01/18/2024-01/23/2024– Introduction to Microeconomics Economics is the study of choice and how we choose to deal with the scarce resources to try to satisfy their wants ★ The Scarcity Principle ★: people have unlimited wants but limited resources. ● Resources and policies affect human choices. ○ This is how we study how rational people make choices. Market Economy (U.S. USES THIS): parties directly involved with decision-making ● Invisible Hand (Adam Smith) ● Individual interests and their choices based on those interests drive the market economy. ● Market economy pushes resources in the direction of their most valuable uses (allocation). ● Market failures occur Economics is split into two categories: ● Microeconomics is the study of the choices/decisions people make (ex. businesses) and the interactions of those decisions (ex. in markets) ○ Why do people make the decisions they make? ● Macroeconomics is the study of the national economy and global economy and how it works together 1. Resources are scarce– the quantity available isn’t large enough to satisfy all productive uses. a. Resource: anything that can be used to produce something else i. Ex. land, labor, capital & time, attention, etc.) 2. Incentive Principle: a. Incentives drive people’s choices i. Positive incentives: actions are more likely to be taken if their benefits rise ii. Negative incentives: actions are less likely to be taken if their costs rise 3. The real cost of something is what you must give up to get it a. Opportunity cost: what you must give up in order to get it i. The real cost of an item ii. The opportunity cost of an action is the value you place on the next best alternative. iii. Includes both implicit and explicit costs b. Opposite of opportunity costs are sunk costs– costs that were incurred in the past and cannot be recovered anymore i. They exist no matter whether a certain activity is conducted or not ii. Ex. Money is spent on something whether or not you change your mind about it later 4. “How much?” is a decision at the margin a. We make a trade-off when we compare the costs with the benefits of doing something. b. Marginal decisions: decisions about whether to do more or less of an activity are. c. Making trade-offs at the margin: comparing the costs and benefits of doing more of an activity or less of it. d. Practice Question: i. Monster drink # WTP Total benefit Price Total Net Benefit 1 $4 $4 $2.50 $1.50 2 $3 $7 $2.50 $2 3 $2 $9 $2.50 $1.50 4 $1 $10 $2.50 $0 How many monster drinks should you buy? A) 0 B) 1 C) 2 D) 3 E) 4 5. The Cost-Benefit Principle 6. People usually take advantage of opportunities to make themselves better off 7. There are gains from trade a. Individuals engage in trade b. People can get more of what they want through trade than they could if they tried to be self-sufficient. 8. Markets move toward equilibrium a. Equilibrium (in an economic situation): when no individual would be better off doing something different. b. Any time there is a change, the economy will move to a new equilibrium 9. Resources should be used as efficiently as possible to achieve society’s goals a. An economy is efficient if it takes all opportunities to make some people better off without making other people worse off. i. Easier to define b. Equity: everyone gets his or her fair share. i. Harder to define c. It is good for society to be efficient because we increase what we have, but that does not necessarily mean everyone will get a large portion. 10. Markets usually (but not always) lead to efficiency a. Resources are usually put to good use. 11. When markets don’t achieve efficiency government intervention can improve society’s welfare Economy-wide interactions ● 12: one person’s spending is another person’s income ● 13: overall spending sometimes gets out of line with the economy’s productive capacity ● 14: Government policies can change spending Week 1 Smart Book Notes: Applying the cost and benefit principle ● A rational person: someone who tries to fulfill their goals as best as they can. ★ Cost-Benefit Principle ★: if the outcome has extra benefits that exceed the extra costs. ● Economic Surplus: the benefit of taking an action minus its cost ○ As an economic decision maker, it is their job to make the choice that has the largest possible economic surplus. ● Trade-off example: choosing between a cheaper keyboard and the free time gained by avoiding the trip. ● The value of an opportunity cost is the value of everything you must sacrifice to engage in it. ○ Or the opportunity cost could refer to the implicit value of opportunities not chosen. ● People can’t do everything that they want in life because of time Three important decision pitfalls ● Marginal cost: the increase in total cost from carrying out one additional unit of an activity. ● Marginal benefit: the increase in total benefit that results from carrying out one additional unit of an activity. ● Average cost: the total cost of an activity by undertaking n units and dividing it by n ● Average benefit: the total benefit of an activity by undertaking n unit and dividing it by n ● If undertaking an activity includes both explicit and implicit costs, then, according to the textbook, the opportunity cost of that activity is the sum of both explicit and implicit costs. Three important decision pitfalls: ● Measuring costs or benefits proportionally ○ Absolute dollar amounts should be used to measure costs and benefits. ● Ignoring implicit costs ○ Should take into account all costs even if they’re implicit. ● Failing to think at the margin ○ Ignore sunk costs and average costs and benefits ○ Don’t confuse average costs and benefits with marginal costs and benefits. ○ The level of an activity should be increased only if its marginal benefit exceeds its marginal cost. Normative economics versus positive economics Normative economic principle: says how people should behave ● Ex. The Cost-Benefit Principle says we should ignore sunk costs when we make decisions about the future. Positive (or descriptive) economic principle: describes how we will actually behave ● The Cost-Benefit Principle isn’t always a positive economic principle ● If the cost of an action goes up, it will be predicted that people will be less likely to take that action and if the benefit of an action goes up, it will be predicted that people will be more likely to take that action. ★ The Incentive Principle ★: a positive economic principle. ● A person is more likely to take an action if its benefit rises, and less likely to take it if its cost rises. ● Does not insist that people behave rationally in each instance. Economics: Micro and Macro The economic needs and wants are unlimited but the materials and resources used to satisfy those needs and wants are limited. ● Trade-offs: having more of one good thing means having less of another. Economic Naturalism Economic