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ECONOMICS
LECTURE 1 GRAPHS

Graphs in Economics
Economics is often concerned with the relationship between two variables, X and Y that is, how does a change
in one variable affect another variable
...
A graph is a visual representation of the relationship

between two variables
...
Since income is the cause
or determining factor, income is the independent variable
...
Since consumption spending depends on income, consumption is the dependent variable
...
There is a direct or positive relationship between income and consumption
spending
...

When two variables change in opposite directions, they have an inverse or negative relationship
...


Ticket
Price

Attendance
(1000's)

$25

0

20

4

15

8

10

12

5

16

0

20

These graphs assume (1) that all the factors other than income that might affect consumption spending are
presumed to be constant or unchanged and (2) that anything other than ticket price which might influence
attendance is constant
...

This means that the lines will shift to a new location
...
People will feel less
wealthy so they will spend less at each level of income
...
And,
suppose a minor league team affiliated with the Orioles moves York
...
So, the line shifts down
...

The subject matter of economics can be approached from two levels of analysis: macroeconomics and
microeconomics
...
The key word is individual; microeconomics deals with the behavior of
the individual entities that make up the economy
...
Rather than being concerned with the production of a
single good or service, say, vacuum cleaners, macroeconomics looks at the total production of all goods and
services including vacuum cleaners, coffee makers, and frozen pizza
...

This, of course, is a course in microeconomic principles
...
People make the choices they believe leave them
best off
...
There are three categories of economic resources:
1
...
labor - workers
3
...

We assume that people have unlimited wants
...

Since we have a limited amount of resources, we can produce a limited amount of goods and services
...
This is
known as scarcity and much of economics looks at how people cope with scarcity
...
A choice is a comparison of alternatives
...
Opportunity cost is the value of the next best alternative
...
Since I chose Raisin Bran, my opportunity
cost is oatmeal or the Wheat Chex, whichever I most prefer
...
For an economist, the cost of an activity is everything given up for it, including opportunity costs
...

That something has a value to you; the value of whatever you would have done if you had not attended college
is the opportunity cost of going to college
...
Then, your
opportunity cost of attending college would be the wages you could have earned instead: $15,000 a year for 4
years is $60,000
...
Most decisions involve choosing a little more or a little less
of something
...

Loosely put, the additional costs of undertaking some activity are called marginal costs
...
If the marginal benefits are greater than the
marginal costs, do it; otherwise, do not
...

marginal costs
gas, other car expenses

$2
...
25

opportunity costs (working) 5
...
80

marginal benefits
Knowledge

0
...
15
in class today
were able to socialize with other students

1
...
41

total marginal benefits

$7
...


Lecture 3: Production Possibilities Frontier
production possibilities frontier

Production Possibilities Frontier

Let me provide some numbers to another example of a production possibilities frontier
...

Guns Butter Opportunity Cost of Producing Butter
200

0

-

175

75

1/3

130

125

9/10

70

150

2 2/5

0

160

7



Shifts: the PPF will shift outwards reflecting an increased capability to produce goods and services when (1)
there are increases in the quantity or quality of resources or (2) if there is technological improvement




Lecture 4: Gains from Trade

comparative advantage and trade
an example

















Comparative Advantage and Trade
Tiger Woods can probably mow his lawn faster than anyone else
...
Because he can mow the lawn in less time, Tiger Woods has an absolute advantage in mowing
lawns
...


However, is mowing his lawn the best use of Wood's time? Suppose that in the same 2 hours it takes
him to mow his lawn, he could play golf with Microsoft executives and earn $50,000
...

In contrast, the neighborhood kid's next best alternative is to work at Burger King where he earns $7
...
So, in the 4 hours it would take him to mow Tiger's lawn, he could have earned $30
...

Tiger Woods has an absolute advantage in mowing lawns because he can do the work in less time
...
A person or a country has a comparative advantage when they can produce a good at a
lower opportunity cost compared to someone else
...
Rather than mowing his lawn, Woods should play golf with the
Microsoft executives and hire the neighborhood kid to mow the lawn
...

Countries can benefit from specialization and trade with one another in the same way individuals can
...

Without trade countries must consume at a point on their production possibilties frontier
...














An Example

Once again, in the absence of trade a country must consume the goods and services it produces
...
Without trade
countries must consume at a point on their PPF's
...

Consider two countries (Haiti and the Dominican Republic) and two goods (health care and food)
...


Haiti
health care

Dominican Republic
food

health care

food








(# of people)



Suppose both countries want health care for 500 people
...

The gains from trade come from specialization: concentrating resources in activities in which our
opportunity costs are lowest and then trading for the other things we want
...
Let's calculate the opporunity costs of providing 500 people
with health care
...
Food production in Haiti drops from 10 to 7 tons, making its opporunity cost
equal to 3 tons of food
...
So, Haiti has a comparative advantage in health care while the Dominican
Republic must then have the comparative advantage in food
...
Each produces at point B on their PPF's
...
Suppose Haiti trades health care for 500 people to the Dominican Republic in exchange
for 8 tons of food
...
The Dominican
Republic consumes the health care for 500 people it acquired from Haiti and 2 tons of food (the 10 tons
it produced minus the 8 it traded to Haiti)
...

Trade allows both countries to consume combinations of health care and food that lie in the impossible
regions of their PPF's, combinations of output that lie beyond their own resource capabilities
...
What goods and services are produced and in what quantities?
2
...
Who gets the goods and services that are produced?

