1. Principles of Microeconomics Review for the Final Exam
Akos Lada
August 11th, 2014
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

2. Contents Review of Homework Assignment 10
Introduction to Economics – The Big Picture
A collection of “punch-lines”
Additional Q&A

3. 1. Review of Homework Assignment 10

4. The information
Alfaguara Publishing Co. faces the following demand schedule for the next novel of Mario Vargas Llosa, the prestigious novelist recipient of the 2010 Nobel Prize in Literature:
The author is paid $ 2 million to write the book, and the marginal cost of publishing the book is a constant $10 per book.
Price
Quantity
(1,000s) novels
$100 90
100 80
200 70
300 60
400 50
500 40
600 30
700 20
800 10
900
1,000
The units is in thousand books, so at a price 0, the quantity demanded is 1 million books

5. Compute the total revenue, total cost, and profit at each quantity
Compute the total revenue, total cost, and profit at each quantity. What quantity would a profit-maximizing publisher choose? What price would it charge?
Price
Quantity
(1,000s)
Total Revenue
(millions)
Total Cost
Profit
$100 $0 $2
$-2 90
100 9 3 6 80
200 16 4 12 70
300 21 5 60
400 24 18 50
500 25 7 40
600 8 30
700 20
800 10
900 11 -2
1,000
-12
A profit-maximizing publisher would choose a quantity of 400,000 at a price of $60
or a quantity of 500,000 at a price of $50;
Both combinations would lead to profits of $18 million.

6. Compute marginal revenue. (Recall that MR = ∆TR/∆Q)
Compute marginal revenue. (Recall that MR = ∆TR/∆Q). How does marginal revenue compare to the price? Explain.
Price
Quantity
(1,000s)
Total Revenue
(millions)
Marginal Revenue
$100 $0
---- 90
100 9 $9 80
200 16 7 70
300 21 5 60
400 24 3 50
500 25 1 40
600 -1 30
700 -3 20
800 -5 10
900 -7
1,000 -9
Marginal revenue is always less than price.
Price falls when quantity rises because the demand curve slopes downward, but marginal revenue falls even more than price because the firm loses revenue on all the units of the good sold when it lowers the price.

7. Graph the marginal-revenue, marginal-cost, and demand curves
Graph the marginal-revenue, marginal-cost, and demand curves. At what quantity do the marginal-revenue and marginal-cost curves cross? What does it signify?
The marginal-revenue and marginal-cost curves cross between quantities of 400,000 and 500,000.
This signifies that the firm maximizes profits in that region.

8. In your graph, shade in the deadweight loss
In your graph, shade in the deadweight loss. Explain in words what this means
The area of deadweight loss is marked “DWL” in the figure.
Deadweight loss means that the total surplus in the economy is less than it would be if the market were competitive, because the monopolist produces less than the socially efficient level of output.

9. If the author were paid $3 million instead of $2 million to write the book, how would this affect the publisher’s decision regarding the price to change? Explain
If the author were paid $3 million instead of $2 million, the publisher would not change the price, because there would be no change in marginal cost or marginal revenue.
The only thing that would be affected would be the firm’s profit, which would fall.

10. Suppose the publisher was not profit-maximizing but was concerned with maximizing economic efficiency. What price would it charge for the book? How much profit would it make at this price?
To maximize economic efficiency, the publisher would set the price at $10 per book, because that is the marginal cost of the book.
At that price, the publisher would have negative profits equal to the amount paid to the author.

