Microeconmics - Final Exam

Laissez-Faire Economy

"Allow them to-do" An economy in which individual people and firms pursue their own self-interest without any central regulation.

Maximin strategy (risk adverse)

maximin strategy in game theory is a strategy designed to maximize the minimum gain that can be earned. Such a strategy may be desirable when a player confronts considerable uncertainty and a risk of a large potential loss. To find a player's maximin strategy, *find the worst possible payoff that a player could receive for each strategy that they have*. Then, choose the strategy that yields the highest payoff among all of the worst-case outcomes.

Short-run equilibrium

may entail economic profits, economic losses, or just breaking even on the part of the firm.

There are two different types of measures of industry concentration:

n-firm concentration ratios the Herfindahl-Hirschman Index HHI

Oligopoly

refers to an industry that is dominated by a small number of large producers.

Consumer Surplus

refers to the difference between the maximum amount that a consumer is willing to pay for a particular good or service and the current market price of that good or service. It equals the area *UNDER the demand curve* and *ABOVE the Price*.

income elasticity of demand

a measure of how much the quantity demanded of a good responds to a change in consumers' income, computed as the percentage change in quantity demanded divided by the percentage change in income

price elasticity of demand

a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price

Price elasticity of demand (midpoint) =

(Q2 - Q1) / [(Q2 + Q1) / 2] over (P2 - P1) / [(P2 + P1)/2]

Private goods

are *both rival and excludable.*

Public goods

are *non-rival and non-excludable.*

If you are asked the elasticity of demand at a point (P1;Q1) of a demand P = a - b * Q;

elasticity = 1 P1 ----- b Q1

Constant Returns to Scale

f (t*L , t*K) = t*f (L,K)

Decreasing Returns to Scale or Diseconomies of Scale

f(t*L , t*K) < t*f (L,K)

Perfectly Elastic Demand

Elasticity Equals Infinity (horizontal demand curve)

Perfectly Elastic Supply

Elasticity Equals Infinity (horizontal supply curve)

Elastic Demand

Elasticity Is Greater Than 1

Elastic Supply

Elasticity Is Greater Than 1

Inelastic Demand

Elasticity Is Less Than 1

Inelastic Supply

Elasticity Is Less Than 1

Descriptive Economics

Entails putting together data that describe economic phenomena

Average variable cost (AVC)

Equals the total variable cost divided by the number of units of output - i.e., AVC = TVC/Q.

Marginal Benefit

Evaluate only the benefits associated with the choice involved

Marginal Cost

Evaluate only the costs associated with the choice involved

Normative economics

Examines economic outcomes and asks whether they are desirable or undesirable, and whether they can be improved upon; Normative economics involves value judgments, as well as prescriptions for public policy. As a general rule, "should" questions are normative, since they entail judgments about the desirability of different economic outcomes. Normative economics is frequently referred to as "policy economics."

Microeconomics

Examines the behavior of individual decision-making units in the economy, business firms and households, and the functioning of individual industries.

Macroeconomics

Examines the economy as a whole

Equity

Fairness

Monopolistic Competition

Firms produce differentiated products

Perfect competition

Firms produce identical products

Three key characteristics of monopolistic competition

-Many firms -No barriers to entry -Product differentiation (heterogeneous products)

A Positive Externality

*when left uncorrected, will result in too LITTLE of the activity for social efficiency.*

A Negative Externality

*when left uncorrected, will result in too MUCH of the activity for social efficiency.*

A Game consists of: (three elements)

-A set of players -A set of strategies for each player -A Payoff function that assigns a payoff to each player for all possible strategy combinations

Under monopoly example

-Consumer Surplus = (200 - 120) x 40/2 = $1600. -Producer surplus is equal to (Pm-MC) x Qm. This equals(120 - 40) x 40 = $3200. -Deadweight loss (DWL) is equal to (PM - PC) x (QC - QM)/2. In this case, this equals (120 - 40) x (80 - 40)/2 = $1600

Shutdown Price < Market Price < Breakeven Price

-Firms are making an economic *LOSS* -Some existing firms will exit the market -This will *DECREASE* the market supply -This will *INCREASE* the market price

Market Price > Breakeven Price

-Firms are making an economic *PROFIT* -This will attract entry into the market -This will *INCREASE* market supply -This will *DECREASE* the market price

Market Price < Shutdown Price

-Firms are producing nothing, and the market vanishes

Every firm must make three interrelated decisions in order to maximize profit

-How much output to produce (quantity to supply). -How to produce that output (what technology of production will be used). -How much of each input to demand.

Coase Theorem

-Only a few parties involved -Low cost of negotiation -Property rights are clearly defined is a legal and economic theory that affirms that where there are complete competitive markets with no transactions costs, an efficient set of inputs and outputs to and from production-optimal distribution are selected, regardless of how property rights are divided.