There are two extreme systems for answering these questions
...
In a market economy, the questions get answered through the interaction of buyers and sellers
in the market
...
In the United States,
consumer demands determine the answer to the first question
...
Consumer sovereignty refers to the ability of
consumers through their purchases to determine what goods and services get produced in a market economy
...
If firms do not minimize
costs, then they cannot maximize profits
...
Income is determined by the prices of
the resources households own
...


Markets and Prices

A market is a place or service that enables buyers and sellers to exchange goods and services
...
Some markets are worldwide like the gold, oil, and rubber
markets
...
Arbitrage, profiting from different prices for the same
product, is what drives prices to be similar among different locations
...
If gold sells for
$559 an ounce in York and $560 an ounce in Lancaster, I would earn profits of $32,000 minus $100 if I bought
1 ton of gold in York, drove it over to Lancaster in the Ryder truck, and sold it
...
Arbitrage will drive up the price in York
and drive the price of gold in Lancaster down until there were no further arbitrage profits available
...

As products get heavier and heavier and their value relative to their weight diminishes, shipment to distant
points to take advantage of price differences becomes less and less profitable
...
This does not even cover the costs of
renting the Ryder truck
...
The brick
prices in the two cities would stay different while the price of gold would become close to the same in both
cities
...
So, the gold market is worldwide, but the
brick market is strictly local
...


A price is the amount paid for a specified quantity and quality of a good or service
...
provides incentives
2
...
signaling mechanism

Lecture 6: Supply and Demand, Part 1
demand
supply

Demand

Demand is willingness and ability of buyers to purchase goods and services
...
When constructing a demand
schedule, everything else that might affect demand is held constant
...
This "law of demand" is due to consumers substituting purchases away from a good whose price has risen
towards relatively less expensive goods
...


Supply

Supply is willingness and ability of firm to offer goods for sale in a market
...

Price
Quantity Supplied
($/doughnut) (number of doughnuts)
$10
8
6
4
2

16
12
6
4
1

Businesses are in business to make profits
...
So, firms will devote more resources to the production of a good whose price has risen
...


A supply curve is a graph of the
supply schedule
...


Lecture 7: Supply and Demand, Part 2
market equilibrium
supply and demand curves
shifts of the demand curve
things that shift the demand curve

Market Equilibrium

Equilibrium is a situation in which there is no tendency for change
...
This occurs at the price where quantity
demanded equals quantity supplied
...

Quantity Demanded

Price

Quantity Supplied

2
3

$10
8

16
12

excess supply
excess supply

price falls
price falls

6
10
15

6
4
2

6
4
1

excess demand
excess demand

price rises
price rises

Equilibrium occurs at a price of $6
...
When the price is above the
equilibrium of $6, quantity supplied is greater than quantity demanded
...
There is an excess supply and there is pressure for the price to fall
...
Only at the equilibrium price
is there no pressure for price to rise or fall
...
Equilibrium occurs where the
supply and demand curves intersect at an equilibrium price of $6 and an equilibrium quantity bought and sold of
6 doughnuts
...


Shifts of the Demand Curve

A change in the price of a good causes a movement along the demand curve for that good
...


An increase in demand means that
consumers wish to purchase more of the
good at each possible price than before
...


A decrease in demand, on the other hand, means that
people wish to purchase less of this good at every price
than before
...


Things that Shift the Demand Curve

A change in the price of a good causes a movement along the demand curve for that good
...
A change in anything else that effects the demand for the good
causes the demand curve to shift
...
normal goods

income demand increases

income demand decreases
2
...
The quantity
demanded changes but demand there is no change in demand
...







changes in tastes/preferences
changes in income
changes in the prices of related goods
1
...
complements - goods that are usually consumed together

price of good A demand for good B decreases

price of good A demand for good B increases
changes in the number of potential buyers
o more buyers demand increases
o fewer buyers demand decreases
changes in expectations of future prices
o expect higher prices demand increases now
o expect lower prices demand decreases now

Changes in Supply
An increase in the price of a good (due, say, to an increase in demand) has no effect on the supply curve
...
A change in anything else that effects supply causes
the supply curve to shift
...
This is an increase in supply
...

This is an decrease in supply
...
The quantity supplied
changes but supply is unchanged
...








changes the costs of inputs
o higher costs supply decreases
o lower costs supply increases
new technology
o new technology supply increases
weather and other "Acts of God"
o adverse supply decreases
o beneficial supply increases
changes in the prices of related goods
1
...
oint products - goods that are normally produced together

price of good A supply of good B increases

price of good A supply of good B decreases
changes in expectations of future prices
o expect higher prices supply decreases now
o expect lower prices supply increases now
changes the number of sellers
o more sellers supply increases
o fewer sellers supply decreases

Lecture 9: Government Price Controls
demand and supply shifts and the market equilibrium
price ceilings and floors

Demand and Supply Shifts and the Market Equilibrium

1
...

3
...


increase in demand
price and quantity bought and sold
decrease in demand
price and quantity bought and sold
increase in supply
price and quantity bought and sold
decrease in supply
price and quantity bought and sold

Price Ceilings and Floors

A price floor is a legal minimum price
...
A price floor creates an excess
supply or surplus
...
Rent control is an example
...

There are 4 alternatives to the market as a way of allocating a scarce good:
1
...

