Difference between revisions of "Economics Lecture Thirteen"

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{{Economics_Lectures}}
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This lecture is the final review for this course, in preparation for the final exam.  A student who took this class in 2007 sent me the following feedback from college:
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{{cquote|My microeconomics class has been almost all review for me, because of the similar class I took from Mr. Andy Schlafly ....  Although other students who attended public schools may have taken 'economics' before, they have struggled with microeconomics this semester, because their high school classes completely ignored the free-market and Austrian economics<ref>"Austrian economics" is an approach to economics that emphasizes the free markets, minimizing governmental interference, respecting private property rights, and promoting gold as a monetary standard.  Beware, however, that Austrian economics organizations are often more libertarian than conservative on social issues, and Austrian economics itself has been slow in incorporating new economic insights such as the Coase theorem.</ref> which are taught [in college].}}
  
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Thirteenth Lecture – The Big Picture
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Let's begin this lecture by summarizing the percentages the CLEP exam devoted to particular topics.  This will help organize the material we have covered in this course.  Our online final exam next week will use a similar distribution in topics as the CLEP exam, but without over-emphasizing government policy.
  
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Instructor, Andy Schlafly
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== Topics on Exam ==
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Here is a list of the topics on the CLEP exam, along with how many questions are asked about each topic (as a percentage of the overall exam), plus tips about each concept:
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{| class="wikitable"
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|-
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|cost measures (e.g., ATC, AFC, AVC) || 10% || FC is total cost when output is zero; convert to average costs by dividing by output.  Remember that ATC=AFC+AVC, and know when a firm should shut down.
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|-
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|Government policy || 10% || price ceilings cause shortages and taxes cause social (deadweight) loss; but beware of CLEP questions designed to make government regulation appear beneficial, as in reducing pollution
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|-
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|Inputs to a Firm (espec. labor) || 10% || key here is applying logic and other concepts to reason back from product demand to a firm's need for labor (workers); know effects of minimum wage laws; might also be asked about capital
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|-
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|Perfect Competition || 6% || costs and profits and price are lowest for this type of market. P=MC=ATC and "economic profits" are squeezed to zero. If price falls, shut down in short run when P<AVC; shut down in long run when P<ATC.
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|-
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|Monopolistic Competition || 6% || can set its price above MC, but the low barrier to entry allows competitive forces that prevent long run profits and require P=ATC
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|-
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|Production Possibilities ||6% || trade-off among goods made by a nation; to reach points beyond the "frontier" (curve), it requires a technological advance or other big change
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|-
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|Price Elasticity || 5% || measures how demand responds to price changes; "elastic" means big change in demand for a small change in price of good
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|-
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|Monopoly || 4% || the firm sets its price above marginal cost, but not higher than where MR=MC; economic profits are greater than zero; economic rent exists. P>MC. P>ATC.
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|-
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|Demand Curve || 4% || what the public will pay; all firms in all kinds of markets are restrained by the Law of Demand
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|-
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|MR || 4% || marginal revenue is the ''increase'' in total revenue due to selling one more unit; profit maximized where MR=MC
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|-
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|MC || 4% || marginal cost, which equals price in perfect competition.  For a monopoly P>MC but equals MR=MC
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|-
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|Public Goods || 3% || know the difference between these and private goods: public goods cannot exclude people from using the good without paying for it.
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|-
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|Returns to Scale || 2% || think of Wal-Mart for increasing returns to scale; think of a kitchen for decreasing returns to scale ("too many cooks spoil the broth")
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|-
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|Consumer Surplus || 2% || what someone was willing to pay above what the good actually cost
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|-
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|Comparative Advantage || 2% || nation with lower production costs should do what it does best
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|-
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|Oligopoly || 2% || only a few firms, like two gas stations at an intersection far away from any others; usually one Nash Equilibrium-type exam question
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|-
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|Imperfect Competition || 2% || P>MC for this market, which is "allocatively '''in'''efficient" (is not efficient in the allocation of resources); it takes perfect competition to drive P down to MC
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|-
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|Utility || 2% || overall satisfaction; recall our problem about hiking and reading.  Marginal utility is your next bit of utility.  Indifference curve shows trade-off in utility.
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|-
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|Cross-Price Elasticity || 2% || Comparing change in demand for one good due to change in price for a ''different'' good
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|-
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|Opportunity Cost || 2% || keep in mind that "economic costs" include opportunity costs in addition to actual out-of-pocket (accounting) costs
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|-
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|Substitutes || 2% || think Coke versus Pepsi
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|-
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|Complements || 2% || think ketchup with French fries
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|-
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|Long Run v. Short Run || 2% || in the long run all costs are variable and can be minimized; short and long run mentioned in 20% of questions, to distinguish between quick changes and permanent ones
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|-
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|Externalities || 2% || two types: positive (music in an open-air park) and negative (pollution)
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|-
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|Inferior v. Normal Goods || 1% || when income goes up, demand for an inferior good or service goes down (e.g., demand for bankruptcy services)
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|-
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|substitution and income effects || 1% || increase in price means less demand because public uses substitutes (substitution effect of price increase) and becomes poorer (income effect of price increase)
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|-
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|Cartel || 1% || an oligopoly that illegally agrees to fix (set) prices, as OPEC does
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|-
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|Price discrimination || 1% || charging different prices for the exact same good; only possible if the market allows the firm to set its own price
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|}
  
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==Introduction==
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Some important topics are missing from the CLEP exam, such as the invisible hand, free market, charity, transaction costs, the time value of money, interest rates, the Coase theorem and Gresham's Law.  The reason is exam bias.  For example, once a student realizes how inefficient transaction costs are, he or she will probably not like government regulations much!  Instead of these concepts, the CLEP exam adds lots of questions about government regulation to try to make regulation look good.  But other than bias in the '''''selection''''' of question, bias is rare in answers to economics questions.  Pick the answer that you think is correct, without worrying about bias.
  
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We’ve covered all the issues concerning individual decisions by companies and consumers.  We’ve discussed supply and demand.  We’ve addressed marginal revenue and marginal cost. 
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=== Test-taking Tips ===
  
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This class we will explain the big picture of trade.  We also begin our final review.
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As always, be sure you fully understand the question before you answer it, and use common sense and logic.  In fact, many economics questions can be answered correctly with patience and basic reasoning skills.
  
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==Trade==
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== Maximizing Marginal Utility in Studying for Exam ==
  
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What is “trade”?  It is an exchange of goods or services or money by one person for goods or services or money from another.  When I give you an Alex (“A-Rod”) Rodriguez baseball card in exchange for your giving me a Derek Jeter card in return, this is called a trade.  We would not make the exchange unless each of us felt we would be better off as a result.  Maybe I have two “A-Rod” cards and the second one doesn’t mean as much to me as it would to you, for example.
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Let's put our knowledge from this course to good use in studying for our final exam, and preparing for the CLEP exam.  We maximize our utility by scoring as high as possible on these exams.  To do so, we need to maximize our marginal utility in allocating our time towards the exam topics listed above.  If we spend all our studying time on "price discrimination," which is only 1% of the exam, then we are not maximizing our marginal utility and will not reach our full potential.
  
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When Pokeman cards were the big fad for children, they quickly learned to trade cards to improve their collections.  Note that both sides must perceive a benefit for a trade to occur.
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This is similar to our homework problem earlier in the course about maximizing our marginal utility with respect to hiking and reading.  This time, however, the decision each student must make is which topic to focus on first in the above list, and how much time to spend on it before moving on to another topic in the list.  The answer may be different for each student.
  
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Dutch traders supposedly bought the island of Manhattan from Indians for only $24 in beads and trinkets over 300 years ago.  At the time, Manhattan did not appear to be worth much.  Land was plentiful, and it was difficult to get to Manhattan from the New Jersey side.  If the story is true, then both sides felt they were better off from the trade.  In the 1970s, New York City nearly went bankrupt and it was not worth a great deal then either. Would the Indians have taken it back?!
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This same challenge in optimizing strategy could be expressed as a problem of "allocative efficency": allocating resources (time and information) in the most efficient way.  Just as efficiency is essential to successful businesses, efficiency is also important to becoming a successful student.  Spending your time efficiently in preparing for the final exam, and preparing for the CLEP, is crucial to your ability to do well on them.  Look at the above list of topics and how often they appear, and ask yourself: where should you focus first in order to pick up the most points in the shortest amount of time?
  
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Trade benefits both sides to the deal.  It appears “win-win” for both parties, or one would not do it (assuming there is not any trickery involved).  Generally, economists favor “free” trade, which means trade without government interference.
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Should you simply start reviewing at the top of the list and work your way down to the bottom?  That strategy has the advantage of focusing on the most important topics first.  If you run out of time in reviewing, then you will miss only the less important topics.  But you might improve further on that strategy by moving more quickly through topics that you already understand well.  Alternative, there may be topics that you find too difficult to understand, and you might give up some points there in order to focus better on topics where you can pick up more points.
  