Things that change Labor Supply curve

1. Change in immigration laws 2. Change in the wages of other industries 3. Change in qualifications to be in the industry

Things that change Labor Demand curve

1. Changes in the demand for output 2. Changes in technology 3. Changes in the quantity of other inputs

Things that cause a change in DEMAND

1) A change in preferences* 2) A change in income*: Normal Good & Inferior Good 3) A change in the price of related goods*: Complements & Substitutes 4) A change in expectations (price or income)* 5) A change in the number of consumers in the market 6) A tax levied on consumers 7) Advertising

Things that cause a change in SUPPLY

1) A change in the cost of production 1a) An increase in the cost of production will cause a decrease in Supply. 1b) A decrease in the cost of production will cause an increase in Supply. - Change in input prices - Change in technology 2) A change in the number of firms in the market (Inversely proportional) 3) A tax levied on producers 4) Weather / Natural Disasters

What are the two types of asymmetric information discussed in your textbook? Define and give an example of each.

1. Moral hazard - when there are two parties to a contract and one party passes the cost of its behavior onto the other party. An example of moral hazard would be when a person buys health insurance and after buying the insurance engages in new behaviors that are risky to one's health (like smoking or bungee jumping). 2. Adverse selection occurs when one party to a transaction has more information than the other. For example, people that smoke in bed might be more likely to buy fire insurance than those who do not smoke. In this example the smoker has more information than the insurance company. As a result the fire insurance company writes more risky policies than would be optimal.

What are the three conditions that are required for the Coase Theorem to work? Briefly explain each condition.

1. Property rights must be defined. For example, either a company has the right to pollute a nearby river, or the townspeople have a right to pollution free river. 2. Low transactions costs to bargaining. Those involved with the externality must be willing and able to bargain and the costs of that bargaining should be small or zero. 3. Only a small number of people can be involved. The larger the number of people involved, the more difficult it is to collectively agree on a solution.

Types of Price Discrimination

1st degree price discrimination (or perfect price discrimination) refers to the extreme case of price discrimination where each buyer pays exactly what they are willing to pay for a good. 2nd degree price discrimination refers to a situation where buyers are charged different prices depending on the quantity of the good that they purchase. This is a more complicated type of pricing strategy. 3rd degree price discrimination refers to a situation where a firm charges different groups of consumers different prices. *This is the most common type of price discrimination.*

Increase in Demand and Increase in Supply

= P? , Q↑

Decrease in Demand and Decrease in Supply

= P? , Q↓

Increase in Demand and Decrease in Supply

= P↑ , Q?

Decrease in Demand and Increase in Supply

= P↓ , Q?

Marginal Product Labor (MPL)

= This is the extra output generated by an extra worker.

Average Product Labor (APL)

= Total Output / Number of workers

Tax or Subsidies

A *tax* can be used to correct for a *negative externality*. The amount of the tax should be equal to the marginal damage (external) cost. A *subsidy* can be used to correct for a *postive externality*. The amount of the subsidy should be equal to the Marginal External Benefit. If an agent is creating a negative externality, the government could impose a tax on their activity equal to the marginal damage cost. This would cause the agent to pay the full marginal social cost, since it would pay the marginal private cost plus the marginal damage cost (in the form of a tax).

Stability

A condition in which national output is growing steadily, with low inflation and full employment of resources

Economic Growth

An increase in the total output of an economy

Sunk Costs

A cost that has already been incurred and cannot be recovered.

Ceteris Paribus

A device used to analyze the relationship between two variables while the values of the other variables are held unchanged; Also known as 'all else equal'

Supply Curve

A graph of a supply schedule (typically runs through the y-axis because the company needs a minimum demand to even start producing the good).

Time Series Graph

A graph that illustrates how a variable changes over time

Post Hoc (aka: Ergo Propter Hoc)

A logical fallacy (of the questionable cause variety) that states "Since event Y followed event X, event Y must have been caused by event X.

Monopoly

A market with a single seller that sells a good with no close substitutes. -A monopolist faces the (downward sloping) market demand)

Price Ceiling

A maximum price set by the government that sellers can charge for a good or service -A classic example of price ceilings is provided by rent controls, where cities establish maximum rents in an effort to keep housing "affordable." If this ceiling keeps the market price below the equilibrium price, it creates a SHORTAGE that persists (since the market price is prevented from rising to its equilibrium level).

Variable

A measure that can change from time to time or from observation to observation.

Vertical Differentiation

A product difference that, from everyone's perspective, makes a product better than rival products

Decrease in Supply

A shift of the left of the Supply curve (even though the line goes above the original line; think left, not up or down)

Decrease in Demand

A shift to the left on the demand curve

Increase in Supply

A shift to the right of the Supply curve (even though the line goes below the original line; think right, not up or down)

Increase in Demand

A shift to the right on the demand curve

Product Differentiation

A strategy that firms use to achieve market power. Accomplished by producing goods that differ from others in the market.

Supply Schedule

A table showing the Qs at different prices

per-unit excise tax

A tax based on the quantity of the good that is sold. So for example, the government might set a tax of $.50 per gallon of gasoline, or $2.00 per pack of cigarettes.

Marginalism

A theory of economics that attempts to explain the discrepancy in the value of goods and services by reference to their secondary, or marginal, utility.