3
...


standing in line
preferred customers
rationing by coupon
black markets

Lecture 10: Price Elasticity of Demand
elasticity

Elasticity

We want to measure the magnitude by which consumers change the quantity demanded in response to a change
in the price of the product
...

percentage change in quantity demanded
price elasticity of demand = ---------------------------------------percentage change in price

the price elasticity of demand



tells us the percentage change in quantity demanded resulting from a 1% change in price
is always negative, so the negative sign is dropped

when the price elasticity of demand is




greater than 1, demand is elastic: consumers respond a lot to a price change
equal to 1, demand is unit elastic
less than 1, demand is inelastic: consumers do not respond much to a change in price

Although the price elasticity of demand declines as we move down a straight-line demand curve, generally, the
steeper the demand curve, the more inelastic the demand

Lecture 11: Applications of Elasticity, Part 1
midpoint formula
determinants of price elasticity of demand
elasticity and total revenue

Midpoint Formula

Calculating the price elasticity of demand with the formula
percentage change in quantity demanded
price elasticity of demand = ---------------------------------------percentage change in price

gives a different answer depending on whether price increases or decreases
...

New Quantity - Old Quantity
Old Price + New Price
----------------------------- X ----------------------Old Quantity + New Quantity
New Price - Old Price

The price elasticity of demand declines as we move down a straight line demand curve
...
existence of substitutes: the more substitutes, the more elastic the demand
2
...
time period under consideration: the longer the time period, the more elastic
4
...
definition of the market: the more broadly defined the market, the more inelastic the demand, e
...
food vs
...





if demand is elastic, a rise in price causes a fall in TR
if demand is inelastic, a rise in price causes TR to increase
if demand is unit elastic, TR does not change when price changes

Lecture 12: Applications of Elasticity, Part 2
price discrimination
tax incidence
other elasticities
Price Discrimination

Price discrimination refers to charging different customers different prices for the same product, e
...
senior
citizens discounts on movie tickets
...

Tax incidence

Suppose that the equilibrium price initially is $1
...
The tax shifts up the supply curve by the amount of the tax
...
10
...
00 to $1
...

So, buyers pay 10¢ of the tax
...
00 per unit sold
...
10 but keep just 85¢ after paying the 25¢ tax
...
For the relative inelastic
demand, buyers pay 20¢ of the tax while sellers pay the remaining 5¢
...


Other Elasticities
Cross Price Elasticity of Demand
percentage change in the quantity demanded for good A
------------------------------------------------------percentage change in the price of good B

When the cross price elasticity of demand is positive, goods A and B are substitutes
...

Income Elasticity of Demand
percentage change in the quantity demanded for good A
------------------------------------------------------percentage change in income

The income elasticity of demand is greater than zero for normal goods and less than zero for inferior goods
...

The elasticity of supply depends on the ability of firms to change production techniques or switch from
producing one good to another, for example, a bakery versus an automaker
...
We
assume that consumer behavior is rational in the sense of aiming at maximum satisfaction of personal wants
...
The higher the total utility a
consumer obtains the better off she is
...
In other words, consumers maximize utility
...


Utility of Bananas (measured in money terms)
Number of Pounds per Day Total Utility (in $) Marginal Utility (in $)
0

$0

---

1

0
...
60

2

1
...
56

3

1
...
44

4

1
...
36

5

2
...
14

6

2
...
10




when MU > 0, TU is increasing
when MU < 0, TU is decreasing

The more of a good a consumer has, the less marginal utility an additional unit will bring
...
The idea is based on the assertion that every person has a hierarchy of uses to
which she will put a particular commodity
...
Each pound of bananas, for example, contributes something to the satisfaction of the consumer's needs
...
So, each additional purchase provides less additional satisfaction than the previous one
...
For example, at an "all you can eat" buffett, you consume until your marginal utility equals zero
...


Lecture 14: Consumer Equilibrium
choosing between goods
substitution and income effects
consumer and producer surplus

Choosing Between Goods

The consumer should continue to purchase each good until the marginal utility received from the last dollar
spent on each good is the same
...

Price of good Z

A change in the price of one good will disturb the consumer's equilibrium
...
Suppose in the the cake, coffee, and water example, that the price of cake
falls to $1
...
The consumer should reallocate her
budget among the goods
...
substitution effect - other goods become relatively more expensive so consumers buy more of the less
expensive good and less of the more expensive good
2
...


producer surplus
the difference between the market price and the lowest price the firm is willing to accept

Graphically, producer surplus is the area
above the supply curve below the
market price
...

The combinations of pizza and beer are called bundles
...
X is preferred to Y
2
...
she is indifferent between X and Y: she likes bundles X and Y equally well

Suppose she is indifferent between X and Y
...
An indifference
curve shows all combinations of pizza and beer that the consumer is indifferent among
...






Indifference curves are downward sloping
...

Indifference curves cannot cross
...
Consumers want to be on the highest possible indifference
curve
...


Let the blue line in the figure above be the consumer's original budget line
...
A change in the price of one of the goods, on the other
hand, rotates the budget line along the axis of the good experiencing the change
...
An increase in the price of the good on the X-axis would rotate the budget line in, for example,
to the green line
...
The budget line shows all the
bundles the consumer can afford
...
In the diagram below, consumer equilibrium occurs at point E
...


Lecture 16: Firms in the Economy
business firms

Business Firms

A business firm is an organization that brings together different resources to produce a good or service and is
controlled by a single management
...
S
...
A proprietorship is owned by one person who receives all the profits and is
responsible for all the debts incurred by the business (unlimited liability)
...
The disadvantages of a proprietorship are (1) the difficulty in raising funds
for the business and (2) the proprietor's unlimited liability for the debts of the business
...
A partnership consists of two or more owners who share the
profits and responsibility for the firm's losses
...
More owners also gives partnerships
access to a larger source of funds for the business
...
Also, the
partners have unlimited liability for the debts of the business
...
A corporation has the legal standingof a fictional
individual and is a legal entity owned by shareholders whose liability for the firm's debts is limited to the value
of the stock they own (limited liability)
...
A second disadvantage is the separation of ownership from control
...


