ECON 101 KONGMidterm 2

CMP Review Session

Benefit, Cost, Surplus – Consumers (1)A consumer benefits from the consumption of a

product• this benefit determines Willingness to Pay• graphically represented by the Demand Curve

Demand Curve:• x-axis shows units of the product, i.e. quantity• y-axis shows the Marginal Willingness to Pay,

in $• marginal -> for 1 MORE unit, what is the max

the consumer is willing to pay

The more you have, the less you value a thing• demand curve slops DOWN

Chapter 5 Efficiency and Equity

Benefit, Cost, Surplus – Consumers (2)

Market Demand Curve:• adding up all consumers’ demand curve HORIZONTALLY

Consumer Surplus:• big idea: area under the demand curve = the total $ that

consumers are Willing to pay for a given number of units• CS = the area under the demand curve and above the

price line

Benefit, Cost, Surplus – Producers

Producer must sell to cover the cost of making a product

Marginal Willingness to Sell:• to deliver 1 more unit, the price producers must

charge• equals the cost to produce that unit = Marginal

Cost• graphically represented by the supply curve

Market Supply Curve:• adding up all suppliers’ supply curve

HORIZONTALLY• big idea: area underneath the supply curve = total

cost of producing a given number of units

Producer Surplus:• area below the price line and above the

supply curve

Efficient Market – p* & q*

Equilibrium price (p*) and quantity (q*) is where market supply curve and demand curve crosses.

Reasons:• price > p*: producers want to sell more than

consumers are willing to buy• producers will drop price due to competition for

customers until price = p*• price < q*: consumers want to buy more than

producers are willing to sell• consumers bid up price until p = p*

Efficient Market – Total Surplus

Total surplus = CS + PS• CS + PS = total area under the demand curve and

above the supply curve• maximized when market is Efficient

Deadweight Loss• occurs when price ≠ p*, quantity ≠ q*• when market isn’t efficient• lost benefit that should have been available to

society if market was Efficient• … or harm done to society when more than efficient

quantity is produced (wasteful use of resources)

Chapter 6 Government Actions

KEY: don’t memorize, draw graphs

Ways government can “mess with” a market• Price ceiling (e.g. rent ceiling)• Price floor (e.g. minimum wage)• Taxes• Subsidy• Quota

When a policy forces the market equilibrium AWAY from the efficient price and quantity, it always leads to inefficiency and DWL

Price Controls

Price ceiling/cap: maximum price producers can charge• no effect if ceiling ≥ p*, otherwise shortage occurs• rent ceiling leads to less than efficient quantity of

houses, longer Search Time, black market and DWL

Price floor: minimum price that must be paid to producer• no effect if floor ≤ p*, otherwise excess of supply• minimum wage leads to unemployment (i.e. quantity

of labour available in excess of the quantity demanded)

• effects: increased job search, DWL

Taxes

1. Tax on consumers, demand curve shifts down by per unit tax

2. Tax on producers, supply curve shifts up by per unit tax

Big idea: consumers and producers want to be able to recreate their original condition before taxes

Taxes create a NEW equilibrium that is NOT efficient

Tax Incidence: how much of the tax Ultimately falls on consumers vs producers; careful! doesn’t matter who is taxed, results are the same

Effect of taxes given different elasticity? Draw graphs to find out!

Subsidy

Production quota: the max the producers can make• no effect if quote ≥ q*, otherwise underproduction• leads to (don’t memorize!):• decrease in supply• higher price• lower Marginal cost• company wanting to cheat and produce more than

quota

Production Quota

Subsidy: government gives monetary aid to firms to help with production• opposite of taxing the producer• encourages over production and DWL

Chapter 10 Organizing Production

Firms want to maximize Economic ProfitEconomic Profit: total revenue minus total cost, this is the opportunity cost of production

Opportunity Cost: value of the best option NOT chosen

Total cost INCLUDES Normal Profit – the amount the owner earns on average from starting a business

Constraints that limit a firm’s profitability:• Technology: a WAY of producing a product• Information: conformation is costly• Market: consumers have a limit to their budget!

Technologically efficient: when firm can’t produce the quality with less inputs

Economically efficient: when firm can’t produce the quality at a lower cost

An economically efficient method has to be technologically efficient.

The relative price of inputs determines the economically efficient method

Production Efficiency

Types of business: choices of funding1. Sole Proprietorship: funded by ONE owner2. Partnership: funded by TWO or MORE owners3. Corporation: funded by a large number of owners

who will not be liable to pay debt if company goes bankrupt

Types of market: level of competition4. Perfect competition: large number of firms

producing identical products5. Monopolistic competition: large number of firms

producing somewhat different products6. Oligopoly: few firms in the market7. Monopoly: only one firmLow barrier to entry can work to keep price down!

Businesses & Markets (1)

Types of market: level of competition1. Four-Firm Concentration Ratio: percentage of sales

accounted for by the largest 4 firms (0-100)2. Herfindahl-Hirschman Index: sum of the

percentage of sales accounted for by the largest 50 firms

Careful about limitations of indexes specific to A industry

Production activity of coordinated by3. firm: lower transaction cost and economies of team

production4. market: sellers and buyers of resources uses price

to coordinate productionUsually a mix of the two!

Businesses & Markets (2)

Chapter 11 Output and Costs

1. Short-Run: period of time before the firm can alter ALL factors of production

2. Long-Run: period of time after the firm CAN alter all factor of production

Plant (capital) is the building / machines / big investments - usually the hardest to alter.For simplicity: long-run = after a firm can change its plant

An existing plant is considered a sunk costSunk Cost: cost that has already been incurred and can’t be alter anymore (reduced, reclaimed, etc)

Short-Run Production Behaviour

Product schedule• Remember short run = plant doesn’t change• Schedule relates total product to marginal product

to average product• Total Product: total output given an amount of

labour• Marginal Product: amount of extra output that can

be achieved by using one more worker• Average Product: total output divided by total

labour

Laws:1. Increasing Marginal Return at the beginning due to

specialization (division of labour)2. Decreasing Marginal Return due to crowding and

plant limitations

Costs

Total Cost: cost of all factors: TC = TFC + TVCTotal Fixed Cost: doesn’t vary by level of productionTotal Variable Cost: costs that increases or decreases as output increases or decreases – costs of labour and capitalMarginal Cost: cost needed to produce 1 MORE unit

Relationships between average and marginalMarginal > Average: average increaseMarginal < Average: average deceases

Graph tips: 1. vertical distance between ATC and AVC = the height

of AFC2. MC cuts AVC and ATC at their minimum

Cost curves VS Product curves

Costs curves align with product curves• MP going up -> MC going down• AP going up -> AVC going down• AP cuts MP at the output where MC cuts AVC (or the

quantity where AVC is lowest)

Don’t memorize! Think it through, graph on P.260

Long-Run Production Behaviour (1)

Long-run = plant (amount of capital) can change

Long-Run Production Function: shows how output varies with both labour AND capitalKEY: capital also has increasing and diminishing marginal returns

Long-Run Average Cost Curve:• draw all the Short-Run Average Cost Curves, one for

each possible plant, on the same graph• trace out the lowest segments of the curves to get

LRAC• LRAC curve is the LOWEST average cost to produce a

given a quantity when firm can alter both labour AND capital

Long-Run Production Behaviour (2)

As output increases, firms can decrease ATC by switching to larger plants – Economies of Sale

There comes a point when more output requires large plants that raises ATC due to diminishing returns from capital – Diseconomies of Scale

THE output quantity in the long run when firm achieves the lowest ATC is called Minimum Efficient Scale