COMMON MISTAKES ON THE AP MICRO EXAM Compiled by: John Ostick Malvern Prep Malvern, PA 19355

Consumer and Producer Surplus

Dead Weight Loss

Dead Weight Loss When the Price is Above P* Q/t P Demand Supply A C 0 Q’ Q* E F P’ P* B Value to the Consumer: 0AEQ’ Consumers Pay Producers: OP’EQ’ The Variable Cost to Producers: OBFQ’ Consumer Surplus: P’AC Producer Surplus: BP’EF DWL FEC

Dead Weight Loss When the Price is Below P* Q/t P Demand Supply A P* C 0 Q’ Q* E F P’ B Value to the Consumer: 0AEQ’ Consumers Pay Producers: OP’FQ’ The Variable Cost to Producers: OBFQ’ Consumer Surplus: P’AEF Producer Surplus: BP’F DWL FEC

ELASTICITY Tax Incidence & Effects on Revenue and Prices

Tax Revenues Efficiency Loss of a Tax Role of Elasticities Qualifications Redistributive Goals Reducing Negative Externalities TAX INCIDENCE AND EFFICIENCY LOSS

Perfectly Inelastic Demand D Q/t P S2S2 Q 1 =Q 2 P2P2 S1S1 P1P1

Perfectly Elastic Demand Q/t P D S2S2 P 1 =P 2 Q2Q2 S1S1 Q1Q1

Inelastic Demand (at moderate prices) P Q/t D S1S1 P1P1 Q1Q1 Q2Q2 S2S2 P2P2

Elastic Demand (at moderate prices) Q/t P Q1Q1 D S1S1 P1P1 S2S2 P2P2 Q2Q2

DIMINISHING RETURNS  Explanation: As additional units of a variable input (labor) are added to a fixed input (capital), at some point the additional output resulting from the addition of one more unit of variable input declines. This decline is referred to as diminishing marginal return. At this point, total product increases at a decreasing rate.

 Rationale: As the variable input increases and the fixed input, by definition, remains the same, there is less fixed input with which the variable input can be combined. Example: As more workers are added but capital remains the same, there is less capital per worker.

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and marginal product, MP Quantity of Labor Total Product Marginal Product Average Product Increasing Marginal Returns

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and marginal product, MP Quantity of Labor Total Product Marginal Product Average Product Diminishing Marginal Returns

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and marginal product, MP Quantity of Labor Total Product Marginal Product Average Product Negative Marginal Returns

Two Approaches to Find the PROFIT MAXIMIZING QUANTITY ( PRICE)

$1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1, Total revenue and total cost Total Revenue Total Cost Maximum Economic Profits $299 Break-Even Point (Normal Profit) Break-Even Point (Normal Profit) TOTAL REVENUE-TOTAL COST APPROACH

$ Cost and Revenue MC MR AVC ATC Economic Profit $ $97.78 MARGINAL REVENUE-MARGINAL COST APPROACH Profit Maximization Position

Key Micro Formulas

RELATIONSHIPECONOMIC INTERPRETATION MR = MCWhen MR = MC, we know that the firm has chosen the output that maximizes profits. P > ATCFirm is earning ECONOMIC PROFITS P = ATCFirm is earning NORMAL PROFIT (Break-Even Point) (economic profit = 0) P < ATC P > AVC Loss Minimization P = AVCSHUTDOWN POINT (firm will loseTFC if they produce or Shutdown and produce 0. P < AVCFirm does not produce

Finding the Perfectly Competitive Firm’s Supply Curve

Cost and Revenue, (dollars) MC MR 1 AVC ATC MARGINAL REVENUE-MARGINAL COST APPROACH Quantity Supplied MR 2 MR 3 MR 4 MR 5 P1P1 P2P2 P3P3 P4P4 P5P5 Q2Q2 Q3Q3 Q4Q4 Q5Q5 Marginal Cost & Short-Run Supply Do not Produce – Below AVC

Cost and Revenue, (dollars) MC MR 1 MARGINAL REVENUE-MARGINAL COST APPROACH Quantity Supplied MR 2 MR 3 MR 4 MR 5 P1P1 P2P2 P3P3 P4P4 P5P5 Q2Q2 Q3Q3 Q4Q4 Q5Q5 Marginal Cost & Short-Run Supply Yields the Short-Run Supply Curve Supply No Production Below AVC

Long Run Equilibrium (Perfectly Competitive Firm)  Productive Efficiency  Allocative Efficiency