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Now move to the big picture.  Consider the massive amounts of trade that occurs between companies and people located in different countries.  “Exports” are the goods that companies in one country make to be sold in another country.  Those goods exit the country of origin and are purchased by foreigners.  “Imports” are the opposite: they are goods that are made in a foreign country but purchased here.
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For the rest of this class this lecture will focus on topics which might provide the greatest marginal increase in your exam scores.  This takes into consideration the topics we have already reviewed (you have the materials for those), and avoids duplication of that review.  You may, however, decide for yourself that you can benefit most from reviewing those prior topics.
  
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Whenever you hear new economic concepts, try to think of examples yourself.  What are some imports that you buy?  Look at where your clothes are made.  Labels disclose this information when you buy the clothes.  Clothes are usually imports, often made in Mexico or China (if inexpensive) or Italy (if expensive).  What are some cars that are imported?  Examples are Toyota (made in Japan), Hyundai (made in Korea), BMW (made in Germany), and Jaguar (made in England).
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Your instructor emphasizes studying strategy for a reason.  The biggest reason why some students do not succeed is a lack of effort.  But the second biggest reason is poor studying and test-taking strategies, like a football team that runs ill-advised plays.  Education, like business and perhaps even life itself, rewards good strategies and punishes misguided ones.
  
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More difficult is to imagine goods that we export.  You do not purchase any of those.  Those are goods made in the United States for sale in a foreign country.  Can you think of any examples?  Music and movies are examples, as people around the world like to buy what Hollywood produces.  Computer software is an other example, as the Microsoft monopoly is exported to the rest of the world.
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==Review: Inputs to a Firm (Espec. Labor)==
  
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Here is something we export that is controversial: we export jobs.  Called “outsourcing”, this consists of a company firing an employee in the United States and then hiring a replacement at much lower wages in a foreign country, such as India.  The foreign employee can be hired free of many government regulations that make jobs costly here, such as social security taxes, health benefits, taxes, risk of lawsuits, pensions, and so on.  An employee hired at a wage of $30,000 in the United States may cost the employer $60,000 when all the regulatory costs are added.  Not so if the company can hire a similar employee in a foreign country.
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For many students, the most additional points can be obtained by reviewing the "Inputs to a Firm" category.  It will be on 10% of the questions on the final exam and the CLEP exam.  That's a significant chunk of these exams.  Without review, these questions look hard and are easy to miss.  But with some extra preparation, you should be able to answer nearly all of them correctly.  In maximizing your score and making the best use of your time, this category may result in the biggest increase in correct answers with the least amount of effort.  That's what maximizing marginal utility is all about.
  
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Do we ever import jobs from foreign countries? Not many.  The Japanese car company Toyota did build some car manufacturing facilities here in response to complaints that it was hurting our automobile industry.  Generally, however, it is more expensive for foreign countries to hire workers here than it would be to hire them elsewhere in the world.
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Accordingly, in economic terms, the greatest marginal utility from studying for the exam is probably obtaining by focusing on this topic first. We've already covered the other two topics comprising 10% apiece of the exam (cost measures and government regulation), so there may not be many more points to pick up there.  Realize that you will probably get some exam questions right without additional studying, and other questions you may get wrong no matter how much you study.  But in this category of "inputs to a firm," you can pick up some points that you would otherwise miss.  Let's review it now.
  
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China is the fastest growing exporter of goods in the world, and India is second.  In 1980, China exported $18.2 billion in goods to other countries.  By 2000, China exported $249.3 billion in goods.  Why?  Because China has very cheap labor.  But it is also a Communist country.  Some of those profits go into building up its military, and menacing its democratic neighbors.  It points nuclear missiles at our western cities, like Los Angeles.
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Questions about inputs to a firm focus on what a firm will do with its inputs (typically labor, but sometimes capital) in order to maximize its profits.  The questions usually concern the following:
  
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You can export or import cash itself.  We export dollars to pay for imported goods.  More generally, exports are what we sell in exchange for imports.
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#impact of improvement in technology on the production by a firm
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#adjusting inputs to minimize the overall cost at a constant level of output
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#the effect of minimum wage on the competition for labor
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#comparing the cost of an input (usually labor) relative to the additional revenue that results
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#why a firm's "demand for labor" is called a "derived demand"
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#what causes an increase in demand for labor
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#the relation between hiring additional workers and the marginal cost
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#calculating overall costs (total cost and average variable cost) based on wages
  
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Sometimes you will hear on the news mention of the “balance of payments” or “trade deficits.”  These terms apply to the difference between how much we import versus how much we export. Because goods are made more cheaply in foreign countries, we typically import far more than we export.  That means the United States has a large trade deficit (amount that total exports exceed total imports).
+
Review the above list now.  How many of the above 8 topics do you know well enough to answer a question about them correctly? Let's briefly review each of these concepts so you can maximize your score on this big part of the exam.
  
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The “balance of payment account” consists of two accounts that keep track of the goods and services entering and leaving a country: the “capital account” and the “current account.”  The capital account monitors physical and financial assets; the current account monitors goods and services.  Familiarity with these terms suffices, and do not worry if you do not fully understand them.
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1.  "the impact of an improvement in technology on the production by a firm"
  
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==“Free Trade” versus “Protectionism”==
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:If technology improves, as in helpful new inventions or advances in communication (like the internet), then this helps shift the Production Possibilities Frontier (Curve) ''outward''.  A firm can produce more output now.  So an improvement in technology enables a firm ''to increase its output or its supply to the market''.
  
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One of the oldest political issues is the debate between “free trade” and “protectionism”.  This has been an issue in American politics for over 200 years.  What is the controversy?
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2.  "adjusting inputs to minimize the overall cost at a constant level of output"
  
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Supporters of “free trade” oppose government interference in trade between foreign countries.  They feel that we should be able to import as many goods as possible from China, and export as many jobs as desired to China.  They argue that trade makes both sides better off, so it should be allowed.  
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:How does a firm adjust its inputs (e.g., workers or equipment) so that the firm reaches its lowest possible overall cost?  By making sure that the firm is getting the most '''''for each input'''''.  In other words, the firm makes sure that each input is producing the most marginal product per dollar spent on that input.  If one worker is producing more than another worker, and both are being paid the same, then the owner has not lowered his costs to a minimum.  He could fire the lazy worker and hire a part-time worker like his good one, and then produce the same output at less cost.
  
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But what about the jobs that are lost in the United States due to the shift to foreign producers of goods and the outsourcing of the work? Advocates of “free trade” point out that the people who buy the imports are better off, and they save money by obtaining goods at a lower price.  They do not need to make as much money from jobs because their expenses are decreasing.
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:Summarizing the above, a firm minimizes its overall costs '''''by making sure the marginal product per cost for each input is equal'''''. If one input (e.g., one worker) is producing more marginal product per cost than another, then the overall costs are not minimized.  The unproductive worker is wasting the firm's money.
  
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The free trade advocates also argue that our economy becomes stronger due to the imports, and new jobs will be created for those who lost their prior jobs.  When jobs were lost in the steel industry due to cheaper imports, new jobs were created in the services industry.  The dot-com boom created many new jobs in the 1990s.  There are temporary dislocations, but these are like growing pains until better jobs arise.  That’s the argument in favor of free trade.
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3.  "the effect of the minimum wage on the competition for labor"
  
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Free traders cite the Law of Comparative Advantage: nations are better off by exporting goods it produces at a lower relative price than others, and importing goods that it cannot make as cheaply.  If China makes trinkets more cheaply than we can, then let’s save money by buying them from China and let’s focus our work on what we do best.
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:Increasing the minimum wage has the effect of increasing unemployment.  Workers who have jobs make more money when the minimum wage is increased, but firms can afford to hire fewer people.  The number of the unemployed (the people who cannot get jobs) increases when the minimum wage is increased.
  
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Opportunity cost supports this view.  You lower your opportunity cost by spending your time most efficiently working on what you do best.  Ford Motor can make a car more efficiently than you can.  But perhaps you can provide medical or legal services more efficiently than Ford Motor can.  So spend your time making money as a doctor or lawyer, and buy your cars from Ford Motor.  You’ll have extra money that way.  If you spend all your time trying to build a car, then you’d go broke and incur enormous opportunity cost.
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:Also, although this will never be asked on a CLEP exam, raising the minimum wage causes more high school students to drop out and pursue jobs rather than stay in school, which would enable them to obtain higher-paying jobs in the future.
  
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For the purposes of economics courses and the CLEP exam, “free trade” and the above arguments are the correct answers.  There is much to be said in their favor.  The free traders also think they are promoting peace. “If goods cannot cross borders, then soldiers will” is one of their favorite sayings.
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:Sometimes the CLEP exam will twist the question about minimum wage to obscure its harmful effect, by asking what happens when the labor supply increases when there already is a minimum wage.  This makes it look like the fault is an increase in the labor supply rather than the minimum wage law.  The correct answer is the same in both cases: unemployment increases.
  
