ECON 1A Chapters 1-5
Chapter 5 Summary
1. A firm's objective is to maximize profit, which is the excess of total revenue over total cost. 2. Revenue is what the firm receives from selling its products to customers it is the quantity sold times the price per unit (P × q). 3. Costs are the payments to production factors: labor and capital. 4. Profit is maximized when marginal revenue from selling the next unit of output just equals its marginal cost of production. 5. Explicit costs are the out-of-pocket cash outlays. 6. Implicit costs are forgone benefits without an explicit cash outlay. 7. The sum of explicit and implicit costs is called economic cost. 8. Economic profit equals total revenue minus economic cost. 9. The short run is the period of time that is too short for a firm to be able to change the amount of some inputs. 10. The long run is a period of time long enough for a firm to change the amounts of all of its inputs. 11. Fixed cost is the cost associated with the fixed inputs in the short run. There is no fixed cost in the long run, as all inputs are variable in the long run. 12. The firm would incur a fixed cost in the short run, even if it did not produce any output. 13. Variable cost is the cost of the variable input. 14. Marginal cost is the cost of producing the next unit of output. 15. Average cost is the cost of producing one unit of output on average. It is also called unit cost. 16. Average total cost is the sum of average fixed cost and average variable cost. 17. The marginal cost curve intersects the average cost curve at the minimum point of the average cost curve.
We are going to make two assumptions about consumers:
1. A typical consumer has perfect information about the prices and qualities of the goods and services she buys. As a result of this assumption our consumer will be able to compare different goods and services and make intelligent purchase decisions. The assumption will also make our model simple. Later in the book we will see what happens if some parties to a transaction do not have perfect information about the qualities of products they are buying. 2. There are a large number of small consumers in the market so that no one consumer is big enough to be able to dictate his or her preferred price on the producers or other consumers. In other words, no consumer has market power: the power to influence the market prices of goods and services. We say that the consumer is a price taker: she takes the market prices as given and makes her purchase decisions based on those prices. We will relax this assumption later in the book to see the effect of market power on the prices and the quantities of goods and services traded in different markets. So we start with a simple and pure case.
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
= 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒−𝐸𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡
MC
=W / MPL
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝐶𝑜𝑠𝑡
=𝐸𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡 + 𝑁𝑜𝑟𝑚𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 =𝐿𝑎𝑏𝑜𝑟 𝐶𝑜𝑠𝑡+𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐶𝑜𝑠𝑡+𝐹𝑜𝑟𝑒𝑔𝑜𝑛𝑒 𝐷𝑖𝑠ℎ𝑤𝑎𝑠ℎ𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 =𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝑁𝑜𝑟𝑚𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 =𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐸𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡 −𝑁𝑜𝑟𝑚𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 Collecting the last two terms: =𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − (𝐸𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡 + 𝑁𝑜𝑟𝑚𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡) = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝐶𝑜𝑠𝑡
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
=𝑃 ×𝑞
Long run
A period of time that is long enough for the firm to change the amounts of all of its inputs including plat and equipment.
Decision making unit
A person or an entity that makes a decision by considering the costs and benefits of the decision.
Economist Concern
Economics is concerned with how to make the best use of the society's scarce resources to achieve maximum satisfaction of human material wants.
Income and Substitution Effects
Economists believe that a change in the own price of a product affects the quantity demanded by a consumer for two reasons, called the income effect and a substitution effect.
Positive and Normative Statements
Economists distinguish between two types of statements. Some statements are about how things are, or how we think they are. These statements make no value judgment on whether any particular state or outcome is good or bad. Here are some examples: The average price of gasoline in the United States is $4 per gallon. We are entering a recession, and therefore unemployment could increase. OPEC raised the price of oil, so we expect goods prices to rise in the United States. If the Fed increases the interest rate, the U.S. inflation rate could go down. More than 100 million people in the United States do not have health insurance.
Implicit Cost
Forgone benefit without an explicit cash outlay.
Consumer Surplus
Gain from trade: It is measured by the consumer surplus for a consumer and the producer surplus for a producer.
Consumer Income
normal goods: A good that we buy more of if our income increases. inferior goods: A good that we buy less of if our income rises. This is generally because superior substitutes exist for such goods. This category includes things like secondhand goods and generic drugs. The superior substitutes for these goods include new goods and brand-name drugs.
Positive statements
Positive does not mean "true." You can affirm or refute a positive statement. In fact, you can use this as a criterion to tell whether a statement is a positive statement. You can say "Yes, that is true"; "No, that is not true"; or "No, I don't think that is true." For example, the last statement about health insurance probably is not true (in 2014). At the time of writing this book, an estimated 50 million Americans did not have health insurance. Nevertheless, the statement is a positive statement. A positive statement by an economist: In the short run, you can either reduce inflation or unemployment, but not both.
Normal profit
The minimum amount of accounting profit that investors require in order to start a business or stay in an existing business. It is the opportunity cost of the owners' own resources invested in the firm. Note a few things about normal profit: 1. It only includes the opportunity costs of resources supplied to the firm by its owners. These resources help produce goods and services. For Leopold, it is his time and effort that is important in the production of laptops and dishwashers. The fact that he also misses his wife and kids does not enter into the calculation of the normal profit. 2. It is an implicit cost. It is important to business owners, but not to accountants. 3. It is a fixed cost: Leopold would lose $250,000 of dishwashing income per year no matter how many laptops he produced. 4. Finally, note the obvious that even though we call it a profit, the normal profit is actually a cost: it is just the implicit cost of doing business with a different name.
