1. Microeconomics: Review

2. International Trade
Interdependence and trade allow everyone to enjoy a greater quantity and variety of goods & services.
Comparative advantage means being able to produce a good at a lower opportunity cost. Absolute advantage means being able to produce a good with fewer inputs.
When people – or countries – specialize in the goods in which they have a comparative advantage, the economic “pie” grows and trade can make everyone better off.

3. A C T I V E L E A R N I N G 4: Absolute & comparative advantage
Argentina and Brazil each have 10,000 hours of labour per month, and the following technologies:
Argentina
producing one pound coffee requires 2 hours
producing one bottle wine requires 4 hours
Brazil
producing one pound coffee requires 1 hour
producing one bottle wine requires 5 hours
Which country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine? 3

4. A C T I V E L E A R N I N G 4: Answers
Brazil has an absolute advantage in coffee:
Producing a pound of coffee requires only one labour-hour in Brazil, but two in Argentina.
Argentina has a comparative advantage in wine:
Argentina’s opp. cost of wine is two pounds of coffee, because the four labour-hours required to produce a bottle of wine could instead produce two pounds of coffee.
Brazil’s opp. cost of wine is five pounds of coffee. 4

5. Markets and Competition
A market is a group of buyers and sellers of a particular good or service.
A competitive market is one in which there are so many buyers and so many sellers that each has a negligible impact on the market price.
A perfectly competitive market:
all goods are exactly the same
buyers & sellers so numerous that no one can affect the market price – each is a “price taker”
In this chapter, we assume markets are perfectly competitive.
In the real world, there are relatively few perfectly competitive markets. Most goods come in lots of different varieties – including ice cream, the example in the textbook. And there are many markets in which the number of firms is small enough that some of them have the ability to affect the market price. For now, though, we look at supply and demand in perfectly competitive markets, for two reasons: First, it’s easier to learn. Understanding perfectly competitive markets makes it a lot easier to learn the more realistic but complicated analysis of imperfectly competitive markets. Second, despite the lack of realism, the perfectly competitive model can teach us a LOT about how the world works, as we will see many times in the chapters that follow.

6. Demand Curve Shifters: Income
Demand for a normal good is positively related to income.
An increase in income causes increase in quantity demanded at each price, shifting the D curve to the right.
(Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.)

7. Summary: Variables That Affect Demand
Variable A change in this variable…
Price …causes a movement along the D curve
No. of buyers …shifts the D curve
Income …shifts the D curve
Price of related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve
Students should notice that the only determinant of quantity demanded that causes a movement along the curve is price. Also notice: price is one of the variables measured along the axes of the graph.
Here’s a handy “rule of thumb” to help students remember whether the curve shifts: If the variable causing demand to change is measured on one of the axes, you move along the curve. If the variable that’s causing demand to change is NOT measured on either axis, then the curve shifts.
This rule of thumb works with all curves in economics that involve an X-Y relationship. (I.e., it works for the supply curve, the marginal cost curve, the IS and LM curves, among many others, but it doesn’t apply to curves drawn on time series graphs.)

8. Summary: Variables That Affect Supply
Variable A change in this variable…
Price …causes a movement along the S curve
Input prices …shifts the S curve
Technology …shifts the S curve
No. of sellers …shifts the S curve
Expectations …shifts the S curve
Again, the price is the only determinant of quantity supplied that causes a movement along the curve. A change in any of the other determinants causes the supply curve to shift.

9. A C T I V E L E A R N I N G 2: Supply curve
Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios?
A. Retailers cut the price of the software.
B. A technological advance allows the software to be produced at lower cost.
C. Professional tax return preparers raise the price of the services they provide.
Examples of tax return preparation software include TurboTax by Quicken and TaxCut by H&R Block.

10. A C T I V E L E A R N I N G 2: A. fall in price of tax return software
Quantity of tax return software
The S curve does not shift.
Move down along the curve to a lower P and lower Q. S1 P1 Q1 Q2 P2

11. The S curve shifts to the right:
A C T I V E L E A R N I N G 2: B. fall in cost of producing the software
Price of tax return software
The S curve shifts to the right:
at each price, Q increases. S2 S1 P1 Q2 Q1
Quantity of tax return software

12. A C T I V E L E A R N I N G 2: C. professional preparers raise their price
Price of tax return software
Quantity of tax return software S1
This shifts the demand curve for tax preparation software, not the supply curve.