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However, there are many smart people who would be considered “protectionists” (though they would dislike the pejorative label).  Can you think of reasons to oppose “free trade”?
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4.  "comparing the cost of an input (usually labor) relative to the additional revenue that results"
  
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The first argument is the simplest: money isn’t everything.  Put another way, overall utility is about more than money.  Even if free trade makes me better off, I may still not want to do it if it helps wrongdoing or promotes evil.  Someone may choose not to buy lottery tickets even if he thinks he will win, if he is morally opposed to gambling.  Many of us oppose how China persecutes Christians, requires abortion, and points nuclear weapons at our cities.  Even if we benefit from trading with them, we don’t want them to benefit and continue the activities we oppose.  But you won’t hear economists making this argument.
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:This type of question probes how a firm increases its inputs in relation to the additional revenue that results from such an increase.  The key here is to be very careful and very logical.  A firm will increase an input (such as labor) until the ''value'' of the marginal product of that input equals the marginal cost of that input.  Read that sentence over and over until you understand it.  It simply means that the firm will equate the marginal cost of the additional input (such as an additional worker) to the marginal revenue that the additional input produces.
  
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The second argument for “protectionism” questions whether the foreign trade is really “free”.  China is a Communist country.  What is “free” about trading with it?  It does not have free enterprise.  Neither does India.  Why should we let these government-controlled economies take jobs away from ours?  With great risk and many failures through trial and error, we developed successful industries.  Why should we allow foreign governments to be copycats for our successes, at our expense in siphoning away jobs?  Let them promote free enterprise in their countries first, and then we can copy them as much as they copy us.  Through discipline and protectionist measures, perhaps we could induce these countries to embrace free enterprise more.
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:Often students miss this type of question because they are not careful to compare dollars to dollars.  If you have the marginal cost in terms of dollars (such as a wage rage for the additional worker), then you need to equate it to the marginal value of the marginal product of the labor (value is in dollar units), not the marginal product itself (which is a unit quantity).
  
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The third argument for “protectionism” is as follows.  Workers facing loss of jobs due to the outsourcing to other countries ask this: why aren’t the executive jobs exported in addition to the jobs of the employees?  Sure, workers are cheaper in China and India than American counterparts.  But moving the highly paid executive jobs to those countries would save even more money (per worker)!  The advocates of free trade appear to be selective about which jobs they support moving offshore.  Why not start with moving their job to a foreign country first?  They do not seem to be volunteering for that.
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5.  "why a firm's "demand for labor" is called a "derived demand"
  
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==Tariffs==
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:This is an easy point to pick up on an exam.  A firm's demand for an input (such as labor) is called a "derived demand" because it depends on the demand for the goods produced by that input.  For example, a restaurant's demand for waitresses is entirely dependent on the public's demand to be served at the restaurant.  If there is no public demand to be waited on at the restaurant, then the restaurant (the firm) has no demand for waitresses!
  
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Tariffs are a tax on imports.  They raise the price of imported goods, and the supplier must then reduce its received price to attain the same level where supply meets demand.  This has the effect of reducing supply, which is exactly what the protectionists want.  A tariff on Toyota cars, for example, would reduce the supply of Toyota cars in the market.  Ford and GM like that.
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6.  "what causes an increase in demand for labor"
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:This is another easy issue, similar to the prior one above.  If the public demand for the product of the labor increases, then there is an increase in demand for the labor itself.  If more people want to eat McDonald's hamburgers, then there is more demand for workers to make McDonald's hamburgers.
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:How do we know when the demand by the public for the product of certain labor increases?  When the price of the good or service produced by the labor increases.  When that price goes up, then there is an increase in demand for the workers who make that good or service.
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 +
7.  "the relation between hiring additional workers and the marginal cost"
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 +
:This is a more challenging issue that requires two steps rather than one in order to answer correctly.  Marginal cost is additional cost to a firm for making one more unit.  It is measured in dollars, not in units.  Making sure you have the right measure (dollars or units) for your answer will help you reduce mistakes.  ''The answer for any question about marginal cost must be in dollars (or cents) per unit''.
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 +
:Accordingly, if you are told how many additional units are produced by each additional worker, then calculating the marginal cost requires dividing the cost of the additional worker by the additional number of units he produces.  The more units an additional worker produces, the lower the marginal cost that results from adding that worker.
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 +
:''Example'':  suppose a firm hires Tom and sees the output increase by 20 units, and then hires Mary at the same wage and sees the output increase by 15 units.  When is the marginal cost of the firm the lowest?  After it hires Tom, but ''before'' it hires Mary.  That's because the marginal cost of hiring Tom is his wages divided by 20, while the marginal cost of hiring Mary is the same wage divided by 15.  A wage divided by 20 is less than the same wage divided by 15, so the marginal cost to the firm after hiring Tom is less than after hiring Mary.
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 +
8.  "calculating overall costs (total cost and average variable cost) based on wages"
 +
 
 +
:The key here is simply to be careful in doing the calculations, and then double-check your answer.  '''''You need to be sure you are using the correct level of output before you calculate the total cost (TC) and average variable cost (AVC) at that level of output'''''.  To find the total cost, add the fixed cost (FC) to the variable cost (the variable cost is usually the labor cost: total wages times the number of workers), '''''for a given level of output'''''.  Then, to find the average variable cost, find the total variable cost (TVC=TC-FC) and divide by that level of output.
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 +
:''Example'':  a firm can produce 100 units with 5 workers and 200 units with 10 workers.  Its fixed cost is $50 and its wage rate is $20 per worker.  What is its total cost and average variable cost to produce 100 units?
 +
 
 +
::''Answer'':  notice first that the question asks about the costs at 100 units in output, not 200 units.  Total cost at 100 units is the fixed cost ($50) plus the labor cost ($20 times 5 workers, or $100), for a total of $150.  The average variable cost is the total cost ($150) minus the fixed cost ($50), divided by the output (100), for a total of $1 per unit.
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 +
Master the above eight issues, and you'll convert 10% of the exam from wrong answers to correct ones.  That could enable you to earn college credit.
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 +
== Review: Different Types of Markets ==
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 +
You instructor wonders what topic will maximize our marginal utility next.  About 20% of the exam is devoted to questions about different types of markets, ranging from the most advantageous for the public (perfect competition) to the least advantageous for the public (monopoly).  That's a large chunk of questions, and with some extra review here students can convert potentially wrong answers into correct ones.
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 +
The key to answering these questions correctly is to realize that the more competition there is, the lower the price of the goods and services and the lower the profits for the firms.  Some of these questions are special cases and should simply be memorized:  a cartel is an oligopoly that illegally agrees to fix (set) its prices, and an oligopoly is an industry where just a few firms dominate the market.  When given a grid about where an oligopoly ends up selling its goods (its Nash Equilibrium), the answer is always symmetric (all firms sell at the same price) and usually not the highest price that a monopoly could sell at.
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 +
The monopoly questions look harder than they really are.  The monopolist sets his price higher than marginal cost, which would be the optimal price from the standpoint of the public (or government).  Instead, the monopolist price sets his price where marginal revenue equals marginal cost (MR=MC).  If shown a graph, you may have to find the quantity where MR=MC, and then find the corresponding price on the demand curve.  Notice that a monopolist has no supply curve, because a supply curve represents many firms in an industry and a monopolist is the only firm in the industry.
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 +
There can be general questions about these markets.  A perfectly competitive market uses resources in a perfectly efficient way.  At the other end of the spectrum, a monopoly uses resources the least efficiently of all.  Its high pricing causes a huge social loss ("deadweight loss") by eliminating consumer surplus.  The monopoly reduces output in order to cause a scarcity that increases the price to an artificially high level.  This is bad for everyone, except the owner of the monopoly, who enriches himself.  This is how Bill Gates became the wealthiest person in the world.
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 +
Here is a puzzle to leave you with.  What is the impact on quantity of a price ceiling in a competitive industry compared to a price ceiling in a monopoly?  In which one (competitive v. monopoly) might a clever price ceiling actually increase quantity?  Think about it, and learn to ask yourself questions like this in order to master economics.  The answer is in this footnote.<ref>A price ceiling is a maximum price limitation, just as a real ceiling in a house limits the height.  A perfectly competitive industry is already selling at its maximum output, so a price ceiling can't help there.  But a monopoly increases its price by reducing its output.  If a price ceiling is imposed against a monopoly, then it must reduce its price and increase its output, which benefits the public.</ref>
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 +
Be sure to spend time on the review sections in the prior lectures for more information about this and other topics on the exams.
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 +
== Review: Public Goods ==
 +
 
 +
A public good is a good which is nonexcludable and nondepletable. The first condition means that it is impossible to exclude consumers from partaking in the good, and the second condition means that one consumer's consumption of the good does not prevent others from consuming it.
 +
 
 +
Explained another way, a public good is available to all such that consumption by one person does not reduce its availability to others. An example of a public good is national defense, as it protects everyone and its benefits to one person do not diminish its benefits to others.
 +
 