Commitment device

Actions that individuals take in one period to try and control their behavior in the future period.

Command Economy

An Economy in which a central government either directly or indirectly sets output targets, incomes, and prices.

Inferior Good

An increase in income causes a decrease in Demand, and vice-versa.

Normal Good

An increase in income causes an increase in Demand, and vice-versa.

Search Goods

Are goods that a consumer can evaluate before they are purchased. For example, you may know exactly what size and style of clothing that you prefer.

Experience Goods

Are goods that you must consume before you can evaluate them. A meal at a restaurant is a good example.

Fallacy of composition

Arises when one infers that something is true of the whole from the fact that it is true of some part of the whole (or even of every proper part). For example: "This fragment of metal cannot be fractured with a hammer, therefore the machine of which it is a part cannot be fractured with a hammer."

Average fixed cost (AFC)

As simply total fixed cost divided by the quantity of output - i.e., AFC = TFC/Q.

Long-Run Equilibrium Under Monopolistic Competition

Because of free entry and exit, long-run equilibrium under monopolistic competition is characterized by zero economic profit and by firms that confront demand curves that are tangent to their ATC curves.

Sequential Games

Can be solved by "backward induction" (see chart)

Total cost of production (TC)

Sum of the fixed costs and variable costs together TC = TFC + TVC ∆TC = ∆L*W (W = wage rate, the price of labor)

Cross-price elasticity of demand =

Cross-price elasticity of demand = Percentage change in quantity demanded of good 1 / Percentage change in the price of good 2

Unit Elastic Supply

Elasticity Equals 1

Quantity Demanded

Depends on the price of a good or service in the marketplace, regardless of whether that market is in equilibrium. The quantity demanded is determined at any given point along a demand curve in a price vs. quantity plane.

Long-Run Equilibrium Under Monopolistic Competition

Easy entry and exit P > ATC => firms make a positive economic profit Other firms enter Demand facing existing firms goes down (residual demand)

Price < ATC

Economic Loss

Substitution Effect

Economists think of the wage rate as the opportunity cost of consuming leisure. If you decide to take the day off from work, what you are giving up is the forgone income that you could have earned from working. In short, the substitution effect tells us that the higher the wage rate, the higher the quantity supplied of labor. This implies that the supply curve for labor is upward sloping

Over long time horizons goods have ____ demand

Elastic - Goods tend to have more elastic demand over longer time horizons

Goods with substitutes have ____ demand

Elastic - Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others

Luxuries have ____ demand

Elastic - Luxuries have elastic demands

Narrowly defined markets have ____ demand

Elastic - Narrowly defined markets tend to have more elastic demand because it is easier to find close substitutes for narrowly defined goods

over long time horizons goods have ____ supply

Elastic - supply is usually more elastic in the long run than in the short run

Perfectly Inelastic Demand

Elasticity Equals 0 (vertical demand curve)

Perfectly Inelastic Supply

Elasticity Equals 0 (vertical supply curve)

Unit Elastic Demand

Elasticity Equals 1

Substitutes vs. Complements have ____ cross-price elasticity

For substitutes, the cross-price elasticity is positive, indicating that an increase in the price of A increases the quantity of B demanded. For complements, the cross-price elasticity is negative, indicating that an increase in the price of A reduces the quantity of B demanded.

"Excess Demand" or a "Shortage."

If P^A < P*, then Qd > Qs. There is a tendency for the price to RISE to "clear" the market. (P^A = Actual Price)

Drop-in-the-bucket-problem

If a public good is consumed by a large number of people, then everyone's contribution to the good is very small relative to its total value. In this case, a person would realize that their failure to contribute to the production of the good would not prevent it from being produced. For example, our national defense budget is funded by our entire population. It is seriously doubtful that if any single person failed to contribute, that national defense would not be provided.

This illustration represents production of a good with a negative externality present.

If the externality is left uncorrected, the firm will produce Q1 units of the good. This is because that is the level where the Marginal Benefit (MB) is equal to the Marginal Private Cost. However, for each unit of the good produced after quantity Q0, the marginal benefit is less than the Marginal Social Cost. This tells us that from the viewpoint of society, these units of the good should not be produced since the cost of producing them exceeds the benefit from their production. So the socially optimal level of output is Q0.

The FTC uses the following guidelines to challenge a merger:

If the post merger HHI < 1000, the merger will go unchallenged. If the post merger HHI is between 1000 and 1800, then a merger that increases the HHI by 100 or more will be challenged If the post merger HHI > 1800, then a merger that increases the HHI by 50 or more will be challenged.

Persuasive Advertising

Is designed to change a consumer's preferences, and is typically associated with Experience Goods.

