Economics Lecture Eight

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

Next week: Midterm exam, about 30 multiple choice questions. Closed book. No penalty from wrong answers (the CLEP exam has no penalty for wrong answers either).

<Add material about the meaning of the word "economy" from the Greek word for "household", and elaborate on the significance of that>

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 Do not cite the demand when determining the returns to scale.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

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

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

Easy

definitions: economics, competition, efficiency, microeconomics (the study of individual “micro” market decisions, companies, consumers)

opportunity cost

transaction cost

rational economic action P (price) & Q (quantity or output)

graphing supply and demand curves (with P on y-axis, and Q on x-axis)

supply meets demand: this defines the market price and quantity in a free, competitive market

scarcity: wants exceed free availability. Scarcity is what makes economics meaningful.

utility

net benefits

equilibrium

firm = company = supplier = seller

marginal benefit of a firm’s output decision for producing one more Q: marginal benefit is P (price it is sold at)

Law of Demand: when price goes up, then demand goes down. YOU MUST USE THIS LAW.

supply side

demand side

substitutes

complements

Medium

consumer surplus (savings by consumers who would pay more than the market price for a good)

indifference curve

fixed costs (FC) (these are costs that do not vary with a company’s output. E.g., rent payments)

variable costs (VC) (costs that do vary directly with output. E.g., fuel, labor)

average total cost (ATC) (this is all the costs divided by the quantity of output Q)

average variable costs (AVC) (total variable costs divided by the quantity of output Q)

total costs (TC = TVC + TFC)

elastic demand

inelastic demand

price elasticity of demand (percent change in quantity demanded divided by percent change in price, dropping the negative sign)

marginal cost (MC = change in total cost (TC) due to producing one more unit of output Q)

(note: total fixed costs (TFC) do not change as more is produced, thus MC = change in TVC due to one more output Q)

marginal revenue (MR)

short run (period when only some inputs are increased in order to increase output; e.g. overtime)

long run (period when any and all inputs are increased to increase output; e.g., build new stadium)

alternative definition of the “long run”: enough time to adjust all inputs in order to produce a given Q at the lowest possible cost

variable inputs (inputs that are increased to produce more Q in the short run)

fixed inputs (inputs that cannot be increased in the short run to produce more Q)

returns to scale (increasing, decreasing or constant? Look at whether output Q increases for increase in input I) Note that "economies to scale" is the same as "increasing returns to scale."

income effect

substitution effect

inferior good (a good that sees a decrease in demand when income increases, and vice-versa)

marginal product (increase in output due to additional input: Q = sum MP)

law of diminishing marginal return

perfect competition (know the conditions for it)

economic point at which firms sell their goods (where MR=MC)

accounting profit (total revenue minus explicit cost)

economic profit (total revenue minus both explicit and implicit costs)

In a perfectly competitive market ...

the increase in profit from an additional Q = P - MC

the firm increases Q only if P > MC

the optimal level of Q is where P = MC

the company stays in business in the short run at level Q only if P equals or exceeds AVC

otherwise the company changes Q until it equals or exceeds AVC

if no such Q exists then the company is better off shutting down

Honors

price discrimination

cross-elasticity of demand (percent change in demand for good X divided by percent change in price for good Y)

income elasticity of demand (percent change in demand for good X divided by percent change in income)

law of equiproportional marginal benefit

condition for reducing production (MC>MR)

condition for shutting down (P<AVC in short run or P<ATC in long run)

Coase theorem

mathematical solutions and specific calculations

Equations

At Q = 0, TC = TFC

At Q = 1, MC = TVC

At all Q > 0, AVC = TVC / Q

At all Q > 0, AFC = TFC / Q

At all Q, ATC = AVC + AFC

MC = W / MP (where W is wage per unit of labor, and labor is the only input)

TVC = sum of MC

AVC = W / AP when labor is the only input and W is the wage or cost of the labor

TFC = Q x AFC

TVC = Q x AVC

TC = Q x ATC

long run average costs (LRAC) are never more than short run average costs (SRAC) for a given Q. Why? See the alternative definition of “long run” in “Medium” list above

LRAC = P x (I / Q), where I is input and Q is output and P is price of the input

Excise Taxes and "Deadweight Loss"

<Define and explain these two concepts>

There is a sample problem about this in the last section below.

Example: Homeschool Dinner Event

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

On the “supply side”:

We established three different committees for the different tasks:

1. Selection Committee. This included choosing the location (such as a church or banquet hall), a caterer (we used a bidding process and selected a Long Valley restaurant), and a date (we chose a Thursday). 2. Presentation Committee. This included planning the evening program (designed to be informative about homeschooling) and picking an outside speaker (we chose Michael Farris at our first dinner). 3. Event Committee. This included designing and printing a written program for guests, and supervising the service of food to guests.

On the “demand side”:

Committees helped on the "demand side" also:

1. Ticket Sales Committee. This included setting the prices, marketing the event, and selling the tickets. 2. Program Sales Committee. This included seeking business, church and individual sponsors, in exchange for featuring them in the written program. 3. Door Committee (managing the door at the event itself: taking and selling tickets, collecting late payments, and making sure the customers are happy).

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

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

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

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

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

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

Perhaps you would like to show initiative and organize the next homeschool dinner! Perhaps a Christmas event?

Sample problems and answers

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

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

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

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

Would marginal cost (MC) be at its average (choice (c))? No reason to think so. Marginal cost would be higher for the first few units produced by the firm, and lower as volume increases. Most likely MC is below its average as the last unit is produced.

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

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

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

(a)
(b)
(c)
(d)
(e)

Assignment

Study for the midterm exam next week.