P MR Q MC ATC Quantity Price Price = MC = Minimum ATC (normal profit) LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM

How an Increase in Demand Changes Long- Run Equilibrium for the Firm and Industry

Temporary Profits and the Reestablishment Of Long-Run Equilibrium S1S1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN MR D1D1

An increase in demand increases profits… MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D2D2 Economic Profits S1S1

New Competitors increase supply and lower Prices decrease economic profits MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D2D2 Zero Economic Profits S1S1 S2S2

How an Decrease in Demand Changes Long- Run Equilibrium for the Firm and Industry

Decreases in demand, Losses and the Reestablishment of Long-Run Equilibrium S1S1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D1D1 MR

A decrease in demand creates losses… MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D2D2 Economic Losses S1S1

MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D2D2 Return to Zero Economic Profits S1S1 S3S3 Competitors with losses decrease supply and prices return to zero economic profits

Price and Marginal Revenue for a Monopoly

MONOPOLY REVENUES & COSTS Dollars $ $ Q Q

MONOPOLY REVENUES & COSTS Dollars $ $ MR Elastic D Q TR Q

MONOPOLY REVENUES & COSTS Q Dollars $ $ TR MR D InelasticElastic Q

Failing to remember how to shade the area of ECONOMIC PROFIT THE PROFIT-MAXIMIZING POSITION OF A MONOPOLY

Profit Maximization Under Monopoly D MC ATC MR $94 $122 Profit MR = MC Profit Per Unit OUTPUT AND PRICE DETERMINATION Q Price, costs, and revenue Remember the MR=MC Rule?

And the Shading of Economic Losses LOSS MINIMIZATION OF THE IMPERFECT COMPETITOR

Loss Minimization Under Monopoly D MC ATC MR A PmPm Loss MR = MC Loss Per Unit OUTPUT AND PRICE DETERMINATION Q Price, costs, and revenue AVC QmQm V Since P m exceeds AVC, the firm will produce

Monopoly vs. Competition

PURE COMPETITION MONOPOLY MR = MC The firms maximizes profit. MR = MC The firm maximizes profit. P = ATC The firms just BREAK-EVEN (NORMAL PROFITS) in the Long Run. P > ATC Long Run ECONOMIC PROFITS. P = min ATC Firm is forced to operate with maximum productive efficiency PRODUCTIVE EFFICIENCY (Least-Cost Method Production) P > min ATC Firm is not forced to operate with maximum productive efficiency. PRODUCTIVE INEFFICIENCY (Least-Cost Method Production not necessary) P = MC There is an optimal allocation of resources. ALLOCATIVE EFFICIENCY P > MC There is an UNDERALLOCATION of resources. ALLOCATIVE INEFFICIENCY P = MR The firm’s DEMAND CURVE is infinitely ELASTIC. P > MR The firm’s DEMAND CURVE is less than infinitely ELASTIC.

Q INEFFICIENCY OF PURE MONOPOLY P D MR S = MC PcPc PmPm QcQc QmQm At MR=MC A monopolist will sell less units at a higher price than in competition An industry in pure competition sells where supply and demand are equal

Q INEFFICIENCY OF PURE MONOPOLY P D MR S = MC PcPc PmPm QcQc QmQm At MR=MC A monopolist will sell less units at a higher price than in competition Monopoly pricing effectively creates an income transfer from buyers to the seller!

Not being able to GRAPH a Natural Monopoly and the Socially- Optimal Output and Fair-Return Output Levels

Natural Monopolies Rate Regulation Socially Optimum Price P = MC Fair-Return Price P = ATC Dilemma of Regulation REGULATED MONOPOLY Graphically…

REGULATED MONOPOLY Q D MR MC ATC P Price and Costs Monopoly Price MR = MC QmQm PmPm

REGULATED MONOPOLY Q D MR MC ATC P Price and Costs Socially-Optimum Price P = MC QrQr PrPr

REGULATED MONOPOLY Q D MR MC ATC P Price and Costs Fair-Return Price Normal Profit Only QfQf PfPf

REGULATED MONOPOLY Q D MR MC ATC P Price and Costs MR = MC Fair-Return Price Socially-Optimum Price QmQm QfQf QrQr Dilemma of Regulation Which Price? PmPm PfPf PrPr

Single PRICE Monopoly vs. Price Discrimination

Conditions Monopoly Power Market Segregation No Resale Consequences More Profit More Production PRICE DISCRIMINATION Graphically…

Q D MR MC ATC P Q1Q1 Price and Costs Economic profits with a single MR=MC price PRICE DISCRIMINATION

Q D MC ATC P Q1Q1 Price and Costs PRICE DISCRIMINATION Q2Q2 A perfectly discriminating monopolist has MR=D, producing more product and more profit! MR=D

Q D MC ATC P Q1Q1 Price and Costs Economic profits with price discrimination PRICE DISCRIMINATION Q2Q2 MR=D

Monopolistic Competiton What is it? Monopoly? Competition?

