Economics Lecture Eight

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Next week: Midterm exam, about 15 multiple choice questions. Closed book. Answer every question, because there is no penalty for wrong answers (the CLEP exam has no penalty for wrong answers either).

The word "economy" is derived from the Greek word for "household", which is the most basic and perhaps the most efficient unit of an economy. Think of how there is division of labor among family members; diminishing marginal utility for activities; supply and demand for food in the refrigerator; both "long run" and "short run" decisions; economies of scale in buying dinner; and very few transaction costs within a family. The family or household unit may be the most efficient structure possible.

As we prepare for the midterm next week, it is worth emphasizing two important points. First, keep “supply” and “demand” separate in your mind. When asked about “returns to scale,” for example, realize that is purely a function of supply. It has nothing to do with demand. Do not cite the demand when determining the returns to scale. This is a common mistake. Avoid it.

Second, realize that the market acts in ways that are contrary to what you would prefer. We may care what happened yesterday, for example, but the demand curve does not. Nor do stock buyers care if selling off their shares will cause a company to go out of business and everyone to lose their job. The free market maximizes efficiency, which can sometimes have unfortunate or counter-intuitive results. Someone who opposes communism in China can affect his own buying decisions, but do not confuse his views and utility with that of the market, which may not care at all whether something cheaper was made in communist China. The market sets the price.

Let’s pause for a moment and divide key economic concepts into three levels of difficulty: Easy, Medium and Honors:

Contents

Easy

  • definitions:
    • economics
    • competition
    • efficiency
    • free market (a synonym is "free enterprise")
    • microeconomics (the study of individual “micro” market decisions, companies, consumers)
  • scarcity (when "wants" exceed free availability of the good; scarcity is what makes economics meaningful)
  • invisible hand
  • opportunity cost
  • transaction cost
  • rational economic action
  • P (price) & Q (quantity or output)
  • graphing supply and demand curves (with P on y-axis, and Q on x-axis)
  • supply meets demand: this defines the market price and quantity in a free, competitive market
  • demand side
  • Law of Demand: when price goes up, then demand goes down. YOU MUST USE THIS LAW.
  • equilibrium
  • supply side
  • concept of a "firm" = company = supplier = seller
  • "inputs" into production by a firm
  • fixed costs (FC) (these are costs that do not vary with a company’s output. Examples: rental payments, taxicab license fee)
  • variable costs (VC) (costs that do vary directly with output. Examples: fuel, labor)
  • marginal benefit of a firm’s output decision for producing one more Q: marginal benefit is P (price it is sold at)
  • point at which firms sell their goods (where MR=MC)
  • utility
  • net benefits (excess of benefits over costs, as in the consumer surplus)
  • substitutes
  • complements
  • accounting profit (total revenue minus explicit cost)
  • economic profit (total revenue minus both explicit and implicit costs)
  • short run (period when only some inputs are adjusted in order to change output; e.g. overtime)
  • long run (period when any and all inputs are adjusted to change output; e.g., build new stadium)
  • time is money
  • inflation, CPI (consumer price index for a "basket" of basic goods, in order to measure inflation)
  • Gresham's Law (bad money drives out good)