Income elasticity of demand =

Income elasticity of demand = Percentage change in quantity demanded / Percentage change in income

Broadly defined markets have ____ demand

Inelastic - Broadly defined markets tend to have more inelastic demand because it is harder to find close substitutes for broadly defined goods

Necessities have ____ demand

Inelastic - Necessities tend to have inelastic demands

Week 6

Input Markets: -Determine the marginal revenue product schedule for an input when given appropriate data, and explain how a profit-maximizing firm decides how much of the input it will employ -Identify the determinants of the demand for a factor of production -Find the least-cost combination of resources when given appropriate data, and explain and apply the rule used by a profit-maximizing firm to determine how much of each of several resources to employ -Explain the unique aspect of land as a factor of production, and indicate what determines economic rent -Explain how the interest rate serves to allocate capital in the capital market

Deadweight loss

Is a loss of economic efficiency that can occur when equilibrium for a good or service is not achieved or is not achievable.

Price Elasticity of Demand

Is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price, ceteris paribus.

Price Floor

Is a minimum price that must be paid in a market - i.e., exchange at a lower price is prohibited. Governmental bodies typically establish price floors. Two examples are the minimum wage and support prices for agricultural products. If a price floor keeps the market price above the equilibrium price, it creates a SURPLUS that persists (since the market price is prevented from falling to its equilibrium level).

Change in Quantity Supplied (Qs)

Is a movement along a given Supply curve. A change in Qs occurs because of a change in the Price of the good or service.

Self-fulfilling Prophecy

Is a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behavior.

Law of Increasing Opportunity Cost

Is a principle that states that once all factors of production (land, labor, capital) are at maximum output and efficiency, producing more will cost more than average. As production increases, the opportunity cost does as well.

Change in Supply

Is a shift of the Supply curve. A change in Supply occurs because of a change in something other than Price.

excise tax

Is a tax on a particular product such as gasoline or tobacco

The equilibrium output with Monopolistic Competition

Is given by the quantity at which marginal cost equals marginal revenue (Q* in the figure). Equilibrium price (P*) is given by point A - the point on the demand curve corresponding to the output level Q*.

Marginal Revenue

Is the additional revenue that will be generated by increasing product sales by one unit. It can also be described as the unit revenue the last item sold has generated for the firm.

Producer Surplus

Is the difference between what a producer receives for a product (the price) and the *minimum* they would be willing to accept to produce an additional unit of a good (the marginal cost).

Marginal cost

Is the single most important cost concept. measures the addition to total cost resulting from producing one more unit of output. Mathematically, MC = ∆TC/∆Q. MC = ∆TC/∆Q MC = ∆L*W/∆Q (W = wage rate, the price of labor) Since ∆L/∆Q is equal to the reciprocal of the marginal product of labor, MPL, MC = W/MPL. Hence, as the marginal product of labor declines, the marginal cost of output rises, and vice versa.

Total variable cost (TVC)

Is the sum of the different costs that vary with the level of output in the short run (TVC) = AVC X Output

Total Revenue

Is the total receipts of a firm from the sale of some given quantities of a product.

Long Run Average Cost (LRAC)

LRAC = TC/Q

What was learned in each week?

Lesson 1: Marginal Cost and Marginal Benefit Lesson 2: Comparative Advantage and Production Possibilities Lesson 3: Supply and Demand in Competitive Markets Lesson 4: Elasticity Lesson 5: Production and Costs Lesson 6: Input Markets (Factors of Production - Land, Capital, Cost Minimalization) Lesson 7: Perfect Competition (Short Run and Long Run Equlibrium) Lesson 8: Monopoly, Pareto Efficiency, and Price Discrimination Lesson 9: Monopolistic Competition Lesson 10: Oligopoly, Game Theory, and Antitrust Law Lesson 11: Externalities, Public Goods, and Asymmetric Information Lesson 12: Per-Unit Excise Taxes

MRPa =

MPa*Px = Pa

MRPk =

MPk*Px = Pk

P(L) =

MRP(L) = MP(L) * Px

Marginal Revenue Product (MRP)

MRPL = MPL x Px Hence, MRPL, the marginal revenue product of labor, shows how much additional revenue the firm earns as an additional unit of labor is added to a fixed quantity of capital. This additional revenue will equal the value of the extra output produced by the last worker (MPL). MPL = The marginal product of labor Px = price of the product

What happens when marginal cost increases or decreases in relation to the average cost?

Marginal > Average → Average Increases Marginal < Average → Average Decreases

Efficiency

Means allocative efficiency, an efficient economy is one that produces what people want at the least possible cost

Week 8

Monopoly, Pareto Efficiency, and Price Discrimination: -Determine the profit-maximizing level of output and price for a firm operating under conditions of monopoly -Calculate price, quantity, consumer surplus, producer surplus and deadweight loss under each market structure -Understand the notion of Pareto Efficiency, and see why a monopoly creates an outcome that is not socially efficient -Explain why profits and output will be higher for a discriminating monopoly than for a non-discriminating monopoly

Moral Hazard

Moral Hazard refers to a situation where one party of a contract passes the cost of its behavior on to the other party to the contract.

n-firm concentration ratios

Most frequently, n equals either four or eight firms. Hence, the fact that the four-firm concentration ratio for breakfast cereals is close to 80 tells us that production of the four largest firms in the breakfast cereal industry accounts for about 80 percent of industry output.

Horizontal Differentiation

Products differ in ways that make them better for some people and worse for others

Normal vs. Inferior goods have ____ income elasticities

Normal goods have positive income elasticities. Inferior goods have negative income elasticities.