D MR P1P1 ATC Price and Costs Q1Q1 Economic Profits Expect New Competitors PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Quantity A1A1 MC

D MR P1P1 ATC Price and Costs Q1Q1 Economic Profits Expect New Competitors PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Quantity A1A1 New competition drives down the price level – leading to economic losses in the short run MC

D MR MC P2P2 ATC Price and Costs Q2Q2 Economic Losses PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Quantity A2A2

D MR MC P2P2 ATC Price and Costs Q2Q2 Economic Losses PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Quantity A2A2 With economic losses, firms will exit the market – Stability occurs when economic profits are zero

D MR MC P 3 = A 3 ATC Price and Costs Q3Q3 PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Quantity Long-Run Equilibrium Normal Profit Only

NOW, for the RESOURCE (Factor) MARKETS

Remember… Product Market: MR = MC Resource Market: MRP = MFC

Units of Resource Total Product (Output) Marginal product (MP) Product Price Total Revenue Marginal Revenue Product (MRP) ] ] ] ] ] ] Q P Resource price (wage rate) Quantity of resource demanded Pure Competition MRP AS A DEMAND SCHEDULE ] ] ] ] ] ] $2 2 $ 0 14 $ 14

Units of Resource Total Product (Output) Marginal product (MP) Product Price Total Revenue Marginal Revenue Product (MRP) ] ] ] ] ] ] Q P Resource price (wage rate) Quantity of resource demanded Pure Competition MRP AS A DEMAND SCHEDULE ] ] ] ] ] ] $2 2 $ $ 14 12

Units of Resource Total Product (Output) Marginal product (MP) Product Price Total Revenue Marginal Revenue Product (MRP) ] ] ] ] ] ] Q P Resource price (wage rate) Quantity of resource demanded Pure Competition MRP AS A DEMAND SCHEDULE ] ] ] ] ] ] $2 2 $ $

Units of Resource Total Product (Output) Marginal product (MP) Product Price Total Revenue Marginal Revenue Product (MRP) ] ] ] ] ] ] Q P Resource price (wage rate) Quantity of resource demanded Pure Competition MRP AS A DEMAND SCHEDULE ] ] ] ] ] ] $2 2 $ $ The purely competitive seller’s demand for a resource

Units of Resource Total Product (Output) Marginal product (MP) Product Price Total Revenue Marginal Revenue Product (MRP) ] ] ] ] ] ] Q P Resource price (wage rate) Quantity of resource demanded Pure Competition MRP AS A DEMAND SCHEDULE ] ] ] ] ] ] $2 2 $ $ The purely competitive seller’s demand for a resource Now, consider the case of resource demand under Imperfect Competition

Units of Resource Total Product (Output) Marginal product (MP) Product Price Total Revenue Marginal Revenue Product (MRP) ] ] ] ] ] ] Q P Resource price (wage rate) Quantity of resource demanded Imperfect Competition MRP AS A DEMAND SCHEDULE ] ] ] ] ] ] $ $ $ The imperfectly Competitive seller’s demand for a resource

LABOR MARKETS: Wage Determination

PURELY COMPETITIVE LABOR MARKET Purely competitive labor market: Many Firms Numerous Qualified Workers “Wage Taker” Behavior Market Demand for Labor Market Supply of Labor

Non- Labor Costs Labor Costs LABOR SUPPLY AND DEMAND PURELY COMPETITIVE MARKET Labor Market S D = MRP (  mrp’s) WcWc (1000) Individual Firm S = MRC d = mrp WcWc Quantity of Labor Wage Rate (dollars) Quantity of Labor ($10) (5) $10 Includes Normal Profit

Wage Rate (dollars) S Quantity of Labor MONOPSONISTIC LABOR MARKET In monopsony MRC lies above the supply curve

Wage Rate (dollars) MRP S WmWm Quantity of Labor MRC QmQm MONOPSONISTIC LABOR MARKET MRP = MRC Q m units of labor hired

