1
Q
Fundamental Nature of Economics
A
- Use of scarce resources to satisfy unlimited human wants
2
Q
Resources
A
- Land (natural endowments)
- Labour (mental + physical human efforts)
- Physical capital (tools, machinery, equipment)
- Human capital (stock of skills + knowledge we’ve acquired by investing in ourselves through education + training)
3
Q
Final Goods vs Intermediate Goods
A
- Final goods: consumption creates satisfaction (utility)
- Intermediate goods: help to produce what we consume. Satisfaction (utility) not from their direct consumption, but from consumption of final goods they produce
- Ex/ a t-shirt is a final good, cotton is an intermediate
4
Q
Tangibles vs Intangibles
A
- Tangibles: what we can touch or feel (ex/clothing)
- Intangibles: services. can’t physically tough yet give satisfaction (hairdresser service)
5
Q
Scarcity implies…
A
- Choice. this creates opportunity cost
6
Q
Opportunity Cost
A
- Benefit forfeited by not putting those same resources to their next-best alternative use. Something is scarce when it has a positive opportunity cost
7
Q
Goods vs Bads
A
- Goods: increase our satisfaction - positive utility
- Bads: reduce satisfaction - negative utility. Like pollution, which is a byproduct of goods we produce to give utility. To get a positive, we create a negative. But bad have opp costs too - not creating bads means creating fewer goods. And removing bads uses resources that could otherwise have produced goods
8
Q
Production Possibilities Boundary (PPB)
A
- Illustrates scarcity, choice + opp cost (represented by negative slope)
9
Q
Effect of Economic Growth on PPB
A
- Growth in productive capacity shifts PPB outward so that previously unattainable points become attainable
10
Q
Concepts Illustrated by PPB
A
- On boundary, factors of production are fully employed
- In boundary, there is unemployment of some factors
- Choice involves marginal decisions - not all-or-nothing
- PPB is concave to origin - not all resources equally adaptable to production of all goods
11
Q
Implication of Unequal Adaptability
A
- Resources aren’t equally productive in all areas
- Make best use of time by specializing in areas of comparative advantage + trading output among us for consumption
12
Q
Implications of Specializing in Areas of Comparative Advantage
A
- A country cannot produce outside its PPB, but can consume outside its PPB
- Reflects division of labour within our econ which increases productivity (increases total output from same amount of input)
13
Q
Why does money facilitate trade?
A
- B/c it eliminates need for “mutual coincidence of wants”
14
Q
What does a point on the PPB show?
A
- How much is consumed, but not how consumption is distributed
15
Q
Nature of Market Economies
A
- Comes from large # of consumers + producers who make decisions + act independently for own self-interests who will coordinate econ’s allocation of resources + determine production + consumption of many dif goods + services
16
Q
Adam Smith’s Theory
A
- Self-interest, not benevolence, is foundation of econ order
- Everyone following their own self interest creates an invisible hand that coordinates free-market econs
17
Q
Incentives + Self-Interest
A
- Through selfish response to incentives, econ agents seek to max their utility (consumers) + profit (producers)
- Actual quantities + prices of G+S are coordinated results of choices made by individualized self-interest econ agents aimed at maxing their own utility
- Responses to incentives are marginal decisions
18
Q
Globalization
A
- Increased importance of international trade
- 2 major factors are reduction in transportation costs + IT
19
Q
Protectionism
A
- Bad for trade, especially for smaller countries that need access to larger markets
- Reduces globalization
20
Q
Mixed Economies
A
- Mostly organized by price mechanism (invisible hand) in private sector w/gov’t intervention (public sector) affecting outcome
- Degree of gov’t intervention is highly variable
21
Q
Normative Statements
A
- Depend on value judgments + opinions - can’t be proven by facts
22
Q
Positive Statements
A
- Don’t involve value judgment - statements about what is, was, or will be. Need not be testable in practice
23
Q
Why do economists disagree in public discussions?
A
- Different comparison points
- Short term vs long term
- Media showing opposite extremes
- Don’t want to admit full state of their ignorance
- Not differentiating between positive vs normative
24
Q
Probability + Law of Large #s
A
- Predict behaviour of average individual
- Irregularities in individual behaviour among many ppl offset each other, leaving just the regularities. Theory tries to explain/predict regularities
25
Positive Correlation
- X + Y move together
26
Negative Correlation
- X + Y move in opposite directions
27
Correlation vs Causation
- Correlation not same as causal relationship!
| - Most econ predictions based on causality
28
Index Numbers
- Compare changes relative to some base period
- Value of index in given period = (absolute value in given period/absolute value in base period) x 100
- Value = 100 in base period (select a year)
29
Consumer Price Index (CPI)
- Time series index of inflation
- Looks at changes in cost of many G + S combined
- Ave family's change in spending on dif G+S can be b/c of changes in P or Q or both
- To isolate changes in P's, study cost of same basket of G+S consumed by ave household - basket of base year
30
Quantity Demanded
- Total that consumers desire to purchase/t
- Q bought (exchanged) is an actual purchase
- Qd is a flow, not a stock
31
What determines Qd?
- Qd is the dependent (endogenous) variable
- Main independent (exogenous) variables in demand f(x) are product's own price (negatively related), price of other goods (subs (positively related), complements (negatively related), independent goods (unrelated)), ave household income (normal goods (positively related), inferior goods (negatively related), no relationship), preferences, expectations about future prices, population (# of demanders), weather)
32
How are P and Qd related?
- Negatively because of opp cost + purchasing power.
