTAGE

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TestyourUnderstandingConsiderthemarketfororanges.Drawoutthesupplyanddemandcurvesbasedonthefollowingsupplyanddemandschedule:

1. Drawoutthesupplyanddemandcurvesbasedonthisinformation.Whereistheequilibrium priceandquantity?

2. Suppose thereisanexceptionallycoldwinterinFloridawithfrostsruiningmanygroves.Whathappenstothismarket?Illustrate.

3. Whathappens ifthepriceofapplesfalls?Illustrate.

Price QD QS

$5 10 50

$4 20 40

$3 30 30

$2 40 20

$1 50 10

$0 60 0

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• EquilibriumP=$3• EquilibriumQ=30

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• Whenthereisafrost– increasesthecostofproduction(weather– inputinproduction)

• SUPPLYCURVESHIFTS(INorLEFT)• At$3:S1<D– shortageinthemarketfororanges

• PricesmustadjusttoP2– movementalongdemandcurve

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• Ifthereisadecreaseinthepriceofapples–changeinthepriceofarelatedgood

• DEMANDCURVESHIFTS• Thisisasubstitutegood– soifthepriceofapplesfalls– morepeoplebuyapplesanddemandlessoranges

• SHIFTSINorLEFT• Equilibriumpricefalls• Equilibriumquantityfalls• Nochangeinwillingnessofsellers– movementalongthesupplycurve!

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Ifhappenssimultaneouslywithfrost(shiftsinbothcurves)• Definitefallinequilibriumquantity• Ambiguousimpactonequilibriumprice

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KeyTakeaway

• MarketEquilibriumbringstogetherthedecentralizeddecisionsofbuyersandsellers

• Becauseeachagentislookingoutfortheirownbestinterest– wegettheoptimalresultsinthemodel

• ShiftsintheSorDcurvemustcomefromachangeinoneofthefactorsthatchangeeither“willingnesstosell”or“willingnesstobuy”

• S-DGraphiscriticalinhelpingusfindequilibriumandanalyze/understandchangesinthemarket.

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PrinciplesofMicroeconomicsModule2.1(C)

PriceControls

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• Inthisvideo,wewilldiscusswhathappenswhenthegovernmentimposesapricecontrolinamarket.Wewillseehowthisdistortstheequilibriumoutcomesinthesupplyanddemandmodel

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PriceControlsIneconomics,weargue:• Bestpossibleoutcomesoccurwithnogov’tinterference• Yieldsmostefficientallocationofresources• Whenpoliciestocontrolthepriceinterfereinthemarket,theycreatedistortions

Thesedistortions cause:• Shortages• Surpluses

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WhatarePriceControls?

Pricecontrols• Settingapricemaximum(priceceiling)orpriceminimum(pricefloor)inagivenmarket

• Non-bindingpricecontrol:theequilibriumisnotdistortedandthemarketoutcomesareefficient

• Bindingpricecontrol:theequilibriumcannotbereachedandthemarketoutcomesareinefficient(shortageorsurplus)

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TestyourUnderstandingConsidertwolabormarkerswherealawyer’swagerateisapproximately$100/hr andahousecleaner’swagerateisapproximately$8/hr.• Thegovernmentdecidestoimposeaminimumwagelawof$12/hr.

1. Whatimpactdoesthishaveonthemarketforlawyers?Drawoutthesupplyanddemandmodel.

2. Whatimpactdoesthishaveonthemarketforhousecleaners?Drawoutthesupplyanddemandmodel.

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MinimumWageLaws

Q

PP

Q

MarketforLawyers MarketforHousecleaners

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$100

$8

S

D

S

D

MarketEquilibrium

MarketEquilibrium

MinimumWageLaws

Q

PP

Q


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$100

$8

S

D

S

D

PriceFloorMin.Wage

PriceFloorMin.Wage

$12 $12

MinimumWageLaws

Q

PP

Q


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$100

$8

S

D

S

D

PriceFloorMin.Wage

PriceFloorMin.Wage

$12 $12

Qd =Qs Qd Qs

MinimumWageLaws

Q

PP

Q


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$100

$8

S

D

S

D

PriceFloorMin.Wage

PriceFloorMin.Wage

$12 $12

Qd =Qs Qd Qs

Qd =Qs:Noeffectofthemarketforlawyers

MinimumWageLaws

Q

PP

Q


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$100

$8

S

D

S

D

PriceFloorMin.Wage

PriceFloorMin.Wage

$12 $12

Qd =Qs Qd Qs

Qd <Qs:At$12:SurplusofHousecleaners

KeyTakeaways• Governmentpoliciescancausedistortionsinthemarketforgoodsandservicesbypreventingsupplyanddemandtoreachequilibrium

• Thesedistortionscreate• Shortages• Surpluses• Mismatchbetweenpricesforbuyersandsellers

• Policiesareputinplacemanytimesduetothesocialbenefitsoutweighingtheeconomiccosts

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PriceElasticityofDemandandSupply

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• Inthisvideo,wewillintroducetheconceptofelasticity– whichallowsustocalculatethesizeofchangesweobserveinthesupplyanddemandmodel

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WaysthatDemandandSupplyChange

Changesindemandandsupplycomefrom:• Movementalongthecurve– somefactorchangesthatdoesnotdirectly

affectthewillingnessofbuyertopayorsellertosell

• Shiftinthecurve– somefactorchangesthatdirectlyaffects thewillingnessofbuyertopayorsellertosell

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WaysthatDemandandSupplyChange

Changesindemandandsupplycomefrom:• Movementalongthecurve– somefactorchangesthatdoesnotdirectly

affectthewillingnessofbuyertopayorsellertosell

• Shiftinthecurve– somefactorchangesthatdirectlyaffects thewillingnessofbuyertopayorsellertosell

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PriceElasticityPriceElasticityofDemand:• ByhowmuchdoesQd changewhenthereisapricechange?

• MovementalongthedemandcurvefromAtoB• Responsiveness ofquantitydemandedtopricechange

PriceElasticityofSupply:• ByhowmuchdoesQschangewhenthereisapricechange?

• MovementalongthesupplycurvefromAtoB• Responsiveness ofquantitysuppliedtopricechange

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PriceElasticity

PriceElasticityofDemand:• ByhowmuchdoesQd changewhenthereisapricechange?

• MovementalongthedemandcurvefromAtoB• Responsiveness ofquantitydemandedtopricechange

PriceElasticityofSupply:• ByhowmuchdoesQschangewhenthereisapricechange?

• MovementalongthesupplycurvefromAtoB• Responsiveness ofquantitysuppliedtopricechange

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MidpointMethodforPriceElasticityChangeinQuantity=!"#!$%&'%(

)

ChangeinPrice=+"#+$,&',()

PriceElasticity=𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑷𝒓𝒊𝒄𝒆

𝑄𝑏 − 𝑄𝑎𝑄𝑏 + 𝑄𝑎

2/𝑃𝑏 − 𝑃𝑎𝑃𝑏 + 𝑃𝑎

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ElasticityofCurves

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Anychangeinpriceyieldsalargechangeinquantitydemanded:

- Luxurygoods:designer jeansà notanecessity- Gourmet foods:$15lbcheeseà manysubstitutes- Kitkat barsà manysubstitutes

ElasticityofCurves

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Changeinpriceyieldsasmallchangeinquantitydemanded:

- Medicine- Food- Peakrailroadtickets

ElasticityofCurves

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Changeinpriceyieldsalargechangeinquantitysupplied:

• Firmoperatingbelowcapacity• Anyincreaseinprice– willdefinitely

producemore

ElasticityofCurves

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Changeinpriceyieldsasmallchangeinquantitysupplied:

• Agriculture intheshortterm– can’timmediatelyproducemore

• Nuclearpower



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PriceElasticityofDemand

Supposeagrocerystoreownerisdecidingtoincreasethepriceofsmokedsalmonby10%from$11.00to$12.10.Thequantityofsmokesalmonhecansellfallsfrom40unitsto25units.

• Whatisthepriceelasticityofdemandforsmokedsalmon?Isitelasticorinelastic?

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PriceElasticityofDemand

• Ifheincreasesinthepriceofsmokedsalmonby10%from$11.00to$12.10,thequantityofsmokesalmonhecansellfallsfrom40unitsto25units.

ChangeinQ = LM#NO)P'QR)

= −0.462

ChangeinP = XL.XO#XXY).YR'YY

)= 0.095

Ped = − O.N]LO.O^M = | − 4.86| > 1 ELASTIC

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PriceElasticityofSupplyNowsupposethatthisgrocerobservesthathisneighborhoodischanging,andmanynewpeoplearemovingin.Thenumberofbuyersisincreasing.