Lecture 17: Inputs and Output
accounting vs
...
long-run
relationship between output and resources

Accounting vs
...
However, the funds and time invested in a firm could have been used in
some other business
...
These implicit costs are part of
the costs of doing business so we subtract it from accounting profits to get economic profit
...
This is a normal profit and simply means that the firm
earned as much in this line of business as it could have earned in some other line of business
...
This is called negative economic profits
...

Remember that from now on, costs always include the opportunity costs of capital, the implicit costs, and that
profits always means economic profits
...
Long-run

In the short-run, the size of a firm's capital stock is fixed
...
In the long-run, all input
levels can be changed
...

Marginal Physical Product
Marginal physical product, MPP, equals the additional units of output which result from using one more unit of
the variable resource
...


Here's an example of making these calculations:
number of workers
0
1
2
3
4
5
6

TPP
0
15
34
48
60
62
60

MPP

APP

15
19
14
12
2
-2

15
17
16
15
12
...

Notice that whenever MPP > APP, APP is rising and when MPP < APP, APP is falling
...
Whenever the marginal is greater than the average, we are adding in numbers that are
greater than the current average
...
When marginal is less than average, we are adding
in numbers that are less than the current average
...

Here's an example
...
Then your average exam score is 80
...
Your marginal test grade is 100
...
Suppose you get a 30 on the next exam
...
Now your average exam score is 70
...
If your
marginal exam score, the grade on the fourth exam, equals 70, then your average exam score does not change
...
fixed costs: those costs that do not change as output increases and are incurred even if no output is produced at
all, e
...
interest, depreciation, fire insurance
2
...
The MC curve
intersects the AVC and ATC curves at the minimum point of each AC curve
...
5
11
...
8
7
5
...
4

24
20
20
21
...
3
25
...
9

59
37
...
7
30
30
...
6
35
41
...
In the long tun the levels of all
resources are variable
...
For each plant size, there is a corresponding short-run average cost
curve
...
In the short-run, the firm can choose only the number of
typesetters, printers, paper, and ink it uses
...


Each size printing press has a different short-run average cost curve: SL for the small printing press and BG for
the big printing press
...
If the firm chooses the smaller printing press, its average
cost curve will be SL
...
The firm

may wish that it had purchased the bigger press, which would have enabled it to cut average costs to 9 cents
(point W)
...

In the long run, the machine must be replaced and management has its choice again
...
If it expects a
circulation of only 20,000 copies, it will use the smaller press and average costs will be 12 cents
...
The long-run average cost curve consists of all the lower segments of the short-run average
cost curves: STG
...
economic profits
demand curve facing the firm
barriers to entry
finding profits graphically

Accounting vs
...

Recall that profit means economic profit
...

These implicit costs are the opportunity cost of the owner's time and money
...


A zero economic profit means that the owners could not use their time or money better in any other business
...
The accounting profits in this business are equal to the level of profit
that the owners could get in their next best alternative
...

A positive economic profit is an above normal profit and attracts new firms into the industry
...


Demand Curve Facing the Firm

We assume that firms choose the price and quantity produced so as to maximize profits
...
One important factor is the
demand curve facing the firm
...
It only chooses the quantity to produce
...


Facing a perfectly inelastic demand curve, the firm only
chooses the price since the quantity is determined by how
much consumers want
...
Firms can reduce elasticity by reducing
the availability of substitutes
...
Differentiation can occur through advertising, price, service, quality, location, et cetera
...

A barrier to entry is anything that makes it difficult or costly for a firm to enter a market
...
Other barriers to
entry are economic in nature
...
These are sunk costs which must be
paid before any output is even produced
...
An airline must lease planes, gates at airports, and landing rights
...
These high capital costs make it hard for new firms to enter
the market
...

Desktop publishing has low fixed costs: just a computer and a printer
...
Therefore, desktop publishers will not make above-normal profits for long
...
New firms will be forced to enter the market as large firms or else
face a huge cost disadvantage
...


Finding Profits Graphically

Economists assume that the goal of firms is to maximize profit
...


TR = ABCD
TC = EFCD
Profits = ABFE

Lecture 21: Profit Maximization, Part 2
the profit maximizing level of output
finding the profit maximizing level of output graphically

The Profit Maximizing Level of Output
Marginal Cost
MC is the additional cost of producing one more unit of output
Marginal Revenue
MR is the additional revenue obtained from selling one more unit of output

If



MR > MC, the firm can increase its profits by producing more output
MR < MC, it costs more to produce another unit of output than the firm can sell it for so the firm can increase its
profits by producing less

Price QD TR

TC

MR

MC

Profits

-

-

$-3

$5

0

$0

$3

4

1

4

3
...
50

0
...
50

1
...
50

0

2
...
50

4

4

11

-2

3
...
00

5

0

15
...
50

-15
...
Once MR equals MC, any further increase in output lowers the firm's profits
...
There is no other level of output which gives greater profits
...

Graphically, this occurs where the
marginal revenue and marginal
cost curves intersect
...
To find the profit
maximizing price, follow Q* up to
the demand curve and over to
the vertical axis, P* = $6
...
AC* = $4
...

Profits per unit of output are the
price, $6, minus the average cost
of $4, which equals $2
...
Graphically, profits are equal
to the cross-hatched area
...

2
...

4
...

An individual firm in that
market cannot charge more
than the market price and
will not charge less
...


What Does the MR Curve look like for a Perfect Competitor?