 +
Other examples of public goods are law enforcement (protection by the police), public fireworks, clear air, street lights, radio and television transmissions, lighthouses, and some inventions.  Some of these examples, such as lighthouses, are contested as to whether they must be a public good, as it is possible to charge ships port fees to pay for them.  Also, while radio and television transmissions are available to all to receive them, it does cost money to buy radios and television sets, so these are not truly public goods either.
 +
 
 +
[[Liberals]] like to emphasize the concept of [[public good]]s on exams in order to support the argument for more government.  Under this view [[public good]]s represent market failure and the need for government services supported by taxes.
 +
 
 +
==Final Tips on Test-taking in Economics==
 +
 
 +
Good test-taking techniques are particularly important to doing well on an economics exam.  Simple questions are often intentionally disguised as something more complicated.  It is easy to become confused and misguided in analyzing economic issues.  99% of the public would say that we would be better off if Congress put a price ceiling or cap on gasoline at $1 a gallon.  It takes a bit more thought to realize that massive shortages would result, and we would all have to waste hours each week waiting in line for gasoline.  Some who really need gas in hurry, such as people trying to take someone to a hospital, may not be able to obtain gas in time.
 +
 
 +
The ability to eliminate wrong answers can help. Let’s try the elimination technique on these questions:
 
   
 
   
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Ironically, our government uses quotas rather than a tariff to appease Ford and GM.  Instead of imposing a tariff on Toyota’s imports, our government negotiated an agreement with it so that it would not sell more than a fixed quota of certain types of cars each year.  This reduces supply also, but without any revenue to the government.  Many criticize these import quotas by observing that the effect is the same as a tariff, but without the benefits of the revenue that government would receive from a tariff.
+
''Question'': Consider the poverty-level of income for a family of four in America. Which of the following can be said about ''how'' the government defines this specific income level?
  
−
For most of our country’s history (until the Sixteenth Amendment legalized the income tax), our federal government’s major source of revenue was tariffs. The issue of the tariff was a recurrent controversy that divided the pro-tariff North from the anti-tariff South.
+
:(A) It helps determine who is eligible for Social Security benefits.
 +
:(B) It decreases when there is an increase in welfare benefits.
 +
:(C) It proves that 50% of Americans live in poverty.
 +
:(D) It is determined by tripling the cost of a nutritionally adequate diet by three.
 +
:(E) Government does not adjust this number due to changes in the cost of living (inflation).
  
−
==Possibilities of Production==
+
Virtually none of you would know the answer to this question at first glance.  This question is not really appropriate for a "micro"-economics exam ("micro"-economics concerns individual buying and selling decisions), but CLEP asks it anyway.  Questions about poverty, gaps between the rich and poor, and government programs are always favorites among liberal educators.  You will see many more questions about these issues than about the invisible hand or the creation of wealth.
  
−
“Possibilities of production” is an important concept. It means all the different combinations of goods a nation can produce.  The United States can produce X cars and Y bundles of wheat, for example.  Or it could produce more than X cars and fewer than Y trucks. We could graph the number of cars on the Y-axis and the number of trucks on the X-axis, and draw a “production possibility” curve through all the possible combinations. It would be downward sloping: more cars means less trucks, and vice-versa.  The opportunity cost of producing more cars is the loss in production of trucks.  In the production possibility curve for cars and boats shown in Figure A (attached), the opportunity cost of moving from point A to point B is 100 cars.
+
So what do we do when faced with this question?  Simply give up? Move to the next question and hope it is easier? Blindly guess at an answer? None of the above.   
  
−
If the overall number of workers or investment capital increased, then you could produce more of everything.  The entire production possibilities graph (or “frontier”) would shift upward and to the right.  An improvement in technology would have the same effect.  An increase in bureaucracy or administrative costs, however, would have the opposite effect, forcing a contraction in overall production.
+
We can narrow the choices, and thereby reduce our risk of error, by eliminating wrong answers.  Basic economic principles (or common sense) serve as our guide.
  
−
Sometimes in politics this is described as “guns versus butter.” The more guns (e.g., military weapons) we make, the less butter (e.g., food and domestic services) we can produce.  The idea is that there is a trade-off between spending money on our military and spending it on domestic goods and services.
+
Let’s start with choice (C).  Think about it: is half of our nation living in poverty?  What would that mean for elections?  Who would pay to run government? If we called half of us "poor", then what word would be use for the really poor?  Choice (C) can't be true. Using common sense, we can eliminate this answer.
  
−
On a personal level, it is usually impossible to do two things at once.  Either you spend the next hour working on this course, or you spend it doing something else.  You could graph a production possibility curve for how you spend 24 hours each day. It could be 10 hours sleeping, 2 hours playing sports, 3 hours cooking and eating, 4 hours studying, 1 hour relaxing, and 4 hours working at a job.  If you take an hour away from one activity, then you can add it to another.  Your production possibility curve would represent all the possibilities.
+
Let’s turn to choice (E).  Why wouldn’t it be adjusted? Poverty must be relative to the cost of living.  If the cost of living doubled, then the numbers in poverty would increase greatly.  But failure to adjust for the cost of living would miss that effect.  Again, common sense leads us to eliminate this answer.
  
−
Economists observe that utilizing the Law of Comparative Advantage can improve the production possibilities.  Suppose your job paid you $9 but you could hire a cook for $6.  Then it might make sense for you to work one more hour and hire someone to save you one hour of cooking.  In the absence of taxes, you would be $3 better off.  Then you could work one-third of an hour less to make the same money (after expenses) as before.  That extra one-third of an hour could be added to your sports or relaxation time.  You have moved your “production possibilities frontier” (the curve of all possibilities) outward, for greater benefit.
+
Next we can turn to choice (A).  That doesn't work either, because everyone who pays into Social Security has a right to receive benefits when they grow old, regardless of whether they are rich or poor.  “Social security” is not “security only if you’re poor.” We can eliminate this choice.
  
−
==Review==
+
We’re left with only two possibilities: (B) and (D).  Realize that has increased our odds of choosing the right answer to 50% now.  If you took the CLEP and at least narrowed every difficult question down to two choices, then you would likely pass the test.  How do we next make our best choice among these final two options?
  
−
The key to mastering economics is to learn to quiz yourself on the principles to make sure you understand it.  The review list in Lecture #10 should be useful, and return to it again and again.
+
Option (D) seems to have the right amount of detail, and fits the question well grammatically.  In contrast, Option (B) does not fit the question as well or make as much sense (definition of what the poverty level is should not change based on distributing some benefits).  Even if you had no idea between (B) and (D), (D) is a better fit.  It’s our best guess.  (D), indeed, is correct.
  
−
What is the most important concept of the course? Perhaps it is the obvious desire of companies to maximize their profits.  Whether it is a monopoly or a perfectly competitive firm, the firm shares this common goal with all other firms: it wants to make more profits.  You can answer 20% or more of the questions on any microeconomics exam simply by applying that basic rule.  And at what point does any company maximize its profits?  Where marginal revenue (MR) declines to the point where it equals marginal cost (MC).  When marginal revenue declines further (or marginal cost increases more), then the company is losing profits.  It won’t do that.
+
It helps to choose an answer that gives the most meaning to the purpose of the question. The purpose of this question is to ask about how poverty-level income is calculated.  Answer (D) most directly furthers that goal.  It makes for a good guess if you did not otherwise know.  You won’t always be able to guess the right answers, but by increasing your chances you can significantly increase your overall score.
  
−
You need to understand the supply and demand curves thoroughly.  Know what elasticity is, in all its forms.  Appreciate what substitutes and complements are.
+
Let’s try one more CLEP-inspired question, this time relating to labor:
  
−
Know the difference between the “short run” and the “long run.” In the “short run,” inefficient changes to inputs and outputs are made.  For example, an employee is asked to work overtime at wages 1.5 times ordinary wages.  But in the “long run,” inefficiencies are eliminated by better planning.  Overtime is avoided.
+
''Question'': Assume a perfectly competitive market for both inputs and output.  If capital is fixed and the price for the output increases, then a firm in the short run will increase its production by which of the following ways:
  
−
Acquire a solid understanding of “marginal cost” (MC), “average variable cost” (AVC) and “average total cost” (ATC).  See Figure B (attached).  Notice how an increase in MC causes a delayed increase in AVC and ATC.  MC moves quickly because it is just the additional cost for one additional unit of output.  AVC moves more slowly because it is an average over all the output.  If a star baseball player bats “1000" in a game by going 4-for-4, his batting average for the entire season is not going to jump to that level.  Nor does AVC jump around with every variation in MC.  Meanwhile, ATC is always higher than AVC, because ATC includes fixed costs.
+
:(A) increase capital until P=MR
 +
:(B) increase labor until the value of the marginal product for workers equals the wage rate
 +
:(C) increase capital until its average product equals the price of the additional capital
 +
:(D) increase labor until its marginal product equals the wage rate
 +
:(E) increase labor until the ratio of the price of the output to labor's marginal product equals the wage rate
  
−
Why is AVC and ATC so important? Because that helps determine your profit or loss.  You’ll shut down your company if you lose money from making additional goods, which happens in the short run when AVC > P.
+
This type of question benefits from being reread.  “Capital is fixed,” according to the question.  So capital cannot be increased.  Answers (A) and (C) can be eliminated that easily. Many students sometimes miss the obvious on economics exams.  They fail to read and understand the question.
  