• Asaresult,thepriceofhisgoods,onaverageincreasesfrom$5to$7andthequantityofgrocerygoodssuppliedincreasesfrom1000to1250.

• Whatisthepriceelasticityofsupply?

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PriceElasticityofSupplyNowsupposethatthisgrocerobservesthathisneighborhoodischanging,andmanynewpeoplearemovingin.Thenumberofbuyersisincreasing.

• Asaresult,thepriceofhisgoods,onaverageincreasesfrom$5to$7andthequantityofgrocerygoodssuppliedincreasesfrom1000to1250.

ChangeinQ =1250 − 10001250 + 100

2= 0.22

ChangeinP = c#Md'P)

= 0.33

Pes = O.LLO.gg = 0.667 < 1 INELASTIC

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PrinciplesofMicroeconomicsModule2.2(C)


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IncomeElasticityofDemandByhowmuchdoesQd changewhenthereisachangeinincome?

ChangeinQuantity=jL#jXk)'kY)

ChangeinIncome=lmnopqL#lmnopqXrstuvw)'rstuvwY)

IncomeElasticity=𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑰𝒏𝒄𝒐𝒎𝒆

𝑄2 − 𝑄1𝑄2+ 𝑄1

2/𝐼𝑛𝑐𝑜𝑚𝑒2 − 𝐼𝑛𝑐𝑜𝑚𝑒1𝐼𝑛𝑐𝑜𝑚𝑒2 + 𝐼𝑛𝑐𝑜𝑚𝑒1

293

IncomeElasticityMagicHatandsupposetheaverageincomeofa23year-oldis$45,000.The23year-oldconsumesonaverage5MagicHatsamonth.

• Whenhisincomerisesto$50,000,heconsumes9MagicHatspermonth.

• Whatishisincomeelasticityofdemand?• Isthisanormalgoodoraninferiorgood?

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IncomeElasticityMagicHatandsupposetheaverageincomeofa23year-oldis$45,000.The23year-oldconsumesonaverage5MagicHatsamonth.

• Whenhisincomerisesto$50,000,heconsumes9MagicHatspermonth.

MagicHat:

ChangeinQ =9 − 59 + 52

= 0.571

ChangeinIncome= MO�#NM�PR�'QP�

)= 0.105

Ied =0.5710.105 = 5.43

MagicHatsareanormalgood95

CrossPriceElasticityofDemandByhowmuchdoesQd changewhenthereisachangeinthepriceofarelatedgood?

ChangeinQuantity(GOODA)=jL�#jX�k)�'k)�)

ChangeinPrice(GOODB)=�L�#�X��)�'�Y�)

CrossPriceElasticity=𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚𝒐𝒇𝑮𝒐𝒐𝒅𝑨𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑷𝒓𝒊𝒄𝒆𝒐𝒇𝑮𝒐𝒐𝒅𝑩

𝑄2𝐴 − 𝑄1𝐴𝑄2𝐴 + 𝑄2𝐴

2/𝑃2𝐵 − 𝑃1𝐵𝑃2𝐵 + 𝑃1B

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CrossPriceElasticityConsider,onceagain,themarketforbeer.

• Whenthepriceofpretzelsmovesfrom$4to$3,theconsumptionofbeerincreasesfrom100unitsto120units.

1. Whatisthecrosspriceelasticityofdemandforbeerwhenthepriceofpretzelsrises?

2. Howarethesemarketsrelated?

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CrossPriceElasticityConsider,onceagain,themarketforbeer.

• Whenthepriceofpretzelsmovesfrom$4to$3,theconsumptionofbeerincreasesfrom100unitsto120units.

BeerandPretzels:

ChangeinQ =120 − 100120 + 100

2= 0.182

ChangeinPriceofpretzels = g#NQ'�)= −0.287

XPed = O.X¡L#O.L¡c = −0.636

Pretzelsareacomplimentarygood tobeer

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KeyTakeaways• Understandingelasticityallowsustoquantify thechangesindemandandsupply.

• Providesanadditionalanalysistounderstandhowresponsiveness demandandsupplyaretopricechanges,incomechangesandchangesinpricesofrelatedgoods.

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ConsumerSurplusandProducerSurplus

100

WelfareEconomics• Howtheallocationofresourcesandmarketoutcomesaffecteconomicwell-being

• Reachingequilibrium:maximizeswelfare(inmostcases)

• WelfareEconomics:ConsumerSurplus,ProducerSurplusandTotalSurplus

101

ConsumerSurplus

Willingnesstopay– priceactuallypaid

• Everybuyerhasamaximumpricetheyarewillingtopayforeverygood

• Atlowerprices,hisconsumersurplusislarger– heis“betteroff”becausenotpayinghisfullmaximumprice

102

ConsumerSurplus

Willingnesstopay– priceactuallypaid

• Everybuyerhasamaximumpricetheyarewillingtopayforeverygood

• Atlowerprices,hisconsumersurplusislarger– heis“betteroff”becausenotpayinghisfullmaximumprice

103

ConsumerSurplus

• Ifthepriceofwaterisactually$2.50perbottle,wouldyoubuythewater?

• Ifyourmaxpriceis$5thenyes!Yourconsumersurplus is$2.50

• Ifyourmaxpriceis$2thenno

• Whathappensifthepricefallsto$70perday?

• Ifyourmaxpriceis$100:Yourconsumersurplusrisesto$30

• Ifyous maxpriceis$85– nowyoubuytheticketsandhavepositiveconsumersurplusof$15

Considerwhatyouwouldpayforabottleofwateratasummerconcert

104

$2.50CS

P

Q

ConsumerSurplus

• Ifthepriceofwaterisactually$2.50perbottle,wouldyoubuythewater?

• Ifyourmaxpriceis$5thenyes!Yourconsumersurplus is$2.50

• Ifyourmaxpriceis$2thenno

• Whathappensifthepricefallsto$1.50perday?

• Ifyourmaxpriceis$5:Yourconsumersurplusrisesto$3.50

• Ifyourmaxpriceis$2– nowyoubuythewaterandhavepositiveconsumersurplusof$1

Considerwhatyouwouldpayforabottleofwateratasummerconcert

105

NEWCS$1.50

$2.50CS

P

Q

ProducerSurplusPriceactuallyreceived– willingnesstosell

• Everysellerfacesaminimumvaluetheyarewillingtoaccepttoselltheirgoods

• Thisreflectsthecostofproduction

• Athigherprices,hisproducersurplusislarger– heis“betteroff”fromsellinghisgoodsabovecost

106

ProducerSurplusPriceactuallyreceived– willingnesstosell

• Everysellerfacesaminimumvaluetheyarewillingtoaccepttoselltheirgoods

• Thisreflectsthecostofproduction

• Athigherprices,hisproducersurplusislarger– heis“betteroff”fromsellinghisgoodsabovecost

107

ProducerSurplusConsiderindependentfoodandbeveragevendorsatthesummermusicfestival,eachwiththefollowingwillingnesstosellabottleofwater:

Willingness tosell

VendorA $3.00

VendorB $2.75

VendorC $2.00

108

ProducerSurplus• Ifthepriceofabottleofwateris$2.25,howmanyvendorswillsellwater?

• OnlyvendorC• P.S.willbe$0.25

• Whathappensifthepricerisesto$3.50perbottle?

• Allvendorswillsellwater• PSVendorA:$0.50• PSVendorB:$0.75• PSVendorC:$1.50

109

$2.25

P

Q

PS

ProducerSurplus• Ifthepriceofabottleofwateris$2.25,howmanyvendorswillsellwater?

• OnlyvendorC• P.S.willbe$0.25

• Whathappensifthepricerisesto$3.50perbottle?

• Allvendorswillsellwater• PSVendorA:$0.50• PSVendorB:$0.75• PSVendorC:$1.50

110

$2.25

P

Q

PS

$3.50

NewPS

TotalEconomicSurplus• Combinesconsumersurplusandproducersurplus

TotalSurplus=ValuetoBuyers– CosttoSellers

111

TotalSurplusandFreeMarketOutcomes

• GOODSWILLBEALLOCATEDTO:• Buyerswhovaluethemmosthighly,asmeasuredbytheirwillingnesstopay.

• Sellers whocanproducethematthelowestcost.

Thefreemarketyieldsanequilibriumquantityandpricethatmaximizesbothconsumerandproducersurplus

112

$2.75

P

Q

PS

CS

TotalSurplusandFreeMarketOutcomes

• GOODSWILLBEALLOCATEDTO:• Buyerswhovaluethemmosthighly,asmeasuredbytheirwillingnesstopay.