A firm maximizes profits by producing where MR=MC
...

Q

P

0

$1

TR
$0

MR
-

1
2
3
4

1
1
1
1

1
2
3
4

$1
1
1
1

Profit Maximization

A perfect competitive firm faces a perfectly elastic demand curve at the market price
...


Lecture 23: Perfect Competition in the Long Run
the shutdown decision
firm's short-run supply curve zero long run profits
consumer surplus
producer surplus

The Shutdown Decision

In the short-run, certain costs, such as rent on land and equipment, must be paid whether or not any output is
produced
...
When the firm is deciding whether or not to produce any output at all
(the level of output is given by MR=P=MC), the firm looks only at its variable costs
...




produce if TR > TVC (if P > AVC)
shutdown if TR < TVC (if P < AVC)

Firm's Short-Run Supply Curve

Recall that a perfectly competitive firm in the short run will



produce if TR > TVC (if P > AVC)
shutdown if TR < TVC (if P < AVC)

The short-run supply
curve of a perfectly
competitive firm is the
portion of its Marginal
Cost curve above the
Average Variable Cost
curve
...
Economic profits will encourage firms to enter the
industry
...
Firms will leave the industry when economic losses are being incurred
...
In the long run, firms in
a perfectly competitive market earn zero economic profit
...
Firms will be producing the good
at the least cost
...


Consumer Surplus

Recall from chapter 6 that the demand curve measures the value an individual places on each unit of the good
...


The consumer pays less than she would be willing to for the good
...


Producer Surplus

The height of the supply curve measures the cost of producing an additional unit of the good
...

Producer surplus is the difference between the price firms would have been willing to accept and the price they
actually receive
...


Consumer surplus is the area below the demand curve above the market price
...
When the total surplus increases, society is better off
...
Since a perfectly competitive market produces
the market equilibrium quantity, perfect competition maximizes the sum of consumer and producer
surplus
...

1
...

3
...


single seller and many buyers
unique product
entry is impossible
perfect information

Types of Monopolies:
1
...
natural monopoly
o grows out of economies of scale and demand conditions
o its long-run average cost curve slopes continually downward over the relevant range of output
o long run average cost is minimized when only one firm enters the market
3
...


The demand curve lies above the marginal revenue curve meaning that MR < P because the monopolist must
lower the price to increase sales
...
Because there is no possibility of another firm
entering the market, a monopolist can earn above-normal (or economic profits) in the long run
...
The purpose is to increase profits by extracting more consumer
surplus
...






firm cannot be a perfect competitor
customers must have different price elasticities of demand for the product
firm must be able to separate customers according to price elasticity of demand
firm must be able to prevent resale of the product

The profit maximizing price discriminator will charge a price in each market so as to equalize marginal revenue
in each market
...
The higher price is charged in the
market with the buyers that are less responsive to price changes, t hat is, with the relatively inelastic demand
...
We create benefits for people by
giving them something they value; the value of something is equal to what people are willing to pay for it
...
So, under certain assumptions, the benefits society
receives from consuming a good are represented by the demand curve
...
The industry supply curve is the same as the marginal cost curve
...
For levels of output below the efficient quantity, the benefits society receives from consuming a unit of
the good are greater than the costs of producing a unit of the good; for levels of output greater than the efficient
amount, the costs are greater than the benefits from consuming a unit of the good
...
So, the monopoly
produces too little output and
charges too high a price
compared to the efficient
outcome generated by a
perfectly competitive market
...
It represents the net
social benefits from the lost
output from having a monopoly
in the market rather than
perfect competition
...
) The deadweight
loss may be overstated because
the monopoly fears that entry
or government intervention
could occur
...


Lecture 23: Monopolistic Competition
characteristics of monopolistic competition
inefficiency of monopolistic competition

Characteristics of Monopolistic Competition
1
...

3
...


many buyers and sellers
slightly different products
free entry and exit
perfect information

In a monopolistically competitive market, firms use product differentiation more than price to compete
...
So, the makers of Crest have a monopoly in the market for Crest while the makers of Aim have a
monopoly in the market for Aim
...
They
produce the quantity of output at which MR = MC
...
New products are
introduced as long as economic profits are positive
...


Inefficiency of Monopolistic Competition

In monopolistic competition:




too little of the good is
produced
the price is too high
average costs are too high

The inefficiency of monopolistic competition results from consumer preferences for product differentiation
...
Product
differentiation can result from style, quality, and location
...
Product differentiation reduces the price elasticity of demand because of brand loyalty
...


Lecture 26: Oligopoly
characteristics of oligopoly
kinked demand curve
game theory and oligopoly behavior
cartels

Characteristics of Oligopoly
1
...

3
...


many buyers and few sellers
identical or differentiated product
entry is difficult to due high fixed costs
perfect information

In an oligopolistic market, one firm's price and quantity decisions affect the other firms' decisions
...


Kinked Demand Curve

Strategic behavior occurs when what is best for A depends on what B does and vice versa
...
Suppose
that your competitors will follow or copy price decreases but not price increases
...
This makes the demand curve inelastic
and steep
...
Thus, the demand curve
facing your firm has a kink in it at the current market price
...
Marginal cost can
fluctuate between MC1 and MC2 without cuasing a price change
...
However, neither this prediction nor the underlying assumption about how
competitors react to price changes has any basis in the real world
...


A's dominant strategy is to charge a low price; since Firm B's alternatives are the same as A's, B's dominant
strategy is to charge a low price
...


Cartels

Oligopolists are better off if they cooperate to limit production and keep the price high
...
OPEC is a cartel: an organization of individual
competitors that join to form a single monopolist
...

