Microeconomics exam 2 - review questions
What are the items that make opportunity cost differ from the accountant's measure of cost?
A firm's opportunity cost includes the cost of using resources bought in the market, owned by the firm and supplied by the firm's owner. Economists and accountants both include the price of resources bought in the market as costs. But accountants omit costs included by economists. For instance, use of a building the owner has already purchased has an opportunity cost that accountants do not include. Additionally the normal profit, interest foregone, and economic depreciation are other opportunity costs not recorded by an accountant.
If a household's money income changes and prices do not change, what happens to the household's real income and budget line?
A household's real income is the household's income expressed as a quantity of goods the household can afford to buy. For example, the vertical intercept for a budget line measuring soda on the vertical axis is (y/Psoda), which is the consumer's real income in terms of sodas. A change in a household's money income changes the household's real income in terms of both goods and causes a parallel shift of the budget line. If a household's money income increases, its budget line shifts rightward and if a household's money income decreases, its budget line shifts leftward.
Why do accountants and economists calculate a firm's cost and profit in different ways?
Accountants and economists have different reasons for computing a firm's costs. An accountant calculates a firm's cost and profit to ensure that the firm pays the correct amount of income tax and to show its investors how their funds are being used. An economist calculates a firm's cost and profit in a way that enables him or her to predict the firm's decisions.
What is an indifference curve and how does a preference map show preferences?
An indifference curve shows those combinations of goods for which a consumer is indifferent. The consumer has the same level of satisfaction for any combination on a given indifference curve. The family of indifference curves is the preference map. This map shows the person's preferences because it shows how the person ranks each combination of goods. In particular, the person prefers combinations on higher indifference curves to combinations on lower indifference curves.
Explain the relationship between marginal product and average product.
As the quantity of labor initially increases the firm experiences increasing marginal returns and the marginal product of labor increases. The marginal product of labor is greater than the average product over this range of labor, so the average product of labor increases when the quantity of labor increases. Eventually, diminishing marginal returns causes the marginal product of labor to fall. When the marginal product of labor falls below the average product, the average product decreases as the quantity of labor increases.
How does marginal cost change as output increases (a) initially and (b) eventually?
At small outputs, marginal cost decreases as output increases because of greater specialization and the division of labor, but as output increases further, marginal cost eventually increases because of the law of diminishing returns.
Why is normal profit an opportunity cost?
Normal profit is the return to a firm's owner for the owner's supply of entrepreneurial ability and labor to the firm's production process. Using the owner's ability to run the business implies that the owner could have received a return for using it in another capacity, such as running another firm. This cost is an opportunity cost for the firm because it is the cost of a forgone alternative, which is running another firm, and must be included in calculating the firm's opportunity cost of production.
Why is a sunk cost irrelevant to a firm's current decisions?
Sunk cost is irrelevant because it cannot be changed by any decision. It is already incurred and so must be paid. The only costs that concern the firm are costs that the firm can change with its current decisions.
Distinguish between the short run and the long run.
The short run is a period of time during which the quantity of at least one factor of production is fixed and cannot be changed. The long run is a period of time long enough so that the quantities of all factors of production can be varied.
Explain the distinction between a command system and an incentive system.
A command system uses a managerial hierarchy, where commands pass downward through the hierarchy and information (feedback) passes upward. These systems are relatively rigid and can have many layers of specialized management. Incentive systems use market-like mechanisms to induce workers to perform in ways that maximize the firm's profit.
What is a firm's fundamental goal and what happens if the firm doesn't pursue this goal?
A firm's fundamental goal is to maximize its profit. If the firm fails to maximize profit it is either eliminated or bought out by other firms maximizing profit.
What does a firm's production function show and how is it related to a total product curve?
A firm's production function is the relationship between the maximum output attainable and the quantities of both capital and labor. The total product curve shows the maximum output that a given quantity of labor can produce for a given quantity of capital.
What do behavioral economics and neuroeconomics seek to achieve?
Behavioral economics and neuroeconomics seek to explain why we do not always make rational economic decisions. Behavioral economists study how the bounded limitations they study affect people's decisions so that not all decisions are the consequence of rational behavior. Neuroeconomists study how the brain works to make decisions so that neuroeconomists have a better understanding of the decisions people make.
