review principle of micro economics 1

Review Principle of Micro Economics

Spring 2006

Professor Rutstrom

Learning Objectives:

• Why scarcity of resources necessitates that choices must be made,

• and thus why trade-offs occur when decisions are made.

Scarcity

• Not enough of a good to fulfill everyone’s wants• Leads to positive price since many people want it for

many different uses – competing uses• A good that is not scarce would have a price of zero• Choices have to be made regarding what to use the

resource for• There are trade-offs between different uses

– Opportunity costs

• Shortage – completely different concept: Quantity demanded exceeds the quantity supplied at the price floor

Opportunity cost

• Includes both explicit and implicit costs

• Explicit costs: outlay of money– This money could have gotten you something

else of equal monetary value

• Implicit costs: other opportunity costs that do not involve money outlays– The best alternative opportunity

Example:

• You have $50 to spend on either a ticket at House of Blues or on a ticket at the Hard Rock Café.

• You value both concerts at $90.• Parking free at HOB but it is $10 at HRC.What is

the opportunity cost of going to HOB?• Answer: $80. Explanation: $90 value of HRC

minus the additional cost of parking $( = $80)• Why is the $50 for the ticket not included? It is

part of explicit costs.• OC=50+(90-50-10)=90-10=80

Next best alternative

• What if you could also go to the Carr Performing Art Center for a $50 ticket.

• There you can find free parking• The value of the concert at Carr is $70• What is the opportunity cost of HOB:• The rank ordering is: 1) HOB, 2) HRC, and

3) Carr• Thus opportunity cost of HOB is HRC

($80) and not Carr ($70)

Learning Objective

• To differentiate between comparative and absolute advantage, and to explain why the former is the key principle behind gains from trade.

Comparative advantage

• Constant or increasing opportunity cost

• Production Possibility Frontier– Scarcity forces choices

• You have a comparative advantage in doing that which you have a lower opportunity cost for than anyone else

• Numeric example based on labor cost or productivity

Numeric example based on production possibility frontier (linear)

Fred

01234567

0 1 2 3 4 5 6 7 8 9 10

Tap shoes

Bal

let

slip

per

s

Ginger

0

2

4

6

8

10

0 1 2 3 4 5 6

Tap shoes

Bal

let

slip

per

s

Table 1 The Production Opportunities of the Farmer and Rancher

Copyright © 2004 South-Western

Table 2 The Gains from Trade: A Summary


Gains from trade

• The Rancher has a lower total explicit cost (measured here in time rather than in money) than the farmer for both meat and potatoes

• Rancher has a lower opportunity cost in meat (foregone potato production) than the farmer

• Farmer has a lower opportunity cost in potatoes (foregone mean production) than the rancher

• Lower opportunity cost means it takes less potatoes to compensate him for the time it takes to produce meat

• Thus opportunity cost is the key principles behind maximizing the gains from trade

Comparative and Absolute Advantage

• Can you have an absolute advantage in all activities and still benefit from trade?

• Can you have a comparative advantage in all activities?

• Can you have an absolute advantage in some activity that you do not have a comparative advantage in?

• Can you have a comparative advantage in some activity that you do not have an absolute advantage in?

Learning Objective

• To calculate, in addition to articulate the distinction among, the various costs of production, and furthermore describe why certain costs matter for making economic decisions and why others do not.

Cost curves

• Production function– Diminishing marginal product (returns) to variable

factor (labor) because of fixed factors in short run– Upward sloping MC curve (TC curve has an

increasing slope)

• Cost functions in short run– ATC and AVC– MC intersects ATC and AVC in minimum points– MC = ΔTC= ΔVC– AFC is everywhere decreasing

• Draw the curves and calculate costs in table

Figure 6 Big Bob’s Cost Curves


(b) Marginal- and Average-Cost Curves

Quantity of Output (bagels per hour)

Costs

$3.00

2.50

2.00

1.50

1.00

0.50

0 42 6 8 141210

MC

ATCAVC

AFC

How do costs matter for decisions?

• All cost curves capture opportunity cost (explicit plus implicit cost)

• Profit maximizing decision of Q depends only on MC

• MC depends only on VC, not on FC

• FC influences total profits/losses at that Q

• Profits (economic) = TR-TC

• Profits = (P-ATC) * Q

Learning Objectives

• To identify and classify the determinants of demand functions, that is to say, to be able to recognize the single factor that causes a change in quantity demanded, versus those factors that cause a change in demand.

• To identify and classify the determinants of supply functions, that is to say, to be able to recognize the single factor that causes a change in quantity supplied, versus those factors that cause a change in supply.

Demand and Supply

• What is the only factor that causes a change along a demand curve? Law of Demand

• What are the factors that cause a shift in demand?

• What is the only factor that causes a change along a supply curve? Law of Supply

• What are the factors that cause a shift in supply?

Table 1 Variables That Influence Buyers

Copyright©2004 South-Western

Table 2 Variables That Influence Sellers


Learning Objective

• To define, calculate, and determine the economic implications of price elasticity of demand, price elasticity of supply, income elasticity, and cross-price elasticity of demand.

Elasticities

• Percentage change in quantity divided by percentage change in price (using midpoints on the lines)

• Price Elasticity of Demand• Cross Price Elasticity of Demand

– Substitutes and Complements

• Income Elasticity of Demand– Normal and Inferior goods

• Price Elasticity of Supply

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities• The midpoint formula is preferable when

calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

P rice e las tic ity o f d em an d =( ) / [( ) / ]

( ) / [( ) / ]

Q Q Q QP P P P2 1 2 1

2 1 2 1

2

2

The Price Elasticity of Demand and Its Determinants

• Demand tends to be more elastic :– the larger the number of close substitutes.– if the good is a luxury.– the more narrowly defined the market.– the longer the time period.

Determinants of Elasticity of Supply

• Ability of sellers to change the amount of the good they produce.– Beach-front land is inelastic.– Books, cars, or manufactured goods are

elastic.

• Time period. – Supply is more elastic in the long run.

Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand


Demand

Quantity0

Price

Revenue = $100

Quantity0

Price

Revenue = $240

Demand$1

100

$3

80

An Increase in price from $1 to $3 …

… leads to an Increase in total revenue from $100 to $240

Total Revenue Increases with an Increase in Price

Figure 4 How Total Revenue Changes When Price Changes: Elastic Demand


Demand

Quantity0

Price

Revenue = $200

$4

50

Demand

Quantity0

Price

Revenue = $100

$5

20

An Increase in price from $4 to $5 …

… leads to an decrease in total revenue from $200 to $100

Total Revenue Decreases with an Increase in Price

MR curve

• Lowering price when P is high and Q is small– Increases total revenue = positive MR

• Lowering price when P is low and Q is large– Decreases total revenue = negative MR

• Total revenues are maximized at the midpoint of a linear demand curve– Where we have unit elasticity

Learning Outcome

• To determine the market clearing price and quantity in a market, and to predict the effect on the equilibrium price and quantity when the factors that shift a demand or supply curve change.

Predicting Competitive Market Outcomes

• Equilibrium price and quantity• Increase in Demand and increase in Supply –

– both shift right along Q axis thus Q increases, D shifts up and S down along P axis thus P ambiguous

• Increase in Demand and decrease in Supply• Decrease in Demand and increase in Supply• Decrease in Demand and decrease in Supply

Table 4 What Happens to Price and Quantity When Supply or Demand Shifts?


review principle of micro economics 1

Business

tapshoesballet

lower opportunity

opportunity

total revenue

ballet slippers

tap shoes

absolute advantage

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