With a cartel, joint profits are maximized at Popec and Qopec
...

At qopec, MR > MC

each member is assigned a quota,

profits rise if the country expands production
...

But, if all members cheat, total production rises

the price of oil falls

competitive outcome

Lecture 27: The Demand for a Resource
resource markets
resource supply
resource demand: deciding how much of a resource to hire

Resource Markets

Recall that there are three categories of economic resources: natural resources, labor, and capital
...


Resource Supply

Imagine that the market for accountants is characterized by perfect competition: many employers and many
accountants, accountants are identical, there is free entry into the accounting profession, and perfect
information
...


The market wage is $150
...
If the firm offers
less than $150, accountants will work elsewhere
...


Resource Demand: Deciding How Much of a Resource to Hire

Firms demand resources
...
They have value because they can
be used to make something of value
...
MRP is equal to MR times MPP
...

Marginal revenue product gives the value to the firm of hiring another accountant
...
Marginal
resource cost (MRC) is the additional cost of hiring another unit of a resource, e
...
how much it costs to hire
another accountant
...
Then, the marginal resource cost equals $150
...


When the firm can hire fractional units of a resource, the firm will hire the quantity of the resource at which
MRC = MRP
...
So, the rule for hiring a
resource becomes wage = MRP in a perfectly competitive resource market
...
Resources are wanted for what they can produce
...

shifts in resource demand: MRP = MPP x MR
1
...

3
...


changes in the price of the product it is used to produce
changes in technology
changes in the number of buyers of the resource
changes in the price of substitute resources

Monopsony

A monopsony is a single buyer of a resource
...

Therefore, in order to obtain more of a resource, the firm must offer a higher price
...

# of
accountants
1
2
3
4
5
6

MRP
$100
1300
600
400
200
100

wage
$25
50
100
150
200
250

TRC
$25
100
300
600
1000
1500

MRC
$25
75
200
300
400
500

The monopsonist will hire 4 workers since the costs of hiring the 5th worker are greater than the benefits
...
In a monopsony, resources are paid less than their MRP
...
The price of leisure is an opportunity
cost: the wage the worker could have received had she chosen to work rather than consume leisure
...
Any price change has two effects:
1
...
income effect: an increase in wages leads to a fall in hours worked because the higher income leads people to
purchase more of all normal goods including leisure

At low wage rates, the substitution effect dominates so that a rise in wages is associated with an increase in
desired hours worked
...
So, the individual
labor supply curve is backward bending
...
The market supply curve is upward sloping
...
The market demand curve is the sum of the individual
demands
...


Wage Differentials

The above model of the labor market implies that all workers receive the same wage
...


compensating wage differentials

Compensating wage differentials make up for high risk or poor working conditions
...

human capital

Human capital is the knowledge, skills, education, training, and ability possessed by workers
...
Skilled workers receive a
higher wage than unskilled workers because (1) skilled workers have a higher MRP than unskilled workers and
(2) the supply of skilled workers is smaller than the supply of unskilled workers
...


Lecture 29: The Market for Capital
production of capital
present value
demand for capital

Production of Capital

Capital is the physical tools of production: buidling, machinery, factories, and equipment
...
Current
consumption must be sacrificed in order to accumulate capital with which more output can be produced in the
future
...


Present Value

A profit maximizing firm will hire capital up to the point at which the marginal revenue product of capital is
equal to the marginal resource cost of capital
...
The problem is that dollars received in the future are not as valuable as
today's dollars
...

Present value is the value today of some amount to be received in the future
...
So, the present value of $105 to be received in 1 year is $100
...

present value
of $1 to

=

$1
-------------

be received
in t years

t
(1 + r)

where r = interest rate

For example, the present value of $100 to be received next year (with r = 3%) equals ($100)/(1 + 0
...
03) = $97
...
So, the present value of dollars to be received in the future falls as the interest rate rises
...
The
marginal revenue product of that airplane is the present value of that stream of payments: $24
...
If the price of the airplane (the marginal resource cost) is $20 million then the airline will
buy the plane
...
If the interest rate is
8%, the present value of the plane's MRP is $19
...
The airline will not buy the plane
...


The demand
curve for capital
is drawn for a
given interest
rate
...


Lecture 30: Natural Resources
land
market for natural resources

Land

Transfer earnings is the minimum amount necessary to keep the resource in its present use
...
This would be his transfer earnings
...

When the resource supply curve is upward sloping (meaning that units of the resource differ in their willingness
to be supplied), this rent is called inframarginal rent
...
Land
exists in a fixed supply so its price is entirely determined by demand
...

Land is not identical
...
So, the demand for land is not
identical for all units of land
...


Although the total supply of land is fixed, the supply of land for a specific use is positively sloped
...
g
...
g
...
As some of the resource is used up, less is available next year
...

Suppose that you have an oil well
...
Suppose the interest rate is 10%
...

The best choice depends on what the price of oil and costs of extraction are a year from now
...
If the profit in one year is
expected to still be less than $66, you will extract and sell the oil now
...
So, as the interest rate rises more oil is
extracted and sold today
...
In general,



high interest rate use natural resources quickly
low interest rate use natural resources slowly

Lecture 31: Imperfect Information
optimal quantity of information
information problems
adverse selection in the used car market

Optimal Quantity of Information

We have assumed perfect information in each of the four market structures we examined
...
In fact, the optimal quantity of information is likely to be less than 100
percent
...
The cost of acquiring an
additonal piece of information rises with the quantity of information
...