naturalist: someone who uses insights from economics to help make sense of observations from everyday life. 01/23/2024-01/25/2024– Economic Models, Trade-offs, and Trade Trade-offs: The Production Possibility Frontier ● Production Possibility Frontier (PPF): shows the max quantity of one good that can be produced for any given production of the other. ○ Shows the trade-offs for an economy that produces only two goods. ○ Improves our understanding of trade-offs by simplifying the economy that produces only two goods graphically. ○ Can apply on an individual level ● Opportunity cost increases ● ● ● ● Only points that lie on the production possibilities curve are efficient. Points that lie inside the production possibilities curve are inefficient. Points that lie on or inside of the production possibilities curve are attainable. Only points that lie outside the production possibilities curve are unattainable. Increasing Opportunity Costs ● People usually use the resources with the lowest opportunity costs first ○ PPF is concave ○ PPF is a straight line when opportunity costs are constant Economic growth: ● Economic growth: the expansion of production possibilities ○ PPF shifts outward ● PPC neutral technical change → shifts outward ● PPC technical change in y-axis → shifts up, x-axis does not change ● PPC technical change in x-axis → shifts right, y-axis does not change Gains from trade ● Without trade, each person can only consume what they produce. ● When one person is really good in one activity, and the other person in the other activity, they both have an absolute advantage somewhere. ● If one person has an absolute advantage everywhere, Absolute advantage: a producer who is more productive in producing a good ● Not as important as comparative advantage Comparative advantage: a producer who has a lower opportunity cost (has to give up less) of producing a good ● Everyone does best when they concentrate on their comparative advantage. ● Everyone has a comparative advantage somewhere. Sources of Comparative Advantage ● Talent ● Natural resources ● Infrastructure ● Cultures or societal norms ○ Languages ○ institutions Week 2 Smart Book Notes: Gains from exchange are possible if trading partners have comparative advantages in producing different goods and services Production possibilities curve: a graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good. Downward slope of the production possibilities curve shows the scarcity principle 01/30/2024-02/01/2024 Part 1: Overview of Supply and Demand Model and Demand Big Picture: The Circular-Flow Diagram ● Circular-flow diagram: a model that represents the transactions of the economy by flows around a circle. What, How, and For Whom? ● WHAT ○ Which goods will be produced? ○ How much of each ● HOW ○ Which technology? ○ Which resources are used? ● FOR WHOM ○ How are outputs distributed? ■ Need? ■ Income? Competitive Market ● A competitive market consists of: ○ Infinite buyers and sellers ■ Buyers are small fish in a large pond ○ All sell the same good or service Central Planning versus the Market– WE use the mixed economies using both the market and central planning. ● Central planning ○ Decisions by individuals or small groups ■ Agrarian societies ■ Government programs ○ Sets prices and goals for the group ● ○ Individual influence is limited. The Market ○ Buyers and sellers signal wants and costs ■ Resources and goods are allocated accordingly ○ Interaction of supply and demand answer the three basic questions ○ Voluntary transactions between the buyers and sellers determine the outcome. Supply and Demand Model ● The supply and demand model is a model of how a competitive market works. ○ Demand exists in any market– How producers behave ● 5 key elements: ○ Demand curve ■ How we summarize the consumer’s decision on demand (how, what) ○ Supply curve ■ How we summarize the producer’s decision on supply (how, what) ○ Demand and supply curve shifts ○ Market equilibrium ○ Changes in the market equilibrium Demand ● Relationship between the price of a particular good and the quantity of the good → price p consumers are willing and able to buy at this price p during a specific time period, all other things being equal → quantity demanded qd ● The “horizontal interpretation of the demand curve” Demand Schedule ● The demand schedule shows how much of a food or service consumers will want to buy at different prices. ● The relationship between price and how much you are willing and able to buy. ● Quantity demanded is a particular quantity at a given price. ● Demand curve is the graphical representation of the demand schedule; it shows how much of a good or service consumers want to buy at any given price. ○ Any point on the curve is the quantity demanded ● If the price of a good changes, then quantity demanded of this good changes. Law of Demand ● Law of Demand: the higher the relative price of a good, the smaller is the quantity demanded during a given period. ○ Downward slope ● As price goes up, quantity demanded goes down. Reasons for the Law of Demand ● Price of a good increases (own): ○ Substitution effect: price rises → opportunity cost rises ■ You give up more ○ Income effect: relative income decreases → less of everything ■ If income stays the same but prices rise, you will purchase less stuff. ● At a higher price, fewer buyers have reservation prices that are high enough. ● Principle of diminishing marginal utility (happiness) → the more you have of something the less you want to have more of it. Buyer’s reservation price ● Buyer’s reservation price: the max willingness to pay for a good ● “Vertical interpretation of the demand curve” ○ Demand shows the relationship between ■ Quantity of the good, q ■ Marginal buyer’s reservation price for this quantity, p Interpreting the Demand Curve ● Horizontal interpretation of demand: ○ Given price, how much will buyers buy? ● Vertical interpretation of demand: ○ Given the quantity to be sold, what is the reservation price? Movement along the Demand Curve ● When price goes up, quantity demanded goes down ● When price goes down, buyers move to a new, higher quantity demanded ● A change in quantity demanded results from a change in the price of a good. Market versus Individual Demand Curve ● Market demand curve for a private good adds up individual quanities demanded at each price. ○ Horizontal sum of the individual demand curves of all consumers in that market. Shift in Demand ● If buyers are willing to buy more at each price, then demand has increased. ○ Demand curve shifts to the right. ● If buyers are willing to buy less at each price, then demand has decreased. ○ Demand curve shifts to the left. Shift of the demand curve vs. movement along the demand curve. ● Change in the price of a good ○ Change in quantity demanded ○ Movement along the demand curve ● Change in a non-price determinant of demand ○ Change