Negative Externality

Occurs when the action of some economic agent imposes a cost on someone who is not involved with the action. An example is a firm that emits pollution into the environment. The firm pays only its cost of production but does not pay for the problems created by the pollution that are suffered by others. The suffering by others is called an external cost, or is sometimes referred to as a damage cost.

Positive Externality

Ocurs when the action of some economic agent bestows a benefit on someone who is not involved with the action. An example is home improvement. It is often the case that when a particular homeowner improves his or her house, that this will raise the property value of other houses in the neighborhood. The value to the other homeowners in the neighborhood is called an external benefit, or externality, since the benefit is not realized by the person who improved his/her house.

Consequence of a Monopoly

One consequence of a monopoly is that some surplus is transferred from consumers to the monopolist. The remainder of the consumer surplus that occurred under competition, the triangle XYZ, is lost because of the restriction on output by the monopolist. This area is referred to as the deadweight loss of monopoly, and it is a net loss of social welfare.

Distinguishing characteristic of oligopoly is the interdependence of firms:

One firm's market outcomes and activities (price, output, advertising expenditures) will be heavily dependent on the behavior of other firms in the market. One consequence of this interdependence is the absence of any single oligopoly model; another consequence is the widespread use of game theory to analyze the behavior of oligopolistic firms.

Long-Run Equilibrium Under Monopolistic Competition

P < ATC : Firm is making a loss Existing firms will exit the market (not all) Demand facing remaining firms will increase.

A perfectly competitive firm that wants to maximize profit will produce the quantity where:

P = MC

Long Run Equilibrium in a Perfect Competition

P = MC (Because firms are *maximizing profit*) P = ATC (called 'zero' 0 economic condition because it's driven by ENTRY and EXIT of the market) *P = MC = ATC* (ATC is minimized! ...at it's minimum)

Assume that firms try to maximize profit... and in order to maximize Profit, a firm should produce the quantity where MR = MC.

P = TR - TC

Equilibrium

P* -A situation where there is no tendency for change.

"Excess Supply" or a "Surplus."

P^A > P*, then Qd < Qs. There is a tendency for the price to FALL to "clear" the market. (P^A = Actual Price)

Week 7

Perfect Competition: -Identify and describe how perfect competition differs from imperfect competition (the other three market structures, including monopoly, oligopoly, and monopolistic competition), and enumerate the distinguishing characteristics of perfect competition -Determine the profit-maximizing level of output and price in the short run for a firm operating under conditions of perfect competition, given information on the demand curve that the firm confronts and its cost curves, and specify the firm's short-run supply curve -Identify the shut-down point on a firm's cost curve -Distinguish between short-run equilibrium of the firm and long-run equilibrium, and explain in words and graphically how long-run equilibrium is attained.

Price > ATC

Positive Profit

Price elasticity of demand (percentage) =

Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price (drop the minus sign)

Price elasticity of supply =

Price elasticity of supply = Percentage change in quantity supplied / Percentage change in price

What are the differences between public and private goods? Give an example of each type of good.

Private goods are rival in consumption and exclusive in consumption. When a good is described as rival, this means one person's consumption of the good diminishes the amount left for others to consume. When a good is exclusive, the owner of the good can prevent others from consuming the good. Public goods are nonrival and nonexclusive. So one person's consumption of a public good does not reduce the amount left for others to consume, and no one can be excluded from consuming a public good once it has been provided. An example of a private good is a pizza. An example of a public good is a fireworks display.

Week 5

Production and Costs: -Explain the law of diminishing returns and provide the rationale for this law Differentiate between the short run and the long run, and explain why the law of diminishing returns is relevant in the short run but not in the long run -Average fixed cost, average variable cost, average total cost, and marginal cost, and total cost -Explain the relationship between average and marginal product, on the one hand, and average and marginal cost, on the other

Definition of Profit

Profit = TR - TC. TR = P x Q TC = ATC x Q (to see this, review the definition of average total cost). So profit can be written as: Profit = P x Q - ATC x Q = Q x (P - ATC).

If MR = MC

Profit is maximized

Increasing Returns to Scale or Economies of Scale

Q = f(L,K) and t > 1 f(t*L , t*K) > t*f (L,K) L = Labor , K = Capital

Associated Quantity

Q*

Adverse Selection

Refers to a situation where the less informed side of the market must choose from a selection of products that are mostly of lower quality. (healthcare, sick people buy it more than healthy people)

The Marginal Damage Cost (MDC)

Refers to the part of the cost of producing one extra unit of a good that is not borne by the producer of the good.

Marginal Private Cost (MPC)

Refers to the part of the total cost of producing one extra unit of a good that is borne by the producer. For example if production costs rise from$1,000 to $1,050 as one more unit of a good is produced the marginal private cost is $50.

Repeated games in economics

Repeated games open up the possibility of strategic reactions that have the same effect as tacit collusion.

Economic theory

Second component of positive economics; An economic theory ordinarily consists of a statement or group of related statements that focus on cause and effect, and frequently ask the question, if a particular action is taken, what will be the reaction?