Principle of decreasing marginal utility
The notion that a consumer derives less and less utility (satisfaction, joy, happiness) from additional units of a good consumed.
Principle of diminishing marginal productivity
The notion that as a firm hires workers, or other inputs, the later additional produce less than the previous ones.
Chapter 3 Summary
1. Economics is concerned with how to make the best use of the society's scarce resources to achieve maximum satisfaction of material wants. 2. All societies must answer three basic economic questions: what goods and how much of each good to produce; how to produce them; and how to distribute them. 3. Full employment means all those who want to work have a job. This is a necessary condition for productive efficiency. 4. Productive efficiency means resources are fully employed and are used to their maximum potential. This is a necessary condition for economic efficiency. 5. Economic, allocative, or Pareto efficiency means production of the types and quantities of goods and services the society wants the most. 6. A production possibilities frontier (PPF) is a table, graph, or formula that shows the maximum amount of a good that can be produced, given the production levels of other goods. 7. A PPF is downward sloping due to scarcity. 8. A PPF is concave to the origin (bowed out) due to relative specialization of the resources in different industries. 9. A PPF can shift out if the quantities of resources increase or industries experience technological progress. 10. Technology is knowledge of how to produce things. 11. The marginal social cost of producing the next unit of a good—X—is the amount of other goods that the society must sacrifice to produce that unit of X. 12. Efficiency means the absence of waste. 13. Efficiency analysis assumes a given income distribution.
Factors of production
1. Land: Land consists of all the resources given to us by nature. Perhaps natural resource would be a better term for this production factor. Land includes land itself that is used in agriculture—as well as forests, underground resources, minerals, and underwater resources. If we stretch the definition a bit, we can also include such things as solar energy or wind power to produce electricity in this category. At any given point in time, these are limited in supply. In the long run, we might be able to increase their supply somewhat using more efficient cultivation techniques, better fertilizers, new discoveries, and so on. In this book, we will generally assume that the amount of land is constant and we will ignore it. This is to keep our stories simple without affecting any of our conclusions. 2. Labor: Labor is human effort. It is measured by the "person-hour." If we have one worker working 10 hours and another working 5 hours, then the total is 15 person-hours. This resource is limited for two reasons: a. There are a limited number of people in any society over a given period of time. b. Each person has a limited number of hours available to him or her during that time period. 3. Capital: By capital, we mean all produced means of production. There are goods that human beings produce in order to use them to produce other goods. They include private capital owned by private citizens, such as trucks, tractors, and manufacturing plants, as well as public capital, owned collectively by the public, such as roads, bridges, or national parks. Another capital category is the human capital. By this term, economists mean all the knowledge, skills, and expertise acquired and possessed by an individual. This fits the definition of capital because an individual acquires it through education or learning by doing.
Chapter 2 Summary
1. Microeconomics studies how individuals faced with scarcity make decisions to achieve maximum satisfaction. 2. Scarcity is the fact that human material wants are unlimited, while the resources to satisfy them are limited. 3. Scarcity necessitates choice or decision. 4. In making a decision, decision makers consider and compare the costs and benefits arising from that decision. 5. The cost arising from a decision is called the marginal cost of that decision. Marginal cost is the same as opportunity cost: the value of the best alternative forgone because of a decision. 6. Marginal costs include both explicit and implicit costs. a. Explicit costs are out-of-pocket cash outlays. b. Implicit costs are benefits forgone without an explicit monetary expenditure. 7. Marginal costs exclude sunk and fixed costs. a. Sunk costs have been incurred in the past and cannot be recovered. b. Fixed cost are ongoing, but are not affected by your decisions. 8. The benefit arising from a decision is called the marginal benefit of that decision. It is the value of the decision to the decision maker. 9. Costs avoided because of a decision are a part of the marginal benefit of a decision. 10. The rule for maximum satisfaction is: a. Increase the level of an activity if its marginal benefit outweighs its marginal cost. b. Reduce the level of activity if the marginal cost of the activity exceeds the marginal benefit. c. Maintain the level of activity if the two are equal. This level of activity results in maximum satisfaction. 11. Incentives matter. A change in the level of marginal cost or marginal benefit will cause changes in the level of activity. 12. The sunk cost fallacy is the observation that some decision makers incorporate sunk costs in their decisions 13. Government policy affects the private marginal costs and benefits of individuals' decisions.