−
==Assignment==
+
Only labor can be increased, which is possible under answers (B), (D) and (E).  We've improved our odds of success to a 33% chance.  Those are good odds on a difficult question like this.  But we can improve our chances even more.
  
−
The assignment is to begin studying for the final exam.  These questions are for review only.  The answers will be posted on www.conservapedia.com .  You do not have to hand in answers.
+
(B) and (D) look similar so let’s turn to (E) first.  The “marginal product of labor” is the additional units (“product”) produced due to an additional unit of labor.  Remember “MP”?  The term does not include “revenue” or “price”, so it only gives you the quantity.  We need to multiply that quantity by product price to obtain revenue, what the firm owner cares the most about.  Choice (E) makes no sense by dividing terms that should be multiplied together.  We can eliminate it.
  
−
===Introductory:===
+
Back to (B) and (D).  The only difference between the two is the term “value of” in (B).  Think about what “marginal product” is.  It is a quantity, not a dollar amount.  Yet we are comparing it to “wage rate,” which would be in dollars.  We need to insert “value of” to convert a quantity into equivalent dollars.  (B) is must be the correct choice because it compares dollars to dollars, while choice (D) does not.
  
−
1.  The curve that illustrates how much a company or country can produce of multiple items is called the ________________________.
+
The key to good test-taking, particularly on economics exams, '''''is to make sure you fully understand each question before trying to answer it'''''.
  
−
2.  A monopolistic competitive firm has the following characteristic that is lacking for a perfectly competitive firm:
+
=== CLEP Exam Bias Concerning Regulation and Efficiency===
  
−
(a) There are low barriers to entry
+
There are only two or three questions (out of nearly 100) on the CLEP exam that have biased answers.  They concern regulation and efficiency.  You can expect to see one or two CLEP questions where the correct answer is to support government regulation against pollution.  The best way to think about pollution is in terms of its "negative externality," but the CLEP exam writers cast the issue in terms of an efficient use of resources.  Under this view, pollution is inefficient because it results in inefficient harm to the environment.  Laws against pollution supposedly increase efficiency by preventing harm to the "resource" of the environment.  These regulations that prohibit pollution cause less output but supposedly ensure a more efficient use of environmental resources. 
  
−
(b) MR = MC in the long run.
+
While most of us support a cleaner environment, efficiency is usually associated with ''greater'' output, not ''less'' output.  Government regulations almost never ''improve'' efficiency; the free market does that best without government interference.  That said, you can pick up one or two easy points on the CLEP exam '''''by assuming that environmental regulation increases efficiency by protecting the "resource" of the environment for its better uses'''''.
  
−
(c) P > MC
+
When companies are allowed to pollute without paying for it, their marginal cost (MC) is artificially lower than it should be.  These companies are avoiding the cost of their own pollution.  A lower MC means they will produce more goods than if their MC were higher.  The term “marginal social cost” is used by economists to represent the true cost of their activities, including the cost of their pollution.  Because companies produce ''more'' than they would if they had to pay for the cost of their pollution, some consider this to be '''''inefficient'''''.  On the CLEP exam, it takes regulation to make it efficient by preventing the companies from putting out the pollution.
  
−
(d) There are many competitors.
+
You might wonder what a conservative, free market approach to reducing negative externalities (like pollution) would be.  One approach would be to require full disclosure to the public by companies of their negative externalities, so that the public could stop buying the companies' products if the public were concerned about the negative externalities.  This would enable the free market to solve this problem in an efficient way.
  
−
===Intermediate===
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'''''Outside the topic of government regulation on the CLEP exam, there are no biased answers.  Do not choose one answer instead of another for reasons of bias except in one or two rare cases.'''''
  
−
3.  A customer to our imaginary homeschool dinner expected to pay $40, but we only charged him $25.  An economist would call the $15 difference the  ___________.  (Hint: see Lecture #10 review list)
+
===Other Questions Concerning Government===
  
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[[Image:Econ13ab.jpg|right|250px|thumb|Figures A and B]]
+
In areas unrelated to pollution, government establishes price floors, supports and ceilings.  Do we all recall the differences?  Price “ceilings” (or controls) are the easiest: the government says that the good cannot be sold for a higher price.  Just as you cannot reach above your ceiling, the price is prohibited from rising above the ceiling that the government sets for it.  It would be requiring gas to be sold for no more than $1.50, for example.  The quantity supplied will decrease (move down the supply curve), while the quantity demanded will increase (move up the demand curve).  '''''Shortages result from price ceilings'''''.
  
−
4. Look at Figure B (right).  If the price of sale falls below P1 then the firm in the short run will (a) increase Q, (b) increase labor, (c) increase price, or (d) shut down. How much profit is it making at a price of P2?
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What is a price floor? Just the opposite of a ceiling.  We cannot reach below the floor, and a price floor prevents the price from falling below a certain level.  It would be a government law that prohibited milk from selling for less than $2 a gallon, for example.  It would be intended to help the suppliers, such as dairy farmers.  What happens when government imposes a price floor? There is a surplus of the good, as supply exceeds demand.
  
−
5. Look again at Figure B (right).  Assume the firm is perfectly competitive.  Explain what AFC is, and use the labels on the graph to describe its amount.
+
Now, how about a price support?  That occurs when the government buys large quantities of good, such food, at prices higher than the competitive equilibrium. The government does this to “support” a higher price, instead of passing a law to require a higher price.  A price support is designed to help the firms producing the goods, such as farmers.  The rationale is that farmers are politically important and that pure competition is too brutal on their business and their lives, and also that foreign countries engage in the same practices.  The effect of a “price support” is similar to a price floor: it creates a surplus of the good when the support is above the equilibrium price
  
−
6. Now turn to Figure A (right).  What is the opportunity cost of shifting production from B to C?
+
When government regulates labor, the analysis is similar to its regulation of price. A “price floor” is created by the minimum wage: the buyer (an employer) must pay at least a certain amount for a service (labor).  The minimum wage creates an oversupply of the service: too many workers.  Not all of them will be able to obtain jobs at a wage higher than equilibrium.  Unemployment results from a minimum wage that is higher than the equilibrium wage.
  
−
7.  Suppose that is your firm in Figure A (attached).  What changes might enable you to move production to point D?
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== Final Comments ==
  
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8.  The term “normal profit” means “zero economic profits,” which occurs when total revenue equals explicit costs (like cash expenditures) plus implicit costs (like opportunity costs of wasted time).  In Figure B (attached), at point A, what kind of profits does the company have: (a) more than a “normal profit”, (b) equal to a “normal profit” or (c) less than a “normal profit.”? Explain.
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You have all learned a great deal of material in this course, information that will help you the rest of your lives.  The insights and powerful concepts covered by this course can yield greater and greater benefits the more you think about them.  Every week I see still something new and helpful in concepts taught in this course.  Many students say that this is the best course they took from me, among other helpful courses.  Use this course for your benefit.
  
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9.  Do you support “free trade” or “protectionism”? Explain your view.
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If there is one unifying theme to this course, then I suggest it is summarized in Jesus's Parable of the Talents.  Be productive, and God can multiply the benefits of your work.  If you reach out, if you do more, if you make good use of your time, if you maximize your efficiency, if you consider the opportunity costs, and if you increase your output, then you give God more to work with. But if you bury your talents in the ground or if you are like the tree that does not bear fruit, then you give God less for His purpose.
  
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===Honors:===
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'''''Carpe diem'''''.  And be the good that drives out the bad as we discussed in connection with Gresham's Law.
  
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[[Image:Econ13c.jpg|right|250px|thumb|Figure C]]
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==Assignment==
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−
10.  Look at Figure C (right).  Assuming it represents the long run, describe what type of industry this is (e.g., monopoly, oligopoly, monopolistic competition, or perfect competition).  Explain your answer.
 
  
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11.  Economics is sometimes called the “dismal science” because economists predicted population to grow faster than the food supply, marginal returns to diminish, and profits to vanish.  But, in fact, there is an abundance of food and profits have not vanished. Why is economics not so dismal after all?
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Read this lecture and study for the final exam, which will be the first week in June.  It will be 30 multiple-choice questions, similar in format to the quizzes.
  