in demand ○ Shift of the demand curve Non-price Determinants of Demand ● Prices of related goods → substitutes, complements ● Income → normal goods, inferior goods ● Tastes, preferences, information ● Expectations (about future prices and income) ● Number (and age) of consumers Substitutes and Complements ● Substitutes: goods that can serve as replacements for one another ○ When the price of one increases, the demand for the other one increases. ● Complements: used in conjunction with one another ○ A decrease in the price of one, an increase in demand for the other and vice versa Normal and Inferior Goods ● Normal goods: goods for which demand increases as income increases. ● Inferior goods: goods for which demand decreases as income increases. An Increase in Demand ● An increase in population and other factors generate an increase in demand - a rise in the quantity demanded at any given price. ● A shift of the demand curve is a change in the quantity demanded at any given price, represented by the change of the original demand curve to a new position, denoted by a new demand curve. 02/01/2024- Part 2: Supply Supply ● Supply is a relationship between two variables: ○ The price of a particular good → price p ○ The quantity of the good sellers are willing to sell at this price p during a specific time period, all other things being equal → equal supplied qs Supply Schedule ● Shows how much of a good or service would be supplied at different prices. ○ Entire table = supply schedule/supply ○ Point on table = specific quantity supplied at a given price Supply curve ● Supply curve shows graphically how much of a good or a service people are willing to sell at any given price. ● Supply on a graph = the entire curve ● If the price of a good changes, then quantity supplied of this good changes. Week 3 Smart Book Notes: ● ● ● ● ● ● ● When two parties produce the good or service for which they wield a comparative advantage, there are gains from specialization and exchange. In general, this means each can consume a combination of goods that would have been unattainable otherwise. A bow-shaped production possibility curve that becomes steeper as production of the good on the x-axis increases reflects the fact that as you produce more of the good on the x-axis, the opportunity cost of producing that good increases. ○ The Principle of Increasing Opportunity Cost tells us that as we produce more of a good, we should first use the resources with the lowest opportunity cost before turning to resources with higher opportunity costs. The slope of the production possibilities curve tells us the opportunity cost of producing an additional unit of the good on the x-axis. So, if the production possibilities curve becomes steeper as production of the good on the x-axis increases, then this reflects increasing opportunity cost. As the price of a product increases, the quantity demanded decreases, while the quantity supplied increases. The substitution effect captures the change in the quantity demanded of a good that results because buyers switch to or from substitutes when the price of the good changes. The Principle of Comparative Advantage states that everyone does best when each person (or country) concentrates on the activities at which he or she has a comparative advantage. The income effect captures the change in the quantity demanded of a good that results because a change in the price of a good changes the buyer's purchasing power. 02/06/2024- Part 2: Supply Continued Law of Supply ● All other things being equal, the higher the price of a good, the greater is the quantity supplied ● Reason: increasing opportunity cost of additional production Seller’s Reservation Price ● Seller’s reservation price = minimum willingness to accept: smallest amount at which seller is willing to sell an additional unit of good Interpreting the Supply Curve ● Horizontal interpretation of supply: ○ Given price, how much will supplies offer? ■ At price of $2, supplies are willing to sell 8,000 slices/day ● Vertical interpretation of supply: ○ Given the quantity to be sold, what is the opportunity cost of the marginal seller? ■ If 8,000 slices are sold, the marginal cost of producing the 8,000th slice is $2 ○ The cost of producing it is greater Market supply curve ● Adds up individual quantities supplied at each price ○ → horizontal sum ● 2+1=3 ● 3+2=5 Shift of the supply curve vs. movement ong the supply curve ● Change in the price of a good ○ → change in quantity supplied ○ → movement along the supply curve ● Change in a non-price determinant of supply ○ → change in supply ○ Shift of the supply curve Non-price determinants of supply ● Input prices ○ Cost of labor ● Prices of related goods ● Technology ● Natural Disruptions ● Expectations ● Number of firms in the market An increase in supply ● Increase in supply– a rise in the quantity supplied at any given price. ○ Rightward shift in supply Movement along the supply curve ● A change in the quantities supplied of a good that is the result of a change in that good’s price. 02/06/2024- Part 3: Equilibrium ● Equilibrium in a competitive market: when the quantity demanded of a good equals the quantity supplied of that good. ○ The price at which this takes place is the equilibrium price: every buyer finds a seller and vice versa ○ The quantity of the good bought and sold at the price is the equilibrium quantity. ○ Quantity supplied = quantity demanded Market Equilibrium ● On a graph where the two curves intersect, is the equilibrium. ● The price at which the quantity demanded is equal to the quantity supplied is known as equilibrium price. ● The price in a competitive market is mostly determined by both production of costs of sellers and the buyers’ willingness to pay. Surplus and Shortage ● At prices above the equilibrium, there is a surplus ○ Quantity demanded is less than quantity supplied and there is pressure on the market price to fall. ● At prices below the equilibrium, there is a shortage ○ Quantity demanded is greater than quantity supplied and there is pressure on the market price to rise. Surplus ● Surpluses occur when the price is above its equilibrium level Incentive Principle: Excess Supply SURPLUS at $4 ● Each supplier has an incentive to decrease the price in order to sell more ● Lower prices decrease the surplus ● As price decreases: ○ The quantity offered for sale decreases along the supply curve ○ The quantity demanded increases along the demand curve Shortage ● Shortages occur when the price is below its equilibrium level. High prices, producers want to produce more but consumers want to buy less. What happens to the equilibrium when supply and/or demand change? ● 8 cases: ○ 2 with only a change in demand ○ 2 with only a change in supply ○ 4 with simultaneous changes 02/08/2024- Part 3: Equilibrium Continued… EXAMPLE: Tennis Market ● Rent for tennis court