Economic Models
1. Understand economic events 2. Predict economic events 3. Design economic policies
Three Fundamental Economic Questions
1. What goods and services should the society produce? Should we produce more consumer goods, such as food and clothing, or more capital goods, such as trucks, tractors, and computers? Should we produce more civilian goods, or more military goods? 2. How should these goods and services be produced? Having decided what to produce, we now have to figure how to produce them. There are generally different ways of producing the same goods. We can produce cars, either by using a lot of labor and not much capital equipment, or by a lot of robotics and not much labor. We can produce agricultural products by using a lot of land, but without any fertilizers and pesticides, or with less land, and a lot of fertilizers and pesticides. We can produce electricity using fossil fuel, such as oil and natural gas, or using renewable sources, such as wind, water, or solar energy. 3. For whom should we produce these goods and services? Having decided what to produce and how to produce them, we now have to figure out how to distribute these goods and services among the members of the society. Should the distribution be nearly equal so that all members of the society can buy the same amounts of the goods and services produced, or should we allow some inequality in the distribution? How much inequality is tolerable?
Fixed Cost
A cost is fixed with respect to a particular activity if you would incur it even if you did not undertake that activity.
The Effect of a Price Change on Consumer Surplus
A decrease in the price of a product will result in an increase in consumer surplus and an increase will result in a reduction in consumer surplus.
Market Power
A producer or a consumer has market power if it can affect the market price of the product it selling or buying. NOTE: Private incentives of individuals will be in conflict with public interest in four cases: externalities, market power, public goods, and information asymmetries. Only in these cases, government policies may be justified.
Ratios
A ratio of two numbers such as X and Y is written as: 𝑅𝑎𝑡𝑖𝑜 𝑜𝑓 𝑌 𝑡𝑜 𝑋= 𝑌/𝑋 A ratio is the amount of what is in the numerator per unit of what is in the denominator. All ratios have this meaning, no exceptions. For example, if you worked 40 hours in a week and received a wage of $400 for it, then 𝑊𝑎𝑔𝑒 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟= $400 𝑊𝑎𝑔𝑒 /40 𝐻𝑜𝑢𝑟𝑠 𝑊𝑜𝑟𝑘𝑒𝑑 =$10 𝑜𝑓 𝑤𝑎𝑔𝑒 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟 𝑤𝑜𝑟𝑘𝑒𝑑 If you hire 3 workers and they collectively produce 90 pizzas per day, each of them on average produces 30 pizzas per day. 𝑃𝑖𝑧𝑧𝑎𝑠 𝑝𝑒𝑟 𝑤𝑜𝑟𝑘𝑒𝑟= 90 𝑃𝑖𝑧𝑧𝑎𝑠/ 3 𝑤𝑜𝑟𝑘𝑒𝑟𝑠 =30 𝑝𝑖𝑧𝑧𝑎𝑠 𝑝𝑒𝑟 𝑤𝑜𝑟𝑘𝑒𝑟
Variable cost
Cost that is affected by the level of an activity so that you will not incur it if the level of the activity is zero.
Fixed cost
Cost that is not affected by the level of an activity so that you will incur it even if the level of the activity is zero. The producer would have to pay this amount in the short run even if it did not produce any output.
Marginal product of labor
Addition to total output as a result of hiring one more unit of labor.
Positive Externality
An externality situation in which a decision made by a decision maker benefits other people. Consider education. If we completely leave the education of children to parents and private schools, some parents may choose not to send their children to school due to high costs. This is a particularly serious problem in developing countries. By now, you know the reasons for the parents' choice. If the marginal cost of sending children to school outweighs the perceived benefits, some parents may choose not to send their children to school.
Negative Externality
An externality situation in which a decision made by a decision maker harms other people.
Marginal Analysis
Analyzing the behaviors of decision-making units by studying the marginal costs and marginal benefits of the decisions.
A Crucial Question
At this point, we need to address an important question: Is the behavior described above what people actually follow, or is it the behavior they should follow in order to be rational? The answer to the second question, of course, is in the affirmative. If you want to be rational, you should compare the MC and MB of each decision, and undertake an activity only if the MB of that activity exceeds its MC. But do people actually follow such a pattern of behavior? The answer is that some people in some cases may behave irrationally. For instance, some people may ignore implicit costs or factor in sunk costs in their decision making. However, we assume that society as a whole acts as if its individual members are rational, so we take a typical rational individual from the society and assume that he or she represents the whole society. Empirical evidence generally supports this assumption despite occasional departures from it. The next section describes how some people may mistakenly incorporate sunk costs into their economic decisions.
Average Cost Curves
Average fixed cost (AFC): Fixed cost per unit produced, calculated as the fixed cost divided by the number of units produced. Average variable cost (AVC): Variable cost per unit produced, calculated as the variable cost divided by the number of units produced.
From Factors of Production to Production Costs
Labor market: An institution that brings employers and employees together.
Consumer Taste
Changes in such factors as fashion or health-related concerns will cause the consumer demand for a product to change. The demand function will shift to the right or to the left, depending on the case. For example, if the consumer hears in the news that consumption of a particular brand of cereal lowers his cholesterol, then he will be willing to buy more at any price level. The effect will be a rightward shift in the demand function.
Rational Economic Behavior
Comparing the marginal cost and benefit of an activity and undertaking it if the benefit outweighs the cost. Moreover, the marginal cost should exclude sunk and fixed costs but should include explicit and implicit costs.
Chapter 4
Consumer Behavior
The Effect of a Price Change on Consumer Expenditure
Consumer expenditure moves in the direction of the greater percentage change.