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12. Look again at Figure C (attached).  This question has three parts.  (I) At what point is there an allocatively efficient quantity?  (II) At what point is revenue maximized?  (III) At what point is profit maximized?  Explain your answers.
+
== References ==
  
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<references/>
 
[[Category:Economics lectures]]
 
[[Category:Economics lectures]]
 
{{DEFAULTSORT: Economics Lecture 13}}
 
{{DEFAULTSORT: Economics Lecture 13}}

Latest revision as of 14:34, May 28, 2013

Economics Lectures - [1 - 2 - 3 - 4 - 5 - 6 - 7 - 8 - 9 - 10 - 11 - 12 - 13 - 14]

This lecture is the final review for this course, in preparation for the final exam. A student who took this class in 2007 sent me the following feedback from college:

“ My microeconomics class has been almost all review for me, because of the similar class I took from Mr. Andy Schlafly .... Although other students who attended public schools may have taken 'economics' before, they have struggled with microeconomics this semester, because their high school classes completely ignored the free-market and Austrian economics[1] which are taught [in college]. ”

Let's begin this lecture by summarizing the percentages the CLEP exam devoted to particular topics. This will help organize the material we have covered in this course. Our online final exam next week will use a similar distribution in topics as the CLEP exam, but without over-emphasizing government policy.

Topics on Exam

Here is a list of the topics on the CLEP exam, along with how many questions are asked about each topic (as a percentage of the overall exam), plus tips about each concept:

cost measures (e.g., ATC, AFC, AVC) 10% FC is total cost when output is zero; convert to average costs by dividing by output. Remember that ATC=AFC+AVC, and know when a firm should shut down.
Government policy 10% price ceilings cause shortages and taxes cause social (deadweight) loss; but beware of CLEP questions designed to make government regulation appear beneficial, as in reducing pollution
Inputs to a Firm (espec. labor) 10% key here is applying logic and other concepts to reason back from product demand to a firm's need for labor (workers); know effects of minimum wage laws; might also be asked about capital
Perfect Competition 6% costs and profits and price are lowest for this type of market. P=MC=ATC and "economic profits" are squeezed to zero. If price falls, shut down in short run when P<AVC; shut down in long run when P<ATC.
Monopolistic Competition 6% can set its price above MC, but the low barrier to entry allows competitive forces that prevent long run profits and require P=ATC
Production Possibilities 6% trade-off among goods made by a nation; to reach points beyond the "frontier" (curve), it requires a technological advance or other big change
Price Elasticity 5% measures how demand responds to price changes; "elastic" means big change in demand for a small change in price of good
Monopoly 4% the firm sets its price above marginal cost, but not higher than where MR=MC; economic profits are greater than zero; economic rent exists. P>MC. P>ATC.
Demand Curve 4% what the public will pay; all firms in all kinds of markets are restrained by the Law of Demand
MR 4% marginal revenue is the increase in total revenue due to selling one more unit; profit maximized where MR=MC
MC 4% marginal cost, which equals price in perfect competition. For a monopoly P>MC but equals MR=MC
Public Goods 3% know the difference between these and private goods: public goods cannot exclude people from using the good without paying for it.
Returns to Scale 2% think of Wal-Mart for increasing returns to scale; think of a kitchen for decreasing returns to scale ("too many cooks spoil the broth")
Consumer Surplus 2% what someone was willing to pay above what the good actually cost
Comparative Advantage 2% nation with lower production costs should do what it does best
Oligopoly 2% only a few firms, like two gas stations at an intersection far away from any others; usually one Nash Equilibrium-type exam question
Imperfect Competition 2% P>MC for this market, which is "allocatively inefficient" (is not efficient in the allocation of resources); it takes perfect competition to drive P down to MC
Utility 2% overall satisfaction; recall our problem about hiking and reading. Marginal utility is your next bit of utility. Indifference curve shows trade-off in utility.
Cross-Price Elasticity 2% Comparing change in demand for one good due to change in price for a different good
Opportunity Cost 2% keep in mind that "economic costs" include opportunity costs in addition to actual out-of-pocket (accounting) costs
Substitutes 2% think Coke versus Pepsi
Complements 2% think ketchup with French fries
Long Run v. Short Run 2% in the long run all costs are variable and can be minimized; short and long run mentioned in 20% of questions, to distinguish between quick changes and permanent ones
Externalities 2% two types: positive (music in an open-air park) and negative (pollution)
Inferior v. Normal Goods 1% when income goes up, demand for an inferior good or service goes down (e.g., demand for bankruptcy services)
substitution and income effects 1% increase in price means less demand because public uses substitutes (substitution effect of price increase) and becomes poorer (income effect of price increase)
Cartel 1% an oligopoly that illegally agrees to fix (set) prices, as OPEC does
Price discrimination 1% charging different prices for the exact same good; only possible if the market allows the firm to set its own price

Some important topics are missing from the CLEP exam, such as the invisible hand, free market, charity, transaction costs, the time value of money, interest rates, the Coase theorem and Gresham's Law. The reason is exam bias. For example, once a student realizes how inefficient transaction costs are, he or she will probably not like government regulations much! Instead of these concepts, the CLEP exam adds lots of questions about government regulation to try to make regulation look good. But other than bias in the selection of question, bias is rare in answers to economics questions. Pick the answer that you think is correct, without worrying about bias.

Test-taking Tips

As always, be sure you fully understand the question before you answer it, and use common sense and logic. In fact, many economics questions can be answered correctly with patience and basic reasoning skills.

Maximizing Marginal Utility in Studying for Exam

Let's put our knowledge from this course to good use in studying for our final exam, and preparing for the CLEP exam. We maximize our utility by scoring as high as possible on these exams. To do so, we need to maximize our marginal utility in allocating our time towards the exam topics listed above. If we spend all our studying time on "price discrimination," which is only 1% of the exam, then we are not maximizing our marginal utility and will not reach our full potential.

This is similar to our homework problem earlier in the course about maximizing our marginal utility with respect to hiking and reading. This time, however, the decision each student must make is which topic to focus on first in the above list, and how much time to spend on it before moving on to another topic in the list. The answer may be different for each student.

This same challenge in optimizing strategy could be expressed as a problem of "allocative efficency": allocating resources (time and information) in the most efficient way. Just as efficiency is essential to successful businesses, efficiency is also important to becoming a successful student. Spending your time efficiently in preparing for the final exam, and preparing for the CLEP, is crucial to your ability to do well on them. Look at the above list of topics and how often they appear, and ask yourself: where should you focus first in order to pick up the most points in the shortest amount of time?

Should you simply start reviewing at the top of the list and work your way down to the bottom? That strategy has the advantage of focusing on the most important topics first. If you run out of time in reviewing, then you will miss only the less important topics. But you might improve further on that strategy by moving more quickly through topics that you already understand well. Alternative, there may be topics that you find too difficult to understand, and you might give up some points there in order to focus better on topics where you can pick up more points.

For the rest of this class this lecture will focus on topics which might provide the greatest marginal increase in your exam scores. This takes into consideration the topics we have already reviewed (you have the materials for those), and avoids duplication of that review. You may, however, decide for yourself that you can benefit most from reviewing those prior topics.

Your instructor emphasizes studying strategy for a reason. The biggest reason why some students do not succeed is a lack of effort. But the second biggest reason is poor studying and test-taking strategies, like a football team that runs ill-advised plays. Education, like business and perhaps even life itself, rewards good strategies and punishes misguided ones.

Review: Inputs to a Firm (Espec. Labor)

For many students, the most additional points can be obtained by reviewing the "Inputs to a Firm" category. It will be on 10% of the questions on the final exam and the CLEP exam. That's a significant chunk of these exams. Without review, these questions look hard and are easy to miss. But with some extra preparation, you should be able to answer nearly all of them correctly. In maximizing your score and making the best use of your time, this category may result in the biggest increase in correct answers with the least amount of effort. That's what maximizing marginal utility is all about.

Accordingly, in economic terms, the greatest marginal utility from studying for the exam is probably obtaining by focusing on this topic first. We've already covered the other two topics comprising 10% apiece of the exam (cost measures and government regulation), so there may not be many more points to pick up there. Realize that you will probably get some exam questions right without additional studying, and other questions you may get wrong no matter how much you study. But in this category of "inputs to a firm," you can pick up some points that you would otherwise miss. Let's review it now.

Questions about inputs to a firm focus on what a firm will do with its inputs (typically labor, but sometimes capital) in order to maximize its profits. The questions usually concern the following:

  1. impact of improvement in technology on the production by a firm
  2. adjusting inputs to minimize the overall cost at a constant level of output
  3. the effect of minimum wage on the competition for labor
  4. comparing the cost of an input (usually labor) relative to the additional revenue that results
  5. why a firm's "demand for labor" is called a "derived demand"
  6. what causes an increase in demand for labor
  7. the relation between hiring additional workers and the marginal cost
  8. calculating overall costs (total cost and average variable cost) based on wages

Review the above list now. How many of the above 8 topics do you know well enough to answer a question about them correctly? Let's briefly review each of these concepts so you can maximize your score on this big part of the exam.

1. "the impact of an improvement in technology on the production by a firm"

If technology improves, as in helpful new inventions or advances in communication (like the internet), then this helps shift the Production Possibilities Frontier (Curve) outward. A firm can produce more output now. So an improvement in technology enables a firm to increase its output or its supply to the market.