decreases, demand for tennis balls increases EXAMPLE: Apartments Near DC Metro ● If government wages rise, demand for apartments near metro stations increases ○ Demand increases ■ Price increases ■ Quantity increases ○ Demand for a normal good increases when income increases ■ Vice versa Shifts in Supply: Skateboards Shift in Supply: Home Construction ● An increase in demand causes a shortage to occur at the original price, which leads to increase in equilibrium price and equilibrium quantity Looking Ahead… Surplus ● Buyer's surplus: buyer’s reservation price (max amt to pay) minus the market price ● Seller’s surplus: market price minus the seller’s reservation (min amt willing to sell) ● Total surplus: buyer’s surplus + seller’s surplus ○ Total surplus is buyer’s reservation price - seller’s reservation price ○ Represents the value of the transaction that occurred in the market. Week 4 Smart Book Notes: ● As the price of ketchup increases, the demand for hot dogs will fall, leading to a decrease in the equilibrium price and quantity of hot dogs. 02/13/2024- Elasticity (How much?) General idea behind “elasticity” ● Measures how much one variable changes in response to a change of another variable. ● Four main cases: ○ Price elasticity of demand ■ How much does quantity demanded change in response to a change in price? ■ “Law of demand” says only HOW quantity demanded changes but not HOW MUCH ○ Cross-price elasticity of demand ■ If the price of one good changes, how does that impact the quantity demanded of another good ○ Income elasticity of demand ○ Price elasticity of supply Price Elasticity of Demand ● Price elasticity of demand describes the change of quantity demanded following a change in price. ● It is calculated as the percentage change in quantity demanded over percentage change in price (without the minus sign) Calculating the Price of Elasticity of Demand ● < 1 = inelastic ● > 1 = elastic ● new-old/old Three “classes” of Price Elasticity ● Inelastic ● Elastic ● Unit-elastic ● Price elasticity shows us how to use price in situations Elastic Demand ● If price elasticity is greater than 1, demand is elastic ○ Percentage change in quantity is greater than percentage change in price ○ Demand is responsive to price Unit Elastic Demand ● ● If price elasticity is 1, demand is unit elastic Price and quantity change by the same percentage Inelastic Demand ● If price elasticity is less than 1, demand is inelastic ○ Percentage change in quantity is less than percentage change in price ○ Quantity demanded is not very responsive to price Perfectly inelastic and elastic demand ● Two extreme cases: ○ Demand is perfectly inelastic when the quantity demanded does not respond at all to changes in the price. ■ ○ When demand is perfectly inelastic, the demand curve is a vertical line. ● Increase in price, the demand stays the same Demand is perfectly elastic when any price increase will cause the quantity demanded to drop to zero. ■ When demand is perfectly elastic, the demand curve is a horizontal line. ● At a certain price, quantity demanded will buy at any quantity ○ Price is increased, quantity demanded = zero Price Elasticity of Demand and Total Revenue ● It helps predict how changes in the price of a food will affect the total revenue earned by producers from the sale of that good. ● Total Revenue = Price * Quantity Sold ○ (total revenue = total expenditure) Elasticity and Total Revenue ● Price change → two opposite effects: ○ Price effect: after a price increase, each unit sold sells at a higher price, which tends to raise revenue ○ Quantity effect: after a price increase, fewer units are sold. Which tends to lower revenue. ● Dependent on which effect is stronger 02/15/2024- Elasticity (How much?) Continued… Price elasticity of demand depends on: ● Closeness of substitutes ● Whether the good is a necessity or a luxury ● Proportion of income spent on the good ● Time ● Definition of market ○ The broader we define the market, the less substitutes there are, the less responsive people are Sign of Cross-Price Elasticity of Demand ● Cross-price elasticity of demand: ○ What is the percent change in the quantity demanded of one good divided by the percent change in the other good’s price? ● Cross price elasticity of demand is positive → ○ Substitutes ● Cross price elasticity of demand is negative → ○ Complements Income Elasticity of Demand ● Income elasticity of demand: ○ Percent change in the quantity of a god demanded divided by the percent change in the consumers’ income Sign of Income of Elasticity of Demand ● Income elasticity of demand is positive → ○ Normal good ● Income elasticity of demand is negative → ○ Inferior good Price elasticity of supply ● Percent change in the quantity supplied divided by percent change in the price ○ Positive Price elasticity of supply depends on ● Availability of inputs (how flexible are sellers to change the amount of the good they sell) ○ Larger the number, the more producers are willing to sell ● Time ○ Price of soda goes up, how many more can i make in the next 15 mins vs 5 years 02/20/2024- Consumer Behavior Needs vs Wants ● Needs: goods that are required for subsistence ● Beyond subsistence, behavior is driven by wants ● Wants depend on price Overview ● Consumer behavior: the decision-making process that consumers use to allocate their scarce resources ● Consumers are constrained by their budget and must make choices Budget Line ● Budget line: how we represent the consumption opportunities available to the consumer. ○ Shows the combinations of the goods and services consumers are able to consume, given the income and prices. ○ Shows trade-offs ● Allows us to understand what happens when income changes and when price changes. Budget Line Characteristics ● Each point on the budget line represents consumption bundles of goods that can be purchased at current prices with a given amount of income ● Budget line is a straight line with a negative slope ○ Slope of budget line = ○ Represents the trade-offs between the goods ● Intercepts of the budget line represent the maximum amounts of the goods that the consumer can buy ○ Divide income/price of each good ● Consumption bundles outside the budget line cannot be purchased with the given income. Food for Thought on Budget Constraints ● Examples: limited amount of closet space for clothes and a fixed number of hours in a day ● Like a consumer, choosing a consumption bundle: points are the equivalent of prices, and the overall point limit is the equivalent of total income. Where does the Budget Line Come From? 