Summary

EC102, Fall 2013

Why Economics?
Scarcity forces Choice
Opportunity Cost is what is given up
Cost/Benefit is method
Individual wellbeing is fundamental
criterion
Self-interest is individual criterion
Individuals search for Economic Surplus

Equilibrium
A tendency not to change
Price

Only price both like is intersection

Supply

Demand

Quantity

Examples
Demand Shift
Demand for heating fuel up
now
More customers, same QS
Increasing P
Increasing Q
Along Supply Curve
Supply shift
Cost of oil up affecting
trucking
Less Supply, same QD
Increasing P
Decreasing Q
Along Demand Curve

P
P2
P1

D
Q1

Q2

Q
S

P
P2
P1

D
Q2 Q1

Price Ceiling
Rent control forces
price below
equilibrium
Does not change D or S
QD > QS
Since price mandated,
price cannot adjust
Shortage permanent

P
S

P1

D
Q1

Price Floor
Agricultural price
supports force price
above equilibrium
Does not change D or S
QS > QD
Since price mandated,
price cannot adjust
Surplus permanent

P
S

P1

D
Q1

Demand Shift Factors

Prices of Substitutes price of pens affects demand
for pencils
Prices of Complements price of speakers affects
demand for stereo receivers
Income income affects demand for expensive cars
Number of Consumers number of families in area
affects demand for housing
Preferences Fads affect demand for specific clothing
Price expectations Expected future price affects
demand for a stock
Advertising affects preferences in any market

Supply Shift Factors

Cost of inputs labor cost affects supply of
cars
Technology technological improvements
affects the supply of computer power
Weather (acts of nature) Florida freeze affects
supply of oranges
Number of suppliers Internet has increased
the number of suppliers in book market
Expectations price expectations affects
willingness of oil companies to supply oil now

Buyers (Consumers) Surplus

Demand shows value of good or service
Max price willing to pay = value
Price

Surplus is value you dont have to pay for

Supply

Pe
Demand

Qe

Quantity

Consumers pay Pe for goods and services worth more.

Sellers (Producers) Surplus

Supply shows lowest asking price
Min price willing to accept = (opportunity) cost

Sellers surplus is revenue without cost

Price

Supply

Pe

Qe

Demand
Quantity

Consumers pay Pe for goods seller would have sold for less.

Calculating Elasticity
Elasticity =
P
Change in
Price

Change in Quantity
Quantity
Change in Price
Price

Which Price and Quantity?

Pave
D
Qave

Q
Change in
Quantity

Average Price and

Quantity

Factors affecting Price Elasticity

Substitution Possibilities
Number of substitutes (shoes, many alternatives; designer
clothes, unique)
Closeness of substitutes (brands of pens, close; car vs
motorcycle, not close)
If I can easily substitute, price changes have great effect

Budget share
If I normally spend a lot on the good, I will be greatly affected by
price change=> I respond (cars vs. pencils)

Time
If I have time to respond, I can more easily change my spending
pattern

Effect of Price Elasticity

Price

Elasticity shows whether revenue goes up

or down as price changes
Revenue at higher price

30

Revenue at lower price

20

Revenue
received at
either price

MR
20

40

Quantity

Elastic Demand: MR > 0 and revenue rises with Q increase

Inelastic Demand: MR < 0 and revenue falls with Q increase

Supply Elasticity
= (% Qs) / (%P)
Measures supply responsiveness to price

Depends on
Flexibility of inputs get more from other uses
Mobility of inputs get more from other
locations
Ability to substitute other inputs
Time

Income Elasticity
Y=(% Q) / (%Y) = ( Q/Q)/( Y/Y)
Normal Goods Y > 0
Luxuries
Necessities

Y > 1
1 > Y > 0

Inferior Goods 0 > Y

Cross Price Elasticity

A,O = (%QdApples) / (%POranges)
Relationship between two goods
Substitutes A,B > 0
Complements

A,B < 0

Measures the closeness of the relationship

Ex: Which products do we put on sale?