13. Surplus:
when quantity supplied is greater than quantity demanded P Q
Facing a surplus, sellers try to increase sales by cutting the price. S D
Surplus
This causes QD to rise
and QS to fall…
…which reduces the surplus.

14. Shortage: P Q S D Shortage
when quantity demanded is greater than quantity supplied P Q
Facing a shortage, sellers raise the price, S D
causing QD to fall
and QS to rise,
…which reduces the shortage.
Shortage

15. A C T I V E L E A R N I N G 3: Changes in supply and demand
Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads.
Event A: A fall in the price of compact discs
Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell.
Event C: Events A and B both occur.
In case it’s not clear: The royalties that sellers must pay the artists are part of the sellers’ “costs of production.” Typically, this royalty is a fixed amount each time one of the artist’s songs is downloaded. Event B is a reduction in this cost.

16. A C T I V E L E A R N I N G 3: A. fall in price of CDs
The market for music downloads P Q S1
STEPS D1 D2
1. D curve shifts P1 Q1
2. D shifts left P2 Q2
3. P and Q both fall.
This is an extension of Active Learning exercise 1C, where we saw that a fall in the price of compact discs would cause a fall in demand for music downloads, because the two goods are substitutes.

17. A C T I V E L E A R N I N G 3: B. fall in cost of royalties
The market for music downloads P Q S1 S2
STEPS D1
1. S curve shifts P1 Q1
2. S shifts right Q2 P2
(royalties are part of sellers’ costs)
NOTE: Don’t worry that the text on this slide looks garbled in “Normal view” (i.e. edit mode). It works fine in “Slide Show” (i.e. presentation mode).
Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. This event causes a fall in “costs of production” for sellers of music downloads. Hence, the S curve shifts to the right.
3. P falls, Q rises.

18. A C T I V E L E A R N I N G 3: C. fall in price of CDs AND fall in cost of royalties
STEPS
1. Both curves shift (see parts A & B).
2. D shifts left, S shifts right.
3. P unambiguously falls.
Effect on Q is ambiguous: The fall in demand reduces Q, the increase in supply increases Q.
It’s not necessary to draw a graph here. The answers to steps 1 and 2 should be clear from parts A and B. The answer to step 3 is a combination of the results from A and B.

19. The Determinants of Price Elasticity: A Summary
The price elasticity of demand depends on:
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.
This slide is a convenience for your students, and replicates a similar table from the text.
If you’re pressed for time, it is probably safe to omit this slide from your presentation.

20. A C T I V E L E A R N I N G 3: Elasticity and changes in equilibrium
The supply of beachfront property is inelastic. The supply of new cars is elastic.
Suppose population growth causes demand for both goods to double (at each price, Qd doubles).
For which product will P change the most?
For which product will Q change the most?
This is one of the “Problems and Applications” at the end of the chapter. 20

21. A C T I V E L E A R N I N G 3: Answers
Beachfront property (inelastic supply):
When supply is inelastic, an increase in demand has a bigger impact on price than on quantity. P Q S D1 D2 B Q2 P2
In this slide and the next, the initial price and quantity and the two demand curves are the same. The only difference is the elasticity of supply and slope of the supply curve.
[The D curve shifts to the right, but not in a parallel fashion: at each price, quantity demanded is twice as high, so the new D curve will be flatter than the initial one.]
In the text box containing the verbal explanation, “bigger impact” is shorthand for “bigger percentage impact” or “bigger proportional impact.” Q1 P1 A 21

22. A C T I V E L E A R N I N G 3: Answers
New cars (elastic supply):
When supply is elastic, an increase in demand has a bigger impact on quantity than on price. P Q D1 D2 S Q2 P2 B Q1 P1 A 22

23. Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand P Q
In this case, buyers bear most of the burden of the tax. D PB S
Buyers’ share of tax burden
Tax
Price if no tax
Sellers’ share of tax burden PS
We have just seen that tax incidence is not affected by whether the government makes buyers or sellers pay the tax. So what, then, does determine tax incidence? Turns out it’s elasticity – specifically, the price elasticities of supply and demand.
There are two cases: 1) supply is more price-elastic than demand (this slide), and 2) demand is more price-elastic than supply (next slide).
When supply is more price-elastic than demand, sellers are relatively more responsive to changes in price, and the supply curve is less steep than the demand curve. Buyers have relatively fewer alternatives, so they have to “eat” most of the price increase caused by the imposition of the tax.

24. Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply P Q
In this case, sellers bear most of the burden of the tax. S D
Buyers’ share of tax burden PB
Tax
Price if no tax
Sellers’ share of tax burden
The size of the tax is the same in this diagram as in the one on the preceding slide.
When demand is more price-elastic than supply, buyers are relatively more price-sensitive, and the demand curve is less steep than the supply curve. Buyers have relatively more alternatives, so they can avoid most of the tax. Sellers are less flexible, so they have to “eat” a greater share of the price increase caused by the tax. PS

25. Other Elasticities
The income elasticity of demand measures the response of Qd to a change in consumer income.
Income elasticity of demand =
Percent change in Qd
Percent change in income
Recall from chap.4: An increase in income causes an increase in demand for a normal good.
Hence, for normal goods, income elasticity > 0.
For inferior goods, income elasticity < 0.
This topic and the next one (cross-price elasticity) do not appear anywhere else in the book. Instructors who are pressed for time may consider cutting these topics.
(This is not the official position of Greg Mankiw or Thomson/South-Western, it’s just my suggestion.)

26. Other Elasticities
The cross-price elasticity of demand measures the response of demand for one good to changes in the price of another good.
Cross-price elast. of demand =
% change in Qd for good 1
% change in price of good 2
For substitutes, cross-price elasticity > 0 E.g., an increase in price of beef causes an increase in demand for chicken.
For complements, cross-price elasticity < 0 E.g., an increase in price of computers causes decrease in demand for software.

27. Evaluating the Market EquilibriumP Q
Market eq’m: P = $30 Q = 15,000
Total surplus = CS + PS
Is the market eq’m efficient? D CS S PS

28. A C T I V E L E A R N I N G 1: Answers to B
A $100 tax on airplane tickets P Q $ CS
= ½ x $150 x 75
= $5,625 D S
PS = $5,625
PB =
tax revenue
= $100 x 75
= $7,500
PS =
To compute DWL, simply subtract total surplus with the tax ($18750) from total surplus without the tax ($20,000, which was computed on the preceding slide).
total surplus = $18,750
DWL = $1,250 28

29. Analysis of a Tariff on Cotton Shirts
free trade
CS = A + B + C D + E + F
PS = G
Total surplus = A + B + C + D + E + F + G
tariff
CS = A + B
PS = C + G
Revenue = E
Total surplus = A + B + C + E + G P Q
Cotton shirts
deadweight loss = D + F D S A B
$30 40 70
The tariff benefits domestic producers, by allowing them to sell for a higher price. Producer surplus increases by C.
The tariff makes consumers worse off, because they have to pay a higher price. Consumer surplus falls by C + D + E + F.
The tariff generates revenue for the government equal to E.
The losses from the tariff exceed the gains, so total welfare falls. The tariff reduces total surplus by (D + F). C E D F
$20 25 80 G

30. A C T I V E L E A R N I N G 2: Elasticity and DWL of a tax
Would the DWL of a tax be larger if the tax were on
A. Rice Krispies or sunscreen?
B. Hotel rooms in the short run or hotel rooms in the long run?
C. Groceries or meals at fancy restaurants?
These examples (rice krispies vs. sunscreen) were chosen not because they are exciting real-world policy debates, but because they link back to the examples used in Chapter 5 to help students deduce the factors that determine elasticity.
Suggestion: Display all three questions and give students a few moments to think about it. Then, proceed to the following slides…
It might be worth mentioning to students: For each pair of goods, we are considering taxes of similar relative magnitude. (E.g., it wouldn’t be fair to ask whether a $10 per bottle tax on sunscreen has a bigger DWL than a $0.01 tax on boxes of Rice Krispies.) 30

31. A C T I V E L E A R N I N G 2: Answers
A. Rice Krispies or sunscreen
From Chapter 5: Rice Krispies has many more close substitutes than sunscreen, so demand for Rice Krispies is more price-elastic than demand for sunscreen.
So, a tax on Rice Krispies would cause a larger DWL than a tax on sunscreen.
Suggestion: Display the first line, then invite students to volunteer their answers before displaying the explanation. 31

32. A C T I V E L E A R N I N G 2: Answers
B. Hotel rooms in the short run or long run
From Chapter 5: The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run.
So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run. 32

33. A C T I V E L E A R N I N G 2: Answers
C. Groceries or meals at fancy restaurants
From Chapter 5: Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants.
So, a tax on restaurant meals would cause a larger DWL than a tax on groceries. 33