. What are the three limitations on human rationality that behavioral economics emphasizes?
Behavioral economics studies bounded rationality (the point that people's brain-computing power is limited and this limits people's ability to make rational decisions), bounded willpower (the point that people's will power is limited so that at times they make decisions they know they will later regret), and bounded self-interest (the point that at times people make decisions that do not advance their selfinterest).
Define behavioral economics.
Behavioral economics studies the ways that limits on the ability of people's brains to compute and implement rational decisions influence their economic actions.
Is a firm economically inefficient if it can cut its costs by producing less? Why or why not?
Economic efficiency occurs when the firm produces a given level of output at the least cost. If a firm can decrease production costs by decreasing output, it is not necessarily economically inefficient. If it is producing the new level of output at the least possible cost, it is achieving economic efficiency.
What are the two ways in which economic activity can be coordinated?
Firms and markets both coordinate resources.
When the price of a good falls and the prices of other goods and a consumer's income remain the same, explain what happens to the consumption of the good whose price has fallen and to the consumption of other goods
When the price of a good falls, the marginal utility per dollar for that good increases. The marginal utility per dollar for other goods does not change. To maximize total utility, a consumer makes marginal utility per dollar equal for all goods, so the consumer buys more of the good that has experienced the fall in price and less of the goods whose marginal utilities per dollar have not changed.
What two conditions are met when a consumer is maximizing utility?
i) all available income is spent, and ii) the marginal utility per dollar spent is equal for all goods and services consumed.
If the price of a normal good falls, what happens to the quantity demanded of that good?
If the price of a normal good falls, the quantity demanded of that good increases because the substitution effect and the income effect both bring an increase in the quantity demanded.
Into what two effects can we divide the effect of a price change?
A price change can be divided into a substitution effect and an income effect. The substitution effect is the effect of a change in price on the quantity bought when the consumer remains indifferent between the original situation and the new situation. The income effect is the effect of a change in income sufficient to get the consumer to the highest indifference curve that is affordable on the new budget line reflecting the price change.
If the price of one good changes, what happens to the relative price and the slope of the household's budget line?
A relative price is the price of one good divided by the price of another good. For example, the magnitude of the slope of the budget line (Pmovie/Psoda) is the relative price of a movie in terms of soda. This relative price shows how many sodas must be forgone to see an additional movie. A fall in the price of the good on the horizontal (vertical) axis increases the total affordable quantity of that good, decreases its relative price, and decreases (increases) the magnitude of the slope of the budget line.
What determines whether a firm or markets coordinate production?
1. Firms may reduce transactions costs, which are the costs arising from finding someone with whom to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled. 2. Firms can capture economies of scale, which occurs when the cost of producing a unit falls as its output rate increases. 3. Firms can capture economies of scope, where one firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise. 4. Firms can engage in team production, in which the individuals specialize in mutually supportive tasks. Firms coordinate economic activity when they can perform a task more efficiently than markets can. In such a situation, it is profitable to set up a firm. If markets can perform a task more efficiently than a firm can, firms will use markets, and any attempt to set up a firm to replace such market coordination will be doomed to failure.
What are the two measures of concentration? Explain how each measure is calculated
1. The four-firm concentration ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry. 2. The Herfindahl-Hirschman Index (HHI) equals the sum of the squared market shares of the 50 largest firms in the industry.
Under what conditions do the measures of concentration give a good indication of the degree of competition in a market?
1. The industry market is national in scope, rather than local or international. 2. There are no concerns about over-stating or under-stating the extent of barriers to entry. 3. Firms are not misclassified with respect to their markets.
Elaborate on your answer to the previous question by using demand curves. For which good does demand change and for which good does the quantity demanded change?
After the price of a good falls, the consumer increases consumption of the good to lower the marginal utility per dollar. This action means that more of the good is consumed at the lower price, which implies that the demand curve for the good is downward sloping. The consumer increases the quantity demanded of this good. Additionally, the consumer decreases the quantity of the other goods and services consumed, despite the price of other goods and services remaining unchanged. This change implies that the demand curves for each of the other goods and services shift leftward.