Wage Rate (dollars) MRP S WmWm Quantity of Labor MRC WcWc QmQm QcQc The competitive solution would result in a higher wage and greater employment MONOPSONISTIC LABOR MARKET

EXTERNALITIES Negative Positive

COST-BENEFIT ANALYSIS Marginal Cost = Marginal Benefit Rule Spillover Costs Overallocation Spillover Benefits Underallocation Externalities

P Q SPILLOVER COSTS AND BENEFITS Illustrating a Negative Externality D 0 Spillover costs StSt S Overallocation Q0Q0 QeQe

P Q SPILLOVER COSTS AND BENEFITS Illustrating a Positive Externality 0 QeQe Q0Q0 D DtDt Spillover Benefits StSt Underallocation

Taxation Concepts

APPORTIONING THE TAX BURDEN Benefits-Received Principle Ability-to-Pay Principle Progressive Tax Regressive Tax Proportional Tax

TAX APPLICATIONS: Personal Income Tax Progressive Sales Tax Regressive Corporate Income Tax Proportional - Regressive Payroll Taxes Regressive Property Taxes Regressive Identify whether progressive, regressive, or proportional

Price Supports Surpluses Subsidies

EFFECT OF PRICE SUPPORTS PePe D S QeQe QcQc QsQs Surplus PsPs Surplus being created by the subsidies Q P Price Support Level

International Trade  Comparative Advantage  Case for Free Trade  Export Supply  Import Demand

Total output will be greatest when Each good is produced by the nation that has the lowest domestic opportunity cost for that good. U.S has comparative advantage in wheat Brazil has comparative advantage in coffee Principle of Comparative Advantage PRODUCTION POSSIBILITIES

Terms of Trade Gains From Trade Improved Options Principle of Comparative Advantage PRODUCTION POSSIBILITIES Trading Possibilities Line Graphically…

PRODUCTION POSSIBILITIES A B Coffee (tons) Wheat (tons) Curve For Each Country United StatesBrazil

TRADING POSSIBILITIES LINES Coffee (tons) A B Trading possibilities line Trading possibilities line Wheat (tons) The Gains from Trade United StatesBrazil

TRADING POSSIBILITIES LINES Coffee (tons) A B Trading possibilities line Trading possibilities line A’ B’ Wheat (tons) The Gains from Trade United StatesBrazil

TRADING POSSIBILITIES LINES Coffee (tons) A B Trading possibilities line Trading possibilities line A’ B’ Wheat (tons) The Gains from Trade United StatesBrazil The Case For Free Trade

U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand DdDd SdSd If the world price exceeds the U.S. price by 25 cents... $ Price (per pound; U.S. dollars) Quantity of Aluminum Price (per pound; U.S. dollars) $ Quantity of Aluminum

EXPORTS = 50 U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand $ DdDd Price (per pound; U.S. dollars) SURPLUS = 50 $ If the world price goes further up... SdSd Quantity of Aluminum

EXPORTS = 50 EXPORTS = 100 U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand $ DdDd Price (per pound; U.S. dollars) SURPLUS = 50 SURPLUS = 100 $ If world prices fall below $ SdSd U.S. export supply Quantity of Aluminum

SHORTAGE = 50 U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand $ DdDd Price (per pound; U.S. dollars) SURPLUS = 50 SURPLUS = 100 $ SdSd EXPORTS = 50 EXPORTS = 100 IMPORTS = 50 U.S. export supply Quantity of Aluminum

SHORTAGE = 50 SHORTAGE = 100 U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand $ DdDd Price (per pound; U.S. dollars) SURPLUS = 50 SURPLUS = 100 U.S. export supply EXPORTS = 50 EXPORTS = 100 IMPORTS = 50 IMPORTS = 100 U.S. import demand $ SdSd Quantity of Aluminum

CANADIAN EXPORT SUPPLY AND IMPORT DEMAND Canada’s Domestic Aluminum Market Canada’s Export Supply And Import Demand DdDd SHORTAGE = 50 $ Price (per pound; U.S. dollars) SURPLUS = 100 Canadian export supply Canadian import demand $ SdSd SURPLUS = 50 Quantity of Aluminum

EQUILIBRIUM WORLD PRICE AND QUANTITY OF EXPORTS & IMPORTS Price (per pound; U.S. dollars) U.S. export supply U.S. import demand Quantity of Aluminum Canadian export supply Canadian import demand $ Equilibrium