- When P falls, relative price and opposite cost falls so Qd goes up. Purchasing power goes up, all goods "more affordable" including this one. Qd rises if normal good, falls if inferior good
33
What shifts the D curve?
- A change in variables other than price.
- Like ave household income, P of other products, pop, expectations about future, etc
- Rightward shift = increase in demand. Leftward = decrease in demand
34
Difference Between Shift of Entire D Curve vs Movement Along D Curve
- Change in demand is shift of entire curve
| - Change in Qd is movement along curve
35
Quantity Supplied
- Q of product firms desire to sell in some time period. Qs is what firms want to offer to sale - not what is necessarily sold
- Qs is a flow per time period, not a stock
36
What determines Qs?
- Qs is dependent (endogenous) variable
- Independent (exogenous) variables are product's own price, price of inputs (negatively related), technology (usually positively related), taxes + subsidies, expectations (either positively or negatively related), weather, # of suppliers (positively related)
37
Quantity Supplied + Price
- Positively related b/c producers want to make profits
| - If P of product increases, its production + sale is more profitable
38
Difference Between Movement Along S Curve vs Shift of Entire S Curve
- Change in price causes movement along S curve
| - Change in independent variables (price of inputs, tech, expectations, # of suppliers), will shift entire curve
39
Concept of a Market
- Buyers + sellers negotiate exchange of a G or S
- Differences in degree of competition among various buyers + sellers
- In perfectly competitive market both buyers + sellers are price takers
40
What happens to buyers + sellers at equilibrium price?
- Every buyer finds a seller + every seller finds a buyer - the market clears
41
Effects of Change in Demand on Equilibrium P and Q
- Increase in D causes increase in equilibrium P + Q
| - Decrease in D causes decrease in equilibrium P + Q
42
Effects of Change in Supply on Equilibrium P and Q
- Increase in S causes decrease in equilibrium P + increase in equilibrium Q
- Decrease in S causes increase in equilibrium P + decrease in equilibrium Q
43
For each side of the market are Q and P endogenous or exogenous?
- Q is endogenous, P is exogenous
| - In market as a whole, both P and Q are endogenous
44
Causal Equations
- Qd = a -bPd
- Qs = c + dPs
- At equilibrium, Pd = Ps = P* and Qd = Qs = Q*
45
Joint Production Linkages
- Occurs when 1 product is 'by-product' of another
46
Linkages Through Resource Constraints
- Resources not available in unlimited quantities - they're scarce
- Change in amount of resource used in 1 activity will reduce amount available for other activities
47
Definition of Demand Elastic and Inelastic
- Elastic when Qd is very responsive to changes in own price
- Inelastic when Qd very unresponsive to change in its price
- Related to slope of demand curve - but not exactly the same
48
Measurement of Price Elasticity
- Elasticity (n) = percentage change in quantity demanded/percentage change in price
- n = (delta Qd/Qd)/(delta p/p)
- # is negative due to inverse relationship between Q and P but price elasticity uses positive value
49
What happens to elasticity as you move down a linear demand curve?
- Falls as you move down linear demand curve
| - Perfectly elastic at top, elastic at n>1, unit elastic at n = 1, inelastic if n < 1, perfectly elastic at n = 0
50
What happens to total expenditure when demand is elastic versus inelastic?
- Elastic: TE rises when P falls. Rise in %Q > fall in %Q
| - Inelastic: TE falls when P falls. Rise in %Q < fall in %P
51
When is TE at its maximum?
- When D is unitary elastic and TE is unchanged for small changes around that max
- Rise in %Q = fall in %P
52
What happens to demand elasticity when there are many close substitutes?
- Demand elasticity high
| - A demander's desire to sub influenced by share of income spent on good
53
What is availability of substitutes determined by?
- Length of time interval considered
- Whether the good is a necessity vs a luxury
- How specifically the product is defined
54
Short-Run and Long-Run Equilibrium Following an Increase in Supply
- LR demand curve more elastic than SR demand curve
- Drop in P from Po to Ps in SR changes relative price of this good to other goods
- Speed of move from Short to Dlong and PS to PL depends on consumers' response time to initial change in relative prices
55
Definition of Price Elasticity of Supply
- Measures responsiveness of quantity supplied to change in product's own price
- % change in Qs/% change in price
56
Determinants of Supply Elasticity
- Depends on how easily firms can increase output in response to increase in product's price
- Depends on technical ease of sub in production, time span under consideration + nature of production costs
57
Excise Tax
- Absolute $ amount, not %
- Raises price paid by consumers + reduces price received by producers
- Burden of tax refers to its price incidence
- Incidence on consumers: (Pc-Po) as %v of tax
- Incidence on producers: (Po - Ps) as % of tax
- Delta Pc + delta Ps = T
58
What does the burden of the excise tax depend on?
- Relative elasticities of demand + supply
| - Less elastic demand relative to supply = greater incidence of tax on consumers + less on suppliers
59
Calculating Tax Incidence
- Delta Pd/T = (1/b)/((1/b)+(1/d))
| - Delta Ps/T = (1/d)/((1/b)+(1/d))
60
What does effect on equilibrium quantity/$ of tax depend on?