Ans: those with A,B < 0
Less revenue on this good, but sales of other goods
added.

Cost Curves
1. Total Variable Cost (TVC) is the
sum of costs that vary with
quantity
2. Total Fixed Cost (TFC) is the
cost that does not vary with
quantity
3. Marginal Cost (MC=TC/Q) is
the addition to cost of the last
unit
4. Average Variable Cost
(AVC=TVC/Q) falls if MC < AVC
5. AVC constant if MC = AVC
6. AVC rises if MC>AVC
7. Average Fixed Cost
(AFC=TFC/Q) falls as (constant)
TFC is spread over more units
8. Average Total Cost
(ATC)=AVC+AFC
9. ATC falls if MC < ATC
10. ATC constant if MC = ATC
11. ATC rises if MC>ATC

MC Rises
due to
diminishing
marginal
product

Firm
P
MC

ATC
AVC

Qfirm

Long Run Cost

P
SATC3
SATC1

SATC2

LAC

Q
Each Short run Average Total Cost has fixed capital.
Long run Average Cost allows capital to varyno factors are fixed.
LAC is the least cost at each quantityon or below every SATC.
Only with CRS will LAC be a least cost point of an SATC.

Market Structure Summary

Competition
Monopoly
Monopolistic Competition
Kinked Demand
Price Discrimination
Game Theory

Market Structure Continuum

Red designates key issues for policy
Monopolistic
Competition

Perfect
Competition

Kinked
Demand

Oligopoly

Monopoly

Many Buyers
Many Sellers

Few Sellers One Seller

Small Sellers
Homogeneous
Product

Large Sellers Large Seller

Unique
Product

Some
Differentiation

Some
Barriers

Free Entry
& Exit

Strong
Barriers

Perfect Information
Price Taker

Price Searcher

Impersonal
Competition
LR = 0

Personal
Competition

My
Market
LR > 0

Perfect Competition

1.Many Small Buyers

2.Many Small Sellers

3.Homogeneous product

RESULT

No market power on the buying side

Many alternative vendors
No product loyalty (very elastic)
EXTREMELY ELASTIC DEMAND
Price Taker (takes price as given)

Profits will induce entry

4.No Barriers to Entry
Losses will induce exit
Zero economic profit in Long Run
No mis-steaks (oops, no mistakes)
5.Perfect Information
IMPLICATION: FIRM and MARKET graphs needed

Market and Firm :

Competitive Industry/Market
Long Run Equilibrium
Market
P

Firm
P

MC
ATC
P=Dfirm=MRfirm

P1

AVC

Q1

Qfirm

Competitive Market and Firm:

Effect of a Demand Increase
Market

Firm

P2

MC

P2

ATC
P=Dfirm=MRfirm

P1

AVC
D1
Q1

Q2

D increase
Industry P and Q increase
Firms Demand (P) Rises

Qfirm
MC = P2 => Qfirm rises
Profit () = (P-ATC) x Q rises
Creates incentive for entry of new firms

Competitive Market and Firm:

Effect of a Demand Decrease
Market
P

Firm
P

MC
ATC
P=Dfirm=MRfirm

P1
D1

AVC
TVC

Q2 Q
1
D decrease
Industry P and Q decrease
Firms Demand (P) Falls

Q2 firm

Q1 firm

Qfirm

MC = P2 => Qfirm falls

Profit () = (P-ATC) x Q falls (< 0)
Creates incentive for exit of new firms

Monopoly
1. Many Small Buyers

2. One Seller
3. Unique product

RESULT

No market power on the buying side

No alternative vendors
No close substitutes
LESS ELASTIC DEMAND
Price Setter (must choose price)

4. Barriers to Entry Profits will not induce entry

Losses will not induce exit
No mis-steaks (oops, no mistakes)