• Sellers whocanproducethematthelowestcost.

Thefreemarketyieldsanequilibriumquantityandpricethatmaximizesbothconsumerandproducersurplus

113

$2.75

P

Q

PS

CS

KeyTakeaways

• WelfareEconomicsistheanalysisoftheeconomicwell-beingofproducersandconsumers

• Assumethatmarketoutcomesleadtomaximizedtotalsurplus

114


Taxation

115

TaxesintheSupplyandDemandModel

Taxescause:Pricepaidbybuyer>PricereceivedbysellerInsert“wedge”intheSupplyandDemandmodel

Taxwedgecreatesdeadweightloss:Lossoftotalsurplusoreconomicwell-beingasaresultofthepolicy

116

SalesTaxes• Taxesinsertawedgebetweenthepricepaidbybuyers(Pb)andpricereceivedbysellers(Ps)

• Regardlessofwhopaysthetax(sellersorbuyers)bothsharethetaxburden

• Tax=Pb – Ps• Taxrevenue=Tax*Qt• Taxburden(buyer)=Pb – Pe• Taxburden(seller)=Pe - Ps

117

P

Q

PB

PS

TAX

Qt Qe




118

P

Q

PB

PS

TAX

Qt Qe




119

P

Q

PB

PS

TAX

REVE

NUE

Qt Qe

UnderstandingTaxesConsiderthemarketforsocks,wheretheequilibriumpriceofsocksis$5perpairandtheequilibriumquantityis300.Thegovernmentimposesa$1taxonthemarkettobepaidbytheseller,causingafallinthequantitysoldto200.

• Whathappenswhenthetaxisimposed?Drawoutthesupplyanddemandmodelshowingthemarketbeforethetaxandafterthetax

120

UnderstandingTaxes

S

QD

P

121

Pe =$5

Qe =300

UnderstandingTaxes

S

QD

P

122

Pe =$5

Qe =300

Pb =$5.50

Pb =$4.50

Qt =200

Tax:Pb – Ps$1

UnderstandingTaxes

S

QD

P

123

Pe =$5

Qe =300

Pb =$5.50

Pb =$4.50

Qt =200

Tax:Pb – Ps$1

TaxRevenue=Tax*Qt$1*200=$200

HowdotaxesaffectMarketParticipants?

Analyzethefollowingbeforetaxvs.aftertaxisimposed:• ConsumerSurplus• ProducerSurplus• TotalSurplus• GovernmentRevenue

Howdoesthetaxchangeeconomicwelfare?124

ConsumerSurplus

S

QD

P

125

Pe

Qe QD

P

Pe

Qe

BEFORETAXES AFTERTAXES

S

ConsumerSurplus

Pb

Ps

Qt

ConsumerSurplus

ProducerSurplus

S

QD

P

126

Pe

Qe QD

P

Pe

Qe


Pb

Ps

Qt

ProducerSurplus

ProducerSurplus

S

GovernmentTaxRevenue

S

QD

P

127

Pe

Qe QD

P

Pe

Qe


Pb

Ps

Qt

ProducerSurplus

Gov’tTax

Revenue

S

DeadweightLoss

S

QD

P

128

Pe

Qe QD

P

Pe

Qe


Pb

Ps

Qt

ProducerSurplus

S

DWL

ElasticityandtheTaxBurden

129

KeyTakeaways• Wecanthinkoftaxationinthecontextofsupplyanddemandmodelintermsof

• Howitaffectspricesandquantities• Howitaffectseconomicwell-beingviawelfareeconomics

• Sincetaxescausedistortionsinthemarket(taxwedge)theyyieldinefficientmarketoutcomes

• Whydowehavethem?Derivesomebenefitsfromgovernmentrevenue.

130

PrinciplesofMicroeconomicsModule3

TheoryofConsumerChoiceandDerivingthedemandcurve

131

UnderstandingConsumerChoice

Tounderstandhowconsumersmakedecisionsweneedtwofactors:1. BudgetConstraint- whataconsumercan buy2. IndifferenceCurves- whataconsumerwants tobuy

Combinationofincomeandpreferencesdeterminesconsumerchoices

132

BudgetConstraintAconsumer’sbudgetconstraint determineswhattheycanaffordtobuy

Allconsumershaveincome• Useincometopurchasegoodstheyneedandwant• Constrainedintheirchoicesbasedonhowmuchincometheyhave

133

BudgetConstraintExample

SupposeCharliehas$100/monthtospendontwogoods– pizzaandsoda.Thepriceofpizzais$10andthepriceofsodais$2.

• Howmuchpizzawouldhebuyifhespentallhismoneyonpizza?• Howmuchsodawouldhebuyifhespentallhismoneyonsoda?• Ifhewantstoconsumemorepizza,howmuchsodadoeshehavetogiveup?

134

BudgetConstraintExampleCont.

BudgetConstraint:limitstheconsumptionbundlesaconsumercanafford

Toconsumeonemorepizza,heneedstogiveup5sodas.

Slopeofthebudgetconstraint:rateatwhichaconsumercantradeonegoodforanother

YieldsrelativepriceofgoodXintermsofgoodY

Slope:ΔY/ΔX=-50/10=5Px =$10Py =$2Slope=Px/Py =10/2=5

135







136







137







138

ChangesintheBudgetConstraint

• Ifaconsumer’sincomechanges:canaffordmoreorless

• Ifthepriceofonegoodchanges:trade-offsbetweenthetwogoodschange– differentslope

• ConsumercanconsumeonlyONB.C.notpastit

139

ChangeinaConsumer’sIncome

WhatifCharlie’sincomefallsto$500/month?• Mustconsumelessofbothgoods• BudgetConstraintshiftsin• Nochangeinrelativeprices=nochangeinslopeofB.C.

140

ChangeinthePriceofaGoodWhatifthepriceofpizzarisesto$12.50?• Canconsumeonly8pies/monthatmax• Stillcanconsume50sodas/monthatmax• Relativepriceofpizzatosodahaschanged=changeinslope!

• Newslope=12.50/2=6.25

Nowpizzaismoreexpensiveintermsofsoda– giveupmoresodaforsameamountofpizza– biggertrade-off!

141

ConsumerPreferences• Incomeisnottheonlyfactorthatinfluencesconsumerchoice

• Eachconsumerhasdifferentpreferencesinwhattheywant toconsume

• CaptureconsumerpreferencesbyIndifferenceCurves

Consumerswillbeindifferentbetweentwobundlesgoodsifthebundlesequallysatisfyhisneeds/wants

142

ConsumerPreferences• Incomeisnottheonlyfactorthatinfluencesconsumerchoice

• Eachconsumerhasdifferentpreferencesinwhattheywant toconsume

• CaptureconsumerpreferencesbyIndifferenceCurves

Consumerswillbeindifferentbetweentwobundlesgoodsifthebundlesequallysatisfyhisneeds/wants

143

IndifferenceCurvesAconsumerisindifferent– orequallysatisfied – betweenconsumptionbundlesalongthesameindifferencecurve

• Alwaysprefer:D>B>A• IndifferentbetweenBandC• Alwayspreferanypointonahigherindifferencecurve

144

FourPropertiesofIndifferenceCurves

1. Higherindifferencecurvespreferredtolowerones2. Indifferencecurvesaredownwardsloping3. Indifferencecurvesnevercross4. Indifferencecurvesarebowedinward

145

MarginalRateofSubstitution• Rateatwhichconsumeriswilling totradeonegoodforanother

• MRS=slopeateachpointonindifferencecurve• Notconstant!• Dependsonhowmuchofeachgoodalreadyconsuming• Moreabundantgood– morewillingtotrade• Lessabundantgood– lesswillingtotrade

146



147



148



149

Consumer’sOptimalChoice

Optimalpointofconsumption– wheretheabilitytobuymeetsthe

willingnesstobuy

WherebudgetconstraintmeetsHIGHESTindifference

curve

150

Consumer’sOptimalChoice• ICtangenttoBC• MRS=RelativePriceof2goods

• RelativePrice=rateatwhichthemarketiswillingtotradeonegoodforanother• MRS =rateatwhichtheconsumeriswilling totradeonegoodfortheother

𝑀𝑅𝑆 =�¥�¦

𝑀𝑅𝑆 = §¨¥§¨¦

�¥�¦ =

§¨¥§¨¦

§¨¦�¦ = §¨¥

�¥

Marginal Rate of Substitution is equal tothe relative price at the optimum

Marginal Rate of Substitution reflects therelative level of satisfaction in consumptionof Good X and Good Y

At the optimum:Marginal Utility per dollar spent on Good X isequal to the marginal utility per dollar spent onGood Y

Rate of satisfaction we get from each dollar wespend on Good X is equal to the satisfactionfrom each dollar spent on Good Y

151

IncomeandSubstitutionEffects• IncomeEffect:Thechangeinconsumptionthatresultswhenapricechangemovestheconsumertoahigherorlowerindifferencecurve

• WhenthepriceofGoodXfalls,incomedoesnotchangebutwe“feelwealthier”becauseeachdollarinourpocketcanbuymoreofGoodXandmoreofGoodY

• WithapricefallinGoodXàmovetoanewconsumption bundleonahigherindifferencecurve

• SubstitutionEffect:ThechangeinconsumptionthatresultswhenapricechangemovestheconsumeralongthesameindifferencecurvetoapointwithanewMRS

• WhenthepriceofGoodXfalls,GoodXisnowcheaperintermsofGoodY.TherelativepriceofGoodXhaschanged.