- Sum of slopes (not relative slopes)
| - Delta Q/T = 1/((1/b)+(1/d))
61
Definition of Income Elasticity of Demand
- % change in Qd/% change in income
- If n > 0, normal good (increase in income = increased D for good)
- If n < 0, inferior good (increase in income = decreased demand for good)
- If n = 0, D for good is insensitive to incomes
62
Impact of Income Elasticity on Demand Curve
- Bigger income elasticity = more sensitive D to changes in income = bigger shift in D curve
- Increase in income = shift in D curve to right for normal good, shift to left for inferior good
63
Income Elasticity in Terms of Luxury and Necessities
- More necessary item = less sensitive D to change in income = lower income elasticity
- Income elasticities can vary w/level of income
64
Definition of Cross Elasticity of Demand
- % change in Qd of good X/% change in price of good Y
- If n>0, X and Y are subs (rise in Py increases demand for X)
- If n<0, X and Y are complements (rise in Py reduces demand for X)
65
Effect of Disequilibrium Prices
- If P set above equilibrium (price floor), some sellers unable to find buyers
- If P set below equilibrium (price ceiling), some buyers unable to find sellers
- W/administered prices, quantity sold is lesser of Qd and supply
66
Price Floors
- Prevent price from falling below specified level
- Binding P floor must be above free-market equilibrium P
- Effects on consumer spending on good depends on its elasticity of demand
- Creates incentive for black market (goods sold at illegal prices)
67
Price Ceilings
- Max P that product can be sold
| - Binding P ceiling set below free-market equilibrium price
68
Government's Objectives in Imposing a Price Ceiling
- Restrict production
- Keep specific prices down
- Satisfy (normative) notions of equity
69
Allocation Mechanisms of Excess Demand
- First come, first serve
- Sellers preferences (discrimination)
- Rationing in consumption or production (via quotas)
- Higher prices via scalping + black markets
70
Black Market Pricing
- Black market: goods sold at Ps above legal max
| - May work against gov't objectives
71
First Generation Rent Controls
- Fixed price controls
72
Second Generation Rent Controls
- Regulated rents - allow rent to increase to:
1) Cover increases costs of maintenance
2) Keep pace w/overall P level rises to prevent relative Ps between subsidized rental units + other sub dwelling types becoming undesirably large when tenants change (increases need for 'security of tenure' legislation)
73
Predicted Effects of Rent Controls
- Persistent housing shortage (excess D), which can't legally be eliminated by market forces so other allocation methods on both D and S sides of market take over
74
Supply Side Allocation of Rentals Methods
- Reduce quantity of available low-rent housing units + convert to condos
- Reduce average quality of those remaining, potentially violating legal quality + safety standards (poor maintenance, basement apartments)
75
Demand Side Allocation of Rentals Methods
- Bribery - payments to those who control entry + payments to other tenants ("key money" to recommend prospective tenants so they can "jump the queue")
- Allocation by seller's preferences (discrimination by race, gender, religion, single parents)
- Rush to "get there first"
76
General Analysis of Rental Controls
- Housing is durable good: elasticity of supply increases w/time
- Inelastic supply in SR, causing relatively small fall in Qs when regulation initiated
- Excess demand caused by increase in Qd
- More supply in LR w/fall in Qs adding to excess D
- As time passes + excess D rises, allocation probs get worse. Quantity falls more, quality deteriorates more. Ppl in controlled apartments less likely to leave as their income rises: creates even bigger shortage for low-income fans. Controls become more difficult to abolish - bigger reduction in supply = bigger short-term jump in price on abolition
77
Who gains and who loses in rent controls?
- Existing tenants in rent-controlled apartments gain unless quality deteriorates
- Landlords lose
- Potential future tenants lose - can't find apartments, poorer quality, black market prices, longer search time
78
Policy Alternatives to Rental Controls
- Reduce housing shortages by gov't subsidies to builders or public housing
- Provide lower-income households w/income assistance
79
Import Duties and Tariffs
- By raising P of imported goods, these increase D for domestically-produced subs + domestic market P
- Issues: violate international agreements among countries to reduce tariffs + causes retaliation by other countries
80
Output Quotas
- Reduce supply + increase price to consumers
- If D inelastic, lower output at higher prices increases consumer spending on good
- Which generation is affected tho? Holder of a quota has "alienable property right" to quota, so owner can sell it on open market + keep revenues. Becomes expensive "barrier to entry"
- Must be accompanied by import quotas/tariffs to control domestic P + availability
- Wasted resources when produce in excess of allowable quotas
81
Government Guarantees to Purchase at Price Higher Than Competitive Market Equilibrium Price
- Gov't guarantees price at Pmin: effective D curve facing producers becomes horizontal (perfectly elastic) once price falls to Pmin. Since producers are guaranteed this price by gov't, they won't sell to consumers below this price
- Qs is produced but only Qd sold to consumers, gov't purchases dif. Cost is (Qs-Qd)*Pmin
- If demand inelastic, consumers buy less but spend more on it
82
What can governments do with what they buy when they purchase at price higher than competitive market equilibrium?
- Sell below cost at home
- Sell abroad below costs of production
- Give as foreign aid
- Take it out to sea in barges + tip overboard
83
Price Support for Producers - Government Pays Difference Between Sale Price and Guaranteed Price
- Qs(Pprod - Pcons) paid by gov't (financed by taxpayers)
- W/inelastic demand, consumers buy more good but spend less money on it
- All output consumed, so less wasteful than previous policy. But still opp cost + deadweight loss to society
84
Demand as Value and Supply as Cost
- At given Q:
1) P read from D curve shows highest P consumers willing to pay for that Qd - value of that last unit to consumers
2) P read from S curve shows lowest price firms willing to accept for that Qs - reflects extra cost of producing last unit
85
Economic Surplus and Market Efficiency
- Consumer surplus + producer surplus = total economic surplus
- At competitive equilibrium, output market is "efficient"
86
Why is competitive market equilibrium the most efficient?
