August 25, 2010 Economics science of choice o Definition goes back to economist Gary Becker, showed economic analysis

s can be used to answer issues not related to economics (Who should I marry, How many kids should I have, etc.) o Cost-Benefit Analysis can be applied to any decision with choices to be made Marginal one more/less Gains from Trade under right conditions, economic activity everyone can be better off than they were before o US Pre-Specialization: 500 shrimp/1,000 computers; PostSpecialization: 0 shrimp/2,000 computers o Vietnam Pre-Specialization: 1,000 shrimp/500 computers; PostSpecialization: 2,000 shrimp/0 computers o US Post-Trade: 750 shrimp/1250 computers o Vietnam Post-Trade: 1250/750 shrimp (Numbers are hypothetical) o Specialization more shrimp and more computers for both countries o In economics, value can be created from nowhere o Comparative advantage even if US has absolute advantage in both shrimp and computer, both sides better off through specialization (incentive to trade) Comes from economist David Ricardo Two sides to market = consumers, producers Buyers key number: Qd (quantity demanded; sum of Qd for each individual) o Qd = f (P, Y, Ps, Pc, Ye, Tastes) Y = Income s = Substitute c = Compliment e = Expected

August 30, 2010 Demand Curve: Qd = f(P) o Y, Ps, Pc, Ye, Tastes = ceteris paribus, Everything else held constant Determinants of demand o Economist Alfred Marshal graphs Label Everything o If price stays the same but price of substitute good increases, Qd still changes (graph shifts right), creating new relationship between price and Qd o Change in determinant of demand shift in demand curve Qs = Sum of supply by individual sellers o Qs = g (P, Pi, Pe, Tech)

P: Price Pi: Price of inputs Pe : Expected price, Tech: Technology Supply Curve: Qs = g(P) o P, Pi, Pe, Tech = determinants of demand

Quantity supplied > quantity demanded surplus Quantity demanded > quantity supplied deficit Surplus incentive for suppliers to change behavior o Smaller surplus closer to goal Deficit incentive for buyers to change behavior Equilibrium neither has incentive to change behavior o Never happens in real world

September 1, 2010 EXAMPLES: - Hummer market: increase in gas price (price of compliment) demand curve shifts left o Write: due to ^ Pc (Price of compliment)

Movie ticket market: increase in PPV movies (price of sub) demand curve shifts right Newspaper market: increase in journalists salaries (price of input) supply curve shifts left; big important news (tastes) demand curve shifts right o Change in quantity cant be determined; write: Q1 is unknown Occams Razor simple explanations, al things held equal, are better Al economic activity (including S/D market) gains from trade o Shoe market: shoes cost $45 (explicit cost), could have used money elsewhere (opportunity cost); if willing to pay $47.50, individual gains from trade is $2.50 o If 453 people are willing to pay $47.50, 452 are willing to pay a bit more, 451 more, etc. o Individual gains from trade = 1 person, consumer surplus = gains from trade for all consumers (difference between what was actually given up and what they were willing to give up) Area below demand curve and above equilibrium price o If shoes cost $40 to make, at $45, producers gains from trade = $5 Producer surplus = area to left of supply curve but below equilibrium price

September 8, 2010 - Determinants of Demand: 1) Prices of related goods (Ps, Pc) 2) Income (Y) 3) Tastes/Preferences 4) Expectations (Ye, Pe) - Deadweight Loss - lost value due to lack of trade - Market value/equilibrium ensures max gains from trade o No wasteful trade o Price allows informed decisions o Prices = information o Equilibrium price tells buyer you should only buy product if you are willing to pay at least that much o Equilibrium price tells seller you should only produce/sell product if producing/selling costs at most that much o Only producers with lowest costs will produce products o Everyone who could gain from trade gets involved in the market; everyone else leaves o Economic Efficiency the market creating all gains from trade possible with no wasteful trades o If price for any reason doesnt come from market equilibrium deadweight loss

In case of surplus, quantity demanded is the amount actually traded In case of shortage, quantity supplied is the amount actually traded Consumer surplus remains area above demand curve and above price of all units actually traded Producer surplus remains area below price and above supply curve for all units actually traded Because price is at P1, not at equilibrium, value is lost (not as much consumer/supplier surplus as possible); lost value of society deadweight loss o Deadweight loss in figure above for surplus = Triangle from Q1 to Q2 o Producers still producing now have bigger producer surplus (all producers up to Q1); producers producing between Q1 and Q2 now get nothing o Consumer surplus decreases Price floors exist in labor market (minimum wage) o Surplus in labor market is unemployment Price ceilings exist in organ transplant market (PC = $0)

September 13, 2010 - Elasticity o (% Change in Y)/(% Change in X) o Change in Y always results from Change in X o (% Change in Qd)/(% Change in P) = Epsilon d p (Price Elasticity of Demand) o / =/= over; results from

