# Principles of Microeconomics Review for the Final Exam

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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

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

1. Review of Homework Assignment 10

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

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.

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.

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.

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.

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.

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.

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

3. A collection of “punch-lines”

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

1) Production Possibilities Frontier
A 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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

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

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

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

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.

11) The welfare effect of a Tax
P 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

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?”.

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)

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

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.

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

14) Competition profit Q Qoptimal Costs, P MC P MR ATC
Q 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.

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