- B/c it maxes econ surplus
- There are exceptions where competitive equilibrium doesn't max econ surplus of society as a whole
- Society may have preferences other than efficiency
87
Utility
- Satisfaction consumer receives from consuming some good/service
88
Total Utility
- Consumer's total satisfaction resulting from consumption of given product
89
Marginal Utility
- Additional satisfaction obtained from consuming each additional unit of a product
90
Diminishing Marginal Utility
- MU falls as total consumption of product increases
91
If marginal utility is positive, is total utility rising or falling?
- Rising: whether MU is rising or falling or constant
92
Relationship Between Marginal Utility and Price of Compared Goods
- MUx/MUy > Px/Py
- Extra utility/$ spent on X> extra utility/$ spent on Y
- Can increase TU by buying more X + less Y - continue adjusting until reach equality
- Stop adjusting when MUx/MUy = Px/Py
93
Why do ratios change to get from inequality to equality in the relationship between marginal utility and price of compared goods?
- Diminishing MU
- As more X consumed, MUx falls
- As less Y consumed, MUy rises
94
Utility Maximum Condition
- MUs from last (or next) $ spent on each good are equal
95
How to Derive the Consumer's Demand Curve
- Start at U-max consumption combo + increase Px. Previous consumption combo is no longer U-max combo: ratio becomes MUx/MUy = Px/Py
- Opp cost of X rises - consumer reduces consumption of X + increases consumption of Y (a sub)
- Reducing Q of X raises its MUx, increasing Q of Y lowers its MUy. Both increase ratio of MUx/MUy
- Negative relationship between P + Q
96
Market Demand Curves
- Market demand curve = horizontal summation of all individuals' demand curves for the good
- Since U-max condition holds on each individual's D curve, it also holds on summation of them (on market D curve)
97
The Two Effects of Changing the Price of a Good
- Changes relative prices
| - Changes consumer's purchasing power
98
Substitution Effect
- Response to change in relative prices
- Increases Qd of good whose relative price has fallen, decreases Qd of good whose relative price has increased due to opp cost
99
Income Effect
- Response to change in purchasing power (caused by change in good's own price)
- For fall in P of X, IE increases D for X if it's normal + decreases D for X if it's inferior of a good whose relative P has increased
100
How do the substitution and income effects of a change in the good's own price put pressure on the demand for that good?
- In the same direction for normal goods
| - In opposite directions for inferior goods
101
Giffen Good
- Inferior good that accounts for large share of household spending + has no close subs
102
Conspicuous Consumption Good
- "Look-at-me" effect
| - Service being purchased is "look-at-me" effect, object being purchased is merely vehicle conveying the service
103
Backward-Bending Individual Labour Supply Curve
- Leisure is normal good: wage rate is opp cost of leisure. If wage rate rises:
1) Sub effect: increase in opp cost of leisure time causes sub toward work + away from leisure
2) IE: resulting increase in purchasing power increases D for normal goods including leisure
- But market supply curve of labour curve still upward-sloping b/c more ppl enter market as wages rise
104
Paradox of Value
- Water is inexpensive but invaluable to life, diamonds expensive but unnecessary
- Not really a paradox: expenditure on entire amount bought reflects total value + price reflects marginal value of last unit
- Since market P depends on demand + supply, no paradox in having a product w/high total value (water) but low marginal value since it's abundant - large supply causes low price
105
Two Key Assumptions Regarding Firms
- They're profit-maximizers
- Each firm assumed to be a single, consistent decision-making unit
- Based on these assumptions, economists can predict behaviour of firms in various situations
106
Four Types of Input for Production
1) intermediate products
2) Inputs provided directly by nature
3) Inputs provided directly by ppl, like labour services
4) Inputs provided by services of physical capital (machines)
107
Production Function
- Tech relationship between inputs + outputs
- q = f(L,K)
- Variables are flows: units/time period
108
Time Horizons for Decision Making
- Short run: some of firm's production factors fixed (like capital)
- Long run: all firm's factors of production can be varied but not tech
- Very long run: all firm's production factors and tech can be varied
109
Law of Diminishing Returns
- As more L added to fixed K, specialization of tasks causes MPL to rise - but eventually w/fixed K, MPL likely to fall
110
Total, Average and Marginal Products
- Total product = total Q output produced during given time period
- Average product = TP/L
- L = variable factor (usually labour)
- Marginal product = delta TP/delta L. Slope of TP curve
111
Average Marginal Product Relationship
- If extra worker has MP>AP, AP rises
| - AP curve negatively sloped when MP
112
Profit-Maximizing Output
- Notation: econ profit = pi
| - pi = TR - TC
113
Costs and Profits
- Both implicit + explicit costs
- Unlike accounting def, econ profit includes implicit opp cost of owner's time + capital in firm's costs
- Econ profits < accounting profits
- If econ profit +, earning more than in next best alternative use
114
Defining Short-Run Costs
- Total cost = total fixed cost + total variable cost
- Average total cost = average fixed cost + average variable cost
- MC is increase in TC resulting from increasing output by 1 unit: MC = delta TC/delta Q
- W/constant fixed cost in SR, any change in TC caused by changes in variable cost
115
Short-Run Cost Curves
- TC = TVC + TFC
- AFC declines steadily as output rises - spreading overhead
- Shape of ATC curve:
1) Falling AFC pushes down ATC
2) Rising MC (AVC) pushes up ATC
3) 2nd effect overcomes 1st effect + ATC begins to rise
116
Why are MC and AVC Curves U-shaped?