Consumer's Demand Function
Consumer's expenditure =𝑃×𝑞 Consumer Surplus: The total amount a consumer is willing to pay for a certain quantity of a good less the amount she actually pays for it.
Expected Future Price
Consumers will buy more corn flakes this month if they expect its price to increase next month. The demand function will shift to the right. Note that this result is true only for storable commodities. You are not going to buy more electricity if you expect its price to increase next month, because you cannot store electricity for later use.
MWP < P
Decrease the amount of purchase to increase satisfaction
Economic Efficiency
Economic or allocative efficiency means allocating the society's scarce resources to different economic activities in such a way as to produce the kinds and quantities of goods and services that result in maximum satisfaction for the members of the society.
The Sunk Cost Fallacy
Economists have found many examples of sunk cost fallacy in people's decisions, sometimes involving big multi-million-dollar business investments. Here are some examples. Hal Arkes and Catherine Blumer provided unannounced price discounts on season tickets for a university theater to a randomly selected number of patrons. They observed that those who had not received the price discount attended a larger number of shows. 1 Gourville and Soman found a similar pattern of behavior for the patrons of an athletic facility. Patrons tended to use the facility more often the month immediately after paying their semi-annual dues. 2 Just and Wasnik found that people who were randomly chosen to receive a price discount in an all-you-can-eat pizza place tended to eat less than those who did not receive such a discount. 3 In the above examples, the non-refundable price of the season ticket, dues of an athletic facility after they are paid, or the entry fee to an all-you-can-eat restaurant are sunk costs and should not affect people's forward-looking marginal decisions, but apparently, they do.
Explicit Marginal Cost
Explicit costs are out-of-pocket cash outlays. Suppose you are trying to decide between driving to work and taking a bus. To drive to work, you need to spend $15 on gasoline per week. This is the explicit marginal cost of driving to work. It is affected by your decision: if you decide to drive, then you will incur $15 of gasoline cost. Otherwise, you will not incur that cost. Note that the marginal cost of $15 fits the definition of benefits forgone. If you pay $15 to buy gasoline, you will no longer be able to buy other things using that money. With that $15, you could have seen a movie, bought a small pizza, or bought a used DVD. Be careful! The opportunity cost is not the sum of the values of these alternatives forgone. With that $15, you could not have purchased all of those things, but only one of them. So, what is the opportunity cost of driving to work? It is the value of the best alternative forgone. In this case, the worth of all the alternatives foregone is just $15. So, explicit marginal cost of seeing the movie is just $15.
Giffen Goods
Goods people buy more of if its price increases. A statistician called Robert Giffen observed in the 19th century that when the price of potatoes decreased, poor Irish families ate less potatoes, rather than more potatoes as our demand model predicts. In other words, the demand function for potatoes by poor Irish families was upward sloping! Such goods are called Giffen goods. The reason for this behavior was that because of their low incomes, potatoes were almost all these families could afford. For the same reason, potatoes took a large portion of their budget. Moreover, they were sick and tired of eating potatoes. When the price of potatoes fell, these families could spend less money to buy the same amounts of potatoes as before and could spend the leftover money on other food items such as beef or bread. But since now they were consuming more of these other goods, they did not need to eat as much potatoes as before. So for these families, potatoes were an inferior good because of the negative income effect. Moreover, the income effect dominated the substitution effect, so that at the end they bought fewer potatoes. No other case of Giffen goods has been observed in the real world. Therefore, we will ignore them. When the price of a good increases, Melissa reduces her quality demanded by 6 units due to substitution effect and increases his quantity demanded by 7 units due to income effect. For Melissa, therefore, this must be a Giffen good.
Private Goods
Goods that possess two features simultaneously: they are rival in consumption and excludable by producers. The apple that you buy in a grocery store is classified as a private good, because if you eat it, someone else cannot eat that same apple.
Government Policies
Government policies affect individuals' behavior by affecting the marginal benefits and marginal costs of their decisions. You go to school? Public education is free. This means that the government picks up the tab. The government subsidizes tuitions in certain colleges and universities. You can also receive low-interest student loans. By the way, do you occasionally breathe the air by any chance? Well, you may have to pay for it through your taxes! The government has polices, sometimes very elaborate and costly ones, to reduce air pollution.
Implicit Marginal Cost
Implicit costs are benefits forgone without an explicit cash outlay. In the case of driving to work, you can think of the depreciation of the car as an implicit marginal cost. Depreciation means the reduction in the value of the car. Suppose that because you drive the car to work, its market value declines by $100. This is a reduction in the value of something you own, and so, it is a benefit foregone. You can also think of the risk of getting into a car accident as an implicit cost of driving to work.