Medium

  • Coase theorem
  • consumer surplus (savings by consumers who would pay more than the market price for a good)
  • indifference curve
  • fixed costs (FC)
  • variable costs (VC)
  • average total cost (ATC) (this is all the costs divided by the quantity of output Q)
  • average variable costs (AVC) (total variable costs divided by the quantity of output Q)
  • total costs (TC = TVC + TFC)
  • elastic demand
  • inelastic demand
  • minimum wage
  • cross-elasticity of demand (percent change in demand for good X divided by percent change in price for good Y)
  • income elasticity of demand (percent change in demand for good X divided by percent change in income)
  • price elasticity of demand (percent change in quantity demanded divided by percent change in price, dropping the negative sign)
  • price controls (price ceilings and price floors)
  • marginal cost (MC = change in total cost (TC) due to producing one more unit of output Q)
  • total fixed costs (TFC) do not change as more is produced. Because TC=TFC+TVC, and TFC does not change as more Q is produced, the marginal cost (MC) must be equal to the change in TVC due to producing one more output Q
  • marginal revenue (MR)
  • a clever definition for the “long run”: enough time to adjust all inputs in order to produce a given Q at the lowest possible cost
  • variable inputs (inputs that are increased to produce more Q in the short run)
  • fixed inputs (inputs that cannot be increased in the short run to produce more Q)
  • returns to scale (increasing, decreasing or constant? Look at whether a firm's long run average total costs -- ATC=TC/Q -- increases when the firm's size increases) Note that "economies of scale" is the same as "increasing returns to scale"; "diseconomies of scale" is the same as "decreasing returns to scale."
  • income effect
  • substitution effect
  • normal good
  • inferior good (a good that sees a decrease in demand when income increases, and vice-versa)
  • marginal product (increase in output due to additional input: Q = sum MP)
  • law of diminishing marginal utility
  • perfect competition (know the conditions for it)
  • In a perfectly competitive market ...
the increase in profit from an additional Q = P - MC
the firm increases Q only if P > MC
the optimal level of Q is where P = MC
the company stays in business in the short run at level Q only if P equals or exceeds AVC
otherwise the company changes Q until it equals or exceeds AVC
if no such Q exists then the company is better off shutting down

Equations of Medium Difficulty

("Q" stands for output and "MP" stands for marginal product.)

At Q = 0, TC = TFC
When quantity produced is 0, the total costs are the total fixed costs.
At all Q > 0, AVC = TVC / Q
Whenever quantity produced is greater than 0, average variable cost equals total variable cost divided by quantity.
At all Q > 0, AFC = TFC / Q
Whenever quantity produced is greater than 0, average fixed cost equals total fixed cost divided by quantity.
At all Q, ATC = AVC + AFC
At any quantity, average total cost equals average variable cost plus average fixed cost.
TVC = sum of MC
Total variable cost equals the sum of the Marginal Cost over all the units produced.
TFC = Q x AFC
Total fixed cost equals quantity times average fixed cost.
TVC = Q x AVC
Total variable cost equals quantity time average variable cost.
TC = Q x ATC
Total cost equals quantity times average total cost.
MC = W / MP (where W is wage per unit of labor, and labor is the only input)
Marginal cost equals wage divided by marginal product.
AVC = W / AP when labor is the only input and W is the wage or cost of the labor
Average variable cost equals wage divided by average product.

Honors

  • price discrimination
  • producer surplus
  • supply elasticity
  • division of labor
  • tariffs and quotas
  • condition for reducing production (MC>MR)
  • condition for shutting down (P<AVC in short run or P<ATC in long run)
  • Giffen good

Equations of Honors Difficulty

long run average costs (LRAC) are never more than short run average costs (SRAC) for a given Q. Why? See the alternative definition of “long run” in “Medium” list above
LRAC = P x (I / Q), where I is input and Q is output and P is price of the input

Review

Here are some common mistakes or misunderstandings that your Instructor has seen on homework:

  • a transaction cost is not the overall cost of the transaction. It is not the overall price paid for something, but is the portion of the overall cost that is due to "friction", or the time and expense of obtaining what you really want from the transaction. Examples include tips, taxes, commissions, salesmen, broker fees, gas to drive there, etc.
  • a variable cost is not any cost that varies over time. It is a type of production cost for a firm that varies with output. It is a cost that grows bigger as the number of units made increases, such as more electricity for staying open later, more paper and ink costs for making more copies of lectures, higher gas costs for taking more taxicab rides, etc.
  • Returns to scale is the answer to this question: if you own a firm, and you double the amount of your inputs (such as the size of your factory and the number of employees), does the output of your firm increase precisely double also, or increase by less than 2 times, or more than 2 times? Example: doubling the size of a car can carry more than twice as many people. That means it has increasing economies of scale. But the phrase "too many cooks spoil the broth" means there are decreasing economies of scale in a kitchen.
  • In calculating overall utility, keep in mind in which order someone chooses to maximize his marginal utility. Exam questions might ask how someone specifically spent his third hour of time based on assumptions about how the utility for different activities diminish over time.
  • the concept of marginal product is specific to an input, as in "marginal product of labor," which is the additional overall output (product) produced due to an additional unit of that input (labor).
  • speaking of inputs, we might as well include this concept: factors of production. These include the four basic resources for a firm or company: land, labor, capital and entrepreneurship. Exam questions typically ask most about the input of labor for a firm or company.
  • consumer surplus is the extra amount a consumer would have paid for something, but did not have to because the free market brought the price down lower than what the consumer was willing to pay. The buyer is wealthier by the amount of his consumer surplus in a transaction, because consumer surplus is the excess of what he would have paid above what he did pay for something. It is his net benefit from the transaction.

Example 1: Economic Insights into Politics

Economics affects election outcomes in two ways. First, many people vote based on how they are personally doing economically. Voters who recently lost their job are more inclined to be angry about the incumbents (the politicians currently in power). Those voters may choose not to vote for the incumbent, either by not voting at all or by voting for the opponent. Some economists feel that the outcome of every presidential election can be predicted by looking at key economic indicators (such as unemployment) on Election Day.

Second, the side that spends the most money in a political campaign usually wins. In 2008, we can compare the campaign spending by Barack Obama and John McCain to the votes they actually received. Dividing the total amount the campaign spent by the total amount of votes it received, Obama spent 25% more per vote than McCain did.

One reason Obama spent more was because he received far more in campaign contributions than McCain did. But that was partly due to a strategic decision made by McCain in the summer of 2008: he decided to take federal campaign funds, which prohibited him from raising money from the public after around September 1st. Between September 1st and Election Day (in early November), McCain was stuck with the roughly $75 million provided by law to candidates who choose to take federal financing rather than funds from public donors. Obama made the opposite choice, and elected to receive contributions from the public and not take any federal financing. Obama then raised over $300 million from internet donations during that same period, which is 4 times as much as McCain received.

From this simple observation about the differences in funding, several conclusions can be drawn:

  1. McCain would have done better if he declined the federal funding and raised more money on the internet. It's impossible to know how much better his results could have been.
  2. Freedom is not free. People who want their side to win have to support their side financially.

The political process in the United States is based on competition, just like the free market. Typically the political winner, as in the free market, is the candidate who runs the most efficient campaign and who raises the most money for that campaign from supporters. Efficiency and capital are the keys to both economic and political success.

Suppose you are a campaign manager for a candidate for mayor, and you have $10,000 left to spend in the final week on advertisements, mailings, signs, phone calls, etc. You also have 5 volunteers who are willing make calls, stuff envelopes for a final mailing, put up signs, and/or go door-to-door to campaign for your candidate.

It's your decision how to use your "inputs" of capital (money: the $10,000) and labor (the volunteers). How would you use concepts you've learned in this course to maximize the vote for your candidate? (Note: it's unethical and illegal to pay cash directly to voters, or "buy" votes).

The concept of "marginal product" is useful here. You need to allocate your inputs (capital and labor) in order to maximize your output (votes for your candidate). If you put all your money and volunteers into mailings, then you won't influence people as much as if you could speak directly with them. But mailings reach more people more cheaply. Perhaps you'd allocate your capital and labor on a little of each: some on the phone, some door-to-door, some mailings, and some putting up signs. That's what most campaigns do. It's hard to know if your allocation of inputs to tasks is optimal to maximize output.