The optimal quantity of information is likely
to be less than 100 percent
...


Information Problems


bicycle theft insurance example

Suppose that a replacement bicycle costs $200 and that the probability of having your bike stolen in York is
10%
...

However, 10% is the average theft probability over the whole city
...
Suppose
that the theft rate in East York is 25%, 10% in West York, and 5% in North York
...
However, the insurance
is overpriced for residents of East York so they do not purchase the insurance
...
The insurance company will experience claims
from more than 10% of those who have the insurance
...
Consider the market for used cars
...
After one has owned a car for a
while, one learns something about the quality of the automobile
...

Since the buyer cannot tell the difference between a good and a bad car, both good and bad cars must sell for
the same price somewhere in between the low value of a lemon and the high value of a good car
...
A buyer is willing to pay $2000 for a good car and $1000 for a
lemon
...
Since the price will reflect the
average car quality, all used cars will sell for $1400 (the expected value to a buyer of a random used car)
...
Therefore, only lemons will be offered for sale
...




brand names
guarantees and warranties

Lecture 32 - Auctions
types of auctions
private values
common values

Types of Auctions





English auction - highest bidder gets the object being sold for a price equal to the final bid
Dutch auction - price is lowered until some buyers signals; buyer gets the object at the price called before he
signaled
sealed-bid, first-price auction - bidders write their bids on a piece of paper; object sold to the highest bidder at
the price she bid
sealed-bid, second-price auction - object sold to the highest bidder at the price bid by the second highest bidder

Private Values

In a private values information environment, the object being auctioned has a different value to different bidders
and each bidder does not know what other buyers are willing to pay
...
The object is sold to the person with the highest buyer value at a price nearly
equal to the second highest buyer value
...
So, the object is sold to the person
with the highest buyer value at a price equal to the second highest buyer value
...

A Dutch auction is equivalent to a sealed-bid first-price auction: the object goes to the highest bidder at the
price she bid and the bidder must choose a bid without knowing the bids of any other bidders
...
If all bidders
scale their bids below their willingess to pay by the same proportion, then the winner of a Dutch or sealed-bid
first-price auction will be the bidder with the highest buyer value and she will pay a price below her buyer
value
...

In a sealed bid auction for oil leases, the company that had the highest estimate of the value of the oil deposit
would win the contract and would pay its expected value
...
The company that most badly
overestimated the value would win the bidding
...


Lecture 33: Public Choice and Public Goods
why does the government intervene in the economy?
public goods
how much should the government spend on a public good
how much will be spent?
median voter theorem
representative democracy

Why Does the Government Intervene in the Economy?
1
...
rent seeking: people use government institutions to promote private ends

Assume that people act in the same way in both their private and public roles: in rational pursuit of their own
self-interest
...

Public choice theory is the analysis of collective decision making
...


excludability
a person can be prevented from using the good
rivalry
one person's use diminishes other people's use

Because people can enjoy a public good without paying for it, they have an incentive to be a free rider: to
consume the public good without paying for it
...
So, the efficient quantity of streetlights is 5
...
voluntary contributions

none will be supplied since the MC of the first streetlight is greater than the MB for each person
2
...
They would unanimously vote
for 5 streetlights
...

3
...
They would unanimously vote
for the first streetlight
...
But, Jones and
Brown will vote against the fifth
...


Median Voter Theorem

Notice that Jones always got her way in the votes when the costs were shared equally
...
To
maximize votes, candidates will select a position that reflects the median voter
...


Representative Democracy

In a representative democracy citizens vote for individuals to represent them in government activities
...

The ability of small groups to obtain decisions favorable to special interest groups stems from:
1
...
logrolling - vote trading
3
...
Microsoft
regulation of natural monopolies
Anti-trust Policy

Anti-trust policy is designed to control the growth of monopoly and to prevent undesirable business practices
...
Sherman Antitrust Act (1890)
o outlaws monopoly and restraint of trade
2
...
Federal Trade Commission Act (1914)
o bans unfair methods of competition

phases of antitrust policy:
1
...
per se rule (1914-1980)
o actions that even had the potential to be monopolizing were illegal
3
...
Microsoft

The Department of Justices alleges that Microsoft monopolized the market for PC operating systems and
leveraged this monopoly power in markets for complementary goods such as browsers
...
monopolization of the market for operating systems for PC's
o DOJ needs to show that MS used its monopoly power
o typically, this means charging a high price
2
...
anti-competitive contractual arrangements with various vendors of related goods

The judge in the case made the following findings of fact:






MS has a monopoly in PC operating systems
MS has used its monopoly power and harmed competitors
MS has hobbled the innovation process
MS actions harmed consumers
various MS contracts had anti-competitive implications

The judge ordered that Microsoft be broken up into two separate businesses: one with the operating system and
one with everything else
...

The agreed upon settlement does not prevent Microsoft from tying software like its Web browser, e-mail client
and media player with its operating system -- initially an issue that was a cornerstone of the government's case
against Microsoft but does require the company to provide software developers with the APIs used by
Microsoft's middleware to interoperate with its operating systems, allowing developers to create competing
products that can utilize the integrated functions Microsoft includes in its own middleware
...

The agreement also prohibits Microsoft from retaliating against any PC manufacturers or software makers for
supporting or developing competing software
...
It also bans Microsoft from entering into
exclusive agreements
...

Finally, as noted above, the settlement includes a provision for a panel of three independent monitors, which
will work from Microsoft campuses and have full access to the company's books, records, systems (including
source code), and personnel for five years
...