𝑖𝑛𝑐𝑜𝑚𝑒 ≥ 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑦 * 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑦 + 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑥 * 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑥 ● If i want x (a specific price), I must decrease my y (quantity) Changes in Income ● Changes in income are presented by shifts out of the budget line. Changes in Price ● When the price of a good changes, the budget line pivots (rotating) to reflect the new trade-off. ○ Slope of the budget line is the ratio of prices, if one price changes then the slope changes. Utility Theory ● Deals with what consumers want to do in terms of purchasing goods and services ● Utility: the benefits consumers receive from consuming goods and services. ○ Maximizing ○ Greatest happiness for the greatest number Assumptions about Consumer Behavior ● Consumers maximize their well-being not their income ○ Doesn’t rule out altruism ● Consumers are rational. ○ In any given point in time, people have preferences and that they behave in a consistent manner– consistency in preferences. 02/22/2024- Consumer Behavior Continued… Total Utility ● Total utility: the total satisfaction that a consumer derives from consuming a good or service (all else constant). ○ We assume that we get happiness from goods ○ We tend to think that the more we consume goods, the happier we get. We can also get unhappy the more we consume goods. Marginal Utility ● Consumers make decisions based on the additional benefit from consuming one more unit of a food or service. ○ Marginal Utility (MU): the change in total utility that results from a one unit change in consumption ● We see total utility increases at a decreasing rate– satisfaction of the first good consumed is more than the other ones consumed after. ○ Diminishing Marginal Utility: as a consumption of one good or service increases, and consumption of all other goods and services remains the same, marginal utility eventually declines. ■ Difference of total utility as the quantity increases Maximizing Utility ● Consumers want to maximize their utility even though their income is limited. ● Consumers compare the extra happiness they get from one good to the amount of another good they must give up to get it. Marginal Utility per dollar–Bang for your buck ● Example: ● This calculation adjusts the marginal utility of a good by the price of that good. ● Marginal utility per dollar gets smaller, market utility gets smaller. Utility Maximization ● Consumers maximize their utility by allocating their income to the good that yields the highest MU (happiness) per dollar. ● DMU says that the more you consume of a particular good, the less happiness you receive from consuming that good → the MU per dollar for a particular good decreases the more you consume of it. ● Example: The Equimarginal Principle ● Utility is maximized when the marginal utility per dollar is equal across all goods ● Combination that maximizes utility (happiness) ○ Example: I want the mu of pizza/price of pizza = mu of cd/price of cd Utility Maximization and Individual Demand ● Downward sloping results from consumers maximizing their utility subject to their budget. Week 5 Smart Book Notes: ● ● ● ● ● ● ● ● ● ● According to the rational spending rule, spending should be allocated across goods so that the marginal utility per dollar is the same for each good. The income effect of a price increase is the change in the quantity demanded of a good that results because an increase in the price of the good decreases purchasing power. Price = quantity demanded The income effect of a price increase is the change in the quantity demanded of a good that results because an increase in the price of a good decreases buyers' purchasing power. Real price of a good: the dollar price of a good relative to the average dollar price of all other goods. The absolute price of a good in dollar terms is the nominal price of a good. Profit = total revenue - total cost The amount by which price exceeds the seller's reservation price is producer surplus Price taker: a firm that has no influence over the price at which it sells its product. Producer surplus: price exceeds the seller's reservation price 03/19/2024-03/21/2024- Behind the Supply Curve: Inputs and Costs Big Picture: Buyers and Sellers ● Cost-benefit principle is behind decision making ○ Buyers: buy one more unit? ■ Only if marginal benefit is at least as great as marginal cost. ○ Sellers: sell one more unit? ■ Only if marginal benefit (marginal revenue) is at least as great as marginal cost ● Looking at costs and comparing them to benefits ● Opportunity cost also matters ○ Buyers: hamburger or pizza? ○ Sellers: recycle aluminum or wash dishes? The Production Function ● Production function: the relationship between the quantity of inputs a firm uses and the quantity of output it produces. ● Fixed input: an input whose quantity is fixed for a period of time and cannot be varied. ● Variable input: an input whose quantity the firm can vary at any time. Changes in Productivity Over Time ● Productivity in manufacturing has increased ○ Ex. assembling a car ● Productivity in services has grown more slowly ○ Ex. barbers take just as long to cut hair ● Manufacturing wages and service wages increase at about the same rate ● This is because of the idea of the principle of opportunity cost Long Run versus Short Run ● Long run: the time period in which all inputs can be varied ○ Not a particular time period. Any length of time. ● Short run: the period in time in which at least one input is fixed ○ Not a particular time period because it is defined by each production. ● Total product curve: shows how the quantity of output depends on the quantity of the variable input, for a given quantity of the fixed inputs. Diminishing Returns to an Input ● There are diminishing returns to an input when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input ○ Total: adding up marginal along the way Fixed, Variable and Total Costs ● Fixed cost: a cost that does not depend on the quantity of output produced. It is the cost of the fixed input. ○ Can’t change ● Variable cost: a cost that depends on the quantity of output produced. It is the cost of the variable input. ○ Can change ● Total cost: sum of fixed cost and variable cost ○ TC = FC + VC ● The total cost curve becomes steeper as more output is produced due to diminishing returns. ● When firms make profit-maximizing output decisions, sunk costs are fixed costs that cannot be recovered. Marginal Cost ● More general and applies to larger changes in quantity. ● Idea is still the same. Marginal Product of Labor ● The marginal product of an input is the additional quantity of output that is produced by using one more unit of that input. ● MARGINAL = 1 MORE Why is the Marginal Cost Curve Upward Sloping? ● Because of diminishing returns to inputs ● Implies that more and more of the variable input must be used to produce each additional unit of output ● Since each unit of the variable input must be paid for, the cost per additional unit of output also rises. Questions ● What is the objective of a firm? ○ Maximize profit ■ π = profit ● What