Explain the conditions that are met when a consumer has found the best affordable combination of goods to buy. (Use the terms budget line, marginal rate of substitution, and relative price in your explanation.)
At the optimal consumption choice, the consumer's consumption bundle is 1) on the budget line, 2) on the highest attainable indifference curve, 3) such that the slope of the budget line, which is the relative price of the two goods, equals the slope of the indifference curve, which is the MRS.
What is the shape of the AFC curve and why does it have this shape?
Average fixed cost (AFC) equals total fixed cost divided by total product. As the quantity produced increases, the fixed costs are spread over a larger and larger quantity of output so average fixed cost decreases. So the AFC curve slopes downward as the quantity produced increases.
What are economies of scale and diseconomies of scale? How do they arise? What do they imply for the shape of the LRAC curve?
Economies of scale are features of a firm's technology that lead to falling long-run average cost (LRAC) as output increases. As plant size increases, the minimum attainable average total cost (ATC) for each plant size falls with output. Diseconomies of scale are features of a firm's technology that lead to rising LRAC as output increases. As plant size increases, the minimum attainable ATC for each plant size rises with output. A firm initially experiences economies of scale up to some output level and over this range of output the LRAC curve is downward sloping as output increases. Beyond that output level, it may move toward diseconomies of scale. When there are diseconomies of scale, the LRAC slopes upward as output increases, resulting in a U-shaped LRAC curve.
What are the four market types? Explain the distinguishing characteristics of each.
Economists identify four market types: 1. Perfect competition is a market with many firms, each selling an identical product. There are many buyers and no restrictions on entry of new firms. Firms and buyers are all well informed of prices and products of all firms in the industry. 2. Monopolistic competition is a market with many firms that produce similar but slightly different goods. 3. Oligopoly is a market in which a small number of firms compete and each firm may produce almost identical or differentiated goods. 4. Monopoly is a market in which only one firm produces the entire output of the industry. There are no close substitutes for the monopolist's product and there are barriers to entry that protect the firm from competition of entering firms.
Explain why equalizing the marginal utility per dollar for all goods maximizes utility
Equating the ratio of marginal utility per dollar for each good and service consumed maximizes utility because it measures the utility gained when an additional dollar of a good or service is consumed. This allows the consumer to weigh the utility gained from additional consumption of a dollar's worth of one good against the utility lost from the forgone consumption of a dollar's worth of another good. When the marginal utility per dollar for each good and service is equalized, there is no additional utility available from any other consumption combination.
What are the main reasons why firms can often coordinate production at a lower cost than markets can?
Firms can often coordinate production at a lower cost than can markets because firms lower transactions costs and achieve economies of scale, scope, and team production. These opportunities are not present when markets coordinate production.
For a normal good, does the income effect reinforce the substitution effect or does it partly offset the substitution effect?
For a normal good the substitution effect and the income effect reinforce each other, and a decrease (increase) in the price of a good will always result in an increase (decrease) in the quantity of the good demanded
What is the key assumption about marginal utility?
Generally, more consumption gives more utility. It generally declines as more units of the good are consumed. This assumption is the principle of diminishing marginal utility.
If a consumer's income increases and if all goods are normal goods, explain how the quantity bought of each good changes
If the consumer's income increases and all the goods consumed are normal goods, then the consumption of all goods increase. With the increase in income, the initial consumption possibility is now affordable with money left over. If the consumer's utility for all goods increases with consumption, because the consumer seeks to maximize utility subject to prices and available income, he or she will use the money left over from the initial bundle to increase the quantity consumed for all goods and services. By doing so the consumer increases his or her total utility. This increase occurs while the price of these goods and services remained unchanged, which indicates there is a rightward shift of the demand curve for all goods and services.
Explain how the marginal product and average product of labor change as the labor employed increases (a) initially and (b) eventually.
