Review Principle Of Micro Economics 1

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Review Principle Of Micro Economics 1

  1. 1. Review Principle of Micro Economics Spring 2006 Professor Rutstrom
  2. 2. Learning Objectives: <ul><li>Why scarcity of resources necessitates that choices must be made, </li></ul><ul><li>and thus why trade-offs occur when decisions are made. </li></ul>
  3. 3. Scarcity <ul><li>Not enough of a good to fulfill everyone’s wants </li></ul><ul><li>Leads to positive price since many people want it for many different uses – competing uses </li></ul><ul><li>A good that is not scarce would have a price of zero </li></ul><ul><li>Choices have to be made regarding what to use the resource for </li></ul><ul><li>There are trade-offs between different uses </li></ul><ul><ul><li>Opportunity costs </li></ul></ul><ul><li>Shortage – completely different concept: Quantity demanded exceeds the quantity supplied at the price floor </li></ul>
  4. 4. Opportunity cost <ul><li>Includes both explicit and implicit costs </li></ul><ul><li>Explicit costs: outlay of money </li></ul><ul><ul><li>This money could have gotten you something else of equal monetary value </li></ul></ul><ul><li>Implicit costs: other opportunity costs that do not involve money outlays </li></ul><ul><ul><li>The best alternative opportunity </li></ul></ul>
  5. 5. Example: <ul><li>You have $50 to spend on either a ticket at House of Blues or on a ticket at the Hard Rock Café. </li></ul><ul><li>You value both concerts at $90. </li></ul><ul><li>Parking free at HOB but it is $10 at HRC.What is the opportunity cost of going to HOB? </li></ul><ul><li>Answer: $80. Explanation: $90 value of HRC minus the additional cost of parking $( = $80) </li></ul><ul><li>Why is the $50 for the ticket not included? It is part of explicit costs. </li></ul><ul><li>OC=50+(90-50-10)=90-10=80 </li></ul>
  6. 6. Next best alternative <ul><li>What if you could also go to the Carr Performing Art Center for a $50 ticket. </li></ul><ul><li>There you can find free parking </li></ul><ul><li>The value of the concert at Carr is $70 </li></ul><ul><li>What is the opportunity cost of HOB: </li></ul><ul><li>The rank ordering is: 1) HOB, 2) HRC, and 3) Carr </li></ul><ul><li>Thus opportunity cost of HOB is HRC ($80) and not Carr ($70) </li></ul>
  7. 7. Learning Objective <ul><li>To differentiate between comparative and absolute advantage, and to explain why the former is the key principle behind gains from trade. </li></ul>
  8. 8. Comparative advantage <ul><li>Constant or increasing opportunity cost </li></ul><ul><li>Production Possibility Frontier </li></ul><ul><ul><li>Scarcity forces choices </li></ul></ul><ul><li>You have a comparative advantage in doing that which you have a lower opportunity cost for than anyone else </li></ul><ul><li>Numeric example based on labor cost or productivity </li></ul>
  9. 9. Numeric example based on production possibility frontier (linear)
  10. 10. Table 1 The Production Opportunities of the Farmer and Rancher Copyright © 2004 South-Western
  11. 11. Table 2 The Gains from Trade: A Summary Copyright © 2004 South-Western
  12. 12. Gains from trade <ul><li>The Rancher has a lower total explicit cost (measured here in time rather than in money) than the farmer for both meat and potatoes </li></ul><ul><li>Rancher has a lower opportunity cost in meat (foregone potato production) than the farmer </li></ul><ul><li>Farmer has a lower opportunity cost in potatoes (foregone mean production) than the rancher </li></ul><ul><li>Lower opportunity cost means it takes less potatoes to compensate him for the time it takes to produce meat </li></ul><ul><li>Thus opportunity cost is the key principles behind maximizing the gains from trade </li></ul>
  13. 13. Comparative and Absolute Advantage <ul><li>Can you have an absolute advantage in all activities and still benefit from trade? </li></ul><ul><li>Can you have a comparative advantage in all activities? </li></ul><ul><li>Can you have an absolute advantage in some activity that you do not have a comparative advantage in? </li></ul><ul><li>Can you have a comparative advantage in some activity that you do not have an absolute advantage in? </li></ul>
  14. 14. Learning Objective <ul><li>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. </li></ul>