- Each extra worker adds same TC but dif amount to total output
- Eventually, diminishing AP of variable factor causes rising AVC: AVC at min when AP at max
- Eventually, diminishing MP of variable factor causes rising MC: MC at max when MP at min
117
Capacity
- Output at min SR ATC is capacity of firm
- Capacity is most that can be produced/time period w/out hitting rising average cost
- When Q
118
Shifts in Short-Run Cost Curves
- Change in P of any variable input shifts ATC + MC curves: upward for P increase + downward for P decrease
- Dif SR cost curve for each given quantity of fixed factor
119
Increase in Fixed Costs Only
- Increases AFC at each Q, so increases ATC
| - MC curve doesn't change
120
Technical + Economic Efficiency
- Tech efficiency: to produce any given level of output, can't use smaller quantity of 1 factor w/out using more of another. Focus on quantities of inputs ignores diffs in costs of inputs
- Econ efficiency: for given level of output, can't produce w/smaller $ value of inputs. W/any given set of factor prices, can be many technically efficient combos of inputs but only 1 economically efficient combo
121
Profit Maximization and Cost Minimization
- Maxing profits requires firms to produce output level where MC = MR + choose their inputs to minimize TCs of producing that output
- Costs minimized when MPk/MPL = Pk/PL
- MPs set by production f(x). Ps set by market
- Principle of sub: firms adjust quantities of factors in response to changes in relative factor prices
122
What if firm is at capital/labour ratio such that MPK/MPL < Pk/PL?
- Extra output/marginal $ spent on labour exceeds extra output/marginal dollar spent on capital
- If firm spends $100 more on labour + gain 20 units of output or spends $120 less on capital + loses 20 units of output, no change in total output but cost reduction of $20. Inequality adjusts b/c as firm hires more labour, MPL falls + as it hires less capital, MPK rises
123
How does new and more productive technology affect MPK and K/L ratio?
- Increases MPK, causes sub toward K - increasing K/L ratio. This change doesn't necessarily mean that employment of L will fall: requires fall in L if output remains unchanged but may not stay the same!
- Higher K productivity reduces production costs, reducing P of output, causing increase in Qd and production
- If increase in production is big enough, can mean increase in employment of both K + L
- In countries w/low PL relative to PK, econ efficient to use labour-intensive production methods. In countries w/low PL relative to PK, better to use capital-intensive production methods
124
Long-Run Cost Curves
- Long-run average cost curve shows min average cost at each output level, separating attainable from unattainable cost levels
125
Can a short-run ATC curve fall below the LRAC?
- No
126
Shifts in LRAC Curves
- Changes in tech + factor prices cause long-run cost curve to shift. Rise in factor price shifts LRAC curve upward
- Fall in factor prices or tech improvement shifts LRAC curve downward
127
Productivity
- Used to measure extent of tech change
| - Productivity growth via tech change has been major source of rising living standards over decades + countries
128
Endogenous and Exogenous Technological Change
- Most tech change caused by firms responding to changing econ signals - endogenous (ex/current + future responses to environmental concerns)
- But can also be exogenous: ex/ microchip created many new products + reduced cost of others
129
Competitive Behaviour Versus Competitive Markets
- Competitive behaviour: individual firms try to take business from others (GM + Toyota)
- Competitive markets: firms have no incentive to use competitive behaviour: nothing to gain in using strategies to try taking customers away from other firms (wheat farmers)
130
Assumptions of Perfect Competition
1) All firms sell homogenous (identical) products
2) Consumers have full knowledge of all firms' product + price
3) Each firm's output at min LRAC only small proportion of industry's total output
4) No barriers to enter/exit
131
Demand Curve for Perfectly Competitive Firm
- Industry: downward sloping
| - Firm: horizontal (perfectly elastic). Price-taker
132
Total, Average and Marginal Revenue
- TR: p x q
- AR: (p x q) /q = p
- MR: delta TR/ delta q = p
- For perfectly competitive firm, AR = MR = p
- Perfectly elastic D curve is also AR and MR curve
133
Criteria for Profit-Maximization
1) Max profit is at MC = MR. If AR > ATC, econ profit + firm will produce. If AR = ATC, 0 econ profit + firm will produce. If AR> AVC but < ATC, firm makes econ losses. But as long as AR>AVC firm is covering all its variable costs + part of fixed costs. If it shut down it would pay all fixed costs, meaning even bigger econ losses than if it continued to produce. So firm will continue to produce in SR even w/econ losses if it's better than alternative. If AR = AVC, firm makes same losses whether it continues to produce or shut down. If AR < AVC, econ losses when producing are greater than fixed costs. Since losses will be less if firm doesn't produce, better option is to shut down
2) Firm should produce only if AR(price) > AVC (if price doesn't fall below AVC). Min AVC is shut-down price
134
Short-Run Supply Curves
- Competitive firm will produce where MC = P
- P at min AVC is firm's shut-down P
- Firm's S curve is MC curve above shut-down P
135
Derivation of Competitive Industry's Supply Curve
- Horizontal sum of many firms' S curves
136
Short-Run Equilibrium in a Competitive Market
- When industry in SR equilibrium, market sets P where Qd = Qs + each firm goes to p = MC
137
Positive Economic Profit
- At mkt price P: MC = MR at q* and p>ATC
- Econ profit means firms currently doing better than in next-best alternative + firms not currently in industry have incentive for entry - so industry not in LR equilibrium
138
Negative Economic Profit (Losses)
- At mkt price P: MC = MR at q* and p
139
Zero Economic Profit
- At mkt price P: MC = MR at q* and p = ATC
| - Profits are same as in firm's next-best alternative, so no incentive for entry or exit + industry in LR equilibrium
140
Changes in Short-Run Equilibrium
- Start in LR equilibrium, then market D increases, increasing price of product. In SR, existing firms make econ profit
141
How does positive economic profit affect the number of new entrants?