The Sizes of Income and Substitution Effects
In the real world we need statistical techniques to measure the magnitudes of the income and substitution effects for different goods. All we need to know in this book is that the total change in the quantity demanded in response to a price change must be the sum of these two effects and that the income effect is because of the change in the consumer's purchasing power. The substitution effect of a price change will be larger if the good has a larger number of substitutes. For example, suppose Bradford regarded pizzas as substitutes for hamburgers as well. Then when the price of hamburgers went down to $2, he could substitute hamburgers for both hot dogs and pizzas. This would result in a larger substitution effect. Some goods, such as electricity or natural gas, may not have very many close substitutes. Or, a diabetic's need to take insulin in fixed quantities may mean that he cannot substitute another good for insulin when its price changes. The substitution effect in this case will be zero. In general, necessities have fewer substitutes. Furthermore, if a good is narrowly defined, it will have a larger number of substitutes. For example, vanilla ice cream will have all the other flavors of ice cream, as well as pies and other desserts, as substitutes. However, ice cream in general will have only pies and other desserts as substitutes. Therefore, vanilla ice cream will have a larger substitution effect than ice cream in general. We will assume throughout that the substitution effect of a price change is either zero, as in the case of insulin, or negative, as in the case of hamburgers. In other words, a reduction in price will never result in a decrease in quantity demanded for substitution reasons. The size and sign of the income effect depends on two factors: the nature of the good and the fraction of the income devoted to the good. As to the nature of the goods, we can classify goods into normal, inferior, and Giffen goods.
Private incentives
Incentives faced by individuals.
Economic growth
Increase in the amount of all the goods and services produced in a country over a long period of time.
MWP > P
Increase the amount of purchase to increase satisfaction
Inferior goods
Inferior goods have a negative income effect. The substitution effect of a reduction in price would increase the quantity demanded, but the income effect would decrease it. However, in the end, quantity demanded will increase when the price of an inferior good declines. This implies that for inferior goods, the substitution effect is larger than the income effect. For example, consider demand for used clothing which is considered an inferior good. Suppose a low-income consumer buys 10 used T-shirts per year for her children. If the price of used T-shirts decreases, the consumer could save money if she buys the same number of T-shirts as before, which she can spend on new T-shirts, a superior alternative. But then she does not need to buy as many used T-shirts as before. Suppose that as a result of the income effect she buys 2 new T-shirts so that she needs 2 less used T-shirts. This is the meaning of the negative income effect of a price change for an inferior good. But the fact remains that the price of used T-shirts is lower and the consumer has low income. This low price will induce her to buy more used T-shirts. Suppose that the substitution effect induces him to buy 3 more used T-shirts. Since the substitution effect is bigger, she ends up buying 11 used T-shirts per year. Income Effect quantity decreases Substitution Effect quantity increases
Ceteris Paribus
Latin phrase meaning all else remaining the same. Often, we are interested in analyzing the effect of a change in a variable on the value of another variable, keeping all the other factors unchanged. For example, we ask, all else the same, what would happen to your driving speed on a particular winter day if the rainfall was heavier than normal? In this case, "all else the same" means keeping the other factors affecting your speed—say, the traffic condition—unchanged at its average level. Economists frequently use the Latin phrase ceteris paribus instead of its English equivalent: all else the same
Consumer's Choice Problem
MB > or = MC --> Undertake the activity MB < MC ---> Do not undertake the activity
MWP = P
Maintain the level of purchase, satisfaction is maximized To maximize satisfaction, a rational consumer will buy the quantities of a product up to the point where MWP = P.
Microeconomics
Microeconomics studies the decisions made by one individual decision making unit and economic conditions prevailing in one particular market or industry.
Normal Profit
Opportunity cost of Leopold's own resources (time, effort, money, etc.) supplied to the firm Money Leopold will take home if he runs the dishwashing business instead If a firm's accounting profit is not large enough to at least cover its normal profit, it will contemplate closing the business and exiting the industry. So, normal profit is also defined as the bare minimum amount of accounting profit sufficient to attract capital to a business.
Normal Goods
Normal goods have positive income effects. This means, as you recall, an increase in income results in a higher demand and vice versa. Within normal goods, luxury goods, such as meals at expensive restaurants, have a greater income effect than necessities like food or gasoline. Suppose a consumer was consuming 10 quarts of a particular flavor of ice cream per year. The price of this ice cream falls. The income effect will induce the consumer to buy more ice cream. For example, she will buy 3 more quarts per year for this reason. Moreover, since ice cream is cheaper relative to its substitutes such as other flavors or frozen yogurt, the quantity of ice cream demanded will increase due to substitution effect. For instance, the consumer will buy 2 more quarts for this reason. She will now buy 15 quarts due to the combination of income and substitution effects. If quantity increases in income effect and substitution effect increases quantity then it is a Normal Good.
Explicit Cost
Out-of-pocket cash expense. Also known as accounting cost.
The Role of Incentives
People respond to incentives. Your decision to undertake an activity will change whenever the MB or MC of that activity changes. You will drink less coffee if the price of coffee increases. This will increase the marginal cost of every cup. On the other hand, you will drink more coffee if you hear that it helps reduce certain heart diseases. This news will increase the marginal benefit of every cup. Example: Suppose our government wants to reduce our dependence on foreign oil. How can the government discourage driving in order to reduce gasoline consumption? The fees that we pay to renew our licenses become sunk after we pay them. Our monthly premium payments to the insurance company and interest payments to the bank are recurrent fixed costs. These costs do not affect the marginal cost of driving. To discourage driving, the government needs to increase the marginal cost of driving by imposing a tax on gasoline thereby increasing its price.