Initially, as the quantity of labor is increases, the firm experiences increasing marginal returns, which means that the marginal product increases as more labor is employed. Increasing marginal returns occur because hiring additional workers allows the workers to specialize and become more productive. Eventually, the firm will experience diminishing marginal returns which means that the marginal product decreases as more labor is employed. Decreasing marginal returns occur because eventually the gains from specialization diminish and because more and more workers are working with the same fixed amount of capital. The average product of labor follows the marginal product of labor. Initially, when the marginal product of labor is increasing, the average product also increases. As long as the marginal product of labor exceeds the average product of labor, the average product continues to increase. Eventually when the marginal product is falling it falls enough so that it is less than the average product, at which point the average product of labor decreases.
What is a firm's minimum efficient scale?
Minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. If the long-run average cost curve has the typical U shape, the minimum point of the LRAC identifies the level of output that represents the firm's minimum efficient scale
Define neuroeconomics
Neuroeconomics studies the activity of the human brain when it makes an economic decision.
Is a firm technologically efficient if it uses the latest technology? Why or why not?
Technological efficiency occurs when a firm produces a given level of output using the least amount of inputs. Adopting the latest available technology does not necessarily imply that a firm's production process is technologically efficient. As long as the firm is getting the maximum possible output for a given combination of inputs, it is technologically efficient.
Is the U.S. economy competitive? Is it becoming more competitive or less competitive?
The U.S. economy would be considered competitive since three-quarters of the value of goods and services bought are in markets characterized as perfect competition or monopolistic competition. The U.S. economy has become increasingly competitive over the decades.
What are the shapes of the AVC curve and the ATC curve and why do they have these shapes?
The average variable cost (AVC), and average total cost (ATC) curves are both U-shaped. -The marginal cost (MC) curve shows how total cost changes when output increases by one unit. If the MC curve lies below the AVC curve, AVC is falling. Diminishing marginal returns means that eventually the MC curve slopes upward. At some point the MC curve lies above the AVC curve, and the AVC curve is upward sloping. -ATC is the sum of average fixed cost (AFC) and AVC. Initially the ATC curve falls as the quantity produced increases because the AFC is initially quite large, but drops rapidly as total fixed costs are spread over greater levels of output. However, eventually diminishing returns cause marginal product to fall below average product, and average product decreases. As a result AVC increases as the quantity produced increases. If AVC rises more quickly than AFC falls, then the ATC curve is upward sloping.
If a household has an income of $40 and buys only bus rides at $2 each and magazines at $4 each, what is the equation of the household's budget line?
The budget equation states that a household's spending must equal its income. The budget equation is derived for two goods, bus rides and magazines. The amount spent on bus rides is (Pbus ride)×(Qbus ride), the amount spent on magazines is (Pmagazine)×(Qmagazine), and the consumer's income is y. We know that (Pmagazine)×(Qmagazine) + (Pbus ride)×(Qbus ride) = y. Rearrange this equality by subtracting the amount spent on bus rides from both sides to give (Pmagazine)×(Qmagazine) = y - (Pbus ride)×(Qbus ride). Finally, divide both sides by the price of magazine to give the budget equation Qmagazine = y/Pmagazine - (Pbus ride /Pmagazine)×(Qbus ride). Substituting in our values, y = $40, P bus ride = $2 and Pmagazine = $4, gives Qmagazine = $40/$4 - ($2/$4)×(Qbus ride) which is equal to Qmagazine = 10 - 0.5 Qbus ride
What does a household's budget line show?
The budget line plots combinations of goods that require all a household's income and describes the limits to its consumption choices.
When a consumer chooses the combination of goods and services to buy, what is she or he trying to achieve?
The consumer is trying to achieve the highest level of well being possible.
Explain how a consumer's income and the prices of goods limit consumption possibilities
The consumer is unable to consume limitless quantities of goods/services because they must pay a price for each good/service and the consumer's income is limited. If the consumer's income increases and/or the prices of the goods and services fall, the quantity of goods and services the consumer can afford increases, thereby increasing the consumer's consumption possibilities.
Explain the key distinction between technological efficiency and economic efficiency
The difference between technological and economic efficiency is that technological efficiency concerns the quantity of inputs used in production for a given level of output, whereas economic efficiency concerns the value of the inputs used. Economic efficiency requires technological efficiency, but technological efficiency does not require economic efficiency.
Why does an indifference curve slope downward and why is it bowed toward the origin?