5. Perfect Information
IMPLICATION: FIRM IS MARKET (one graph)

Profit Maximization for

Monopolistic firm
Monopoly
Qfirm based on MR = MC
P

P1 => max, given Qfirm

TR = P1 x Qfirm
Notice: P and Q set using only marginals

MC
P1

ATC
AVC

ATC1
AVC1

ATC1, given Qfirm

AVC1, given Qfirm

MR

Qfirm

D
Q

TVC = AVC1 x Qfirm

TFC = (ATC1 - AVC1) x Qfirm
(profit)= (P1 ATC1) x Qfirm

Because of barriers to entry, these profits can persist.

Monopoly Cost Problem

Quantity

Fixed Variable
Cost

Cost

Total Average Average Average Marginal

Cost

Fixed Variable
Cost

100

Cost

Total

Price

Cost

Total Marginal
Revenue Revenue

300

100

Profit

5
4

100

1200
2

400

Profit

Cost

1
200

Total Marginal

-2

Monopoly with a Loss

Still wanting to Produce
Monopoly
Graph
Hyperlink

MC
ATC
ATC1
P1

Try:
Demand
Shift = 0
= - 400
= - 700

AVC

MR
Qfirm

D
Q

Monopoly with a Loss

Wanting to Shut Down

MC
ATC1

ATC
AVC

P1
MR
Qfirm

D
Q

Effect of Monopoly on Efficiency

Monopoly
Qfirm based on MR = MC
P
MC
P1

P1 => max, given Qfirm

Notice: P and Q set using only marginals
P1 is value of last unit sold
MC @ Qfirm is the cost of the last unit sold.

MR

Qfirm

P>MC @ Qfirm so society loses this surplus

As long as P>MC, surplus exists
Lost surplus is the triangle

Q
Dead Weight Loss

Notice that Setting P=MC (competitive result) will cause no lost surplus

Natural Monopoly
The key issue is the size of the firm
relative to the market.

P
LMC
Pre
ATC1

Economies of Scale are

significant
LAC

MR
Qfirm

QReg

Demand is such that only one

firm has room to be profitable.

D
Q

Profits would occur without regulation

Profits would attract entry => both firms would lose money
Rate regulations gives exclusive right to one firm, keeps price down,
Increases Q,

& assures

Intermediate Market Structures

Monopolistic Competition
No Buyer market power
Many Small Buyers
Many alternative vendors
Many Small Sellers
Non-homogeneous product Some product loyalty
ELASTIC DEMAND
RESULT

Price Setter (must choose price)

Free Entry & Exit

Profits will induce entry

Losses will induce exit
Long Run Profit = 0

RESULT

No mis-steaks (oops, no mistakes)

Perfect Information
IMPLICATION: FIRM and MARKET graphs needed

Monopolistic Competition
Industry
P

Firm
P

Relatively elastic demand

MC
P1

P1

ATC
D

Q1

AVC
Q

Like competition, you need two graphs.

Like Competition, Price set where QS=QD

Q1 firm

MR
Qfirm

Like Monopoly, D is downward sloping

MR<P MR steeper than demand (2x)
Like Monopoly, Set Qfirm where MR=MC
Set Price at max P given Qfirm (on D)
P>ATC Entry (or P<ATC Exit)

Intermediate Market Structures

Kinked Demand
Many Small Buyers
Few Sellers
Non-homogeneous product
RESULT

No Buyer market power

Know competitors, known response
Some product loyalty
Competitors respond to each other
Price Setter (must choose price)
Some Parallel behavior
Demand different for P up than P down

Some Barriers

Profits may induce entry

Losses may induce exit

Perfect Information

No mis-steaks (oops, no mistakes)

IMPLICATION: FIRM P & Q invariate to small MC changes

Intermediate Market Structure:

The Kinked Demand Curve
Behavioral Assumptions
1. Competitors do not
match price increases
- Elastic demand
for P increases
2.Competitors do match
price decreases
- Inelastic demand
for P decreases
Implication: Price stability and
same across competitors
Example: gas stations at a corner

P1
Dinc

MRdec
Q1

Ddec

MRinc
Qfirm

Price Discrimination

Allowing more than one price

Drop price for new customers only
Necessary conditions:
1. Separable Groups of consumers
2. Different price elasticities for groups

Example:
. Kids prices in movies (under 12)

Under 12 are small, hence distinguishable

They have less money, other alternatives (price elastic)

Price Discrimination: Movies

Adults

Kids
P

Lower maximum price

Kids are distinguishable

PAdults

Demand more elastic

PKids
MC
MR
QAdults

MR
Q

QKids

Construct MR (MR <P) for each segment in same way as monopoly

Assume constant Marginal Cost for simplicity.
Find Qfirm as we always do => MC = MR for each section of market
Set Price based upon Qfirm and the relevant demand curves.
Notice: PAdults > PKids because adult Demand less elastic

Game Theory
Players
Actors effected by their own actions and those of others
I think that you think that I think
What opponent does affects the values of alternative actions

Strategies
Depends upon dynamics of market
Is decision making sequential or simultaneous?
Is decision making repeated?
Is learning possible?

Payoffs
May be monetary
Need to quantify

How Game Theory works

Deals with personal competition
Small number of competitors, learn others patterns
Own actions affect others actions, affecting strategy

Individual chooses best expected payoff

Factor in opponents strategy
Factor in importance of gain and loss
Factor in past and potential future impact

Nash Equilibrium
no incentive to change given competitors strategy

GAME THEORY
Two Nash equilibria
Firm B
Advertise Dont Advertise .
Advertise |
2
|
4
|
|
2
|
10
|
|--------------------------|---------------------------|
Firm A
Dont Advertise |
10 |
8 |
|
4
|
8
|
If firm A Advertises, Firm Bs best strategy is to not advertise
If firm A Does not advertise, Firm Bs best strategy is to Advertise
Firm A has the same incentives as Firm B
There are two Nash Equilibria:
Any cell with two arrow coming in is a Nash Equilibrium
Both Nash Equilibria have one firm advertising and the other not

GAME THEORY
Prisoners Dilemma
Firm B
Advertise Dont Advertise
Advertise |
4 |
2
|
|
4
|
10
|
Firm A |--------------------------|---------------------------|
Dont Advertise
|
10 |
8 |
|
2
|
8
|
If firm A Advertises, Firm Bs best strategy is to advertise
If firm A Does not advertise, Firm Bs best strategy is to Advertise
Firm A has the same incentives.
Only one Nash Equilibrium exists:
Both advertise, even though this costs them

Current Value of Future Money

Present Value (PV) (r is interest rate)
I could get (1+r) next year if I loaned $
Dollar next year worth 1/(1+r) today
Dollar 3 years from now worth $/(1+r)3 today
(discounted three years)

Example:
PV of $1,060 next year @ 6%
1060
(1+.06)

=$1,000

PV of $121 two years from now @10%

121____
(1+0.1)(1+0.1)

121__
(1.1)(1.1)

=100

Externalities Definitions
External cost
Cost incurred by a 3rd party
Negative effects on uninvolved parties

External benefit
Benefit received by 3rd party
Positive effects on uninvolved parties

Externality
Effect (+/-) on non-actors

Effect of a Negative Externality

Private market would
choose
Q = 50
P = 50

With each unit causing a

$20 external cost
Increases cost to 70
Society would prefer
Q = 40
P = 60

Deadweight loss is
.5 x $20 x 10 units= $100
Area of triangle w/ corner
@ P = 60, edge Q=50
Due to excess units

Positive Externalities
(External Benefits) Graphically
Demand and Supply measure benefit and
cost for the parties to the transaction

External Benefit

If other people benefit, total benefit is greater than

the private benefit shown on the demand curve (D)

P
S

This additional benefit can be shown by

constructing a 2nd (total benefit) demand curve

P2
P1

With external benefits, total value

exceeds private value
D
Q1 Q2

D, including external benefit

Total value calls for Q2
Q

Private decisions lead to Q1

External benefits lead to lost surplus due to underproduction

Dead weight loss: Society benefit minus society cost
between Q where society is best off and private profit maximum Q.