The government's microeconomic policies are justified if:
Private incentives are in conflict with public interest, The market system cannot resolve this conflict, and if The marginal benefit of the policy exceeds its marginal cost.
Chapter 5
Production Costs
Chapter 3
Production Possibilities Frontier
Productive inefficiency
Productive inefficiency means that we either have unemployment or we are mismanaging our resources, or both, so that our resources are underutilized.
Midterm 1
Review
Opportunity cost
The benefit forgone because of a decision.
Productive Efficiency
Second, the points along the curve are attainable. Examples are points B, C, and D in Figure 1. Along the curve we have productive efficiency. All the resources are fully employed and are producing the most they can. Along the frontier there is no underutilization of resources going on. Productive efficiency means that all the resources are fully employed and the employed resources are producing the most they can. Third, points outside the curve are not attainable. An example is point E. Presently we don't have enough resources or know-how to produce the combinations of the two goods outside the frontier, no matter how hard we try. That is why the curve is called a frontier. This may change in the future if we have more resources or if we learn to produce more. Fourth, the slope of the frontier is negative due to scarcity. Since we have a limited amount of resources and technology in the short run, and since along the frontier they are all fully and efficiently employed, to produce more of one good we have to reduce production of the other. This is because we have to shift some resources from one industry to the other. For example, to move from point B to point C, we have to sacrifice 60 units of Y to produce 6 additional units of X. The 60 units of Y are the social opportunity cost of producing the 6 additional units of X due to scarcity. This is how many units of Y the society loses by producing 6 more units of X. Fifth, the curve is bowed outward, or concave to the origin. This is for two reasons. The first is the relative specializations of the workers in the two industries. The second reason is what is called the law of diminishing returns. To understand these concepts recall our basic assumptions. 1. The quantities of land, labor, and capital are fixed. 2. Technology is fixed. 3. Labor can move between industries, but land and capital are immobile. Sixth, and finally, we have drawn the production possibilities curve assuming a fixed amount of resources and a given technology. If we either have more resources or better technology, the curve will shift out. We could have more resources if the amount of labor increases through migration or natural birth, or if the amount of capital increases through investment. The physical amount of land is fixed, but its productivity can increase through better cultivation techniques. Technological progress means that we learn better ways of producing the same goods or producing new goods.
Public Interest
Something that is in the interest of the whole society.
Prices of Related Goods
Substitutes: Substitute goods are such that if you consumed more of one good, you would consume less of the other. Examples are coffee and tea, Pepsi and Coke, and different brands of corn flakes. If the price of Coke increases, a consumer will buy less Coke and more Pepsi. The demand function Pepsi will shift to the right. So the relationship between the price of Coke and the quantity demanded of Pepsi is positive. Complements: Goods consumers consumes together, so if they consumes more of one, they will also consume more of the other. Examples are coffee and sugar or corn flakes and milk. If the price of corn flakes decreases, a consumer will buy more corn flakes. As a result, she will buy more milk. So the relationship between the price of corn flakes and the quantity of milk consumed is negative. In this example, when the price of corn flakes goes down, the demand for milk shifts to the right.
Rate of Change
Suppose the value of a variable increases from and old value of X1 to a new value of X2. The change in the magnitude of this variable is calculated as the new value minus the old value: Δ𝑋=𝑋2−𝑋1 The Greek letter Δ (delta) reads "the change in". The rate of change in X is written as: Δ𝑋/𝑋= 𝑋2−𝑋1/𝑋1 =𝑁𝑒𝑤 𝑉𝑎𝑙𝑢𝑒−𝑂𝑙𝑑 𝑉𝑎𝑙𝑢𝑒𝑂𝑙𝑑 𝑉𝑎𝑙𝑢𝑒
Marginal Benefit
The benefit from any decision. When the decision is to buy something, marginal benefit is the maximum amount of money or something else that you are willing and able to pay for it. When the decision is to sell something, marginal benefit is what you actually receive for it.
Marginal social benefit
The benefit of decision by a decision maker that accrues to the whole society.
Marginal cost
The cost associated with any decision. When the decision is to buy something, marginal cost is the amount of money or something else that you have to pay for it. When the decision is to sell something, marginal benefit is the minimum amount of money or something else that you are willing to receive for it. Marginal cost is the same as opportunity cost. The marginal cost of an activity is the sum of all the benefits forgone because of undertaking that activity.
Marginal social cost
The cost of a decision by a decision maker that is born by the whole society. Also called the social opportunity cost.
𝑈𝑠𝑒𝑟 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
The cost of using capital over a certain period of time. =𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡+𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒+𝑅𝑒𝑛𝑡
Scarcity
The idea that human wants are unlimited in relation to the available resources in the economy. Unlimited wants means that people, in general, prefer to have more of everything. They want to be able to buy more food, more appliances, better homes, better cars, and so on. Resources are the things we use to produce goods and services.
Income effect
The idea that if the price of a good decreases, the purchasing power of consumers increases as if their income has increased. Conversely, when the price increases.
Substitution effect
The idea that when the price of a good goes down with the prices of all the other goods remaining the same, consumers consume more of the good and less of the now-relatively-more-expensive other goods even if we eliminate the income effect.