11. Public goods & Common Pool Resources Competition vs. Monopoly
2. The Big Picture 8 9 10
Welfare Analysis (CS, PS, DWL) and Efficiency
PERFECT MARKETS 7 8 11
Price controls
(floors, ceilings)
Taxes
(on consumer producer; on elastic / inelastic agent) 2 1 4 5 6
Supply and Demand
How Economists think (principles)
Why Trade? (PPF and Comp Advantage)
Elasticity
(price, income, cross-price)
Comparative Statics 3 4
MARKET FAILURES 12 13 14 14 15
Externalities
(positive, negative)
Public goods & Common Pool Resources
Competition vs. Monopoly
MOTIVATION
TOOLS
APPLICATION

12. 3. A collection of “punch-lines”

13. 0) How economists think…
Economics as the study of how society manages scarce resources
4 principles of how people make decisions
People face trade-offs
The cost of something is what you give up to get it (opportunity cost)
Rational people think at the margin
People respond to incentives
3 additional principles we saw in the course
Trade can make everyone better off
Markets are usually a good way to organize economic activity
Governments can sometimes improve market outcomes

14. 1) Production Possibilities FrontierA B C D E F G
PPF (the production possibilities given the current technology and resources)
Efficient, inefficient and unfeasible points
PPF’s slope and opportunity cost

15. 1) Gains from trade Absolute advantage vs. comparative advantage
Comparative advantage allows for:
Specialization
Increase in the size of the economic pie
Gains from trade
Comparative advantage is the ability to produce a good at a lower opportunity cost than another producer
Japan has comparative advantage in computers (5<10)
The US has comparative advantage in wheat (1/10<1/5)
Opportunity Cost of:
Computer
Wheat (ton)
United States 10
1/10
Japan 5
1/5

16. The graph below shows what Canada and Mexico can produce in a 40-hr workweek. What is the opportunity cost of computers in terms of printers in Canada and Mexico, respectively?
Answer: 2
10 printers in Canada, 2 printers in Mexico
1 printer in Canada, ½ printer in Mexico
1 printer in Canada, 2 printers in Mexico
10 printers in Canada, ½ printer in Mexico

17. When one speaks of “demand” in a particular market, this refers to:
The quantity demanded at a certain price
Only one price-quantity combination on the demand schedule
The slope of the demand curve at one point
The whole demand curve
Answer: 4

18. 2) Demand Shifts vs. movements along the curve Demand Shifters
Number of Buyers
Income
Normal vs. Inferior goods
Prices of related goods
Substitutes vs. Complements
Tastes
Expectations
Demand ≠ Quantity Demanded
Law of demand
Demand Schedule
Individual demand vs. Market demand

19. 2) Supply Supply≠ Quantity Supplied Law of supply Supply Schedule
Individual supply vs. Market supply
Shifts vs. movements along the curve
Supply Shifters
Number of Sellers
Input prices
Technology
Expectations

20. 2) Equilibrium P Q S D
Surplus P*
Shortage Q*

21. 3) Comparative statics To determine the effects of any event,
1. Decide whether event shifts S curve, D curve, or both.
2. Decide in which direction curve shifts.
3. Use supply-demand diagram to see how the shift changes equilibrium P and Q.
No change in Supply
Increase in Supply
Decrease in Supply
No Change in
Demand
P same
Q same
P down
Q up
P up
Q down
Increase in Demand
P ambiguous
Q ambiguous
Decrease in Demand

22. The number of suppliers of Good D has increased
The number of suppliers of Good D has increased. What will be the effect on the market price and quantity for Good E if it is a complement of Good D?
Price Quantity
Increase Decrease
Increase Increase
Decrease Decrease
Decrease Increase
No change Increase
Answer: 2

23. There has been a technological advancement in the production of good B
There has been a technological advancement in the production of good B. Good B is a substitute for Good C. Knowing this, the most likely scenario is that:
The quantity demanded for Good C will increase
The quantity demanded for Good C will decrease
The demand for Good C will increase
The demand for Good C will decrease
Answer: 4

24. 4) Calculating Elasticity
Three steps:
Calculate the percentage changes in quantity and the percentage change in price
Calculate the elasticity using these two numbers as inputs
Interpret the result (inelastic, elastic, unit elastic)
The Midpoint Method
end value – start value
midpoint
x 100%
Price elasticity of demand =
Percentage change in Qd
Percentage change in P

