Review Principle of Micro Economics Spring 2006 Professor Rutstrom

Learning Objectives: Why scarcity of resources necessitates that choices must be made, and thus why trade-offs occur when decisions are made.

Why scarcity of resources necessitates that choices must be made,

and thus why trade-offs occur when decisions are made.

Scarcity Not enough of a good to fulfill everyone’s wants Leads to positive price since many people want it for many different uses – competing uses A good that is not scarce would have a price of zero Choices have to be made regarding what to use the resource for There are trade-offs between different uses Opportunity costs Shortage – completely different concept: Quantity demanded exceeds the quantity supplied at the price floor

Not enough of a good to fulfill everyone’s wants

Leads to positive price since many people want it for many different uses – competing uses

A good that is not scarce would have a price of zero

Choices have to be made regarding what to use the resource for

There are trade-offs between different uses

Opportunity costs

Shortage – completely different concept: Quantity demanded exceeds the quantity supplied at the price floor

Opportunity cost Includes both explicit and implicit costs Explicit costs: outlay of money This money could have gotten you something else of equal monetary value Implicit costs: other opportunity costs that do not involve money outlays The best alternative opportunity

Includes both explicit and implicit costs

Explicit costs: outlay of money

This money could have gotten you something else of equal monetary value

Implicit costs: other opportunity costs that do not involve money outlays

The best alternative opportunity

Example: You have $50 to spend on either a ticket at House of Blues or on a ticket at the Hard Rock Café. You value both concerts at $90. Parking free at HOB but it is $10 at HRC.What is the opportunity cost of going to HOB? Answer: $80. Explanation: $90 value of HRC minus the additional cost of parking $( = $80) Why is the $50 for the ticket not included? It is part of explicit costs. OC=50+(90-50-10)=90-10=80

You have $50 to spend on either a ticket at House of Blues or on a ticket at the Hard Rock Café.

You value both concerts at $90.

Parking free at HOB but it is $10 at HRC.What is the opportunity cost of going to HOB?

Answer: $80. Explanation: $90 value of HRC minus the additional cost of parking $( = $80)

Why is the $50 for the ticket not included? It is part of explicit costs.

OC=50+(90-50-10)=90-10=80

Next best alternative What if you could also go to the Carr Performing Art Center for a $50 ticket. There you can find free parking The value of the concert at Carr is $70 What is the opportunity cost of HOB: The rank ordering is: 1) HOB, 2) HRC, and 3) Carr Thus opportunity cost of HOB is HRC ($80) and not Carr ($70)

What if you could also go to the Carr Performing Art Center for a $50 ticket.

There you can find free parking

The value of the concert at Carr is $70

What is the opportunity cost of HOB:

The rank ordering is: 1) HOB, 2) HRC, and 3) Carr

Thus opportunity cost of HOB is HRC ($80) and not Carr ($70)

Learning Objective To differentiate between comparative and absolute advantage, and to explain why the former is the key principle behind gains from trade.

To differentiate between comparative and absolute advantage, and to explain why the former is the key principle behind gains from trade.

Comparative advantage Constant or increasing opportunity cost Production Possibility Frontier Scarcity forces choices You have a comparative advantage in doing that which you have a lower opportunity cost for than anyone else Numeric example based on labor cost or productivity

Constant or increasing opportunity cost

Production Possibility Frontier

Scarcity forces choices

You have a comparative advantage in doing that which you have a lower opportunity cost for than anyone else

Numeric example based on labor cost or productivity

Numeric example based on production possibility frontier (linear)

Table 1 The Production Opportunities of the Farmer and Rancher Copyright © 2004 South-Western

Table 2 The Gains from Trade: A Summary Copyright © 2004 South-Western

Gains from trade The Rancher has a lower total explicit cost (measured here in time rather than in money) than the farmer for both meat and potatoes Rancher has a lower opportunity cost in meat (foregone potato production) than the farmer Farmer has a lower opportunity cost in potatoes (foregone mean production) than the rancher Lower opportunity cost means it takes less potatoes to compensate him for the time it takes to produce meat Thus opportunity cost is the key principles behind maximizing the gains from trade

The Rancher has a lower total explicit cost (measured here in time rather than in money) than the farmer for both meat and potatoes

Rancher has a lower opportunity cost in meat (foregone potato production) than the farmer

Farmer has a lower opportunity cost in potatoes (foregone mean production) than the rancher

Lower opportunity cost means it takes less potatoes to compensate him for the time it takes to produce meat

Thus opportunity cost is the key principles behind maximizing the gains from trade

Comparative and Absolute Advantage Can you have an absolute advantage in all activities and still benefit from trade? Can you have a comparative advantage in all activities? Can you have an absolute advantage in some activity that you do not have a comparative advantage in? Can you have a comparative advantage in some activity that you do not have an absolute advantage in?

Can you have an absolute advantage in all activities and still benefit from trade?

Can you have a comparative advantage in all activities?

Can you have an absolute advantage in some activity that you do not have a comparative advantage in?

Can you have a comparative advantage in some activity that you do not have an absolute advantage in?

Learning Objective To calculate, in addition to articulate the distinction among, the various costs of production, and furthermore describe why certain costs matter for making economic decisions and why others do not.

To calculate, in addition to articulate the distinction among, the various costs of production, and furthermore describe why certain costs matter for making economic decisions and why others do not.