- Attracts new entrants
| - Entry increases market supply, price falls
142
Effect of Exit Caused by Economic Losses
- Some firms exit, reducing S + raising P. Rises until P = P2, where remaining firms make 0 econ profit - new LR equilibrium reached
143
Long-Run Equilibrium
- No incentive for more entry or exit
- When industry in LR equilibrium, firms must be maxing their profits + they equal 0 + industry profits can't be increased given existing tech
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What happens when the firm is at P initial in a long-run equilibrium scenario?
- Firm at min SRAC making 0 econ profit - but not in LR equilibrium
- Econ profit can be made if firm expands + produces at a Q with lower AC. But as existing firms do this, presence of econ profit stimulates entry, increasing industry S + lowering P
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Minimum Efficient Scale
- In LR equilibrium, each firm at lowest possible AC given tech + factor Ps
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Adjustment to Changes in Technology
- Can take time for entire industry to adjust to new tech
- New plants (or firms) enter w/new tech + initially earn econ profits
- As more enter, increase in output reduces product P
- Old plants still using old tech will continue to produce as long as P>AVC - but will be making econ losses. They'll eventually exit or get new tech
- P falls until it equals min ATC of plants using new tech
- During adjustment period, some firms make econ profit while others make econ losses
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Declining Industries
- Policies which subsidize an industry to purchase new equipment may be waste of taxpayers' money in LR
- Firms will stay in industry + produce as long as p>/equal to AVC
- But as D for industry's product falls, will not be profitable for firms to re-invest in new equipment. Continue to use old equipment for as long as possible, ultimately will wear away + firms will close
- Industry's old equipment is effect of industry's decline, not cause of it
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Market Power
- In perfect comp, many firms. Each is "price taker" w/no market power (horizontal D curve)
- In monopoly, only 1 firm, so D curve is entire market D
- Downward-sloping D curve gives monopoly market power to choose any P + Q combo along that D curve
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Barriers to Entry
- In perfect comp, complete freedom of entry into industry/exit from industry
- As firms respond to incentives for entry created by econ profits + incentives for exit created by econ losses, in LR industry equilibrium, the firms make 0 econ profit
- For profit-maxing monopoly to persist, must have barriers to entry. Creates ability for monopoly to make econ profit in LR
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Natural and Created Barriers to Entry
- Natural: ex/ big econs of scale. Output at MES (min efficient scale) too high for others to compete. Like Quebec Hydro
- Created: advertising campaigns, patent laws, gov't franchise (Canada Post), professional organizations controlling licensing + rules, retaliation threats
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Revenue Concepts for a Monopolist
- Unlike perfectly competitive firm, monopolist faces negatively sloped D curve
- Monopolist faces tradeoff between P it charges + Q it sells
- If monopolist charges same price for all units sold, TR = PQ
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Average Revenue
- TR divided by Q
- PQ/Q = P
- Since D curve shows P of product, D curve is also monopolist's ARC
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Marginal Revenue
- Extra revenue resulting from sale of 1 more unit of product
- MR = delta TR/ delta Q
- B/c of downward sloping D curve, to sell extra unit, monopolist must reduce P that it charges on all units
- So P received for extra unit sold is not firm's MR b/c by reducing P on all previous units, firm loses revenue
- MR = P - lost revenue
- MR resulting from sale of extra unit < P that monopolist receives for that unit
- MR curve below D curve
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Does a monopolist produce on the inelastic part of the demand curve?
- No, unless MC is - but that's unlikely
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Short-Run Profit Maximization
- MC = MR at Qo
- To find profit-maxing output, compare the marginals: MR + MC
- Compare averages: AR : ATC
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How do large economies of scale affect monopoly efficiency?
- They give dif production f(x) + lower costs
| - Monopoly may produce + sell more Q at lower P using same (or less) resources
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The Very Long Run and Creative Destruction
- Monopoly profits = incentive for innovation - major force of econ growth
- Creative destruction via tech change creates new + better products + prodn methods, destroys market for old products
- Bypasses entry barriers, not jumping them
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Research and Development for Innovation May Be By:
- Outside firms trying to get in
- Inside firms to protect themselves
- Independent entities (like universities)
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Cartels as Monopolies
- Competitive firms form a cartel to max join profits
- If it works, cartel can act like monopoly
- Compared to perfect comp, less output at higher P
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Problems That Cartels Face
- Incentive to cheat so cartel won't last
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Can quotas keep output at a monopoly level?
- Issue is enforcement. If you enforce quota restrictions on current firms, it prevents entry of new firms/supplies
- Cartel must be able to punish violators. Threat of punishment must be credible: potential violators must see it's in best interests of threatening firm(s) to carry out threat. If not, they'll ignore it
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Price Discrimination
- Sale by 1 firm of dif units of product at 2 or more dif prices for reasons not associated w/dif in cost
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When is it possible for firms to price discriminate?