  15. 15. Cost curves <ul><li>Production function </li></ul><ul><ul><li>Diminishing marginal product (returns) to variable factor (labor) because of fixed factors in short run </li></ul></ul><ul><ul><li>Upward sloping MC curve (TC curve has an increasing slope) </li></ul></ul><ul><li>Cost functions in short run </li></ul><ul><ul><li>ATC and AVC </li></ul></ul><ul><ul><li>MC intersects ATC and AVC in minimum points </li></ul></ul><ul><ul><li>MC = Δ TC= Δ VC </li></ul></ul><ul><ul><li>AFC is everywhere decreasing </li></ul></ul><ul><li>Draw the curves and calculate costs in table </li></ul>
  16. 16. 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
  17. 17. How do costs matter for decisions? <ul><li>All cost curves capture opportunity cost (explicit plus implicit cost) </li></ul><ul><li>Profit maximizing decision of Q depends only on MC </li></ul><ul><li>MC depends only on VC, not on FC </li></ul><ul><li>FC influences total profits/losses at that Q </li></ul><ul><li>Profits (economic) = TR-TC </li></ul><ul><li>Profits = (P-ATC) * Q </li></ul>
  18. 18. Learning Objectives <ul><li>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. </li></ul><ul><li>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. </li></ul>
  19. 19. Demand and Supply <ul><li>What is the only factor that causes a change along a demand curve? Law of Demand </li></ul><ul><li>What are the factors that cause a shift in demand? </li></ul><ul><li>What is the only factor that causes a change along a supply curve? Law of Supply </li></ul><ul><li>What are the factors that cause a shift in supply? </li></ul>
  20. 20. Table 1 Variables That Influence Buyers Copyright©2004 South-Western
  21. 21. Table 2 Variables That Influence Sellers Copyright©2004 South-Western
  22. 22. Learning Objective <ul><li>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. </li></ul>
  23. 23. Elasticities <ul><li>Percentage change in quantity divided by percentage change in price (using midpoints on the lines) </li></ul><ul><li>Price Elasticity of Demand </li></ul><ul><li>Cross Price Elasticity of Demand </li></ul><ul><ul><li>Substitutes and Complements </li></ul></ul><ul><li>Income Elasticity of Demand </li></ul><ul><ul><li>Normal and Inferior goods </li></ul></ul><ul><li>Price Elasticity of Supply </li></ul>
  24. 24. The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities <ul><li>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. </li></ul>
  25. 25. The Price Elasticity of Demand and Its Determinants <ul><li>Demand tends to be more elastic : </li></ul><ul><ul><li>the larger the number of close substitutes. </li></ul></ul><ul><ul><li>if the good is a luxury. </li></ul></ul><ul><ul><li>the more narrowly defined the market. </li></ul></ul><ul><ul><li>the longer the time period. </li></ul></ul>
  26. 26. Determinants of Elasticity of Supply <ul><li>Ability of sellers to change the amount of the good they produce. </li></ul><ul><ul><li>Beach-front land is inelastic. </li></ul></ul><ul><ul><li>Books, cars, or manufactured goods are elastic. </li></ul></ul><ul><li>Time period. </li></ul><ul><ul><li>Supply is more elastic in the long run. </li></ul></ul>
  27. 27. Figure Linear Demand Curves Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Elasticity > 1 Elasticity = 1 Elasticity < 1 Demand
  28. 28. 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
  29. 29. 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
  30. 30. MR curve <ul><li>Lowering price when P is high and Q is small </li></ul><ul><ul><li>Increases total revenue = positive MR </li></ul></ul><ul><li>Lowering price when P is low and Q is large </li></ul><ul><ul><li>Decreases total revenue = negative MR </li></ul></ul><ul><li>Total revenues are maximized at the midpoint of a linear demand curve </li></ul><ul><ul><li>Where we have unit elasticity </li></ul></ul>
  31. 31. Learning Outcome <ul><li>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. </li></ul>
  32. 32. Predicting Competitive Market Outcomes <ul><li>Equilibrium price and quantity </li></ul><ul><li>Increase in Demand and increase in Supply – </li></ul><ul><ul><li>both shift right along Q axis thus Q increases, D shifts up and S down along P axis thus P ambiguous </li></ul></ul><ul><li>Increase in Demand and decrease in Supply </li></ul><ul><li>Decrease in Demand and increase in Supply </li></ul><ul><li>Decrease in Demand and decrease in Supply </li></ul>
  33. 33. Table 4 What Happens to Price and Quantity When Supply or Demand Shifts? Copyright©2004 South-Western

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