2. "adjusting inputs to minimize the overall cost at a constant level of output"

How does a firm adjust its inputs (e.g., workers or equipment) so that the firm reaches its lowest possible overall cost? By making sure that the firm is getting the most for each input. In other words, the firm makes sure that each input is producing the most marginal product per dollar spent on that input. If one worker is producing more than another worker, and both are being paid the same, then the owner has not lowered his costs to a minimum. He could fire the lazy worker and hire a part-time worker like his good one, and then produce the same output at less cost.
Summarizing the above, a firm minimizes its overall costs by making sure the marginal product per cost for each input is equal. If one input (e.g., one worker) is producing more marginal product per cost than another, then the overall costs are not minimized. The unproductive worker is wasting the firm's money.

3. "the effect of the minimum wage on the competition for labor"

Increasing the minimum wage has the effect of increasing unemployment. Workers who have jobs make more money when the minimum wage is increased, but firms can afford to hire fewer people. The number of the unemployed (the people who cannot get jobs) increases when the minimum wage is increased.
Also, although this will never be asked on a CLEP exam, raising the minimum wage causes more high school students to drop out and pursue jobs rather than stay in school, which would enable them to obtain higher-paying jobs in the future.
Sometimes the CLEP exam will twist the question about minimum wage to obscure its harmful effect, by asking what happens when the labor supply increases when there already is a minimum wage. This makes it look like the fault is an increase in the labor supply rather than the minimum wage law. The correct answer is the same in both cases: unemployment increases.

4. "comparing the cost of an input (usually labor) relative to the additional revenue that results"

This type of question probes how a firm increases its inputs in relation to the additional revenue that results from such an increase. The key here is to be very careful and very logical. A firm will increase an input (such as labor) until the value of the marginal product of that input equals the marginal cost of that input. Read that sentence over and over until you understand it. It simply means that the firm will equate the marginal cost of the additional input (such as an additional worker) to the marginal revenue that the additional input produces.
Often students miss this type of question because they are not careful to compare dollars to dollars. If you have the marginal cost in terms of dollars (such as a wage rage for the additional worker), then you need to equate it to the marginal value of the marginal product of the labor (value is in dollar units), not the marginal product itself (which is a unit quantity).

5. "why a firm's "demand for labor" is called a "derived demand"

This is an easy point to pick up on an exam. A firm's demand for an input (such as labor) is called a "derived demand" because it depends on the demand for the goods produced by that input. For example, a restaurant's demand for waitresses is entirely dependent on the public's demand to be served at the restaurant. If there is no public demand to be waited on at the restaurant, then the restaurant (the firm) has no demand for waitresses!

6. "what causes an increase in demand for labor"

This is another easy issue, similar to the prior one above. If the public demand for the product of the labor increases, then there is an increase in demand for the labor itself. If more people want to eat McDonald's hamburgers, then there is more demand for workers to make McDonald's hamburgers.
How do we know when the demand by the public for the product of certain labor increases? When the price of the good or service produced by the labor increases. When that price goes up, then there is an increase in demand for the workers who make that good or service.

7. "the relation between hiring additional workers and the marginal cost"

This is a more challenging issue that requires two steps rather than one in order to answer correctly. Marginal cost is additional cost to a firm for making one more unit. It is measured in dollars, not in units. Making sure you have the right measure (dollars or units) for your answer will help you reduce mistakes. The answer for any question about marginal cost must be in dollars (or cents) per unit.
Accordingly, if you are told how many additional units are produced by each additional worker, then calculating the marginal cost requires dividing the cost of the additional worker by the additional number of units he produces. The more units an additional worker produces, the lower the marginal cost that results from adding that worker.
Example: suppose a firm hires Tom and sees the output increase by 20 units, and then hires Mary at the same wage and sees the output increase by 15 units. When is the marginal cost of the firm the lowest? After it hires Tom, but before it hires Mary. That's because the marginal cost of hiring Tom is his wages divided by 20, while the marginal cost of hiring Mary is the same wage divided by 15. A wage divided by 20 is less than the same wage divided by 15, so the marginal cost to the firm after hiring Tom is less than after hiring Mary.

8. "calculating overall costs (total cost and average variable cost) based on wages"

The key here is simply to be careful in doing the calculations, and then double-check your answer. You need to be sure you are using the correct level of output before you calculate the total cost (TC) and average variable cost (AVC) at that level of output. To find the total cost, add the fixed cost (FC) to the variable cost (the variable cost is usually the labor cost: total wages times the number of workers), for a given level of output. Then, to find the average variable cost, find the total variable cost (TVC=TC-FC) and divide by that level of output.
Example: a firm can produce 100 units with 5 workers and 200 units with 10 workers. Its fixed cost is $50 and its wage rate is $20 per worker. What is its total cost and average variable cost to produce 100 units?
Answer: notice first that the question asks about the costs at 100 units in output, not 200 units. Total cost at 100 units is the fixed cost ($50) plus the labor cost ($20 times 5 workers, or $100), for a total of $150. The average variable cost is the total cost ($150) minus the fixed cost ($50), divided by the output (100), for a total of $1 per unit.

Master the above eight issues, and you'll convert 10% of the exam from wrong answers to correct ones. That could enable you to earn college credit.

Review: Different Types of Markets

You instructor wonders what topic will maximize our marginal utility next. About 20% of the exam is devoted to questions about different types of markets, ranging from the most advantageous for the public (perfect competition) to the least advantageous for the public (monopoly). That's a large chunk of questions, and with some extra review here students can convert potentially wrong answers into correct ones.

The key to answering these questions correctly is to realize that the more competition there is, the lower the price of the goods and services and the lower the profits for the firms. Some of these questions are special cases and should simply be memorized: a cartel is an oligopoly that illegally agrees to fix (set) its prices, and an oligopoly is an industry where just a few firms dominate the market. When given a grid about where an oligopoly ends up selling its goods (its Nash Equilibrium), the answer is always symmetric (all firms sell at the same price) and usually not the highest price that a monopoly could sell at.

The monopoly questions look harder than they really are. The monopolist sets his price higher than marginal cost, which would be the optimal price from the standpoint of the public (or government). Instead, the monopolist price sets his price where marginal revenue equals marginal cost (MR=MC). If shown a graph, you may have to find the quantity where MR=MC, and then find the corresponding price on the demand curve. Notice that a monopolist has no supply curve, because a supply curve represents many firms in an industry and a monopolist is the only firm in the industry.

There can be general questions about these markets. A perfectly competitive market uses resources in a perfectly efficient way. At the other end of the spectrum, a monopoly uses resources the least efficiently of all. Its high pricing causes a huge social loss ("deadweight loss") by eliminating consumer surplus. The monopoly reduces output in order to cause a scarcity that increases the price to an artificially high level. This is bad for everyone, except the owner of the monopoly, who enriches himself. This is how Bill Gates became the wealthiest person in the world.

Here is a puzzle to leave you with. What is the impact on quantity of a price ceiling in a competitive industry compared to a price ceiling in a monopoly? In which one (competitive v. monopoly) might a clever price ceiling actually increase quantity? Think about it, and learn to ask yourself questions like this in order to master economics. The answer is in this footnote.[2]

Be sure to spend time on the review sections in the prior lectures for more information about this and other topics on the exams.

Review: Public Goods

A public good is a good which is nonexcludable and nondepletable. The first condition means that it is impossible to exclude consumers from partaking in the good, and the second condition means that one consumer's consumption of the good does not prevent others from consuming it.

Explained another way, a public good is available to all such that consumption by one person does not reduce its availability to others. An example of a public good is national defense, as it protects everyone and its benefits to one person do not diminish its benefits to others.

Other examples of public goods are law enforcement (protection by the police), public fireworks, clear air, street lights, radio and television transmissions, lighthouses, and some inventions. Some of these examples, such as lighthouses, are contested as to whether they must be a public good, as it is possible to charge ships port fees to pay for them. Also, while radio and television transmissions are available to all to receive them, it does cost money to buy radios and television sets, so these are not truly public goods either.

Liberals like to emphasize the concept of public goods on exams in order to support the argument for more government. Under this view public goods represent market failure and the need for government services supported by taxes.

Final Tips on Test-taking in Economics

Good test-taking techniques are particularly important to doing well on an economics exam. Simple questions are often intentionally disguised as something more complicated. It is easy to become confused and misguided in analyzing economic issues. 99% of the public would say that we would be better off if Congress put a price ceiling or cap on gasoline at $1 a gallon. It takes a bit more thought to realize that massive shortages would result, and we would all have to waste hours each week waiting in line for gasoline. Some who really need gas in hurry, such as people trying to take someone to a hospital, may not be able to obtain gas in time.

The ability to eliminate wrong answers can help. Let’s try the elimination technique on these questions:

Question: Consider the poverty-level of income for a family of four in America. Which of the following can be said about how the government defines this specific income level?

(A) It helps determine who is eligible for Social Security benefits.
(B) It decreases when there is an increase in welfare benefits.
(C) It proves that 50% of Americans live in poverty.
(D) It is determined by tripling the cost of a nutritionally adequate diet by three.
(E) Government does not adjust this number due to changes in the cost of living (inflation).