1) When firms have market power
2) When consumers differ in their valuations of the product
3) When firms can prevent arbitrage
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Type One Price Discrimination
- Price discrimination among units of output
- Charging dif Ps for dif units sold
- "Perfect" P discrimination shifts all consumer surplus to seller
- But not all P discrimination among units of output reduce consumer surplus: buy 2 get 1 at discount creates more consumer surplus, more producer surplus, less deadweight loss
- Condition: seller must know Q each consumer buys (ex/ electricity meters)
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Type Two Price Discrimination
- Price discrimination among market segments
- More profit if can discriminate by selling Qo at dif Ps in dif markets
- For 2 market segments A and B, firm distributes sales so that MRA = MRB = MC
- Higher P in segment w/less elastic D, lower P in segment w/more elastic D
- Conditions: 1) Dif elasticities of D in dif segments (revenue gained by lowering P on more elastic D curve > revenue lost by raising P on less elastic D curve) 2) Members of dif market segments must be identifiable 3) Must have minimal/no arbitrage (most often for services)
- Ex/ students + seniors vs others
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Type Three Price Discrimination
- Hurdle pricing
- Hurdle used to get consumers to assign themselves according to their elasticities
- Ex/hardback vs paperback
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Consequences of Price Discrimination
- On P side of market it increases firms' profits + may increase firm's output, increasing overall efficiency of production
- On consumption side effect on consumers is unclear. Can cause fall or rise in consumer surplus
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Characteristics of Monopolistic Competition
1) Many small firms providing close subs: highly (not perfectly) elastic D + some downward slope, so some market power in SR
2) No barriers to entry/exit: 0 econ profit in LR
- Ex/ hair stylists
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Monopolistic Competition Versus Perfect Competition
- Higher average costs of production than PC, but higher consumer prices than PC, but greater product variety than PC
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Oligopoly
- A few firms, each w/large market share
- Each produces range of differentiated products
- Each has some market power
- Competitive behaviour (not competitive market)
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How can we measure market power?
- Industry's [ ] ratio
| - Ex/ share of total market sales by largest 2 or 4 or 8 firms?
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Examples of Non-Price Competition
- Competitive behaviour to increase (or maintain) market share:
a) Advertising
b) Brand proliferation/quality range
c) Customer service
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Oligopoly and Game Theory
- Firms in oligopoly have high degree of interdependence
- Firm's own actions must consider expected rxns of rivals
- Firms consider how rivals react, how their expected rxn will affect their own strategy + compete or collude
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Game Behaviour for Duopoly (Two Firms)
- Cooperative outcome: each produces 1/2 monop output, maxing joint profits
- Non-coop: each produce 2/3 of monop output - higher Q, lower P, lower profits
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Nash Equilibrium
- Each doing best it can given what other firm is doing
- No incentive to change behaviour
- Ex/ each firm makes rational choice to compete instead of collude, or each firm chooses to compete regardless of how other firm acts. So competing is dominant strategy for each firm
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Types of Collusive Behaviour
- Explicit collusion: firms agree on strategy (like OPEC)
| - Tacit collusion: cooperation w/out explicit agreement
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Types of Competitive Behaviour
- P + non-P completion for market share
| - R + D for lower costs or better products (creative destruction)
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Economic Efficiency in Terms of Productive + Allocative Efficiency
- Efficient econ has both productive + allocative efficiency
| - Together create econ efficiency
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Productive Efficiency
- Productive efficiency for firm: output produced at lowest possible cost
- Productive efficiency for industry: output distributed across firms so MC same for all firms
- If MCs not equal, switching production from less efficient (high MC) firms to more efficient (lower MC) firms so industry can produce same level of output while using less
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Allocative Efficiency
- All pts on PPB productively efficient
- Must compare MC and MV to society
- MV: max P consumer willing to pay for marginal unit of good
- MC: opp cost of producing marginal unit
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Allocative Efficiency at P = MC
- When MC > Pd: something of higher value to society has been transformed into something of lower value so produce less
- When MC < Pd: something of lower value to society transformed into something of higher value so produce more of this good
- When MC = Pd: neither more/less of good should be produced since current output is optimal allocation of econ's resources - allocatively efficient
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Does perfect competition maximize economic efficiency?
- Yes, at its uncontrolled equilibrium, producing at Pd = MC
- But controls create deadweight loss, producing where Pd>MC
- Controls can include effective price floor/ceilings, quotas, guaranteed prices above equilibrium
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Do unregulated monopolist economies maximize economic efficiency?
- No, produces at MC = MR + sells at Pd > MC
| - But can be more efficient than perfect comp if it has large econs of scale
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Does monopolistic competition maximize economic efficiency?
- No, Pd > MC
| - But gives consumers variety
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Does oligopoly maximize economic efficiency?
