4 The informationAlfaguara 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.PriceQuantity(1,000s) novels$1009010080200703006040050500406003070020800109001,000The 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?PriceQuantity(1,000s)Total Revenue(millions)Total CostProfit$100$0$2$-2901009368020016412703002156040024185050025740600830700208001090011-21,000-12A profit-maximizing publisher would choose a quantity of 400,000 at a price of $60or 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.PriceQuantity(1,000s)Total Revenue(millions)Marginal Revenue$100$0----901009$98020016770300215604002435050025140600-130700-320800-510900-71,000-9Marginal 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 meansThe 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? ExplainIf 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 Picture8910Welfare Analysis (CS, PS, DWL) and EfficiencyPERFECT MARKETS7811Price controls(floors, ceilings)Taxes(on consumer producer; on elastic / inelastic agent)21456Supply and DemandHow Economists think (principles)Why Trade? (PPF and Comp Advantage)Elasticity(price, income, cross-price)Comparative Statics34MARKET FAILURES1213141415Externalities(positive, negative)Public goods & Common Pool ResourcesCompetition vs. MonopolyMOTIVATIONTOOLSAPPLICATION
13 0) How economists think… Economics as the study of how society manages scarce resources4 principles of how people make decisionsPeople face trade-offsThe cost of something is what you give up to get it (opportunity cost)Rational people think at the marginPeople respond to incentives3 additional principles we saw in the courseTrade can make everyone better offMarkets are usually a good way to organize economic activityGovernments can sometimes improve market outcomes
14 1) Production Possibilities Frontier ABCDEFGPPF (the production possibilities given the current technology and resources)Efficient, inefficient and unfeasible pointsPPF’s slope and opportunity cost
15 1) Gains from trade Absolute advantage vs. comparative advantage Comparative advantage allows for:SpecializationIncrease in the size of the economic pieGains from tradeComparative advantage is the ability to produce a good at a lower opportunity cost than another producerJapan has comparative advantage in computers (5<10)The US has comparative advantage in wheat (1/10<1/5)Opportunity Cost of:ComputerWheat (ton)United States101/10Japan51/5
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:210 printers in Canada, 2 printers in Mexico1 printer in Canada, ½ printer in Mexico1 printer in Canada, 2 printers in Mexico10 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 priceOnly one price-quantity combination on the demand scheduleThe slope of the demand curve at one pointThe whole demand curveAnswer:4
18 2) Demand Shifts vs. movements along the curve Demand Shifters Number of BuyersIncomeNormal vs. Inferior goodsPrices of related goodsSubstitutes vs. ComplementsTastesExpectationsDemand ≠ Quantity DemandedLaw of demandDemand ScheduleIndividual demand vs. Market demand
19 2) Supply Supply≠ Quantity Supplied Law of supply Supply Schedule Individual supply vs. Market supplyShifts vs. movements along the curveSupply ShiftersNumber of SellersInput pricesTechnologyExpectations
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 SupplyIncrease in SupplyDecrease in SupplyNo Change inDemandP sameQ sameP downQ upP upQ downIncrease in DemandP ambiguousQ ambiguousDecrease 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 QuantityIncrease DecreaseIncrease IncreaseDecrease DecreaseDecrease IncreaseNo change IncreaseAnswer: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 increaseThe quantity demanded for Good C will decreaseThe demand for Good C will increaseThe demand for Good C will decreaseAnswer:4
24 4) Calculating Elasticity Three steps:Calculate the percentage changes in quantity and the percentage change in priceCalculate the elasticity using these two numbers as inputsInterpret the result (inelastic, elastic, unit elastic)The Midpoint Methodend value – start valuemidpointx 100%Price elasticity of demand=Percentage change in QdPercentage change in P
25 5) Different elasticities Price elasticity of demand= -Percentage change in QdPercentage change in PIncome elasticity of demand=Percent change in QdPercent change in incomeCross-price elast. of demand=% change in Qd for good 1% change in price of good 2
27 6) Determinants of Elasticity DemandSupplyThe extent to which close substitutes are availableWhether the good is a necessity or a luxuryHow broadly or narrowly the good is definedThe time horizon – elasticity is higher in the long run than the short runHow easily sellers can change the quantity they produceE.g: Supply of beachfront property vs. new carsFor many goods, price elasticity of supply is greater in the long run than in the short runFirms can build new factories, or new firms may be able to enter the marketThis 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 shortageEffect is more severe in the long runRationing, informal market, decrease in qualityBinding price floors (e.g. minimum wage)Leads to surplusSize of shortage / surplus depends on elasticity of Supply and DemandGenerally, 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 causeAnswer:2additional unemployment of 20 labor hoursunemployment of 35 labor hoursa labor shortage of 35 labor hoursno change in the equilibrium wage and employment because the minimum wage is not binding.
30 8) TaxesWhat shifts?If imposed on buyers, it is equivalent to a decrease in income, shifts the demand curve leftIf imposed on sellers, it is equivalent to an increase in input costs, shifts the supply curve leftWhat is the size of the shift?The amount of the taxTax 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 casesWhat matters is the elasticity of Supply and DemandIf 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:2because gasoline is a necessity and demand is inelasticbecause suppliers were paying the large part of the tax burdenbecause the supplier will not pass on the tax reduction to the consumersbecause 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 $ 12345102030QP$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$2.5025For 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 curveTotal Surplus (TS) = CS + PS + GRWe think of it as an (imperfect) measure of aggregate welfare in society32
33 9) Calculating changes in welfare (example – changes in CS) QTo calculate the area of the triangles:½ (base x height)To calculate the area of the rectangles:base x height1. Fall in CS due to buyers leaving marketD2. Fall in CS due to remaining buyers paying higher PThe book shows how a lower price increases CS.33
34 10) Market equilibrium and efficiency = CS + PSTotal surplus= (value to buyers) – (cost to sellers)Total surplusDefinition: 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 Tax PQCS = APS = FATax revenue = B + DSPBBCTotal surplus = A + B + D + FEDPSDFDeadweight loss C + EQTQE35
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) ExternalitiesThe uncompensated impact of one person’s actions on the well-being of a bystander.Can be negativeMaking social costs higher than private costsLeads to an over-production of the good (with respect to the optimal quantity)… or positiveMaking social value greater than private valueLeads 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 policiesCorrective taxes (pigouvian taxes) or subsidiesTaxes that induce private decision makers to take into account the social costs generated by a negative externalitySubsidies that induce private decision makers to take into account the social benefits generated by a positive externalityTradable pollution permitsFirms 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 GoodsAre goods that are non- excludable and non-rivalSome important public goods are:National defenseKnowledge created through basic researchFighting povertyPublic 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 waterCongested roadsFish, whales, and other wildlifeLeads 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 resourceImpose a corrective taxAuction off permits allowing use of the resourceIf the resource is land, convert to a private good by dividing and selling parcels to individuals40
41 14) Competition profit Q Qoptimal Costs, P MC P MR ATC QCosts, PCompetitive 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.MCATCPMRQoptimalprofitATCat Q optimalThe 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=MCHowever, unlike competitive firms their MR is lower than their PBecause, since monopolies are the only seller, face the market demand curve – in order to sell additional units they need to lower the priceThey 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 lossQuantityPriceDeadweight lossDMCMRPMCQMP = MCQCIt’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