The European Commission also has ruled that Microsoft violated anti-trust laws on two counts
...
And two, by withholding crucial information about how Windows works, the
company has also disadvantaged competitors in the market for server software that runs networks of PCs
...

In addition to paying a large fine, the EC wants Microsoft to reveal some of the computer code inside Windows
in order to create a level-playing field in the server software market
...


Regulation of Natural Monopolies

The objective of antitrust policy is to enhance the competitive environment by controlling and limiting the
abuse of monopoly power via regualtion
...




economic regulation - control of price and quantity for a specific industry
social regulation - health, safety, performance, and environmental standards

In some cases the government regulates the production of a monopoly in order to promote economic efficiency
...
marginal cost
pricing - require
the firm to
produce the
efficient level of
output (where P
= MC)
2
...
marginal cost
pricing with a
subsidy - cover
the firm's losses
under MC
pricing with a
subsidy

Lecture 35: Externalities
externalities
optimal quantity of pollution

Externalities

Externalities are side effects of production or consumption that impact on third parties
...
Private costs are borne by someone
involved in the transaction that created the externality
...
The same distinction is made between private and external benefits
...


Optimal Quantity of Pollution

Pollution is an example of an externality
...

Reduction of the quantity of waste discharged into the environment is called pollution abatement
...
So, polluters receive benefits from discharging wastes
into the environment
...


The marginal social cost of pollution is the total costs borne by all members of society as a result of one more
unit of pollution
...

The optimal quantity of pollution balances out the marginal social cost of pollution with the marginal value of
waste discharge
...
Assign Property Rights

The Coase theorem says that in the absence of transactions costs, problems of externalities will be resolved
efficiently through private exchange
...
If the fertilizer company owns the lake the brewery can pay it to
reduce emissions
...
Bargaining will
result in the efficient outcome
...
The fertilizer company
would be willing to pay to be permitted to dump wastes in the lake and the brewery will be willing to receive
payments equal to the damage the wastes do to them
...
No matter
who was initially given ownership of the lake we will get the same level of emissions
...
Command and Control

Command and control or government regulation works by mandating a level of performance, usually by
requiring firms to adopt specific pollution control technology
...

3
...


4
...
Emissions Trading

Firms are required to possess permits for each unit of pollution emitted and these permits can be bought and
sold
...
Our firm might receive 6000 permits
...
reduce emissions to 6000 tons
2
...
reduce emissions below 6000 tons, to say 3500 tons, and sell the excess 2500 permits

What do we do? It depends on the costs of reducing sulfur emissions and the price of a permit
...
Those firms that can cheaply reduce emissions will end up selling permits to
those firms that find it expensive to reduce sulfur emissions
...


Firms will be willing to pay up to
the marginal value of waste
discharge (their abatement costs)
for a permit
...


Lecture 37: Poverty in America
income inequality
measuring poverty
who are the poor?
causes of poverty
programs to help the poor
welfare reform
Income Inequality

Why are some families poor even in the world's richest nation?
% of national income (2004)
bottom 20%

3
...
1

bottom 60%

26
...
9

bottom 100%

100

A Lorenz
curve is a
picture of
how income
is
cumulativel
y
distributed
among
members of
a
population
...


Measuring Poverty

A country's measure of poverty must compare relative income levels within that country
...
S
...


In 2004, the poverty level for a family of 4 (2 adults and 2 children) was $19,157
...
0 million U
...

residents live below the poverty line
...
7%
...
The record low poverty rate was
11
...
It rose in the late 1970's but has fallen since
...





the highest incidence of poverty occurs among those who are under age 18: 17
...
8%, is less than that for those age 18 to 64, 11
...
7%) and Hispanics (21
...
8%)
the poverty rate among married couples is 5
...
4%

Causes of Poverty




lack of a job - accounts for 3/4th of those in poverty
place of residence - 2/3 of the poor live in big cities; 1/3 live in rural areas
lack of education - 25% of the people with less than 8 years of schooling live in poverty

Programs to Help the Poor

Social insurance programs are designed to replace the lost income of those who worked but are now retired or
disabled
...

Income assistance programs provide money and in-kind benefits to the poor
...
Also suppose that it takes 3 hours
of labor to produce a bushel of wheat in Germany while it requires 4 hours of labor to produce a bushel of
wheat in Poland
...
Germany also has the absolute advantage in the production of wheat
...
A country has a comparative advantage in producing a good if
it produces the good at a lower opportunity cost compared to another country
...
Poland has the comparative advantage in wheat production
...
Germans are used to exchanging 15 kegs of
beer for 10 bushels of wheat while the Polish farmer is used to getting 10 kegs of beer for 10 bushels of wheat
...


A Graphical Example

If both countries specialize producing the good in which they have the comparative advantage and then trade,
they can end up consuming at points that lie above their production possibilities frontier
...
Once a country opens up to trade, the price of an item becomes the world price
...


For an import good,
the price falls to the
world price, making
consumers better
off
...

Domestic production
of the good falls
...
Domestic
producers are better
off because the
higher price leans
higher profits
...


Tariffs

A tariff is a tax on imports
...

Consumers are losers because
they pay a higher price and
buy less of the product
...


Import Quotas

A quota is a limit on the amount of imports
...
S
...


The quota has the same
effects on producers and
consumers as a tariff
...


Other Barriers to Trade




export subsidies
health & safety standards
government procurement policies

Arguments for Protectionism
1
...

3
...


save and promote domestic jobs - although costs outweigh benefits
infant industries - a subsidy is less costly
national defense - ignores stockpiling and purchases from friendly countries
"fair" trade - unlikely to force other countries to lower their trade barriers



---