• Inotherwords– GoodYhasbecomemoreexpensiveintermsofgoodGoodX• ConsumemoreofGoodXandlessofGoodY

152

IncomeandSubstitutionEffects• IncomeEffect:Thechangeinconsumptionthatresultswhenapricechangemovestheconsumertoahigherorlowerindifferencecurve

• WhenthepriceofGoodXfalls,incomedoesnotchangebutwe“feelwealthier”becauseeachdollarinourpocketcanbuymoreofGoodXandmoreofGoodY

• WithapricefallinGoodXàmovetoanewconsumption bundleonahigherindifferencecurve

• SubstitutionEffect:ThechangeinconsumptionthatresultswhenapricechangemovestheconsumeralongthesameindifferencecurvetoapointwithanewMRS

• WhenthepriceofGoodXfalls,GoodXisnowcheaperintermsofGoodY.TherelativepriceofGoodXhaschanged.

• Inotherwords– GoodYhasbecomemoreexpensiveintermsofgoodGoodX• ConsumemoreofGoodXandlessofGoodY

153

IncomeandSubstitutionEffect

AGoodY

GoodX

IC.1

BC.1

AssumethatthePriceofGoodXfalls

154


AGoodY

GoodX

IC.1

BC.1

Budgetconstraintshiftsoutonabias

BC.2

155


AGoodY

GoodX

IC.1

BC.1

WiththesubstitutioneffectàGoodYisnowmoreexpensiveintermsofGoodX

MovetoanewpointofconsumptionontheexistingIC.1

BC.2

A

A’

156

AGoodY

GoodX

IC.1

BC.1 BC.2

A

A’’

A

WiththeincomeeffectàWecanbuymoreofboth!

MovetoanewpointofconsumptiononthenewIC


IC.2

157

AGoodY

GoodX

IC.1

BC.1 BC.2

A

A’

A

Inreality:BothIncomeandSubstitutionEffectoccursimultaneously!

ConsumermovesfromPointAtoPointB

Whichdominates?


IC.2

A’’

B

158

AOranges

Apples

BC.1

DeterminingDemand

IC.1IC.2IC.3

BC.2 BC.3

AsthePriceofGoodXfalls– Consumerwillhavenewoptimalpointsofconsumptionandnewquantitiesofapplesheconsumes

PriceofApples

QuantityofApples

A $1.99 5

B $1.49 8

C $0.99 10

A BC

5810159

AOranges

Apples

BC.1

DeterminingDemand

IC.1IC.2IC.3

BC.2 BC.3

A BC

5810QuantityofApples

PriceofApples

$1.99

$1.49

$0.99

DemandforApplesConsumerChoiceBetweenOrangesandApples

160

KeyTakeaways

• Consumer’soptimalchoicedependonbothhowmuchtheycanafford(budgetconstraint)andwhattheprefer(indifferencecurves)

• Changesinaconsumer’sincomeaswellaschangesinthepriceofgoodswillaffecttheoptimalconsumptionchoice

• Howconsumersrespondtothechangeinthepriceofagoodwilldeterminethedemandcurve

161


UnderstandingProductionCosts

162

ProductionChoicesofFirms• Allfirmshaveonegoalinmind:MAXPROFITS

PROFITS=TOTALREVENUE– TOTALCOST

• Twowaystoreachthisgoal:• Maximizetotalrevenue

TotalRevenue=PriceXQuantity• Minimizetotalcosts

TotalCosts=FixedCosts+VariableCosts

163

DeterminingProductionviaProductionFunction

ProductionFunction:Relationshipbetweenquantityofinputsandtotaloutput

Q=f(Land,Labor,Capital)

Example:DeterminetheproductionofgoodAifitsproductionfunctionis:Q=100K1/2 +25L1/2

Assumethefirmusesonemachineandincreasesitsworkersby10.

164

DeterminingProductionviaProductionFunction

ProductionFunction:Relationshipbetweenquantityofinputsandtotaloutput

Q=f(Land,Labor,Capital)

Example:DeterminetheproductionofgoodAifitsproductionfunctionis:Q=100K1/2 +25L1/2

165

ProductionFunctionExample

CAPITAL LABOR Prod.Function OUTPUT

1 5 100*11/2 + 25*51/2 156

1 6 100*11/2 + 25*61/2 161

1 7 100*11/2 + 25*71/2 166

1 8 100*11/2 + 25*81/2 171

1 9 100*11/2 + 25*91/2 175

1 10 100*11/2 + 25*101/2 179

Q=100K1/2 +25L1/2

166

No.ofMachinesConstant



1 5 100*11/2 + 25*51/2 156

1 6 100*11/2 + 25*61/2 161

1 7 100*11/2 + 25*71/2 166

1 8 100*11/2 + 25*81/2 171

1 9 100*11/2 + 25*91/2 175

1 10 100*11/2 + 25*101/2 179

Q=100K1/2 +25L1/2

167

No.ofWorkersIncreasingby1



1 5 100*11/2 + 25*51/2 156

1 6 100*11/2 + 25*61/2 161

1 7 100*11/2 + 25*71/2 166

1 8 100*11/2 + 25*81/2 171

1 9 100*11/2 + 25*91/2 175

1 10 100*11/2 + 25*101/2 179

Q=100K1/2 +25L1/2

168

UseProductionFunctionTocalculatehowmuchweproduce

ProductionCostsRentPriceofCapital=$800à FIXEDCOSTWagesofworkers=$25à VARIABLECOST

CostofCAPITAL Cost ofLABOR TOTAL COST

800 125 925

800 150 950

800 175 975

800 200 1000

800 225 1025

800 250 1050

169

MarginalProductofLaborMarginalProduct– Increaseinoutputresultingfroman

increaseinoneoftheinputsMPL=ChangeinOutput/ChangeinLabor

LABOR OUTPUT MPL

5 156

6 161 5.34

7 166 4.91

8 171 4.57

9 175 4.29

10 179 4.06

170

IncreasingLaborOnlyDiminishingMarginalReturns:Outputisincreasingatadecreasingrate

171

ProductionCosts

LABOR OUTPUT FIXEDCOST VARIABLECOST TOTALCOST AFC AVC ATC MC

5 156 800 125 925

6 161 800 150 950

7 166 800 175 975

8 171 800 200 1000

9 175 800 225 1025

10 179 800 250 1050

172

K*$100 L*$25 Fixed+Variable

Toanalyzetheproductiondecisionsofafirm,recallthatafirmconducts“marginalanalysis”Decisionsarebasedonper-unitcalculations

Therefore,needtocalculatecosts/unit

ProductionCosts

LABOR OUTPUT FIXEDCOST VARIABLECOST TOTALCOST AFC AVC ATC MC

5 156 800 125 925 5.13 0.80 8.34

6 161 800 150 950 4.96 0.93 8.68 4.686

7 166 800 175 975 4.82 1.05 9.03 5.095

8 171 800 200 1000 4.69 1.17 9.37 5.474

9 175 800 225 1025 4.57 1.29 9.71 5.828

10 179 800 250 1050 4.47 1.40 10.05 6.162

173

TC/QVC/QFC/Q

Costsperunitofoutputproduced

AverageFixedCostCurve

174

Q

Cost

AFC

AverageVariableCostCurve

175

Q

Cost

AVC

AverageTotalCostCurve

176

Q

Cost

ATC

MarginalCostCurve

• WhenMC<ATCà ATCisfalling• WhenMC>ATCà ATCisrising• MCcrossesATCatminimum– EFFICIENTSCALE 177

Q

Cost MC

ATC

LongRunvs.ShortRunTotalCost

SRATC1 SRATC2 SRATC3 LRATC1

Output

ATC

EconomiesofScale

ATCisfallingwithincreaseinoutput

DiseconomiesofScale

ATCisrisingwithincreaseinoutput

178

KeyTakeaways• Allfirmsareprofitmaximizingandthereforewanttominimizetheircosts

• Tomaketheirproductiondecisions– needtoconsiderATC,AVC,AFCandMC

• NEXT:Mergecostcurveswithrevenuetounderstandhowdifferenttypesoffirmsmakeproductiondecisions

179


UnderstandingProfit

180






181






182

EconomicCostsEconomicCostsforproducersincludeexplicitandimplicitcosts

- ExplicitCosts:Financialcosts- ImplicitCosts:Opportunitycosts

Example:Carolinecanuse$300,000ofhersavingstostartherfirmwhichisinasavingsaccountpaying5%interest.ORCarolineborrow$200,000fromabankatthesameinterestrateandused$100,000fromhersavings.Whichshouldshedo?