Now recall Question No. 11 from Homework Assignment Week 6 (Honors) in this course: Your firm seeks to produce a certain level of output in the most efficient way (the lowest cost). It should use its resources in which of the following ways:

(a) use materials that generate the highest marginal product
(b) use materials that have increasing returns to scale
(c) use as much material as possible until there are diminishing returns
(d) use resources such that their marginal products per unit cost are equal

That's the same problem you would face as a campaign manager for a candidate for mayor. Answer choice (a) is wrong because it doesn't factor in the cost of the materials (or inputs). Perhaps buying ads on television generates the highest marginal product (the most votes), but it may be too expensive for your campaign. Answer choice (b) is incorrect for the same reason: it ignores the cost of the materials, which is what you need to focus on. Answer choice (c) also overlooks cost.

The correct answer choice is (d): use the various inputs such that their marginal products per unit cost are equal (and maximized). If one input has a lower marginal product per cost, then that money or labor should be shifted to a more productive input. The optimal level is when all inputs are producing, per cost, at same optimal level of output.

Think of a rowing boat with 8 oarsmen: the crew is most efficient (and has the best opportunity to win) when all are rowing at the same high level. If one oarsmen is not producing as much as the others (his marginal product is lower per the "cost" of that spot on the team), then he needs to find a way to improve to the higher level of the others, or be replaced.

Example 2: Homeschool Dinner Event

To illustrate the practical aspects of microeconomics, consider a dinner event we held in 2004 and 2005. The goal was to maximize attendance while making a small profit. To maximize efficiency, we set up committees to handle a division of labor.

On the “supply side”:

We established three different committees for the different tasks:

1. Selection Committee. This included choosing the location (such as a church or banquet hall), a caterer (we used a bidding process and selected a restaurant in a nearby town), and a date (we chose a Thursday).

2. Presentation Committee. This included planning the evening program (designed to be informative about homeschooling) and picking an outside speaker (we chose Michael Farris at our first dinner).

3. Event Committee. This included designing and printing a written program for guests, and supervising the service of food to guests.

On the “demand side”:

Committees helped on the "demand side" also:

1. Ticket Sales Committee. This included setting the prices, marketing the event, and selling the tickets.

2. Program Sales Committee. This included seeking business, church and individual sponsors, in exchange for featuring them in the written program.

3. Door Committee (managing the door at the event itself: taking and selling tickets, collecting late payments, and making sure the customers are happy).

Consider for a moment how competition can be very beneficial to this effort, particularly on the “supply side.” To maximize the benefits of competition, the goal is to strive to satisfy the conditions of perfect competition.

In choosing the caterer, for example, we reduced our cost by considering several competitors. We asked each caterer for a bid, and then compared them. We asked if a discount was available for prompt payment, or even payment in advance. We inquired if costs could be reduced by holding the event on a weekday rather than a weekend.

Choosing a speaker requires an element of competition also. If you fix your mind on one person and do not consider alternatives, then you are unlikely to obtain your best speaker at the lowest possible cost. Again, the key is to consider several different possibilities. Consider why a speaker may want to talk to a group of homeschoolers. Advantages are the youth, intelligence and motivation of the audience. Perhaps the speaker could make more talking to a general audience, but he or she will not have as much influence. Realize that out-of-town speakers will have greater expenses for travel and opportunity costs.

Printing costs for a program can be reduced by using competition also. Copying costs vary widely among stores. Shopping around can save quite a bit of money. Quality is an issue here also, as not all types of copies are perfect substitutes for each other.

On the demand side, an opposite perspective must be taken. Here you want to reach the highest possible price in selling tickets or spaces for sponsors in the program. Good salesmen or sellers are often the opposite of good buyers. The roles are the inverse of each other.

What would entice someone to attend a dinner? How can you make the event look as attractive as possible? Could price discrimination be used to maximize the income? One possibility is to replace the speaker, who is a major cost item, with inexpensive music and dancing, which may actually be more popular.

Perhaps you would like to show initiative and organize the next homeschool dinner!

Sample problems and solutions

1. The term "scarcity" in economics would include all of the following EXCEPT:

(a) gold
(b) pennies
(c) paper clips
(d) salt water at the ocean
(e) pencils

Answer: The most basic rule for multiple choice tests is this: be sure to understand the question. See that "EXCEPT"? Typically several miss that, and pick the wrong answer. Be sure never to miss a question because you did not understand the question.

