Econ 2106 Final
Income elasticity of demand
% change in quantity demanded/ % change in income - normal: positive (elastic: >1; inelastic positive but < 1) - inferior: negative
cross-price elasticity of demand
% change in quantity of A demanded/ % change in price of B - substitutes: positive - complement: negative
Price elasticity of supply
% change in quantity supplied/ % change in price
mid-point elasticity formula
(Q2-Q1)/(Average Q)/(P2-P1)/(Average P)
point elasticity formula
(Q2-Q1/Q1)/(P2-P1/P1)
Factors that determine price elasticity of supply
- availability of inputs (expensive: inelastic; cheap: elastic) - time
Antitrust policy
- avoid deadweight loss, the government uses antirust policies to eliminate monopolies
Either-or decision
- choose higher economic profit
Four reasons people rationally choose worse payoff:
- concerns about fairness - non-monetary rewards - bounded rationality ("good enough" option) - risk aversion (sacrifice some economic payoff to avoid potential loss)
Monopoly - Barriers to entry
- control of a scarce resource or input - natural monopoly (large cost advantage to single firm) - technological superiority - network externality (more users = more value) - patent & copyright
When demand is elastic, the quantity effect:
- dominates price effect - increase in price will cause significant reduction in quantity demanded - total revenue decreases as price rises
When demand is inelastic, price effect:
- dominates quantity effect - increase in price will cause only slight reduction in quantity demanded - total revenue will rise when prices rise
Diminishing returns effect
- larger the output, the more variable input required which leads to higher AVC
Characteristics of perfection competition
- many buyers and sellers - price takers - standardized product - free entry and exit
Seven common mistakes in economic decision-making:
- misperception of opportunity cost (does not include sunk) - overconfidence - unrealistic expectations - counting dollars unequally - loss aversion - framing bias (based on how choices are presented) - status quo bias (avoid making decision altogether)
What can public policy do about natural monopoly?
- public (gov) ownership - price regulation
Cartel
- strongest form of collusion - agreement by several producers to restrict output in order to increase joint profits - ex: OPEC
Factors that determine price elasticity of demand:
- substitutes (inelastic: fewer; elastic: more) - necessity or luxury (luxury more sensitive) - share of income spend on good (less sensitive when cheap) - length of time since price change
When demand is unit elastic:
- the quantity effect = price effect - increase in price is balanced by a reduction in quantity demanded - total revenue does not change
Herfindahl-Hirschman Index (HHI)
- the sum of the squares of each firm's share of market sales < 1500 strongly competitive 1,500 to 2,500 = somewhat competitive > 2500 = oligopoly > 1500 = merger
When excise tax is paid mainly by producers
- when price elasticity of demand is high and price elasticity of supply is low, burden falls on producers
When excise tax is paid mainly by consumers
- when price elasticity of demand is low and price elasticity of supply is high, burden falls on consumers
Monopoly - maximize profit
1. at Q where MR = MC 2. choose highest price you can get away with for the quantity
Average fixed cost
AFC = FC/Q
Average total cost
ATC = TC/Q
Average variable cost
AVC = VC/Q
|Ed| > 1
Elastic
If |Ed| < 1
Inelastic
Marginal cost
MC = changeTC/Q - upward slopping because of diminishing returns
Marginal product
MPL = changeQ/changeL
Optimal output rule
MR = MC
Marginal revenue
MR = changeTR/changeQ
Quantity effect
One more unit is sold, increasing total revenue by the price at which the unit is sold
Total revenue
P x Q
|Ed| = infinity
Perfectly elastic - horizontal
|Ed| = 0
Perfectly inelastic - vertical
P > min AVC
Produce
TR > TC
Profit
P > min ATC
Profit - new entrants
Tit for tat
Strategy of playing cooperatively at first, then doing whatever the other player did in the previous period
Total cost
TC = FC + VC - becomes steeper because diminishing returns
Total revenue
TR = P x Q
Benefits principle
Those who benefit from public spending should bear the burden of the tax that pays for that spending
Inelastic
When an increase in price reduces quantity demanded by just a little
P < min AVC
Will not produce
Marginal benefit
additional benefit from producing one more unit
Marginal cost
additional cost incurred by producing one more unit of good
Long run
all inputs can be varied
short run
at least one input is fixed
TR = TC
break even
If goal is efficiency (minimizing deadweight loss), policymakers should:
choose goods with lowest price elasticities
tacit collusion
cooperation among producers, without a formal agreement, to limit production and raise prices so as to raise one another's profits
fixed cost
cost does not depend on quantity of output
Variable cost
cost that depends on quantity of output
Implicit cost
does not require outlay of money; measured in the value of benefits forgone
The fact that is a natural monopoly is revealed by the:
downward-slopping average total cost curve
monopolist
firm that is the only producer of a good with no close substitutes
Collusion
firms cooperating to raise each other's profits
Noncooperative behavior
firms ignoring the effects of their actions on each other's profits
Prisoner's dilemma
game based on two premises - each player has an incentive to choose an action that benefits itself at the other's player's expense - both players are then worse off than if they had acted cooperatively
Deadweight loss is _____ when demand is elastic
larger
Spreading effect
larger the output, the more output over which FC is spread, leading to lower AFC - downward sloping
Profit maximizing principle
largest quantity at which marginal benefit is greater than or equal to marginal cost
If two firms are identical in all respects except one firm has more fixed capital input, the marginal product curve of the firm with more input:
lies above the marginal product curve of the firm with less input
Increasing returns to scale
long-run ATC declines as output increases
Decreasing returns to scale
long-run ATC increases output increases
TR < TC
loss
Oligopoly
market dominated by a small number of firms - profits of large firm depend on actions by other large firms
Incidence of tax
measure of who really pays tax
Shut-down price
minimum AVC - firms will produce if they can cover their variable cost and some of their FC
Imperfect competition
no firm has a monopoly, but producers can affect market prices
Duopoly
oligopoly consisting of only two firms - each realize that profits would be higher if it limited its production (and kept prices higher)
Implicit cost of capital
opportunity cost of the use of one's own capital
Explicit cost
outlay of money
Profit
profit = TR- TC (Price-ATC) Q
Variable input
quantity can vary
Fixed input
quantity is fixed
total product curve
quantity of output depends on quantity of variable input for given fixed input
Production function
relationship between quantity of inputs a firm uses and quantity of output it produces
Nash equilibrium
result when each player chooses the action that maximizes their payoff given the actions of the other player, ignoring the effects of their action on the payoffs received by other player
Accounting profit
revenue - explicit
Economic profit
revenue - explicit - implicit - usually less than accounting
Deadweight loss is ___ when demand is inelastic
smaller
normative statement
statement which describes how the world "should" be
Game theory
study of behavior in situations of interdependence - dominant strategy
Ability to pay principle
those with greater ability to pay a tax should pay more
Price effect
to sell that last unit, the monopolist must cut the market price on all units sold - decreases total revenue
|Ed| = 1
unit elastic
Elastic
when an increase in price reduces quantity demanded by a lot
Long-run average total cost curve
when fixed cost has been chosen to minimize ATC