183

EconomicCostsEconomicCostsforproducersincludeexplicitandimplicitcosts

- ExplicitCosts:Financialcosts- ImplicitCosts:Opportunitycosts

Example:Carolinecanuse$300,000ofhersavingstostartherfirmwhichisinasavingsaccountpaying5%interest.(OR)Carolineborrow$200,000fromabankatthesameinterestrateandused$100,000fromhersavings.Whichshouldshedo?

184

ExampleofEconomicCostsChoiceA:Caroline’scosttostartherbusiness:

• ExplicitCost=$300,000• ImplicitCost=($300,000X5%)=$15,000• TotalEconomicCost=$315,000• TotalAccountingCost=$300,000

ChoiceB:Caroline’scosttostartherbusiness:

• ExplicitCost=$200,000+$100,000+($200,000X5%)=$310,000• ImplicitCost=($100,000X5%)=$5,000• TotalEconomicCost=$315,000• TotalAccountingCost=$310,000

185

ExampleofEconomicCostsChoiceA:Caroline’scosttostartherbusiness:

• ExplicitCost=$300,000• ImplicitCost=($300,000X5%)=$15,000• TotalEconomicCost=$315,000• TotalAccountingCost=$300,000

ChoiceB:Caroline’scosttostartherbusiness:

• ExplicitCost=$200,000+$100,000+($200,000X5%)=$310,000• ImplicitCost=($100,000X5%)=$5,000• TotalEconomicCost=$315,000• TotalAccountingCost=$310,000

186

KeyEquations• TotalRevenue(TR)=PricexQuantity• MarginalRevenue=ChangeinTR/ChangeinQ• MarginalCost=ChangeinTC/ChangeinQ

MarginalRevenue– capturesthechangeinafirm’srevenuefromoneadditionalunitproduced

MarginalCost– capturesthechangeinafirm’scostfromoneadditionalunitproduced

187

KeyEquations• TotalRevenue(TR)=PricexQuantity• MarginalRevenue=ChangeinTR/ChangeinQ• MarginalCost=ChangeinTC/ChangeinQ

MarginalRevenue– capturesthechangeinafirm’srevenuefromoneadditionalunitproduced

MarginalCost– capturesthechangeinafirm’scostfromoneadditionalunitproduced

188

ProfitMaximizingPointofProduction• Firmswillmaximizetheirprofitsbyproducingatthepointwhere

MR=MC• IfMR>MC:Increaseprofitsbyproducingmore• IfMR<MC:Increaseprofitsbyproducingless

189

ProfitMaximizingPointofProduction

• WhereMR=MCtellsusthattheadditionalrevenuegeneratedfromthelastunitproducedisequaltotheadditionalcostofproducingit

• ThefirmcannotincreasetheirprofitsbyproducinganymoreoranylessthanatthepointwhereMR=MC,inotherwords– marginalprofit=0

190

ProfitMaximizingPointofProduction

• WhereMR=MCtellsusthattheadditionalrevenuegeneratedfromthelastunitproducedisequaltotheadditionalcostofproducingit

• ThefirmcannotincreasetheirprofitsbyproducinganymoreoranylessthanatthepointwhereMR=MC,inotherwords– marginalprofit=0

191

KeyTakeaways• Allfirmsareprofitmaximizing• PointofmaximizingprofitsiswhereMR=MCforallfirms

• WhereMR=MC,profitisatitshighestandthefirmcannotproduceanymoreorlesstoincreaseprofitfurther

192


PerfectCompetition

193

PerfectlyCompetitiveMarketsKeyCharacteristics:• Manybuyersandsellers• Goodsareidentical• Firmscanfreelyenterandexitthemarket

Nosinglefirmcanexertpricecontrolinthemarket.Allfirmsarepricetakers.

Tomaximizerevenue– canonlychangequantity!194

ProfitMaximizingPointofProduction• Firmswillmaximizetheirprofitsbyproducingatthepointwhere

MR=MC• IfMR>MC:Increaseprofitsbyproducingmore• IfMR<MC:Increaseprofitsbyproducingless

• NOTE:MarginalRevenueisconstantandequaltopriceONLY underperfectcompetition.

195

PerfectCompetitionConsiderFirmAwhichsellspingpongballs.Thefollowingtabledescribestheirrevenuesandcosts:

- HowmanypingpongballsshouldFirmAproducetomaximizeitsprofits?- WhatdoyouobserveaboutMRandMCatthispoint?

Output Price TotalRevenue

TotalCost Profit Marginal

RevenueMarginalCost

0 $3 $0.00 $1.501 $3 $3.00 $2.002 $3 $6.00 $3.003 $3 $9.00 $4.504 $3 $12.00 $6.505 $3 $15.00 $9.506 $3 $18.00 $12.757 $3 $21.00 $16.258 $3 $24.00 $20.009 $3 $27.00 $24.00

196

PerfectCompetition

Output Price TotalRevenue TotalCost Profit MarginalRevenue

MarginalCost

0 $3 $0.00 $1.50 ($1.50)1 $3 $3.00 $2.00 $1.00 3 $ 0.50 2 $3 $6.00 $3.00 $3.00 3 $ 1.00 3 $3 $9.00 $4.50 $4.50 3 $ 1.50 4 $3 $12.00 $6.50 $5.50 3 $ 2.00 5 $3 $15.00 $9.50 $5.50 3 $ 3.00 6 $3 $18.00 $12.75 $5.25 3 $ 3.25 7 $3 $21.00 $16.25 $4.75 3 $ 3.50 8 $3 $24.00 $20.00 $4.00 3 $ 3.75 9 $3 $27.00 $24.00 $3.00 3 $ 4.00

197

PerfectCompetition

Output Price TotalRevenue TotalCost Profit MarginalRevenue MarginalCost

0 $4 $0.00 $1.501 $4 $4.00 $2.002 $4 $8.00 $3.003 $4 $12.00 $4.504 $4 $16.00 $6.505 $4 $20.00 $9.506 $4 $24.00 $12.757 $4 $28.00 $16.258 $4 $32.00 $20.009 $4 $36.00 $24.00

Whatifthepriceincreasesto$4?

198

PerfectCompetition

NewPriceà NewMarginalRevenueNewoptimalpointofproduction

Output Price TotalRevenue TotalCost Profit MarginalRevenue MarginalCost

0 $4 $0.00 $1.50 ($1.50)1 $4 $4.00 $2.00 $2.00 4 $ 0.50 2 $4 $8.00 $3.00 $5.00 4 $ 1.00 3 $4 $12.00 $4.50 $7.50 4 $ 1.50 4 $4 $16.00 $6.50 $9.50 4 $ 2.00 5 $4 $20.00 $9.50 $10.50 4 $ 3.00 6 $4 $24.00 $12.75 $11.25 4 $ 3.25 7 $4 $28.00 $16.25 $11.75 4 $ 3.50 8 $4 $32.00 $20.00 $12.00 4 $ 3.75 9 $4 $36.00 $24.00 $12.00 4 $ 4.00

Whatifthepriceincreasesto$4?