Virtually none of you would know the answer to this question at first glance. This question is not really appropriate for a "micro"-economics exam ("micro"-economics concerns individual buying and selling decisions), but CLEP asks it anyway. Questions about poverty, gaps between the rich and poor, and government programs are always favorites among liberal educators. You will see many more questions about these issues than about the invisible hand or the creation of wealth.

So what do we do when faced with this question? Simply give up? Move to the next question and hope it is easier? Blindly guess at an answer? None of the above.

We can narrow the choices, and thereby reduce our risk of error, by eliminating wrong answers. Basic economic principles (or common sense) serve as our guide.

Let’s start with choice (C). Think about it: is half of our nation living in poverty? What would that mean for elections? Who would pay to run government? If we called half of us "poor", then what word would be use for the really poor? Choice (C) can't be true. Using common sense, we can eliminate this answer.

Let’s turn to choice (E). Why wouldn’t it be adjusted? Poverty must be relative to the cost of living. If the cost of living doubled, then the numbers in poverty would increase greatly. But failure to adjust for the cost of living would miss that effect. Again, common sense leads us to eliminate this answer.

Next we can turn to choice (A). That doesn't work either, because everyone who pays into Social Security has a right to receive benefits when they grow old, regardless of whether they are rich or poor. “Social security” is not “security only if you’re poor.” We can eliminate this choice.

We’re left with only two possibilities: (B) and (D). Realize that has increased our odds of choosing the right answer to 50% now. If you took the CLEP and at least narrowed every difficult question down to two choices, then you would likely pass the test. How do we next make our best choice among these final two options?

Option (D) seems to have the right amount of detail, and fits the question well grammatically. In contrast, Option (B) does not fit the question as well or make as much sense (definition of what the poverty level is should not change based on distributing some benefits). Even if you had no idea between (B) and (D), (D) is a better fit. It’s our best guess. (D), indeed, is correct.

It helps to choose an answer that gives the most meaning to the purpose of the question. The purpose of this question is to ask about how poverty-level income is calculated. Answer (D) most directly furthers that goal. It makes for a good guess if you did not otherwise know. You won’t always be able to guess the right answers, but by increasing your chances you can significantly increase your overall score.

Let’s try one more CLEP-inspired question, this time relating to labor:

Question: Assume a perfectly competitive market for both inputs and output. If capital is fixed and the price for the output increases, then a firm in the short run will increase its production by which of the following ways:

(A) increase capital until P=MR
(B) increase labor until the value of the marginal product for workers equals the wage rate
(C) increase capital until its average product equals the price of the additional capital
(D) increase labor until its marginal product equals the wage rate
(E) increase labor until the ratio of the price of the output to labor's marginal product equals the wage rate

This type of question benefits from being reread. “Capital is fixed,” according to the question. So capital cannot be increased. Answers (A) and (C) can be eliminated that easily. Many students sometimes miss the obvious on economics exams. They fail to read and understand the question.

Only labor can be increased, which is possible under answers (B), (D) and (E). We've improved our odds of success to a 33% chance. Those are good odds on a difficult question like this. But we can improve our chances even more.

(B) and (D) look similar so let’s turn to (E) first. The “marginal product of labor” is the additional units (“product”) produced due to an additional unit of labor. Remember “MP”? The term does not include “revenue” or “price”, so it only gives you the quantity. We need to multiply that quantity by product price to obtain revenue, what the firm owner cares the most about. Choice (E) makes no sense by dividing terms that should be multiplied together. We can eliminate it.

Back to (B) and (D). The only difference between the two is the term “value of” in (B). Think about what “marginal product” is. It is a quantity, not a dollar amount. Yet we are comparing it to “wage rate,” which would be in dollars. We need to insert “value of” to convert a quantity into equivalent dollars. (B) is must be the correct choice because it compares dollars to dollars, while choice (D) does not.

The key to good test-taking, particularly on economics exams, is to make sure you fully understand each question before trying to answer it.

CLEP Exam Bias Concerning Regulation and Efficiency

There are only two or three questions (out of nearly 100) on the CLEP exam that have biased answers. They concern regulation and efficiency. You can expect to see one or two CLEP questions where the correct answer is to support government regulation against pollution. The best way to think about pollution is in terms of its "negative externality," but the CLEP exam writers cast the issue in terms of an efficient use of resources. Under this view, pollution is inefficient because it results in inefficient harm to the environment. Laws against pollution supposedly increase efficiency by preventing harm to the "resource" of the environment. These regulations that prohibit pollution cause less output but supposedly ensure a more efficient use of environmental resources.

While most of us support a cleaner environment, efficiency is usually associated with greater output, not less output. Government regulations almost never improve efficiency; the free market does that best without government interference. That said, you can pick up one or two easy points on the CLEP exam by assuming that environmental regulation increases efficiency by protecting the "resource" of the environment for its better uses.

When companies are allowed to pollute without paying for it, their marginal cost (MC) is artificially lower than it should be. These companies are avoiding the cost of their own pollution. A lower MC means they will produce more goods than if their MC were higher. The term “marginal social cost” is used by economists to represent the true cost of their activities, including the cost of their pollution. Because companies produce more than they would if they had to pay for the cost of their pollution, some consider this to be inefficient. On the CLEP exam, it takes regulation to make it efficient by preventing the companies from putting out the pollution.

You might wonder what a conservative, free market approach to reducing negative externalities (like pollution) would be. One approach would be to require full disclosure to the public by companies of their negative externalities, so that the public could stop buying the companies' products if the public were concerned about the negative externalities. This would enable the free market to solve this problem in an efficient way.

Outside the topic of government regulation on the CLEP exam, there are no biased answers. Do not choose one answer instead of another for reasons of bias except in one or two rare cases.

Other Questions Concerning Government

In areas unrelated to pollution, government establishes price floors, supports and ceilings. Do we all recall the differences? Price “ceilings” (or controls) are the easiest: the government says that the good cannot be sold for a higher price. Just as you cannot reach above your ceiling, the price is prohibited from rising above the ceiling that the government sets for it. It would be requiring gas to be sold for no more than $1.50, for example. The quantity supplied will decrease (move down the supply curve), while the quantity demanded will increase (move up the demand curve). Shortages result from price ceilings.

What is a price floor? Just the opposite of a ceiling. We cannot reach below the floor, and a price floor prevents the price from falling below a certain level. It would be a government law that prohibited milk from selling for less than $2 a gallon, for example. It would be intended to help the suppliers, such as dairy farmers. What happens when government imposes a price floor? There is a surplus of the good, as supply exceeds demand.

Now, how about a price support? That occurs when the government buys large quantities of good, such food, at prices higher than the competitive equilibrium. The government does this to “support” a higher price, instead of passing a law to require a higher price. A price support is designed to help the firms producing the goods, such as farmers. The rationale is that farmers are politically important and that pure competition is too brutal on their business and their lives, and also that foreign countries engage in the same practices. The effect of a “price support” is similar to a price floor: it creates a surplus of the good when the support is above the equilibrium price

When government regulates labor, the analysis is similar to its regulation of price. A “price floor” is created by the minimum wage: the buyer (an employer) must pay at least a certain amount for a service (labor). The minimum wage creates an oversupply of the service: too many workers. Not all of them will be able to obtain jobs at a wage higher than equilibrium. Unemployment results from a minimum wage that is higher than the equilibrium wage.

Final Comments

You have all learned a great deal of material in this course, information that will help you the rest of your lives. The insights and powerful concepts covered by this course can yield greater and greater benefits the more you think about them. Every week I see still something new and helpful in concepts taught in this course. Many students say that this is the best course they took from me, among other helpful courses. Use this course for your benefit.

If there is one unifying theme to this course, then I suggest it is summarized in Jesus's Parable of the Talents. Be productive, and God can multiply the benefits of your work. If you reach out, if you do more, if you make good use of your time, if you maximize your efficiency, if you consider the opportunity costs, and if you increase your output, then you give God more to work with. But if you bury your talents in the ground or if you are like the tree that does not bear fruit, then you give God less for His purpose.

Carpe diem. And be the good that drives out the bad as we discussed in connection with Gresham's Law.

Assignment

Read this lecture and study for the final exam, which will be the first week in June. It will be 30 multiple-choice questions, similar in format to the quizzes.

References

  1. ↑ "Austrian economics" is an approach to economics that emphasizes the free markets, minimizing governmental interference, respecting private property rights, and promoting gold as a monetary standard. Beware, however, that Austrian economics organizations are often more libertarian than conservative on social issues, and Austrian economics itself has been slow in incorporating new economic insights such as the Coase theorem.
  2. ↑ A price ceiling is a maximum price limitation, just as a real ceiling in a house limits the height. A perfectly competitive industry is already selling at its maximum output, so a price ceiling can't help there. But a monopoly increases its price by reducing its output. If a price ceiling is imposed against a monopoly, then it must reduce its price and increase its output, which benefits the public.
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