are profits equal to? ○ π = total revenue - total cost ○ Total revenue = price * quantity Average Cost ● Average cost is total cost divided by quantity of output produced ○ AC = TC/Q = (Total Cost) / (Quantity of Output) ● Average variable cost and average fixed cost are similarly defined ○ TC = FC + VC —> ■ AVC = Variable/Quantity ■ AFC = Fixed/Quantity ○ TC/Q = FC/Q + VC/Q → ATC = AFC +AVC 03/26/2024-03/28/2024-Behind the Supply Curve: Inputs and Costs Continued… Why is the Average Total Cost Curve Usually U-Shaped? ● The spreading effect: the larger the output, the greater the quantity of output over which fixed cost is spread, leaning to pull down the average fixed cost. ● The diminishing returns effects: the larger the output, the greater the amount of variable input required to produce additional units leading to higher average variable cost. Putting the Four Cost Curves Together ● Marginal cost is upward-sloping (after some point) due to diminishing returns. ● Average variable cost is upward-sloping but is flatter than the marginal cost curve ● ● For low quantities, MC and AVC can be downward-sloping due to specialization of labor Average fixed cost is downward-sloping because of the spreading effect ● Average total cost is U-shaped ● The marginal cost curve intersects the average total cost curve from below, crossing it at its lowest point. Minimum-Cost Output ● Minimum-cost output: the quantity of output at which average total cost is lowest → the bottom of the U-shaped average total cost curve ● At the minimum-cost output, average total cost is equal to marginal cost when marginal cost equals average total cost, we must be at the bottom of the U, because not only at that point is average total cost neither falling nor rising. Where does the Supply Curve come from? ● Key questions for the individual firm: ○ If i produce, how much should I produce ○ Should I produce or shut down ■ Where supply curve comes from ○ Will I earn a profit/loss Perfect Competition Model ● All sellers offer the same commodity ● Many buyers and sellers ● Perfect information ● Free entry and exit Price-Takers in Perfect Competition ● Price-taking producer (or consumer) is a producer (consumer) whose actions have no effect on the market price of the good it (he/she) sells/buys ● A perfectly competitive market is a market in which all market participants are price takers. ● A price-taking firm faces a perfectly elastic (horizontal) demand curve for its product even if the entire demand curve in its market is downward-sloping. ● ● ● ● Marg revenue: extra $.35 Marg revenue = to price of the firm Look at every cell in the profit column and see which one is largest is > or = to marginal cost Optimal Output Rule ● ● Profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to the marginal revenue from the last unit sold. Choose q so that MR = MC ○ ONLY for perfectly competitive firm, P = MC ○ If MR does not equal MC at any output level, then produce all units where MR > MC ■ Assuming it makes sense to produce ○ True for any firm, whether in perfect competition or not. ○ Should I produce? Optimal Output Rule in Perfect Competition ● For a price-taking firm: ○ Marginal revenue = market price ■ Each unit they sell is the market price ■ Demand curve is perfectly elastic ● Modify so that: ○ a firm in a perfect competition should choose the level of output q so that MC = p When is Production Profitable? ● TR > TC, firm is profitable ● TR = TC, firm breaks even ● TR < TC, firm incurs a loss ○ Π = TR - TC Profit, Break-Even or Loss ● Break-even price of a price-taking firm is the marker price at which it earns zero profits ○ P > minimum ATC → profit ○ P = minimum ATC → breaks even ○ P < minimum ATC → unprofitable ● Step one: look at MC curve ● Step two: should I produce ● Step three: am i going to make a profit or loss Shut-down Price and shut-down decision ● Shut-down price of a price-taking firm is the market price at which it makes the same profit from staying open or shutting down ○ P > minimum AVC → revenues are higher than variable costs ○ P = minimum AVC (shut-down price) → revenues are equal to variable costs ○ P < minimum AVC → revenues are smaller than variable costs → loss is smaller if producer shuts down Producer surplus ● Producer surplus is the difference between the market price and the seller’s reservation price ○ Reservation price is on the supply curve ○ Producers like surpluses because they earn more ● Producer surplus is the area above the supply curve and below the market price Short-Run vs Long-Run Costs ● In the short run: fixed cost is completely outside the control of a firm. ● In the long run: all inputs are variable ● → a firm’s fixed cost becomes a variable it can choose. ● The firm will choose its fixed cost in the long run based on the level of output it expects to produce. Long-run Average Total Cost Curve ● The long-run average total cost curve shows the relationship between: ○ Output and average total cost ○ When fixed cost has been chosen ○ To minimize average total cost ○ For each level of output Returns to Scale ● There are increasing returns to scale (economies of scale) when: ○ Long-run average total cost declines as output increases. ● Decreasing returns to scale (diseconomies of scale): ○ Long-run average total cost increases as output increases. ● Constant returns to scale: ○ When long-run average total cost is constant as output increases. If ATC is less than MC, then they should not produce. 04/02/2024-04/04/2024- Efficiency and Exchange The Invisible Hand ● Individuals act in their own interests ○ Aggregate outcome is collective well-being ● Society wants to maximize the happiness it gets from its resources ● Profit motive ○ Produces highly valued goods and services ○ Allocates resources to their highest value use Markets Are Dynamic ● Market dynamics at work: ○ Store for lease ○ Going out of business sale ■ Everything must go ■ Now open ■ Close-out model ■ Under new management Accounting Profit ● Most common profit idea ○ Accounting profit = total revenue - explicit costs ● Explicit costs are payments firms make to purchase ○ Anything that i have a receipt for that shows an explicit transaction taking place ■ Resources ■ Products from other firms ● Explicit costs are… ○ Easy to compute ○ And easy to compare across firms Economic Profit ● Economic profit is the difference between a firm’s total revenue and the sum of its explicit and implicit costs ● Implicit costs are the opportunity costs of the resources supplies by the firm’s owners ● In the long-run, the difference between accounting profit and economic profit is what keeps resources in their current use. ○ “Normal profit” ■ TR - E.C. - I.C. = 0 ● TR - E.C. = I.C. ■ I need to cover those implicit costs ● Firms enter and exit based on economic profit ● Economic profit sends signals to firms for what they should produce