Positive economics

Seeks to describe economic behavior and the working of economic systems, without making any value judgments as to whether the outcomes are desirable or undesirable.

Production Possibility Frontier (PPF)

Sometimes referred to as a production possibility curve (PPC). The production possibility frontier (PPF) is a curve depicting all maximum output possibilities for two goods, given a set of inputs consisting of resources and other factors. The PPF assumes that all inputs are used efficiently.

Production Function

Specifies the maximum output that can be produced with given quantities of different inputs, for a given technology. Q = F(K, L, A), where Q is the quantity of output, K = quantity of capital used in the production process L = quantity of labor A = land F = the state of current technology. Increases in one or more of the inputs (K, L, or A) will result in greater output, and improvements in the technology of production will also serve to increase output.

the Herfindahl-Hirschman Index HHI

The HHI is calculated as the sum of the squares of the market share of each firm in the industry (expressed as a percentage). For example, if an industry had three producers and those firms had market shares of 25, 35, and 40 percent, then HHI = 252 + 352 + 402 = 625 + 1225 + 1600 = 3450. *The more concentrated the industry, the higher will be the value of the HHI*

Sherman Act, which was passed in 1890.

The Sherman Act outlawed "every contract... or conspiracy in restraint of trade or commerce" among states or nations, and it stipulated as well that monopoly and attempts to create a monopoly were illegal.

Quantity Supplied (Qs):

The amount of a good or service that a firm would produce and offer for sale in a given period of time, at a given price.

Suppose a firm has fixed costs in the short run of 100. Also, its variable costs are given by VC = 4q2. The firm's marginal cost is MC = 8q. What is the break-even price for the firm? show or hide answer

The break-even price for the firm is the minimum of Average Total Cost. This occurs where marginal cost equals average cost. Average Total Cost is TC/q where q is the quantity of output. Total Cost = TFC + TVC, so average cost equals (100 + 4q2) / (q) Setting this equal to 8q and solving for q, q = 5. Therefore, marginal cost equals average cost = 40. So 40 is the break-even price. So if the price is above 40, the firm will make a profit. If it is below 40, the firm will make a loss.

Empirical Economics

The collection and use of data to test economic theories

A monopolistically competitive firm differs from a perfectly competitive firm in the long run in that

The demand curve faced by a monopolistically competitive firm is downward sloping, while the demand curve faced by a perfectly competitive firm is horizontal.

Marginal Rate of Transformation (MRT)

The marginal rate of transformation (MRT) can be defined as how many units of good x have to stop being produced in order to produce an extra unit of good y, while keeping constant the use of production factors and the technology being used. It involves the relation between the production of different outputs, while maintaining constant the same level of production factors.

Economic incidence of a tax

The economic incidence of a tax refers to who actually ends up paying the tax.

If MR < MC

The firm can increase Profit by decreases output.

If MR > MC

The firm can increase Profit by increasing output.

In general, firms that practice price discrimination normally produce more than monopoly firms that do not practice price discrimination. In order to practice price discrimination, three conditions are required:

The firm must face a downward-sloping demand curve (so perfectly competitive firms are unable to practice price discrimination). There must be at least two different groups of consumers that have different price elasticities of demand. In general, groups with more inelastic demand, like business travelers and prime-age adults going to the movies, will be charged higher prices than groups with more elastic demand, like vacation travelers and students going to movies. The product or service must be difficult to resell. Otherwise the consumers who are charged the lower price could resell the good to the consumers who are charged the higher price, so that the firm would in principle never be able to sell any of the good or service at the higher price.

Flatter vs. Steeper Demand Curve

The flatter the demand curve that passes through a given point, the greater the price elasticity of demand. The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand.

Flatter vs. Steeper Supply Curve

The flatter the supply curve that passes through a given point, the greater the price elasticity of supply. The steeper the supply curve that passes through a given point, the smaller the price elasticity of supply.

What is the free-rider problem?

The free-rider problem refers to a problem specific to public goods. Public goods are nonexclusive. Since people can consume public goods after they are provided, regardless of whether they pay for them or not, people typically refuse to pay for the public goods. They instead "free-ride" on the payments of others.

Free Enterprise

The freedom of individuals to start and operate private businesses in search of profits.

Consumer Sovereignty

The idea that consumers ultimately dictate what will be produced (or not) by choosing what to purchase (or not).

Legal incidence of a tax

The legal incidence of a tax refers to who pays the tax according to the law.

Total fixed cost (TFC)

The overall sum of expenses that stays constant for a business even though its production output changes. A business that has a relatively high total fixed cost level might be tempted to participate in cut throat pricing practices since producing more revenue tends to involve relatively less additional costs.

The payoffs are typically written in a payoff matrix.