34. A C T I V E L E A R N I N G 3: Discussion question
The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants.
Which should it tax?
Engage your students and give them a brief break from lecture. Show this slide and ask for students to volunteer their thoughts. The question on this slide will almost certainly elicit a few different opinions.
Of course, there is no single “correct” answer – one choice is not unambiguously better than the other. A tax on groceries would be more efficient (smaller DWL) than a tax on restaurant meals. However, a tax on groceries would hurt people with low incomes proportionately more than people with higher incomes, as the former spend a larger percentage of their income on groceries. Hence, such a tax would be regressive.
Once again, we see the tradeoff between efficiency and equity. 34

35. DWL and the Size of the TaxP Q D S
Initially, the tax is T per unit.
new DWL
Doubling the tax 2T Q2
causes the DWL to more than double. T Q1
initial DWL
The new DWL is four times bigger than the initial DWL, even though the tax is just twice as large.

36. DWL and the Size of the TaxP Q D S
new DWL
Initially, the tax is T per unit. 3T Q3
Tripling the tax
causes the DWL to more than triple. Q1 T
initial DWL
The new DWL is nine times bigger than the initial DWL, even though the tax is only three times as large.

37. Revenue and the Size of the TaxP Q D S
When the tax is small, increasing it causes tax revenue to rise. PB Q2 2T PB Q1 T PS PS

38. Revenue and the Size of the TaxP Q D S PB Q3 3T PB Q2
When the tax is larger, increasing it causes tax revenue to fall. 2T PS PS

39. Revenue and the Size of the Tax
The Laffer curve shows the relationship between the size of the tax and tax revenue.
The Laffer curve
Tax size
Tax revenue
The Laffer curves shown here and in the book are symmetric, and their peak occurs in the middle. This need not be the case, and probably is not the case. However, we just don’t know where the peak is – it could be at a tax rate of 20% or a tax rate of 200% - and surely varies across goods.
The textbook has some excellent discussion of the Laffer curve, President Reagan, and supply-side economics, which you should encourage your students to read.

40. EXAMPLE 2: The Various Cost Curves Together$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
ATC
AVC
AFC MC

41. A C T I V E L E A R N I N G 3: Costs
Fill in the blank spaces of this table. Q VC TC
AFC
AVC
ATC MC
$50
n.a.
n.a.
n.a.
$10 1 10
$10
$60.00 2 30 80 30 3
16.67 20
36.67 4
100
150
12.50
37.50 5
150 30 60 6
210
260
8.33 35
43.33 41

42. A C T I V E L E A R N I N G 3: Answers
Use AVC = VC/Q
First, deduce FC = $50 and use FC + VC = TC.
Use AFC = FC/Q
Use relationship between MC and TC
Use ATC = TC/Q Q VC TC
AFC
AVC
ATC MC $0
$50
n.a.
n.a.
n.a.
$10 1 10 60
$50.00
$10
$60.00 20 2 30 80
25.00 15
40.00 30 3 60
110
16.67 20
36.67 40 4
100
150
12.50 25
37.50 50 5
150
200
10.00 30
40.00 60 6
210
260
8.33 35
43.33 42

43. The Revenue of a Competitive Firm
Total revenue (TR)
Average revenue (AR)
Marginal Revenue (MR): The change in TR from selling one more unit.
TR = P x Q TR Q
AR =
= P
∆TR ∆Q
MR =
These revenue concepts are analogous to the cost concepts (TC, ATC, MC) in the previous chapter.

44. profit-maximizing quantity
A Firm With Profits
Costs, P MC
revenue per unit = P MR Q
profit
ATC
profit per unit = P – ATC
cost per unit =
ATC
This slide is “hidden” and will not display in your presentation. I have included it here in case you would like to substitute it for “Active Learning 2A.”
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. Q
profit-maximizing quantity

45. loss-minimizing quantity
A Firm With Losses
Costs, P MC
ATC
cost per unit =
ATC Q
loss
loss per unit
revenue per unit = P MR
This slide is “hidden” and will not display in your presentation. I have included it here in case you would like to substitute it for “Active Learning 2B.”
The height of the rectangle is ATC – P, loss per unit.
The width of the rectangle is Q, the number of units.
The area of the rectangle
= height x width
= (loss per unit) x (number of units)
= total loss. Q
loss-minimizing quantity

46. The Monopolist’s Profit
Quantity
Costs and Revenue
ATC D MR MC
As with a competitive firm, the monopolist’s profit equals
(P – ATC) x Q P
ATC Q
© 2008 Nelson Education Ltd.