Maximum satisfaction
The level of satisfaction that is achieved when the marginal benefit of a decision or activity just equals its marginal cost. Satisfaction could be either in monetary or subjective terms. The managers of business firms measure satisfaction in terms of their profits. The higher their profits, the more satisfied they are. A consumer's satisfaction, on the other hand, could be subjective—the happiness he or she derives from consuming goods and services.
Public Goods
The opposite of private goods. They are both non-rival and non-excludable. National defense, law and order, and fire protection are some examples. Note that "publicness" is a matter of degree. We all sleep safely at night because the government provides national security, as well as law and order.
Short-Run Costs
The period of time that is too short for business firms to be able to change the size and amount of their plants and equipment.
Depreciation
The reduction in the market value of a good due to normal wear and tear. Note: and it is an implicit cost of using capital
The Law of Diminishing Returns
The same as the law of diminishing marginal product of labor.
Asymmetric information
The situation in which one party to a transaction has better information about the product than the other party. Companies can put cheaper or inappropriate ingredients in their products to increase their profits. This is certainly against public interest.
Economic Cost
The sum of explicit and implicit costs. In economics, all costs are benefits forgone.
Total willingness to pay
The total amount of money a consumer is willing and able to pay for certain units of a good.
Profit
The total revenue a firm receives from producing and selling its products minus the cost of producing those products. See also rent.
Other Factors
There is a host of other factors that affect the demand for a good by a consumer, but these are mostly product-specific and less general. For example, demand for electricity or natural gas by a household would depend on the above factors, as well as weather conditions, square footage of the house, age of the house, number and kinds of appliances owned by the household, and the number of people living in that house.
Production Possibilities Frontier
This curve shows the maximum amounts of certain goods a society can produce, given the production levels of some other goods. The whole argument can be demonstrated by assuming that the society produces only two goods. 1. First, we assume that there are fixed amounts of resources available. These include, as you recall, land, labor, and capital. This assumption is easy to understand in the case of land. The amount of capital can increase only in the long run through investments in plants and equipment. These resources cannot increase quickly in a short period of time. Labor can increase through population increase as well as education and training. 2. Second, we assume that technology is fixed. Simply stated, technology means knowing how to produce things, also called know-how. We are essentially assuming that the time frame is too short to expand the resource base or to learn more or better ways of producing the goods. Technology can improve over time through research and development activities, learning by doing, or training and education of workers. 3. Third, we assume that capital and land used in each industry are specific to that industry, and are immobile between industries. This is not a bad assumption, especially in the short period of time on which we are concentrating. For example, agricultural machines and equipment cannot be used in computer production. Or, a small piece of land that is suitable for a manufacturing plant in a city can hardly be converted into agricultural land. Assume, however, that labor is mobile between the two sectors.
Chapter 4 Summary
To Summarize: 1. A consumer's demand function for a product is the same as his or her marginal benefit function for that product. 2. Consumer surplus is the excess of what a consumer is willing to pay for a certain quantity of a product and what the consumer actually pays for it. 3. Consumer surplus is a measure of gains from trade for the consumer and is used as a measure of consumer well-being. 4. If the price of a product falls, the consumer will be willing and able to buy more of the product for two reasons: a. Income effect arises because at a lower price, the consumer will have some money left over if she consumes the same amount as before. This amount can be calculated as m = q × P. b. Substitution effect arises because the good in question becomes cheaper relative to substitutes. 5. Inferior goods have negative income effects. 6. The size of the income effect depends on the nature of the good and the portion of budget spent on the good. 7. The size of the substitution effect depends on the number and availability of close substitutes.
Accounting Profit
Total Revenue Minus Explicit Cost Money Leopold will take home if he runs his laptop production business
Marginal Cost
When the decision is to buy something, the marginal cost is benefit the consumer has to give up in order to get it.
A Change in Price
When the price of a product changes, the consumer moves along her MB function.
A Postscript
We started this chapter with the concepts of marginal cost and marginal benefit. The concept of marginal benefit probably sounded at first somewhat subjective and, thus, not very scientific or quantifiable. We have learned that for a consumer the marginal benefit of a product can be defined as her marginal willingness to pay for that product. What is more, the marginal- willingness-to-pay function is the same as the consumer's demand function for that product. Now the demand function for a product is observable in the marketplace and is quantifiable. We have data on the quantities and prices of many products sold in the economy. However, deriving the demand function through the theory of rational consumer behavior provides a great deal of insight into that demand function. For example, we can use the empirically observed demand functions to estimate consumer surplus, which is a measure of consumer wellbeing.
Marginal Benefit
When the decision is to buy something, the marginal benefit is the maximum amount of money that you are willing and able to pay for it. When the decision is to buy something, the marginal benefit is the amount of money or something else you are willing and able to give for it and remain indifferent. In economics, willingness to pay must be backed with money; otherwise it just becomes a wishful thinking with no effect in the marketplace.
Employer
a firm decides how much labor to hire, given the price of the product it is producing and the wage rate it has to pay. The employer hires labor to produce and sell its product in the goods market at the market price. The revenue that the additional unit of labor would bring into the company is the benefit of hiring that unit, while the wage that the firm would have to pay for that unit is the cost. Firms, of course, have other expenses as well. They have to pay rent on the land and interest on the money they borrow.