199

GraphingProductionDecisions

• FirmAisapricetaker• Ifobservepricechange–increaseto$4– willrespondbyproducingmore

• NewMRà NewpointwhereMR=MC

Newprofitmaxpointofproduction

200

Firm’sShortRunDecisions• Intheshort– firmmustdecideifitshouldproduce ortemporarilyshutdown

• Temporaryshutdown≠Exitfrommarket• Firmissuspendingproductiontemporarily• Muststillpayfixedcosts• Nolongerpaysvariablecosts,nolongerreceivesrevenue

SHUTDOWNWHEN:TotalRevenue<VariableCost

TR=PXQAVC=VCXQ

Shutdown:P<AVC

201

Firm’sShortRunSupplyCurve

Because,intheshortrun,afirmwillproduceonlyifP ≥AVC,thefirm'sshortrunsupplycurvewillbeitsMCaboveAVC

If: TheFirmWill:P≥AVC ProduceoutputlevelwhereMR=MCP<AVC Shutdownandproducezerooutput

MC

ATC

AVC AVC

ShortRunSupplyCurve

Quantity

P(Cost)

P(Cost)

Quantity

202

Firm’sLongRunDecisionsFirmmustdecide:

• Enteramarket?• Continueproducing?• Exitamarket?

Whenenteramarket– TR>0;TC>0• WillenterifTR>TCà P>ATC

Whenexitamarket– TR=0;TC=0• WillexitifTR<TCà P<ATC

203

Firm’sLongRunSupplyCurve

Because,inthelongrun,afirmwillremaininamarketonlyifP ≥ATC,thefirm'slong-runsupplycurvewillbeitsMCaboveATC

If: TheFirmWill:P>ATC EnterbecauseeconomicprofitsareearnedP=ATC NotenterorexitbecauseeconomicprofitsarezeroP<ATC Exitbecauseeconomiclossesareincurred

204

Firm’sLongRunSupplyCurveMC

ATC

AVC AVC

LongRunSupplyCurve

Quantity

P(Cost)

P(Cost)

Quantity

ATC

Because,inthelongrun,afirmwillremaininamarketonlyifP ≥ATC,thefirm'slong-runsupplycurvewillbeitsMCaboveATC

If: TheFirmWill:P>ATC EnterbecauseeconomicprofitsareearnedP=ATC NotenterorexitbecauseeconomicprofitsarezeroP<ATC Exitbecauseeconomiclossesareincurred 205

PROFIT

MeasuringProfitorLossProfit=TR –TC

TR =P xQ TC =ATC xQ

Profit=(P – ATC)xQMC

ATC

P(Cost)

Quantity

MC

ATC

P(Cost)

Quantity

P

ATC LOSSATC

P

MR

MR

206

LongRunEquilibrium

MC

ATC

P(Cost)

Quantity

P= ATC MR

ZeroEconomicProfitsMR=MCP=ATC

207

ImpactofShiftinDemand

MC

ATC

P(Cost)

Quantity

P.1 MR.1

IncreaseinDemandà IncreaseinPriceMRincreases

Intheshortrun:movementalongthesupplycurve(MC)becausenewprice=newMR

P(Cost)

Quantity

P.1

MR.2P.2 P.2

SHORTRUNPRODUCTION

Q.1 Q.2D.1

D.2

S

Q.1 Q.2

PROFIT

208

ImpactofShiftinDemand

MC

ATC

P(Cost)

Quantity

P.1 MR.1

IncreaseinPriceàMRincreasesà ProfitsinShortRunInthelongrun:NewFirmsentertotakeadvantageofpositiveprofits

Shiftinthesupplycurvebecausechangeinnumberofsellers

P(Cost)

Quantity

P.1

MR.2P.2 P.2

LONGRUNPRODUCTION

Q.1 Q.2D.1

D.2

S.1

Q.1 Q.2

S.2

Q.3

209

KeyTakeaways• Perfectlycompetitivefirmsarepricetakers– tochangetheirprofitmaxpointofproductiontheycanonlychangequantity

• Faceshortrunandlongrundecisionsonproduction

• Shortrunprofit/lossdependsonpricesandATC

• Firmswilloperateinthelongrunwithzeroeconomicprofitsbecauseofthefreeentryandexitoffirms

210


Monopoly

211

FundamentalCausesofMonopolyBarrierstoEntrycauseMonopolyPower• ResourceRestrictions:

Monopolyhassoleownershipofakeyresourceinproduction

• Gov’tcreatedMonopoliesMonopolyisgrantedexclusiverightstoproduceorsellagood

• NaturalMonopoliesOnefirmcanprovidethegoodatalowercostthantwoormorefirms

212

PricingandProductionDecisions• Amonopolyfirmhascompletepricecontrolbecausetheyarethesoleproviderofthegood

ConsideredaPriceMaker

• Monopolyfirm– stillfacesadownwardslopingdemandcurve

• Tosellmore=mustlowertheprice

Price:determinedbyfirmQuantity:determinedbydemand

213

UnderstandingMonopolyConsiderthemarketfordiamondswhereDeBeershasamonopoly.Itisdecidinghowmuchtosellandatwhatprice.

• Wherewillitgainpositiverevenue?

• Whatpriceshould itsetandwhereshould itproduce tomaximizeprofits?

• Whatwillbethesizeofitsprofitsatthispoint?

Price Quantity TR TC MR MC

2000 0 0 25,000

1800 100 180,000 100,000

1600 200 320,000 190,000

1400 300 420,000 290,000

1200 400 480,000 400,000

1000 500 500,000 525,000

214

UnderstandingMonopolyConsiderthemarketfordiamondswhereDeBeershasamonopoly.Itisdecidinghowmuchtosellandatwhatprice.

• Anywherebelow$2000

• $1400

• $130,000

Price Quantity TR TC MR MC

2000 0 0 25,000

1800 100 180,000 100,000 1800 750

1600 200 320,000 190,000 1400 900

1400 300 420,000 290,000 1000 1000

1200 400 480,000 400,000 600 1100

1000 500 500,000 525,000 200 1250

215

UnderstandingMonopolyMonopolycansetthepriceanywherebelow$2000

andgainpositiverevenue

Optimalpointofproduction?Needtoconsiderprofitmaximization

MR=MC

IfMR>MC:IncreaseprofitsbyincreasingQsIfMR<MC:IncreaseprofitsbydecreasingQs

216

UnderstandingMonopoly

217

MC

MC

DMR

Quantity

Price(Cost)

ATC

ProfitsforaMonopoly

Profits=TR– TC=(PxQ)– (ATCxQ)=Q(P– ATC)

Profits=300(1400– 966)ATC=290,000/300=966

218

UnderstandingQuickCheck

Foraprofit-maximizingmonopolythatchargesthesamepricetoallconsumers,whatistherelationshipbetweenprice (P), marginalrevenue (MR), andmarginalcost(MC) ?a) P=MRand MR=MC.b) P>MRand MR=MC.c) P=MRand MR>MC.d) P>MRand MR>MC.

219

UnderstandingQuickCheck

Foraprofit-maximizingmonopolythatchargesthesamepricetoallconsumers,whatistherelationshipbetweenprice (P), marginalrevenue (MR), andmarginalcost(MC) ?a) P=MRand MR=MC.b) P>MRand MR=MC.c) P=MRand MR>MC.d) P>MRand MR>MC.

220

WelfareCostsofaMonopoly• SincemonopoliessetpricesandquantitiesatMR=MCandMR≠P– themonopolyoutcomeissociallyinefficient.

• TotalsurpluswouldbemaximizedatP=D=MC• D=MCà SociallyEfficientOutcome• MR=MCà ProfitMaxOutcome

221

DifferencebetweenMonopolyOutcomeandSociallyEfficientOutcomeà Deadweightloss 222

WaystoRegulateMonopolyPower

• IncreasecompetitionwithAntitrustLaws

• Regulatenaturalmonopoliestobringpriceasclosetosociallyefficientpointaspossible

• PublicOwnershipà Governmenttakesover

• Donothing:Costtoregulation>Benefitofregulating

223

KeyTakeaways

• Monopoliesaretheleastcompetitivemarketstructurebuttheystilldependondemandtosetpricesandprofitmaximizingquantities

• Therearesocialcoststomonopolypower,includingdeadweightloss

• Therearemanyharmlessandharmfulexamplesofmonopolypowerintheworldtoday.

224

PrinciplesofMicroeconomicsModule5.4OligopolyandGameTheory

225

OligopolyMarketsFewsellers

Sellinganidenticalgood

• Becausefewsellers,theproductionchoicesofonefirmwillaffecttheoutcomesofallotherfirmsinthemarket

• Firmsmustactstrategicallybecauseprofitsnowdependon:• Howmuchitproduces• Howmuchallotherfirmsproduce

• Tensionbetweencooperation andself-interest

226

OligopolyandGameTheory• Oligopoly:bestoutcomeistocooperate andactasamonopoly

• ProducesmallquantityofoutputatP>MC• Yieldshighestprofits!