- No, likely produces where Pd>MC
| - But gives variety + incentives for R + D
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Regulation of Natural Monopolies
- B/c of large econ of scale, ATC falls over whole range of market output so P controls must take account of special probs
- Policy options: public ownership (QC Hydro) and regulation
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Regulating a Natural Monopoly With Marginal Cost Pricing
- Allocatively efficient but econ losses
| - Not produce in LR w/out gov't subsidy
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Regulating a Natural Monopoly With Average Cost Pricing
- ATC = AR so 0 econ profit
| - But P > MC so allocatively inefficient output
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Regulating a Natural Monopoly With a Two-Part Tariff
- Objective: create allocative efficiency w/out econ loss
1) Produce allocatively efficient output Q1 (where P1 = MC)
2: Charge lump-sum access fee
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Market Failure
- Occurs when free market fails to generate allocative efficiency
- Sometimes gov't regulation/intervention can correct market failure, but sometimes can't
- Sometimes it can but chooses not to do so b/c gov't has alternatives that private sector doesn't have + opp cost in terms of these alternatives is too high
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Causes of Market Failure
1) Market power: allocative inefficiency as Pd>MC - deadweight loss in econ surplus
2) Externalities (private costs not equal to social costs): costs/benefits to 3rd parties who neither produce/consume the good - allocative efficiency but should be assessed according to social costs/benefits
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Social Costs
- Private costs + externalities
- - externality: cost to 3rd parties
- + externality: benefits for 3rd parties
- Net externalities: (-) - (+) externalities
- Socially optimal condition for allocative efficiency is where MB = Pd = MCsocial = MCprivate + NX
- Demonstrates that even perfect comp can be allocatively inefficient
- Pd is value to consumers of marginal unit so D curve is also MB curve
- + externality reduces MCs
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Monopoly With Negative Externality
- MCs = MCp + NX
- W/ large net - externality, monopoly output closer to socially efficient level than competitive market output
- W/small - externality monopoly may not be more allocatively efficient than perfect comp
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How can government intervention help bring output closer to the allocatively efficient level?
- By internalizing the externality which brings firm's MCp closer to MCs
- Ex/ firm creating - externality pays tax/unit of output, raising firm's MCp (carbon tax) or firm generating + externality receives subsidy/unit of output, lowering firm's MCp
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Non-Rivalrous/Non-Excludable Goods
- Rivalrous product: when 1 person consumes it, another can't
- Excludable product: ppl can be prevented from consuming it
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Four Different Types of Goods in Terms of Rivalry and Excludability
- Private goods: rivalrous + excludable
- Public goods: non-rivalrous + non-excludable
- Common-property resources: non-excludable + rivalrous
- Club goods: excludable + non-rivalrous
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Common-Property Resources
- Non-excludability results in there being many participants: 1 participant has no effect + same situation faces all participants so nobody has incentive to restrict own use
- W/- externality, Pd(MCpriv)
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Potential Policies to Manage Excessive Depletion of Resources
- Direct controls by gov't (like Canada closing Atlantic cod fishery)
- Private property rights - make excludable! Like elephants
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How do property rights work?
- W/out ownership, no excludability so no financial incentive to prevent overuse + depletion of future values
- Property rights give ownership, giving incentive + ability to preserve future value b/c overuse would reduce future values, reducing current market P of property right which creates capital loss for owners
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Club Goods
- If non-rivalrous, MC = 0
- If excludable, firms can sell at P>0
- So P>MC... allocative inefficiency
- Gov't ownership often brings output closer to allocative efficiency
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Public Goods
- Non-rivalrous: P = o for allocative efficiency
- Non-excludable: can't make user pay - most ppl won't voluntarily pay. Private firms won't produce it so gov't does it (national defence)
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Asymmetric Information
- Market failure via moral hazard or adverse selection
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Moral Hazard
- Changes behaviour + shifts costs to others
| - Like insurance reducing costs of careless driving + careless drivers raise premiums for others
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Adverse Selection
- Circumstance/program attracts higher-risk participants
- Ex/ higher-risk ppl more likely to buy insurance - pushes up premiums for all so lower-risk groups start to reject insurance, pushing up premium even more. Ultimately only those at greatest risk would buy it, leading to very high premium b/c not spreading risk over many ppl
- Avoid by charging dif premiums for dif groups - may be dif risk levels for individuals w/in group - can't identify them so use group's average risk (statistical discrimination)
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Cost of Government Intervention
- Intervene only if MB intervention > MC intervention
- MC includes opp cost in econ
- Direct costs come w/all gov't intervention using real resources
- Indirect costs are - externalities like pollution
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Economic Rent
- Payment to factor in excess of what's necessary to see it in its current use
- Increase in rent not change behaviour (ex/political influence)
- Seek + receive special treatment even tho it doesn't alter recipients' behaviour
- Unless correcting mkt failure, rent-seeking behaviour not in social interest
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Public Choice Theory
- Gainers get big gains individually - more votes for politician
- Losers = taxpayers: individual taxpayer loses only a little so little/no effect on loser's voting behaviour
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Property Rights and the Coase Theorem
- Derived from his arguments about the reciprocal nature of externalities
- (-) externality hurts 1 party if it's not cleaned up, but hurts other party to clean it up
- Allocative efficiency requires adjustment be made by party incurring east cost, using less of society's resources
- When property rights are well defined, mkts can generate allocatively efficient outcome regardless of who owns property right
- Owner + non-owner can negotiate to get efficient (least cost) outcome
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Conditions Required for Coase Theorem to Work
1) Negotiations are costless. If not, resources used in negotiation process could exceed those saved elsewhere
2) Small # of parties involved: if not, can get free rider prob
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Conclusions of Comparative Advantage
1) If country has comparative disadvantage in 1 product, must have comparative advantage in another
2) When opp costs differ between countries, reallocating resources between products + countries can increase total production
3) To get max world output from given level of resources, each country would specialize until opp cost of getting more of good by producing domestically = opp cost of getting more good by trade
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Additional Gains from Trade with Variable Costs
- If costs vary w/level of output or as experience acquired via specialization, additional gains possible
- Econs of scale: international trade allows small countries to reap benefits of scale econs
- Learning by doing: reduction in costs/unit of output resulting from workers accumulated experience repeatedly performing same tasks
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Sources of Comparative Advantage
- Dif factor endowments, dif climates, human capital, acquired comparative advantage