and what they should be producing at Two Functions of Price ● Rationing function: price distributes scarce goods to the consumers who value them most highly ● Allocative function: price directs resources away from overcrowded markets to markets that are underserved ● How does this relate to the market? ○ Invisible Hand Theory: states that the actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resources. Responses to Profits and Losses ● The firm will remain in business in the long run if it covers all of its costs. ● Firms that earn positive economic profit recover more than their opportunity cost ● Firms that earn economic profit, will attract resources ● Firms that suffering from economic losses, will lose resources Response to Economic Profits Markets with excess profits attract resources ● ● ● ● Aggregate supply and aggregate demand Each firm is a price taker Left graph: existing firm and demand today Right graph: price = marginal cost ● At $2 If they choose to produce, where price = marginal cost they produce 130 ● ● At 130 are they covering the ATC? They are covering their ATC and AVC ● ● Are they going to earn a profit or a loss? @130 bushels, it costs them $1.20 per bushel ● This will attract firms into industry. Will impact the industry by increasing supply if more firms. ● Today, existing firms are earning profit, and people are going to look at this industry and will increase the number of firms + increase supply in corn. Supply increases ● @120 bushels, ATC, bushels are below ● ● Creates outward shift in supply curve Earns less profit Zero economic profits ● Attracts more firms new supply curve and new MC ● Where price = mc, I am losing profit at 90 bushels ● If positive profits in industry that increases firms and supply, puts downward pressure on price and eliminates the industry Resources leave ● @ price of $.75, it will be at 70 bushels ● ● @70 bushels, ATC = $1.05 Will earn a loss. No economic losses ● As firms leave an industry, supply decreases ● When producing 90 at $1, their profit is 0. they do not have an incentive to leave and other firms don’t have an incentive to enter. ● Economic profits are pushed towards zero in the long run because of entry and exit. Constant-Cost Industry 1. If constant cost in industry (adding and subtracting firms) 2. No matter what demand is, it always intersects at an equilibrium of $1. 3. No matter what demand is, each individual firm, it produces where price = mc it occurs at minimum ATC of productive 4. In a perfectly competitive market, each firm is producing at an output level of minimum ATC. Trying to be cheap. 04/09/2024- Efficiency and Exchange Continued → thinking about during quarantine/covid Free entry and exit ● Barrier to entry: any force that prevents firms from entering a new industry ○ Legal constraints that are a barrier to entry ■ Passing the Bar and having a law degree ○ Makes it more difficult to go into the field ■ Zero or higher profits ● Free entry and exit is required for the Invisible Hand to work ○ If we don’t have this, firms earn above zero profits in the long run because other firms cannot move into that market Invisible Hand in the Supermarket ● No cash on the Table Principle says short check-out lines get longer–quickly ○ Information is freely available ● Start in the shortest line ○ Observe the pace of all lines ■ Missing price in your line ■ Complaining customer next to me ○ Decide whether to switch Market equilibrium and Big Payoffs ● In the long-run, equilibrium leaves no opportunities for individuals to gain ○ If there are opportunities to gain, people will move into that area. ○ Non-equilibrium opportunities benefit individuals ■ Exploiting opportunities moves the mark toward equilibrium ● Three ways to earn a big payoff: ○ Work exceptionally hard ○ Have some unique skill or talent ○ Be lucky Invisible Hand and Socially Optimal Outcome ● Markets work best when: ○ Buyers’ marginal benefits = sellers’ marginal costs ○ Society’s marginal benefits = marginal costs ● If there's a buyer of a phone and there’s a seller, a transaction will go through and the benefit exceeds the cost to produce it. ● Buying a cell phone, and factor in costs that other people incur when using a cell phone, maybe it doesn’t make sense to produce and sell it. ○ Look collectively at how society is impacted. ○ If there’s a deviation, the market may not function properly. Market Equilibrium and Efficiency- In context of a perfectly competitive market ● Economic efficiency: exists when no change could be made to benefit one party without harming the other. ○ Sometimes called Pareto efficiency ○ Different form engineering efficiency ○ Equilibrium price and quantity are efficient ○ Prices above or below equilibrium are not ● Takes costs and benefits into account How the market reacts to shocks–how a market moves into and out of an industry because of profit available We evaluate that a market works or not based on how much it generates a surplus 04/09/2024-04/11/2024 Part B: Policies Price Controls ● Not all buyers and sellers like the equilibrium outcome ● The government often intervenes to regulate prices by imposing price controls ● Price ceiling: the maximum price sellers are allowed to charge for a good or service ● Price floor: the minimum price buyers are required to pay for a good or service Example of Price Ceiling = Rental Market Deadweight loss ● Deadweight loss: the reduction in total economic surplus due to the adoption of a police (or some other intervention in a market) ○ Because we are not at that efficient outcome. ○ What are the possible amounts of surplus? ● Book: it occurs whenever an action or a policy reduces the quantity transacted below the efficient market equilibrium quantity. Price Ceilings ● Are typically imposed during crises–wars, harvest failures, natural disasters–because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few ○ Restricting the price from going above surplus How Price Ceilings Cause Inefficiency ● Binding: whether or not a policy or constraint is changing the outcome of the profit ○ For a price ceiling to be “binding”, it has to be below the equilibrium price ● Inefficiently low quantity ● Inefficient allocation to customers ● Wasted resources ● Inefficiently low quality ● Black markets: a market in which goods or services are bought and sold illegally—either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling Price Floors ● Sometimes governments intervene to push market prices up instead of down ○ Can't go below a certain amount ○ Ex. price floor on corn, price floor on milk ● The minimum wage is a legal floor on the wage rate, which is the market price of labor ● Price floors are intended to help some people but generate predictable and undesirable side effects ○ For a price floor to be “binding”, it has to be Week 11: Smart Book Notes ● ● ● ● ● ● ● ● ● ● ● ● ● A firm's