The players choose their strategies simultaneously (or equivalently, each player does not know what strategy the other player has chosen at the time they choose their own strategy) The game is played only once *this is called a one-shot game*

Equilibrium Price

The price at which Qd = Qs

Summary

The price elasticity of demand measures how much the quantity demanded responds to changes in the price. Demand tends to be more elastic if close substitutes are available, if the good is a luxury rather than a necessity, if the market is narrowly defined, or if buyers have substantial time to react to a price change. The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If quantity demanded moves proportionately less than the price, then the elasticity is less than 1, and demand is said to be inelastic. If quantity demanded moves proportionately more than the price, then the elasticity is greater than 1, and demand is said to be elastic. Total revenue, the total amount paid for a good, equals the price of the good times the quantity sold. For inelastic demand curves, total revenue moves in the same direction as the price. For elastic demand curves, total revenue moves in the opposite direction as the price. The income elasticity of demand measures how much the quantity demanded responds to changes in consumers' income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to changes in the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. This elasticity often depends on the time horizon under consideration. In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. If quantity supplied moves proportionately less than the price, then the elasticity is less than 1, and supply is said to be inelastic. If quantity supplied moves proportionately more than the price, then the elasticity is greater than 1, and supply is said to be elastic. The tools of supply and demand can be applied in many different kinds of markets. This chapter uses them to analyze the market for wheat, the market for oil, and the market for illegal drugs.

Absolute Advantage

The principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce a greater quantity of a good, product, or service than competitors, using the same amount of resources.

Marginal Social Cost (MSC)

The sum of MPC and MDC MSC = MPC + MDC is the change in society's total cost brought about by the production of an additional unit of a good or service. It includes both marginal private cost and marginal external cost. For example, suppose it costs a producer $50 to produce an additional unit of a good.

Comparative Advantage

The theory of comparative advantage is an economic theory about the work gains from trade for individuals, firms, or nations that arise from differences in their factor endowments or technological progress.

Law of Supply

There is a direct or positive relationship between Price and Quantity.

Different ways to correct for Externalities

They all involve the same principle—internalizing the externality. Internalizing an externality means that the agent creating the externality is made to realize the full cost (in the event that it is a negative externality) or the full benefit (in the event that it is a positive externality) of its action.

Opportunity Cost

This concept reflects the pervasiveness of trade-offs when we make decisions. The existence of scarcity means that we can't do everything we would like to do, and hence must make choices among competing alternatives.

If buyers are willing to pay only $3000 for a car, it is unlikely that anyone would be willing to sell a "plum" (since it is worth $4000). In this case, only "lemons" would be sold.

This result is called Adverse Selection. It is possible to have either a vanishing market (no high quality goods are offered for sale) or a thin market (only a small proportion of the goods offered for sale are of high quality).

Reciprocal of the Slope

To find the slope of a perpendicular line, take the negative reciprocal of the slope of the given line. (Flip the top and bottom of the fraction and change the sign.) The slope of a line that is perpendicular to a line with a slope of -2/3 is 3/2

In order to maximize profit with Monopolistic Competition in *SHORT-RUN*

To maximize profit in the short run, a firm should produce at that level of output at which MR=MC

Seven cost categories for the short run:

Total Fixed Cost (TFC) Average Fixed Cost (AFC = TFC/Q) Total Variable Cost (TVC) = AVC X Output Average Variable Cost (AVC=TVC/Q) Total Cost (TC = TFC + TVC) Average Total Cost (ATC = AFC + AVC = TC/Q) Marginal Cost (MC = ∆TC/∆Q = ∆TVC/∆Q)

Complements

Two goods are complements if an increase in the price of one good causes a DECREASES in the Demand for the other good.

Substitutes

Two goods are substitutes if an increase in the price of one good causes a INCREASES in the Demand for the other good.

Clayton Act in 1914. This act made several specific actions illegal, including:

Tying contracts that significantly lessen competition Mergers that significantly lessen competition Price Discrimination that significantly lessens competition

Allocative Efficiency and Productive Efficiency

Under perfect competition, in long-run equilibrium firms produce at the minimum point of the long-run ATC curve. This is a condition of productive efficiency - firms are producing at the lowest possible cost. Under monopolistic competition, however, firms are producing at a tangency point between the downward-sloping demand curve and the ATC curve, so they are necessarily producing at an ATC that is higher than the minimum ATC possible. This, then, is a situation of productive inefficiency,

Allocative Efficiency and Productive Efficiency

Under perfect competition, long-run equilibrium is characterized by P=MC. This is a condition for allocative efficiency: the value that consumers place on the good or service at the margin (P) is exactly equal to the value to society of the resources required to produce that good or service (MC). But the monopolistically competitive firm, like the monopolist (and, as we shall see subsequently, the oligopolist), restricts output as part of the process of maximizing profit, and as a consequence we may end up with allocative inefficiency.

What does "internalizing an externality" refer to? How might a positive externality be internalized? How might a negative externality be internalized?

When an externality exists in market, this means that economic decision makers do not consider all of the costs and benefits of consuming and producing the good. Internalizing an externality requires that all parties be forced to consider all costs and benefits of the transaction. A positive externality can be internalized when the government subsidizes the good's production. A negative externality can be internalized when the government taxes the good's production.