Cost curves Production function Diminishing marginal product (returns) to variable factor (labor) because of fixed factors in short run Upward sloping MC curve (TC curve has an increasing slope) Cost functions in short run ATC and AVC MC intersects ATC and AVC in minimum points MC = Δ TC= Δ VC AFC is everywhere decreasing Draw the curves and calculate costs in table

Production function

Diminishing marginal product (returns) to variable factor (labor) because of fixed factors in short run

Upward sloping MC curve (TC curve has an increasing slope)

Cost functions in short run

ATC and AVC

MC intersects ATC and AVC in minimum points

MC = Δ TC= Δ VC

AFC is everywhere decreasing

Draw the curves and calculate costs in table

Figure 6 Big Bob’s Cost Curves Copyright © 2004 South-Western (b) Marginal- and Average-Cost Curves Quantity of Output (bagels per hour) Costs $3.00 2.50 2.00 1.50 1.00 0.50 0 4 2 6 8 14 12 10 MC ATC AVC AFC

How do costs matter for decisions? All cost curves capture opportunity cost (explicit plus implicit cost) Profit maximizing decision of Q depends only on MC MC depends only on VC, not on FC FC influences total profits/losses at that Q Profits (economic) = TR-TC Profits = (P-ATC) * Q

All cost curves capture opportunity cost (explicit plus implicit cost)

Profit maximizing decision of Q depends only on MC

MC depends only on VC, not on FC

FC influences total profits/losses at that Q

Profits (economic) = TR-TC

Profits = (P-ATC) * Q

Learning Objectives To identify and classify the determinants of demand functions, that is to say, to be able to recognize the single factor that causes a change in quantity demanded, versus those factors that cause a change in demand. To identify and classify the determinants of supply functions, that is to say, to be able to recognize the single factor that causes a change in quantity supplied, versus those factors that cause a change in supply.

To identify and classify the determinants of demand functions, that is to say, to be able to recognize the single factor that causes a change in quantity demanded, versus those factors that cause a change in demand.

To identify and classify the determinants of supply functions, that is to say, to be able to recognize the single factor that causes a change in quantity supplied, versus those factors that cause a change in supply.

Demand and Supply What is the only factor that causes a change along a demand curve? Law of Demand What are the factors that cause a shift in demand? What is the only factor that causes a change along a supply curve? Law of Supply What are the factors that cause a shift in supply?

What is the only factor that causes a change along a demand curve? Law of Demand

What are the factors that cause a shift in demand?

What is the only factor that causes a change along a supply curve? Law of Supply

What are the factors that cause a shift in supply?

Table 1 Variables That Influence Buyers Copyright©2004 South-Western

Table 2 Variables That Influence Sellers Copyright©2004 South-Western

Learning Objective To define, calculate, and determine the economic implications of price elasticity of demand, price elasticity of supply, income elasticity, and cross-price elasticity of demand.

To define, calculate, and determine the economic implications of price elasticity of demand, price elasticity of supply, income elasticity, and cross-price elasticity of demand.

Elasticities Percentage change in quantity divided by percentage change in price (using midpoints on the lines) Price Elasticity of Demand Cross Price Elasticity of Demand Substitutes and Complements Income Elasticity of Demand Normal and Inferior goods Price Elasticity of Supply

Percentage change in quantity divided by percentage change in price (using midpoints on the lines)

Price Elasticity of Demand

Cross Price Elasticity of Demand

Substitutes and Complements

Income Elasticity of Demand

Normal and Inferior goods

Price Elasticity of Supply

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

The Price Elasticity of Demand and Its Determinants Demand tends to be more elastic : the larger the number of close substitutes. if the good is a luxury. the more narrowly defined the market. the longer the time period.

Demand tends to be more elastic :

the larger the number of close substitutes.

if the good is a luxury.

the more narrowly defined the market.

the longer the time period.

Determinants of Elasticity of Supply Ability of sellers to change the amount of the good they produce. Beach-front land is inelastic. Books, cars, or manufactured goods are elastic. Time period. Supply is more elastic in the long run.

Ability of sellers to change the amount of the good they produce.

Beach-front land is inelastic.

Books, cars, or manufactured goods are elastic.

Time period.

Supply is more elastic in the long run.

Figure Linear Demand Curves Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Elasticity > 1 Elasticity = 1 Elasticity < 1 Demand

Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Quantity 0 Price An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240 Total Revenue Increases with an Increase in Price Demand Revenue = $100 Revenue = $240 Demand $1 100 $3 80

Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Quantity 0 Price An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100 Total Revenue Decreases with an Increase in Price Demand Revenue = $200 $4 50 Demand Revenue = $100 $5 20

MR curve Lowering price when P is high and Q is small Increases total revenue = positive MR Lowering price when P is low and Q is large Decreases total revenue = negative MR Total revenues are maximized at the midpoint of a linear demand curve Where we have unit elasticity

Lowering price when P is high and Q is small

Increases total revenue = positive MR

Lowering price when P is low and Q is large

Decreases total revenue = negative MR

Total revenues are maximized at the midpoint of a linear demand curve

Where we have unit elasticity

Learning Outcome To determine the market clearing price and quantity in a market, and to predict the effect on the equilibrium price and quantity when the factors that shift a demand or supply curve change.

To determine the market clearing price and quantity in a market, and to predict the effect on the equilibrium price and quantity when the factors that shift a demand or supply curve change.

Predicting Competitive Market Outcomes Equilibrium price and quantity Increase in Demand and increase in Supply – both shift right along Q axis thus Q increases, D shifts up and S down along P axis thus P ambiguous Increase in Demand and decrease in Supply Decrease in Demand and increase in Supply Decrease in Demand and decrease in Supply

Equilibrium price and quantity

Increase in Demand and increase in Supply –

both shift right along Q axis thus Q increases, D shifts up and S down along P axis thus P ambiguous

Increase in Demand and decrease in Supply

Decrease in Demand and increase in Supply

Decrease in Demand and decrease in Supply

Table 4 What Happens to Price and Quantity When Supply or Demand Shifts? Copyright©2004 South-Western