25. 5) Different elasticities
Price elasticity of demand
= -
Percentage change in Qd
Percentage change in P
Income elasticity of demand =
Percent change in Qd
Percent change in income
Cross-price elast. of demand =
% change in Qd for good 1
% change in price of good 2

26. 5) Elasticity (of Demand)Q P Q P
Perfectly inelastic
Perfectly elastic Q P Q P Q P 1% 1%
Inelastic
Elastic
Unit-elastic

27. 6) Determinants of Elasticity
Demand
Supply
The extent to which close substitutes are available
Whether the good is a necessity or a luxury
How broadly or narrowly the good is defined
The time horizon – elasticity is higher in the long run than the short run
How easily sellers can change the quantity they produce
E.g: Supply of beachfront property vs. new cars
For many goods, price elasticity of supply is greater in the long run than in the short run
Firms can build new factories, or new firms may be able to enter the market
This section is not perfectly analogous to the section on the determinants of the price elasticity of demand, but it’s similar enough that you can probably cover it more quickly and with much less hand-holding. 27

28. 7) Price controls Binding vs. non-binding
Binding price ceilings (e.g. rent control)
Leads to shortage
Effect is more severe in the long run
Rationing, informal market, decrease in quality
Binding price floors (e.g. minimum wage)
Leads to surplus
Size of shortage / surplus depends on elasticity of Supply and Demand
Generally, effect larger in the long run when S&D become more elastic

29. Refer to the labor market graph below
Refer to the labor market graph below. The imposition of an $8 minimum wage would cause
Answer: 2
additional unemployment of 20 labor hours
unemployment of 35 labor hours
a labor shortage of 35 labor hours
no change in the equilibrium wage and employment because the minimum wage is not binding.

30. 8) Taxes
What shifts?
If imposed on buyers, it is equivalent to a decrease in income, shifts the demand curve left
If imposed on sellers, it is equivalent to an increase in input costs, shifts the supply curve left
What is the size of the shift?
The amount of the tax
Tax incidence (who pays for the tax burden)
Whether the tax is charged to the producers or to the sellers is irrelevant – the tax incidence is the same in both cases
What matters is the elasticity of Supply and Demand
If Supply is more inelastic, the larger share of the burden falls on the sellers.
If Demand is more inelastic, the larger share of the burden falls on the buyers

31. Why would the removal of the $0
Why would the removal of the $0.18 cents gasoline tax not help consumers much?
Answer: 2
because gasoline is a necessity and demand is inelastic
because suppliers were paying the large part of the tax burden
because the supplier will not pass on the tax reduction to the consumers
because the tax reduction is shot-term and taxes will go up again

32. 8) Welfare Analysis Q P $2.50 25 1 2 3 4 5 10 20 30 $1 2 3 4 5 10 20 30 Q P $
Supply curve shows private cost, the costs directly incurred by sellers.
Demand curve shows private value, the value to buyers (the prices they are willing to pay).
The Consumer Surplus (CS) is the area between the equilibrium price and the Demand curve
$2.50 25
For many students, the concepts are easier to learn in the context of a specific example with numerical values.
Note that maximizing consumer + producer surplus is NOT the same as maximizing TOTAL surplus when the trades impose external costs (or benefits) on bystanders.
The Producer Surplus (PS) is the area between the equilibrium price and the Supply curve
Total Surplus (TS) = CS + PS + GR
We think of it as an (imperfect) measure of aggregate welfare in society 32

33. 9) Calculating changes in welfare (example – changes in CS)Q
To calculate the area of the triangles:
½ (base x height)
To calculate the area of the rectangles:
base x height
1. Fall in CS due to buyers leaving market D
2. Fall in CS due to remaining buyers paying higher P
The book shows how a lower price increases CS. 33

34. 10) Market equilibrium and efficiency
= CS + PS
Total surplus
= (value to buyers) – (cost to sellers)
Total surplus
Definition: An allocation of resources is efficient if it maximizes total surplus.
We say that the market equilibrium quantity is efficient because it maximizes total surplus. This means:
At any other quantity it is possible to increase TS by moving towards the equilibrium quantity.
The goods are consumed by the buyers who value them most highly.
The goods are produced by the producers with the lowest costs.