implicit costs are the opportunity costs of the resources supplied by the firm's owners. Economic profit is the difference between a firm's total revenue and the sum of its explicit and implicit costs. ○ In the long run, a firm should exit the market if its: economic profit is negative. ○ If a firm earns an economic loss, then its economic profit is negative. ○ In the long run, new firms will enter a market if existing firms are earning a positive economic profit. Accounting profit = total revenue - explicit costs If the price of a product is below the equilibrium price, then it's always possible to design a transaction that will help both buyers and sellers. Suppose it's possible to find a transaction that will make some people better off without hurting others. In this case, we know the market equilibrium is not socially optimal. If the price of a good or service lands above the equilibrium, we can conclude that it's always possible to design a transaction that will help both buyers or sellers. The market equilibrium may not be efficient if the market is not perfectly competitive or if the market supply curve and the market demand curve do not capture all of the relevant costs and benefits of a good. If the firms in a market are earning an economic loss, then in the long run there will be exit from the market, leading the equilibrium price to rise. If it's not possible to find a transaction that will make some people better off without harming others, then the market equilibrium is efficient It's always possible to design a transaction that will help both buyers or sellers whenever the price of a product is either above or below the equilibrium price The market equilibrium is only efficient if: ○ The market demand curve captures all of the relevant benefits of buying another unit of the good. ○ The market is perfectly competitive. ○ The market supply curve captures all of the relevant costs of producing another unit of the good. If the total economic surplus from a market is thought of as a pie to be divided among the participants in the market, then imposing price controls will: reduce the size of the pie Price controls are often designed to help the poor, but the fact that they reduce total economic surplus means that alternative policies such as direct income transfers to the poor: would not help the poor 04/16/2024- Part B: Policies Continued… ● Quantity control, or quota: An upper limit on the quantity of some good that can be bought or sold. The total amount of the good that can be legally transacted is the quota limit. An example is the taxi medallion system in New York. ● ● A license gives its owner the right to supply a good. The demand price of a given quantity is the price at which consumers will demand that quantity. ● The supply price of a given quantity is the price at which producers will supply that quantity. ● Wedge/quota rent: Difference between demand price and supply price. Quota Rent ● The difference between the demand and supply price at the quota limit is the quota rent, the earnings that accrue to the license-holder from ownership of the right to sell the goods. ● It is equal to the market price of the license when the licenses are traded. 04/23/2024- Part B: Policies Continued… Tax Incidence ● The incidence of a tax is a measure of who really pays it ● Who really bears the tax burden doesn't depend on who officially pays the tax ● Depending on the elasticities of supply and demand, the incidence of an excise tax may be divided differently. ● Price elasticity of demand low, price elasticity of supply high → burn og excise tax falls mainly on consumers ● Price elasticity of demand high, price elasticity of supply is low → burden of excise tax falls mainly on producers ● Elasticity determines the incidence of an excise tax Revenue form an Excise Tax ● Revenue collected by an excise tax is equal to the area of a rectangle ○ Height is the tax wedge between the supply and demand curves ○ Width is the quantity transacted under the tax Tax Rates and Tax Revenue ● Does doubling the excise tax rate on a good double the amount of revenue collected? ○ No, because the tax increase will reduce the quantity of goods or services transacted. ● In some cases, raising the tax may actually reduce the amount of revenue the government collects. Week 12 Smart Book Notes ● Individuals who engage in activities that generate negative externalities will tend to engage in those activities more than is socially optimal. ● ● ● ● ● ● ● ● Coase Theorem: if, at no cost, people can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities. ○ The Coase theorem says that people should be able to arrive at efficient solutions to the problems caused by externalities if they can negotiate at no cost the purchase and sale of the right to perform activities that cause externalities. If negotiation is infeasible, however, government intervention may be necessary. The government is more likely to develop laws and regulations concerning activities that generate externalities when it is difficult for people to negotiate the purchase and sale of the right to perform those activities. ○ If it is difficult for people to achieve private solutions to externalities, government intervention may be necessary. Antibiotic use generates a negative externality to the extent that antibiotic use by one person can decrease the effectiveness of antibiotics for others because bacteria can develop antibiotic resistance. Individuals who engage in activities that generate positive externalities will tend to engage in those activities less than is socially optimal. The socially optimal level of a negative externality is the level at which the marginal cost of reducing the externality equals the marginal benefit of reducing the externality. ○ The socially optimal level of pollution is the level at which the marginal cost of pollution abatement equals the marginal benefit of pollution abatement. ○ If the cost of pollution abatement differs across firms, then the most efficient system of pollution abatement is one in which firms with the lowest marginal cost of pollution abatement reduce pollution the most. By taxing activities that generate negative externalities, you force those engaged in those activities to take into account the cost they impose on others. One way to improve economic efficiency is to subsidize activities that generate positive externalities. ○ By subsidizing activities that generate positive externalities, you induce those engaged in those activities to take into account the benefit they give to others. The tragedy of the commons is the tendency for a resource that has no price to be used until its marginal benefit falls to zero. ○ The essential cause of the tragedy of the commons is the fact that one person's use of a publicly owned resource imposes an external cost on others by lowering its value.