• Incentivetoactinownself-interest• Eachcaresonlyabouttheirownprofits• Ifonecheats:evenhigherprofits!

• Toreachthemonopolyoutcome– eachfirmreliesontheother(interdependent)

• Colludetosetpricesorquantitiesproducedtoreachthepointofhighestpossibleprofits

• Cartels:groupsoffirmsthatacttogetherandcollude227

UnderstandingOligopolyJackandJillowntheonlywaterwellintown.Eachcanbringinwatertotowntosellitbuttheyneedtoagreeonhowmuchtobringin.AssumeMC=0.

Quantity Price TotalRevenue0 120 010 110 110020 100 200030 90 270040 80 320050 70 350060 60 360070 50 350080 40 320090 30 2700

228

OligopolyOutcomeIfcooperate: reachmonopolyoutcome

P=60;Q=60;Profit=3600JackProfitsà P=60,Q=30,Profit=1800JillProfitsà P=60,Q=30,Profit=1800

Ifonecheats: cangainmore!P=50,Q=70,Profit=3500

Cheaterà P=50,Q=40,Profit=2000Cooperatorà P=50,Q=30,Profit=1500

229

OligopolyOutcomeIfbothcheat:lowerprofitsbutoligopolyoutcome

P=40,Q=80,Profits=3200JackProfits:P=40,Q=40,Profits=1600JillProfits:P=40,Q=40,Profits=1600

OligopolyOutcome:Bothcheat!

Actinownself-interestFailtocooperate

230

NashEquilibriumAgentsthatinteractwithoneanotherwillchoosetheiroptimalstrategygiventhestrategiesthatallother

agentshavechosen

àOnefirm’soptimalstrategytakesintoaccountallotherfirms’choices

à NashEquilibrium:BothCheatCan’tdoanybetterregardlessofwhattheotherpersondoes

231

OligopolyOutcome&NashEquilibrium

N=Numberoffirms

Note: Asthenumberoffirmsgrows– theoligopolyoutcomereachescompetitiveequilibrium

• Largernumberoffirms– eachbecomeslessconcernedabouthowtheyimpactallotherfirms

• Moreincentivetoactintheirownself-interest

𝑶𝒍𝒊𝒈𝒐𝒑𝒐𝒍𝒚𝑶𝒖𝒕𝒄𝒐𝒎𝒆 =𝑵

𝑵 + 𝟏 𝒙𝑪𝒐𝒎𝒑𝒆𝒕𝒊𝒕𝒊𝒗𝒆𝑶𝒖𝒕𝒄𝒐𝒎𝒆

232

OligopolyOutcome&GameTheory

Ifcooperate,collectivelygainhighestprofitsbutindividuallyirrational– becausepotentialtomakeevenmorebycheating!

Regardlessofwhattheotherpersondoes– besttocheat!- Avoidlowerprofits($1500)- Potentialforevenhigherprofits($2000)

JACK

JILL

CHEAT COOPERATE

CHEAT Jack Profits:$1600 Jack Profits:$1500

JillProfits:$1600 JillProfits:$2000

COOPERATE Jack Profits:$2000 Jack Profits:$1800

JillProfits:$1500 JillProfits:$1800

233

OligopolyOutcomes

• Whenthereareonlyafewfirmsinamarket– eachfirmactsstrategically

• Gametheory– guidesthestrategiesthatfirmschoose• Willactintheirownself-interestdespitethepotentialtogainwhencooperate

• Cooperationispossibleinrepetitivegameswhentherulesdon’tchange

234

PrinciplesofMicroeconomicsModule5.5MonopolisticCompetition

MonopolisticCompetition• MonopolisticallyCompetitiveMarkets:

• Havemanybuyersandsellers• Sellsimilarbutdifferentiatedproducts• Freeentryandexitinthemarket

• Firms:• Havesomepricecontrol• Inshortrun:experienceeconomicprofits+actasmonopoly• Inlongrun:zeroeconomicprofits+actasperfectcompetition

Intheshortrun…• Marketoutcomelookssimilartomonopoly

• ProfitMaxPoint:MR=MC• Price>MR=MC

DeterminesquantitybasedonMR=MCDeterminesprice basedondemand

IfP>ATCPOSITIVEECONOMICPROFITSPossibleinShortRun

Inthelongrun…•Marketoutcomesimilartoperfectlycompetitivemarkets

•Reason:FREEENTRY/EXIT

Firmsinthelongrunoperateat:P>MC

Duetofirmfacingadownwardslopingdemandcurve

P=ATCDuetofreeentryandexit intothemarket

LongRunwhenP>ATC• IfP>ATC:Shortrunpositiveprofits• Overtime:morefirmsentertotakeadvantageofprofits

• Increasevarietyofgoodsasmorefirmsenter• Decreaseindemandforeachfirm’sdifferentiatedgood• DecreaseinpriceforfirmsuntilP=ATC

ZeroEconomicProfitsInlongrun

• AdjustuntilP=ATCinLongrun

LongRunwhenP>ATC

240

MC

MC

DMR

Quantity

Price(Cost)

ATC

Price

Quantity

D

S

LongRunwhenP>ATC

241

MC

MC

DMR

Quantity

Price(Cost)

ATC

Price

Quantity

D

SS.2

D.2MR.2

Asnewfirmsenterà supply inthemarketgoesupButforeachindividualfirmà demandgoesdownNochangeincostsà adjustmentuntilP=ATC

LongRunwhenP<ATC• IfP<ATC:Shortrunnegativeprofits– Loss!• Overtime:firmsexitmarkettoavoidlosses

– Decreasevarietyofgoodsasmorefirmsexit– Increaseindemandforeachfirm’sdifferentiatedgood– IncreaseinpriceforfirmsthatstayinmarketuntilP=ATC

ZeroEconomicProfitsInlongrun

• AdjustuntilP=ATCinLongrun

LongRunwhenP<ATC

243

MC

MC

DMR

Quantity

Price(Cost)

ATC

Price

Quantity

D

S

LongRunwhenP<ATC

244

MC

MC

DMR

Quantity

Price(Cost)

ATC

Price

Quantity

D

S

S.2

D.2MR.2

Asfirmsexità supply inthemarketgoesdownButforeachindividualfirmà demandgoesupNochangeincostsà adjustmentuntilP=ATC

WelfareandMonopolisticCompetition

• BecauseP>MCà somecoststosocietyaswithmonopolyoutcome• Regulationofthesefirmswouldbeverydifficultà toomanyfirmstoregulate

• TwoexternalitiesarisefromM.C.outcome:• Product-varietyexternality• Business-stealingexternality

KeyTakeaways

• MonopolisticallyCompetitivefirmsactasbothmonopolies(inSR)andperfectlycompetitivefirms(inLR)

• Havesomeexcesscapacityandmarkupbecausehavesomepricecontrol

• Advertisingonlyworkswhentherearesimilarbutdifferentiatedproducts– onlyinM.C.markets


MarketforInputsinProduction

FactorsofProduction

• Factorsofproduction:theinputsusedtoproducegoodsandservices.

• Similartothemarketsforgoodsandservicesdiscussedearlier,buttheyaredifferentinoneimportantway.

• demandforafactorofproductionisaderiveddemand,• meaningthatthefirm'sdemandforafactorofproductionisderivedfromitsdecisiontosupplyagoodinanothermarket.

DemandforLabor

• Householdssupplylabor• Firmsdemandlabor

• Needtodeterminehowmanyworkerstheymusthiretoreachtheirprofitmaximizingpointofproduction

DemandforLaborWage

QuantityofLabor

DemandbyFirms

ShiftsinDemandforLabor

• Changeinoutputprice• Priceofgoodincreasesà Firmwillproducemoreà demandmorelabor

• TechnologicalChange• Techprogressà workersmoreproductiveà firmneedslesslabor

• Supplyofotherfactors• Ifotherfactorsbecomescarceà firmcanproducelessoverallà lessdemandforlabor

SupplyofLaborWage

QuantityofLabor

SupplybyHouseholds

ShiftsinSupplyofLabor

• Changeinnumberofworkers• Moreworkersinterestedinajobàmorelaboravailable• Influxofworkersà shiftssupplycurve

EquilibriumforLaborWage

QuantityofLabor

DemandbyFirms

SupplybyHouseholds

LinkagesamongtheFactorsofProduction

• Factorsofproductionareusedtogether• Productivityofeachfactordependsonthequantitiesoftheotherfactorsavailable

• Changeinthesupplyofanyonefactorcanchangetheearningsofallofthefactors.