Producer
a firm decides how much of a good to produce and sell, given the market price of its product and production costs. Firms use factors of production—land, labor, and capital—to produce output. The production cost is what they would pay to hire or use factors of production. Revenue is what they receive from selling their output.
Shifts in the Consumer's Demand Function
a. Price of the good itself (called own price); b. Consumer's income; c. Consumer's tastes; d. Prices of related goods (called cross prices); e. Expected future own price; f. Other.
Sunk Cost
are the costs that have been incurred in the past and cannot be recovered Example: Sunk costs are also called historic costs. Going back to the example of driving to work, suppose that two years ago you bought your car for $25,000 and it is now worth only $20,000 in the used car market. The sunk cost is the $5,000 loss in the value of the care. Your decision as to whether to drive to work today or not will not affect that cost. So, it should not affect your decision. Similarly, suppose that two years ago, when you wanted to buy the car, you spent hours doing the Internet search, reading newspaper ads, driving to different dealerships, and negotiating the price. During these hours, you could have worked somewhere and made some money. All these forgone benefits constitute the sunk cost associated with buying the car, and they are all implicit.
Normative Statements
involve norms or value judgments. The person making the statement considers the present state of things or the outcome of a decision to be good or bad. Here are some examples: The price of gasoline is too high. (The present state is bad.) The government should pursue a pro-growth policy in order to increase the rate of growth of output to 3%. (The outcome is good.) We are entering a recession, and therefore the government should try to keep unemployment from rising. (The outcome is good.) The current rate of inflation is too high; it is hurting people. (The present state is bad.) We should try to reduce the inflation rate. (The outcome is good.) We should not pursue active stabilization policies (The outcome is bad.) A normative statement by a policy maker: Current unemployment is a more serious problem. We should reduce unemployment and forget about inflation.
Industry
is a collection of firms that produce identical or nearly identical products. Examples are the textile industry and the automobile industry.
Firm
is any entity that uses the services of production factors such as land, labor, and capital to produce and supply products to consumers to make money.
Asset
is anything that has value because it is expected to bring some benefits to its owner in the future. Examples include stocks, bonds, or real estate. The benefits could be monetary or nonmonetary. For example, a rental property brings rental income to its owner, while a home provides shelter service.
The income effect
is based on the following idea: If the price of a product increases, the consumer will feel poorer than before, in the sense that if she keeps consuming the same amount of the product as before, she will have to spend more money on it and, as a result, she will have less money left to spend on other goods. This is as if her income has decreased. Therefore, she will have an incentive to buy less of the product. Similarly, if the price decreases, she will feel richer than before, in the sense that if she buys the same amount as before, she will have some money left over in her purse that she can spend on everything including the product in question. This will give her an incentive to buy more of the product. The change in quantity demand for this reason is called the income effect of the price change
The substitution effect
is based on the notion that consumption of similar or substitute products would give a consumer a similar degree of satisfaction. For example, a consumer would derive a similar degree of satisfaction from consuming different kinds of breakfast cereals because they more or less serve the same purpose. Therefore, all else the same, she would choose to consume the one that is relatively cheaper. When the price of a product increases, with the prices of all the other goods remaining the same, the product in question becomes more expensive relative to its substitutes. As a result, the consumer reduces her consumption of the product in question in favor of the now cheaper substitutes. The reduction in quantity demand for this reason is called the substitution effect.
Profit
is the excess of what firms receive from the sale of their products to consumers, over their production costs.
Fallacy of Composition
is the notion that what is true for one individual in a group may not be true for all the individuals comprising that group. If an individual fan at a football game stands up, he will see the game better, but if everyone stands up, no one will see the game better. If one bidder at an auction shouts loudly, she will succeed in attracting the attention of the auctioneer, but if every bidder does the same, none will succeed. The following examples apply this concept to demonstrate the distinction between microeconomics and macroeconomics.
Marginal and Total Willingness to Pay
marginal willingness to pay: The increase in the amount of output as a result of hiring one more unit of labor.
Microeconomics
studies how individuals faced with scarcity make choices to achieve maximum satisfaction of material wants.
Worker
you decide how much labor service to supply to business firms, given the wage rate and goods prices. The wage rate is the income you earn per unit of time, say per hour or per year, for your labor services. You would be mindful of the prices of goods and services, because ultimately you are working in order to make money to be able to buy goods and services. Therefore, it is always the relationship between the wages you earn and the prices of the goods and services you buy that is important for your decision. For example, if prices increase from one year to the next, you would want to earn a higher wage rate for the amount of work you are performing.
Consumer
you decide how much of a particular good to buy on the basis of the price of that good, the prices of related goods, and the level of your income. For example, in buying a car, you will consider its price, compare it to the prices of other cars, have one eye on the price of gasoline, and be mindful of your budget. Where did you get the money to pay for the car?
MPL
Δq / ΔL 1−0 / 5−0 =0.20 ΔL=1/MPL = 1/0.20 =5
𝑃𝑟𝑜𝑓𝑖𝑡
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒−𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