The downward slope of an indifference curve illustrates the tradeoff between two goods while maintaining the same level of total satisfaction. Since the consumer is indifferent among all points on an indifference curve, when moving along it any increase in satisfaction from gaining one good must be matched by an equal decrease in satisfaction from a loss in the other good. An indifference curve is bowed toward the origin because the more of good x that is consumed the less you are willing to give up of good y to get more of good x and remain indifferent.
What is the key assumption about a consumer's marginal rate of substitution?
The key assumption about the marginal rate of substitution is that it is diminishing as a consumer moves down an indifference curve, creating the bowed-in shape.
Does the law of diminishing returns apply to capital as well as labor? Explain why or why not
The law of diminishing returns applies to capital as well as labor. The marginal product of capital is the change in the total product resulting from a one-unit increase in capital, holding the quantity of labor constant. As the quantity of capital increases for a given level of labor, the first units of capital will increase output substantially. But as capital continues to increase, eventually the increase in production starts to get smaller and diminishing returns to capital are occurring.
What is the law of diminishing returns? Why does marginal product eventually diminish?
The law of diminishing returns states that as a firm uses more of a variable factor of production with a given quantity of fixed factors of production, the marginal product of the variable factor eventually diminishes. Diminishing marginal returns arises from the fact that ever more workers are using the same capital and working in the same space.
What does the law of diminishing returns imply for the shape of the marginal cost curve?
The law of diminishing returns states: As a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes. The law of diminishing returns means that each additional worker produces a successively smaller addition to output. So to get an additional unit of output, ever more workers are required. The cost of an additional unit of output—marginal cost—is increasing, so the marginal cost curve eventually slopes upward.
What does a firm's LRAC curve show? How is it related to the firm's short-run ATC curves?
The long-run average cost curve (LRAC) shows the relationship between the lowest attainable ATC and output when both plant size and labor are varied. The LRAC curve reflects the minimum possible ATC the firm can attain for any given level of output. For any level of output the firm might choose to produce, the LRAC reflects the lowest possible ATC taken from an ATC curve that corresponds to a particular plant size. Once the firm has chosen that plant size, it will incur costs corresponding to the ATC curve associated with that plant size.
What do we call the magnitude of the slope of an indifference curve?
The magnitude of the slope of an indifference curve is called the marginal rate of substitution (MRS). The MRS measures the rate at which the consumer gives up one good to get more of another good, while remaining on the same indifference curve (keeping the consumer indifferent about the changes). The bowed-in shape of the indifference curve is due to the assumption of diminishing MRS.
How does the relative price and a household's real income influence its budget line?
The magnitude of the slope of the budget line equals the relative price of the good or service measured on the horizontal axis. A fall in the price of the good measured on the horizontal (vertical) axis decreases that good's relative price and decreases (increases) the slope of the budget line. A household's real income is the household's income expressed as a quantity of goods the household can afford to buy. An increase (decrease) in household income causes a parallel shift of the budget line rightward (leftward). The slope of the budget line does not change when income changes.
What relationships do a firm's short-run cost curves show?
The marginal cost (MC), average total cost (ATC) and average variable cost (AVC) curves are all related in the short run: -When the MC curve lies above (lies below) the AVC curve, the AVC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the AVC curve at its lowest point. -When the MC curve lies above (lies below) the ATC curve, the ATC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the ATC curve at its lowest point. -As output increases, the ATC curve becomes vertically closer to the AVC curve.
What is the marginal utility per dollar and how is it calculated?
The marginal utility per dollar equals the marginal utility of the good or service divided by its price. The marginal utility per dollar tells the additional utility gained from spending one more dollar on a good or service.
Why do some firms use large amounts of capital and small amounts of labor while others use small amounts of capital and large amounts of labor?
The mix of resources used, such as large amounts of capital versus small amounts of capital, depends on economic efficiency. Economic efficiency is based on minimizing the value of the resources used, not the quantity. A firm will use the mix that produces output at the lowest possible cost, without regard to specific physical quantities or ratios of inputs. As the cost of capital decreases relative to the cost of other resources, capital-intensive production methods will become economically efficient and firms will avoid labor-intensive methods.
Why does a consumer spend the entire budget?