Next, our test-taking tips encourage us to eliminate wrong answers before trying to select the correct answer. Gold is scarce under any meaning of the word. Knock it out as an answer.

Pennies, paper clips and pencils are all inexpensive, but they do cost something. A penny is not worth much, but it is worth something. If you had a hundred of them, you could buy a chocolate bar. But it doesn't matter how much salt water you might have at the ocean. That's worthless because there is a free oversupply. Nobody would pay anything for it, not even a penny. Thus it is not economically scarce. The correct answer is (d).

2. Imagine a firm in perfect competition, and in long-run equilibrium. Which of the following statements is true?

(a) the total revenue of the firm cannot be increased
(b) AVC > MC
(c) MC is at its average
(d) marginal revenue is at its maximum
(e) the average total cost is at its minimum

Answer: Again, our test-taking tips encourage us to eliminate wrong answers before trying to select the correct answer. Let's look at answer choice (a): the total revenue of the firm cannot be increased. That is wrong because if we increase our output, we could increase our total revenue, even though we may lose money on that additional unit. For example, if we sold chocolate candy bars for $1, we could always increase revenue by selling another one for the below-market-price of 50 cents. We'd lose money on that additional bar, but we'd increase our overall revenue.

Similarly, answer choice (d) must be wrong because we know that we would continue selling until MR (marginal revenue) declines to where it equals MC (marginal cost). That point were MR=MC is probably not where MR is the maximum.

Would marginal cost (MC) be at its average (choice (c))? No reason to think so. Marginal cost would be higher for the first few units produced by the firm, and lower as volume increases. Most likely MC is below its average as the last unit is produced. For example, you can usually hit a baseball more efficiently after you've hit several dozen baseballs before it.

That leaves us with the possible answer choices of (b) and (e). We should try to eliminate one of these to improve our chances of selecting the correct one. To do so, let's reread the question. It says the firm is perfectly competitive and in long-run equilibrium. That means it has done everything possible to lower its costs, and has all the time it needs to get its costs as low as possible. It does not have to pay for overtime workers; it can hire precisely the optimal number of workers needed without incurring overtime costs. Using the fact that we are in the "long run" for a perfectly competitive firm, we know that its costs are as low as they can be. Answer (e) best fits those conditions in the question: "the average total cost is at a minimum."

See how the correct answer fits the question as a key fits a lock. The question asked about the "long run" equilibrium of a perfectly competitive firm, which suggests the fact that costs are low. Only answer (e) conveyed how costs are low. That "unlocks" the question.

3. Suppose a firm has "economies of scale"? What happens when it increases output?

(a) its average total costs increase
(b) its revenue decreases
(c) its marginal cost increases
(d) its average total costs decrease
(e) its costs remain constant

Answer: Think back to what "economies of scale" means. It refers to whether the firm has better efficiency at a bigger size, or better "returns to scale" as the size of a firm increases. We talked about "increasing" returns to scale and "decreasing" returns to scale. The "economies of scale" suggests that the firm can operate more "economically" if it has larger "scale" or size. In other words, "economies of scale" means "increasing returns to scale."

What happens when a firm that has "increasing returns to scale" increases its output? Like Wal-Mart, such a firm does better and becomes more profitable the bigger it is. So (a), (b) and (e) are incorrect.

We're left with a choice between answers (c) and (d). But (c) can't be right either. The firm is better off the bigger it is, when it has increasing returns to scale or "economies of scale."

By process of elimination, the correct answer must be (d). We can confirm it is right by thinking back to the Wal-Mart example: as it increases its "scale", it increases its quantity of its goods, and that enables it to lower the average costs for each good and then lower its prices. Its ATC decreases as it increases its size; it has "economies of scale" or "increasing returns to scale."

Assignment

Study for the midterm exam next week.


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