• Changeintheearningsofanyfactorcanbefoundbymeasuringtheimpactoftheeventmarginalproductofthatfactor.


Externalities

256

Externalities• Theuncompensatedimpactofoneperson’sactionsonthewell-beingofabystander isanexternality

• PositiveExternality:Beneficialforthebystander• NegativeExternality:Adverselyeffectsbystander

257

RecaponSupplyandDemand• Recallthatsupplyreflectsthecosttoprovidethegood/serviceforthefirm

• Reflectsonlyprivatecost• Ifexternalitiesexist– alsoneedsocialcost:thecoststothirdpartiesassociatedwiththeprovisionofthegood

• Recallthatdemandreflectsthevaluebuyersassigntoagood/service• Reflectsonlyprivatevalue• Ifexternalitiesexist– alsoneedsocialbenefit/value:thevaluetothirdpartiesassociatedwiththeprovisionofthegood

258

Pollution:NegativeExternality

Consideracoal-poweredmanufacturingplantmakingwidgets

Pollutionisanegativeexternalityassociatedwiththeproductionofwidgets

FirmswillproducewhereS=DTheydonotaccountforthesocialcost

Toforcethemtoaccountforthecosttosocietyofhigherpollution,governmentcanimposetaxes/quotas

QuantityofWidgets

PriceofWidgets Supply

(PrivateCost)

SocialCost

Demand

259

Education:PositiveExternality

Considerthevalueofeducationtoanindividualandtosociety

Educationyieldspositiveexternalitiesbecausebetter-educatedvotersleadtoabettergovernment.Crimeratesalsodropastheeducationlevelofthepopulationrises.

Toensurehighlevelsofeducation,governmentcansubsidizeeducation,provideitforfree,and/orimposeregulationtoensureallchildrenreceiveit

QuantityofSchooling

ValueofSchooling

Supply

Demand(PrivateValue)

SocialValue

260

Internalizinganexternality

Alteringtheincentivessothatpeopletakeaccountoftheexternaleffectsoftheiractions.

• Becauseprivatecostsdonotaccountforsocialcosts-->governmentcanimposetaxesorregulationtoincreaseprivatecosttomatchsocialcosts

• Bydoingso,theinternalizationforcesthefirmtoproducelessandthereforelowerthesizeofthenegativeexternality

• Becauseprivatebenefitdoesnotaccountforsocialbenefit-->governmentcanintroducetaxbreaks,subsidies,andregulationtoenhancetheprivatebenefit

• Bydoingso,theinternalizationforcestheeconomicagentclosertothehighersocialbenefitpoint.

261

PublicPolicytowardsExternalities

Command-and-control:• Externalitiescanbecorrectedbyrequiringorforbiddingcertainbehaviors.

• IntheUnitedStates,theEnvironmentalProtectionAgency(EPA)developsandenforcesregulationsaimedatprotectingtheenvironment.

• EPAregulationsincludemaximumlevelsofpollutionallowedorrequiredadoptionofaparticulartechnologytoreduceemissions.

262


Market-basedPolicies:• Externalitiescanbeinternalizedthroughtheuseoftaxesandsubsidies.• Correctivetax:ataxdesignedtoinduceprivatedecisionmakerstotakeaccountofthesocialcoststhatarisefromanegativeexternality.

• Thesetaxesarepreferredbyeconomistsoverregulation,becausefirmsthatcanreducepollutionwiththeleastcostarelikelytodoso(toavoidthetax)whilefirmsthatencounterhighcostswhenreducingpollutionwillsimplypaythetax.

• Thus,thistaxallowsfirmsthatfacethehighestcostofreducingpollutiontocontinuetopollutewhileencouraginglesspollutionoverall.

263


Market-basedPolicies:

• TradablePollutionPermits• EPAregulationsrestricttheamountofpollutionthattwofirmscanemitat300tonsofglopperyear.FirmAwantstoincreaseitsamountofpollution.FirmBagreestodecreaseitspollutionbythesameamountifFirmApaysit$5million.

• SocialwelfareisincreasediftheEPAallowsthissituation.Totalpollutionremainsthesamesotherearenoexternaleffects.Ifbothfirmsaredoingthiswillingly,itmustmakethembetteroff.

• IftheEPAissuedpermitstopolluteandthenallowedfirmstosellthem,thiswouldalsoincreasesocialwelfare.Firmsthatcouldcontrolpollutionmostinexpensivelywoulddosoandselltheirpermits,whilethosewhoencounterhighcostswhenreducingpollutionwouldbuyadditionalpermits.

264

KeyTakeaways

• Externalitiesaretheoutcomesofdecisionsmadebyeconomicagentsthataffectbystanderswhoarenotpartofthedecision-makingprocess

• Externalitiescanbebothbeneficialandharmful

• Thesizeoftheexternalitycanbecontrolledbygovernmentinterventionintheformorcommand-and-controlpoliciesormarket-basedpolicies

265


PublicGoodsandCommonResources

TypesofGoodsintheEconomy

• Excludable:Apersoncanbepreventedfromusingthegood• RivalinConsumption:Oneperson’suseofthegooddiminishesotherpeople’suseofthegood

TypesofGoodsintheEconomyRivalinconsumption

Yes No

Excludable

YesPrivateGoods- Ice-creamcones- Clothing

ClubGoods- Movie theaters- CableTV

NoCommonResources- Fishintheocean- Theenvironment

PublicGoods- Nationaldefense- Knowledge

ProvisionofPublicGoods

• Becauseitisdifficulttogetanyonetopayforpublicgoods(becausenon-excludable)à noindividualfirmwillbewillingtoprovidethegood

• FreeriderProblem:apersonwhoreceivesthebenefitofagoodbutavoidspayingforit.

• Example:pavingmainstreetintown• everyonebenefits,• noone’susediminishesanyoneelse’suse• Can’tstoppeoplefromusingit• Thereforeàwillafirmpay?NO!

• Duetothismarketfailureà needthegovernmenttostepintoprovidepublicgoods

CommonResources

• Non-excludablebutrivalinconsumption• Can’tstoppeoplefromusing• Themorepeopleusethegood– thelessitcanbeusedbyothers

• Fishinginthelocalpond(orocean)• Limitedfishinthepond• Everyonecancomeandfish• Themorepeoplefishà thelessfishforeveryoneelse!

RegulatingCommonResources

• Economistshavestruggledwithidentifyingthebestsolutionsforavoidingtheproblemwithcommonresources

• Regulatingquantityfished/used• Vouchersystem• Timeoffishing

• Needregulationandgovernmentinvolvementtosolvethesemarketfailures

KeyTakeaways

• Therearemanytypesofgoodsinoureconomy• Wecangroupthemintofourcategoriesbasedon“excludability”and”rivalryinconsumption”

• Becauseoftheproblemsassociatedwiththeprovisionofpublicgoodsanduseofcommonresources– theseareconsideredmarketfailures

• Needgovernmenthelptocontrolandregulatemarketfailures


IncomeInequality

IncomeInequality

• Incomeinequalityreferstotheunevendistributionofincomeinacountry

• Reflectsthegapbetweentherichandeveryoneelse

• IntheUS– thisgaphasbeengrowingrapidly

AverageIncomeinUnitedStates

http://inequality.org/wp-content/uploads/2014/10/Figure-1-e1455723650211.png

Bottom90%

$33,068



Top10%

$295,845



$448,489

Top5%



$1,260,508

Top1%



$6,087,113

Top0.1%

IncomeInequalityintheUS– OntheRise


Realwageshavenotgrownformost

PovertyintheUnitedStates

In2014:• 46.7millionpeople(14.8%)wereinpoverty.• 15.5million(21.1%)childrenundertheageof18wereinpoverty.• 4.6million(10%)seniors65andolderwereinpoverty.

http://www.feedingamerica.org/

PovertyintheUnitedStates

• 48.1millionAmericanslivedinfoodinsecurehouseholds,including32.8millionadultsand15.3millionchildren.

• 14%ofhouseholds(17.4millionhouseholds)werefoodinsecure.

• 6%ofhouseholds(6.9millionhouseholds)experiencedverylowfoodsecurity.

• Householdswithchildrenreportedfoodinsecurityatasignificantlyhigherratethanthosewithoutchildren,19%comparedto12%.

http://www.feedingamerica.org/

PoliciestoReducePoverty

• Minimumwagelaws• In-kindtransfers• Welfareandhousingassistance• Negativeincometax

DonotsolvethelargerissueofgrowinginequalityintheUS

principles of microeconomics module 1...seamstress 1more bread = ½ sweater 1 more sweater = 2 bread...

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