The more goods and services a person consumes, the higher the person's utility. By spending his or her entire budget, the person is consuming the maximum quantity of goods and services, which means the utility can be at its maximum.
What is the paradox of value and how is the paradox resolved?
The paradox of value asks: "Why is water, which is essential to life, far cheaper than diamonds, which are not essential?" Consumers have diminishing marginal utility for water. The marginal utility of the last unit of water consumed is low because water is readily available and so the quantity consumed is very high. Consumers also have diminishing marginal utility for diamonds. The marginal utility of the last diamond consumed is high because diamonds are very scarce and so the quantity consumed is very low. Consumers maximize utility by equating the marginal utility per dollar for both goods. The scarcity of diamonds (high marginal utility) and the abundance of water (low marginal utility) indicate people are willing to pay a higher price for an additional unit of diamonds than for an additional unit of water.
What is the principal-agent problem? What are three ways in which firms try to cope with it?
The principal-agent problem is the problem of devising compensation rules that induce an agent to actin the best interests of a principal. There are three ways of coping with this problem: Ownership, often offered to managers, gives the agents an incentive to maximize the firm's profits, which is the goal of the owners, the principals; incentive pay links managers' or workers' pay to the firm's performance and helps align the managers' and workers' interests with those of the owners, the principal; long-term contracts tie managers' or workers' long-term rewards to the long-term performance of the firm, encouraging the agents to work in the best long-term interests of the firm owners, the principals.
What are the similarities between utility and temperature?
The scales of both utility and temperature are arbitrary. The units used to measure both can be changed without changing their predictive abilities. For instance, the scale used to "measure" utility can be changed without consequence and the scale used to measure temperature (such as Celsius, Fahrenheit, or Kelvin) also can be changed without consequence. Additionally, although neither utility nor temperature can be directly observed, both can be used to make predictions about the observable world.
What are the three types of firms? Explain the major advantages and disadvantages of each.
The three main ways of organizing a firm have both advantages and disadvantages: -Proprietorship. ADVANTAGES—easy to set up; managerial decision-making is simple and rapid; and profits are taxed only once. DISADVANTAGES—bad decisions on the part of the owner are not subject to review; the owner's entire wealth is at stake because of unlimited liability; the firm dies with the owner; and acquiring capital and labor is expensive. -Partnership. ADVANTAGES—easy to set up; has diversified decision-making so that more than one person's expertise can be utilized; can survive the death or withdrawal of a partner; and profits are taxed only once. DISADVANTAGES—all the owners' wealth is at risk because of unlimited liability; if there are many partners, gaining a consensus about managerial decisions may be difficult; the withdrawal of partner may create capital shortage; labor costs are high compared to corporations; and capital costs can be high. -Corporation. ADVANTAGES—perpetual life; limited liability for its owners; readily available, large-scale, and low-cost capital; can rely on professional managers rather than the talents of the owners; and reduced costs from long-term labor contracts. DISADVANTAGES—potentially complex management structure may lead to slow and expensive decision-making; and profits are taxed twice, once as corporate profit and once as income to the stockholders.
What are the constraints that a firm faces? How does each constraint limit the firm's profit?
The three types of constraints a firm faces are technology constraints, information constraints, and market constraints. Technology is any specific method of producing a good or service and it advances over time. Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output. Information is never complete, for the future or the present. A firm is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. The cost of coping with limited information itself limits profit. Market constraints mean that what each firm can sell and the price it can obtain are constrained by its customers' willingness to pay and by the prices and marketing efforts of other firms. The resources that a firm can buy and the prices it must pay for them are limited by the willingness of people to work for and invest in the firm. The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make.
What is the distinction between total utility and marginal utility?
Total utility is the entire amount of satisfaction an individual obtains from the total amount of goods and services consumed. Marginal utility is the change in total utility from a one-unit increase in the consumption of a good or service.
What is utility and how do we use the concept of utility to describe a consumer's preferences?
Utility is the benefit a person gets from the consumption of goods and services. We use total utility to describe a consumer's preferences by looking at the (total) utility from the consumption of all the goods and services. We use marginal utility to measure the gain in utility from consuming another unit of a good or service.