Coase Theorem
If,
at no cost,
people can negotiate the purchase or sale of the right
to perform activities that cause externalities,
they can always arrive at efficient solutions to the
problems caused by externalities

Example:
Your roommate and you have different preferences
with respect to music
A negotiated sharing arrangement is efficient
I get my music in return for you getting yours

Solutions to externalities
Laws affecting behavior
Traffic laws (limits external costs)
Zoning restrictions (+/- externalities)
Environmental Protection Administration (EPA)
(limits external costs)
Free Speech laws (+/- externalities)
Subsidizing purchase of non-polluting autos
(limits negative externalities)
Cap and Trade (in Europe and proposed here)

Public Goods
Some Definitions
Non-rival good
Ones consumption does not diminish anothers
ability to consume it
Ex. A national park

Non-excludable good
Difficult or costly to stop non-payers from
consuming
Ex. A pretty vista

Public Good non-rival and non-excludable

Public , Private and Hybrid goods

Most goods rival & excludable My consumption uses it up.
Goods with low excludability tend to be over-consumed
Non-rival, non-excludable goods are public goods, under-funded privately
Non-rival, excludable goods can be dealt with privately.
Rival

Low

Low

Commons good
Shared French Fries

Public Good
National defense

High

High

Private Good
Apples

Collective Good
Cable TV

Excludability

Incidence of a Tax
Who physically pays the tax is not issue
Who has less value due to the tax is issue
If the demander is willing to pay a lot of
the tax (has LOW price elasticity),
consumer pays most of the tax
If supplier really wants to sell the product
(low supply elasticity), seller pays most of
the tax.

Effect of a Tax
on Efficiency

Tax

Added cost to Demander

Seller does not get to keep.
Seller keeps Price; Demander pays Price +
Tax.
Lower S is supplier,
Upper S faces Demander.
S + tax

Tax
Revenue

Consumer Surplus
P
S

Tax

P2+tx

Consumer Pays

Producer
Surplus

P1
P2

Producer Pays

D
Q2

Q1

Units not produced

are more valuable
than their cost.
That is, lost benefit
without saved cost.
Deadweight
Loss
Issues with tax:
1. Who pays?
Supplier (gets less)
Demander (pays more)
2. Dead Weight Loss.

Demand for Labor

The added worker adds their Marginal Product
to output
MPL = Q / L
This Q adds Q x MR to revenue
Thus the value of the worker is
MR x MPL (= Marginal Revenue Product)
If the output market is competitive
MR = P => MRP = Value of MP = P x MPL

Hire as long as MRP Wage

Shift Factors in the Labor Market

Demand
Technology
Available cooperating resources
Customer (of the product) demand

Supply
Number of potential workers
Skills
Preferences
Opportunity costs are key

Earnings Differentials
Human Capital
With more skills, MPL rises
Education, work habits, experience, etc.

Unions
Affect alternatives available to employer
Restrict supply of labor
Force wages in non-union sector down
Union
W

Non-Union
S
D
L

S
D
L

Discrimination
Employer
Arbitrary preference by employer for one group
Affects profit differentials will decay with competition

Employees
Again affects profits will erode

Customers
Affects future supply and demand

Socialization
Male/Female roles
Aggression/non-aggression

Differentials will accumulate

Consumer Surplus
Producer Surplus

Minimum Wage

Dead Weight Loss

W

SL
Wmin

W1

DL

L1