35. 11) The welfare effect of a TaxP Q
CS = A
PS = F A
Tax revenue = B + D S PB B C
Total surplus = A + B + D + F E D PS D F
Deadweight loss C + E QT QE 35

36. 11) Elasticities and Deadweight loss
The size of the deadweight loss is determined by the elasticity of supply and demand of a good.
The more elastic the Supply or the Demand of a good is, the larger the deadweight loss.
The less elastic the Supply or the Demand of a good is, the smaller the deadweight loss.
This is very informative for the decision of “What products to tax?”.

37. 12) Externalities
The uncompensated impact of one person’s actions on the well-being of a bystander.
Can be negative
Making social costs higher than private costs
Leads to an over-production of the good (with respect to the optimal quantity)
… or positive
Making social value greater than private value
Leads to an under-production of the good (with respect to the optimal quantity)

38. 12) Policy responses to externalities
Command-and-control policies (regulation)
Market-based policies
Corrective taxes (pigouvian taxes) or subsidies
Taxes that induce private decision makers to take into account the social costs generated by a negative externality
Subsidies that induce private decision makers to take into account the social benefits generated by a positive externality
Tradable pollution permits
Firms with lower costs of reducing pollution can sell their permits to firms with higher costs of reducing pollution.
Market-based policies (theoretically) can achieve the same goals as regulations, but more efficiently

39. 13) Public Goods
Are goods that are non- excludable and non-rival
Some important public goods are:
National defense
Knowledge created through basic research
Fighting poverty
Public goods are difficult for private markets to provide because of the free-rider problem.
If the benefit of a public good exceeds the cost of providing it, government should provide the good and pay for it with a tax.
Economists use cost-benefit analysis to determine how much to provide of a public good.
Cost-benefit analysis is imprecise because benefits are hard to measure.

40. 14) Common Pool Resources
Are goods that are at the same time not excludable but rival.
Some important Common Resources are:
Clean air and water
Congested roads
Fish, whales, and other wildlife
Leads to the overconsumption of the resource (e.g. the tragedy of the commons).
Possible policies available to the government to address this issue include:
Regulate use of the resource
Impose a corrective tax
Auction off permits allowing use of the resource
If the resource is land, convert to a private good by dividing and selling parcels to individuals 40

41. 14) Competition profit Q Qoptimal Costs, P MC P MR ATCQ
Costs, P
Competitive firms maximize profits at the Q where MR=MC
(Any) firm’s profit is the difference between the Price and their per-unit cost (ATC).
In a perfectly competitive market in the long run, all firms make zero economic profit. MC
ATC P MR
Qoptimal
profit
ATC
at Q optimal
The height of the rectangle is P – ATC, profit per unit.
The width of the rectangle is Q, the number of units.
The area of the rectangle
= height x width
= (profit per unit) x (number of units)
= total profit.

42. 15) Monopoly P P = MC MC QM QC Price Deadweight loss MC D MR Quantity
Monopolies, just like competitive firms, maximize profits at the Q where MR=MC
However, unlike competitive firms their MR is lower than their P
Because, since monopolies are the only seller, face the market demand curve – in order to sell additional units they need to lower the price
They set the optimal Q at the place where MR=MC, and then charge the maximum price that they can charge at that quantity.
Because they produce less than the competitive market equilibrium at a higher price, monopolies generate a deadweight loss
Quantity
Price
Deadweight loss D MC MR P MC QM
P = MC QC
It’s worth mentioning the following:
Most people know that monopoly changes the way the economic “pie” is divided: by charging higher prices, the monopoly gets more surplus and consumers get less surplus.
The analysis on this slide shows that the monopoly also reduces the size of the economic pie – by producing less than the socially efficient quantity and causing a deadweight loss. 42

43. 4. Additional Q&A