Fallacy of Composition

When an individual infers that something is true of the whole because it is true of part of the whole. In economics, this reasoning often leads to incorrect conclusions. For example, if you stand up at the baseball game, you can see better.

Relationship between Elasticity and Revenue

When demand is inelastic (a price elasticity less than 1), price and total revenue move in the same direction. When demand is elastic (a price elasticity greater than 1) price and total revenue move in opposite directions. If demand is unit elastic (a price elasticity exactly equal to 1) total revenue remains constant when the price changes.

Law of Demand

When price is high, quantity demanded tends to be comparatively low, and when price is low, quantity demanded tends to be relatively high (There is a negative relationship between Price and quantity demand. (Ceteris Paritus)).

Income Effect

When the wage rate rises, a person who works the same number of hours will now have a higher income. If leisure is a normal good, this will increase the demand for leisure, thus decreasing the supply of labor. Thus, the income effect of a change in the wage rate tells us that an increase in the wage rate will lead to a decrease in the quantity supplied of labor. This implies that the supply curve for labor is downward sloping.

Average total cost (ATC)

Which equals total cost divided by the quantity of output (TC/Q), equals TFC/Q + TVC/Q = AFC + AVC.

Ceteris Paribus

a Latin phrase meaning "with other things the same" or "all or other things being equal or held constant" or "all other things being equal" or "all else being equal"

*Nash equilibrium in game theory*

a combination of strategies where no player can improve their payoff by changing strategies, given the strategies chosen by the other players.

cross-price elasticity of demand

a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good

price elasticity of supply

a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price

elasticity

a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants

Suppose a monopolist faces the following demand curve: P = 4000 - 20Q. If the long run marginal cost of production is constant and equal to $40, a) What is the monopolist's profit maximizing level of output? b) What price will the profit maximizing monopolist charge? c) How much profit will the monopolist make if she maximizes her profit? d) What would be the value of consumer surplus if the market were perfectly competitive? e) What is the value of the deadweight loss when the market is a monopoly? f) What is the price elasticity of demand at the profit maximizing level of output?

a) QM = 99 b) PM = $2020 c) Profit = $196,020 d) CS = $392,040 e) DWL = $98,010 f) -1.0202......

Free-rider problem

if a good is non-excludable, then anyone can use it once it is produced. Therefore, any particular person does not have an incentive to help pay for the good. Why should I pay for something that I'm going to get to consume whether I pay for it or not? The only reason would be if I felt if I did not contribute the good would not be produced. This is addressed in the next paragraph.

A good is non-excludable

if it is difficult or impossible to prevent someone from consuming it once it is produced. A lighthouse is an example. The fact that one ship is using it to prevent it from crashing onto the rocks does not prevent another ship from also using it for the same purpose.

A good is excludable

if it is possible to prevent some people from consuming the good if they don't pay for it. For example, you cannot attend classes at Penn State for credit if you do not pay tuition.

A good is *non-rival* in consumption

if the fact that one person is consuming the good *does not prevent* another person from consuming it also. If I am watching a television show, that does not prevent you from watching the same show also.

A good is *rival* in consumption

if the fact that one person is consuming the good means that someone else *cannot also consume it*. An example of such a good is a cheeseburger. If I eat a cheeseburger, you cannot also eat it.

Pareto Efficiency

is a state of allocation of resources in which it is impossible to make any one individual better off without making at least one individual worse off. All that the Pareto Efficiency concept implies is that nothing is wasted.

Informative Advertising

is designed to provide information about a product's characteristics, availability, and price. This type of advertising is usually associated with Search Goods.

Marginal Product

of a given factor measures the increment to output (∆Q) associated with increasing the input of that factor by one unit, holding the quantities of all other inputs constant. Mathematically, we express the marginal product of labor as MPL=∆Q/∆L, and we express the marginal product of capital as MPK=∆Q/∆K.

Average product

of a particular variable factor of production is the average amount produced by each unit of the factor. Hence, for example, the average product of labor equals total output divided by the total number of units of labor. That is, APL=Q/L.

Law of diminishing marginal returns

provides us with information about marginal product. This law states that as more and more of a variable input is added to a given amount of a fixed input, the increments to output will eventually decline.

A per-unit excise tax equal to

t which is levied on the consumers of a good will shift the demand curve down (decrease in demand) by an amount exactly equal to t. per-unit excise tax = t

In general, other things equal,

the *more inelastic the demand, the greater the proportion of the tax paid by buyers*, and the *more inelastic the supply, the greater the proportion of the tax paid by sellers*.

Price Discrimination

the action of selling the same product at different prices to different buyers, in order to maximize sales and profits.

total revenue

the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold

Ockham's Razor

the principle that irrelevant detail should be cut away

When firms are losing money with Monopolistic Competition

the would exit the market, but can continue to produce if they are covering their fixed cost.

profits =

total revenue - total cost

Constant Returns to Scale

→ Constant Long Run Average Cost

Increasing Returns to Scale

→ Decreasing Long Run Average Cost

Diminishing Marginal Product

→ Increases Marginal Cost

Decreasing Returns to Scale

→ Increasing Long Run Average Cost