1. Chapter 2: A Review of Markets and Rational Behavior “…while the law [of competition] may be sometimes hard for the individual, it is best for the race, because it ensures the survival of the fittest in every department.” Andrew Carnegie “Markets change, tastes change, so the companies and the individuals who choose to compete in those markets must change.” Attributed to An Wang (founder of Wang Laboratories, a defunct computer company) “A commodity appears at first sight an extremely obvious, trivial thing. But its analysis brings out that it is a very strange thing, abounding in metaphysical subtleties and theological niceties.” Karl Marx

2. Perfect Competition  Classical Assumptions for Perfect Competition:  1. Many Buyers and Sellers: This assumption implies that no single producer or consumer will influence prices through individual action. One case which violates this assumption is a monopoly, or a single seller of a product.  2. Perfect information: Every buyer and seller is aware of the price and quality of the goods  3. Homogeneous product : The output of each firm in the market is identical.  4. Free entry and exit, or perfect mobility: Buyers or sellers can enter or leave a market without restriction or cost.  5. No Collusion : No group decision-making, including price fixing.  If the competitive assumptions are approximately true for a given market, both buyers and sellers will be price takers, meaning that no buyer or seller will have the power to influence the market price of the product.

3. Demand Shifts If the variable is NOT on an axis, its effect appears as a shift In the curve. If the variable IS on the axis its effect appears in the slope of the curve.

4. Supply Shifts

5. Figure 2-4: Equilibrium and Disequilibrium

6. Equilibrium with Numbers

7. Elasticity and the Minimum Wage

8. Elasticity and Total Spending

9. The Total and Marginal Value of Consumption Your Turn 2-8 : If Carrie consumes 5 mugs of coffee, what is the marginal value of the last mug? ____ What is the total value of all 5 mugs combined? ____

10. Total Value with a Linear Demand Curve Your Turn 2-9 : Find the total value for coffee purchased given the demand curve in Figure 2-6 below. Hint: find areas A and B first.

11. Consumer Surplus Definition: The net benefit of consumption, or the difference between total value and total spending, is called Consumer Surplus. Your Turn 2-11: Carrie’s Consumer Surplus. See Figure 2-7. Find the number of mugs Carrie will purchase at a price of $3, and then find her total spending, consumer surplus, and total value in dollars.

12. Consumer Surplus with Linear Demand Your Turn 2-12: Calculate the consumer surplus, total spending, and total value for Figure 2-6 below.

13. Your Turn: Equilibrium and Consumer Surplus Demand : Price = 12 - 2Q Supply : Price = 3 + Q Find the equilibrium price and quantity, and sketch both demand and supply curves including endpoints and equilibrium values. Find the consumer surplus, total spending, and total value to the consumer of this market.

14. Producer Surplus and Its Parts  Definitions:  Revenue = price x quantity sold  Opportunity cost: The sum of the marginal costs of producing each unit, and also the area under the supply curve and to the left of the quantity produced.  Producer Surplus equals the total revenue of producers minus the opportunity cost of production. Graphically producer surplus is the area between the market price and the height of the supply curve for a given unit of a good.

15. Producer Surplus Graphs  Figure 2-8: Costs and Benefits of Production Figure 2-9: Revenue, Opportunity Cost and Producer Surplus YOUR TURN 2-14 : Calculate the total spending, opportunity cost, and producer surplus for Figure 2-8. Why won’t firms produce the 7th unit? Your Turn 2-15 : Calculate the producer surplus and opportunity cost for Figure 2-9.

16. The Components of Producer Surplus: Economic Rent vs. Economic Profit  Economic Rent : Total Revenue minus opportunity cost for owners of inputs such as land or resources.  Economic Profit : Total Revenue minus the opportunity cost of production for owners of capital goods such as factories, stores or machines.

17. An example of Economic Rent In Figure 3-10, Jed can produce oil for $5 a barrel, but oil sells at $40 per barrel. The difference will show up in the Market price of Jed’s land and mineral rights. Therefore it is economic rent.

18. Long Run Equilibrium A market is in long run equilibrium if  (1) supply equals demand and  (2) economic profits are zero.  If both conditions exist, there is no incentive for firms to enter or exit the market.

19. Long Run Equilibrium and the Components of Producer Surplus  Economic Rent : Total Revenue minus opportunity cost for owners of inputs such as land or resources.  Economic Profit : Total Revenue minus the opportunity cost of production for owners of capital goods such as factories, stores or machines.  Long Run Equilibrium. A competitive market is in long run equilibrium if (1) supply equals demand and (2) economic profits are zero. If both conditions exist, there is no incentive for firms to enter or exit the market.  If a competitive market is in long run equilibrium, economic profits equal zero, so any producer surplus is made up of economic rent.

20. Net Gains for a Private Market: Consumer plus Producer Surplus Given the numbers on the axes, find the consumer surplus, producer surplus and net gains for this market.

21. Rational Consumer Choice and Incentives

22. The Budget Line: What is Affordable with fixed income and prices? (2-7) Income = P X X + P Y Y = spending on X + spending on Y. The Budget : Budget Line Formulas :

23. Utility Functions and Indifference Curves  ( 2-10) Utility = f(X,Y) This utility function has three dimensions; the level of total utility, the quantity of good X, and the quantity of good Y. The level of utility is determined by the quantities of the two goods consumed. Figure 2-13: Utility Function Figure 2-14: Indifference Curves

24. Utility Maximization: Choosing quantities of X and Y to reach the highest affordable level of utility (U 2 in figure 2-16)

25. Changes in Income Lead to Parallel Shifts in the Budget Line

26. Example of Price and Income Changes  Your Turn 2-19 :  A. Graph a budget line where income = $50 and the prices of X and Y both equal $10.  B. Now graph a new line with the same prices but an income of $70.  C. Now graph a third budget line with an income of $70 and prices of $ 7 for X and $10 for Y. Note how the endpoints and slopes of the budget lines change in each case.

27. Income and Substitution Effects of a Price Change Substitution Effect: The change in the quantities of X and Y caused by a change in their relative prices, holding utility constant. Income Effect: The change in the quantities of X and Y consumed caused by a change in income (or utility), holding prices constant at their new level.

28. Example: Gasoline Tax and Income Tax Rebate A tax on petrol or gasoline will raise the price, discourage consumption, and also lower utility. If income taxes are cut by the same amount as the gas tax revenue, raising the steeper budget line From point B to C, utility will probably remain lower.

29. Free Goods Consumers will consume a free good until they no longer gain any utility for additional units (marginal utility =0).

30. An Inconsistency in Consumer Surplus  Compensating Variation in income is the maximum amount a person is willing to pay for a marketed or non-marketed good.  Equivalent Variation in income is the minimum amount a person will accept in order to face a marketed or non-marketed cost such as a price increase or an increased non-monetary harm.  The two are not necessarily equal.

31. Hicks and Marshall Demand Curves  Concept: The Hicks Demand Curve measures the change in the quantity of X associated with the substitution effect of a price change after any change in utility is eliminated through a change in income.  A normal demand curve is often named the Marshall demand curve.

32. An Illustration of the 2 Types of Demand Curves The 2 types of demands are equal if there is no income effect on the quantity of X-Box games.

33. Conclusion  This chapter provides a review of microeconomic models of the competitive market and the rational consumer.  Concepts such as consumer surplus, producer surplus, and consumer choice provide the basis for comparing the efficiency dimension of public policy.  These models will be the cornerstone of much of the remainder of the book