o (% Change in Qd)/(% Change in Y) = Epsilon d y (Income Elasticity of Demand) o (% Change in Qs)/(% Change in P) = Epsilon s p o Midpoint Method: % Change in Qd = (Change in Qd)/Qbar Change in Qd = Qnew Qold Qbar = (Qnew + Qold)/2 Price elasticity of demand how much quantity demanded changes in response to price (% Change in Qd)/(% Change in Ps or Pc) (Cross Price Elasticity) o (% Change in Hot Dog Price)/(% Change in Hot Dog Bun Price) When CPE is zero, good are not related Negative CPE implies complimentary good Positive CPE implies substitute good The higher the number, the stronger the relationship In epsilon notation, cause is on bottom (in CPE, price on bottom, demand on top) The only determinant for which no elasticity of demand exists is taste The only determinant for which no elasticity of supply exists is technology Labor Market Graph o Minimum wage will cause economic problems such as deadweight loss, unemployment, makes it difficult to allocate resources to the right people o However, some people benefit from minimum wage (being paid more) o Leads to question of costs/benefits o Question can be answered through elasticity; particularly price elasticity of demand and price elasticity of supply o Price control skews information price is able to provide o If firms dont care about the amount of wage they pay (buyers in labor market) and if workers dont care about amount of wage they get (sellers in labor market), then distortions to price have very little effect o Low price elasticity = closer to a vertical line o When price elasticity of S and D are low in labor market (lines are steeper), little deadweight loss, little surplus, high benefit minimum wage is a good idea o When price elasticity of S and D are very elastic, people react to wage more and a different number of workers/hirers results from different wages; high unemployment, high deadweight loss o When demand is elastic, price and total revenue move in opposite directions

September 15, 2010 - Taxes o Excise tax a dollar amount on every unit purchased (as opposed to a percentage)

o Tax for consumers on bowling (homework #2) less bowling by consumers (shift in demand curve to left) o When dealing with taxes, dont think of shifts left or right; think of it as a shift down because it can be measured on price axis exactly how much demand curve is going to move o Suppose $2 tax per game; no way to know change in quantity but we know curve will shift down by exactly $2 o Determinants did not change; determinants affect amount buyers are willing to pay, but with tax, buyers are still willing to pay the same amount o They are willing to pay the bowling alley exactly $2 less than before, but are willing to pay the same amount overall o Consumer Price stays the same (the price paid by buyers) but Producer Price goes down by two dollars (price received by sellers) o Square between Pcp, Ppp, and Q1 is tax revenue o Consumer surplus is between original demand curve and Pcp o Producer surplus is between Ppp and supply curve o Deadweight loss occurs in triangle between Q1 and Q0 because although consumers pay same amount, lose quantity; lost value o Who pays more of tax depends on elasticity; if supply curve is totally elastic, suppliers pay all of the tax and vice versa (because suppliers cannot react to price in this situation) o Whichever is more elastic pays less of the tax o If you can respond to the price, you have less burden because you can push burden to other side o Pcp, Ppp, deadweight loss, tax revenue, consumer surplus, and producer surplus are all exactly the same no matter who pays tax Subsidies o Supply curve changes if government provides subsidies; subsidies shift supply curve right because suppliers are willing to bring more to market for same price o Pcp decreases, Psp increases o Total subsidy = square enclosed by Ppp, Pcp, and Q1 o Additional CS trapezoid enclosed by D, P0, and Pcp o Additional PS trapezoid enclosed by S, Ppp, and P0 o Triangle enclosed by S, D, and Q1 is still deadweight loss because this area represents resources that could have been allocated to producing something else

September 27, 2010 - Consumer Choice Theory o Behavioral Assumptions assumptions that have to be in place for CCT to exist 1. Consumers want to maximize utility a. Utility amount of satisfaction gained 2. People are knowledgeable

3. All consumers are rationaln 4. More is preferred to less a. When you have two baskets of goods, if they have the same number of every good except one has more of at least one good, the basket with more is always better and always provides higher utility 5. Diminishing Marginal Rate of Substitution a. With one Q on X and one Q on Y, line of maximum utility will have decreasing slope b. Indifference curves everything on Ualpha provides same level of utility, everything on Ubeta (above Ualpha) provides higher level of utility c. What is desirable? Reaching highest indifference curve because more is preferred to less Simplifying Assumptions assumptions that have to be in place to draw graphs of CCT 1. Only two goods exist 2. There is only one time period 3. Income is equal to PQ for good 1 plus PQ for good 2 Goods are mangos and pluots Y = PmQm + PpQp Y-PpQp = PmQm Y/Pm (Pp/Pm)Qp = Qm Qm = (Y/Pm)(Pp/Pm)Qp Y = b + mx b = how many mangos if 0 pluots?

Budget line represents how many of each good could be consumed if all income is used (looks like PP graph) Feasible set/Budget set include all values under BL Labels: Y axis is labeled Qm (for mango; specific point = Y/Pm), X axis is labeled Qp (for pluot; specific point = Y/Pp) Inflation no change Says nothing about what decision is desirable without indifference curves; only shows what is feasible At some indifference curve tangent to the budget line, maximum utility within feasible set represents equilibrium in CCT o Equilibrium no decision maker has any incentive to change his/her behavior Marginal Rate of Substitution tradeoff in consumers mind; slope of indifference curve Diminishing return shape of indifference curve Slope of budget line = slope of indifference curve at equilibrium

o Tradeoff in consumers mind and tradeoff in market are same at equilibrium o (Pp)/(Pm) = (MUp)/(Mum) (Mum)/(Pm) = (MUp)/(Pp) Law of demand is not a law; law of demand is a hypothesis that can be proven wrong o Yet to be proven wrong

October 6, 2010 Perfect Substitutes provide the same amount of utility o Perfect Substitutes rate of substitution is NOT diminishing; marginal rate of substitute is constant, straight indifference curve o Perfectly elastic individual demand curve With a pair of shoes, one more left shoe does not increase utility; L shaped indifference curve Perfectly inelastic individual demand curve

October 11, 2010 Profit is the goal of an individual firm o Profit = capital pi o Profit = Total Revenue Total Costs o Costs =/= Expenses o Costs = opportunity costs Q = TP = F (L, K, Land, E.T.) o K = Capital (means of production) o L = Labor o E.T. = Entrepreneurial Talent Two kinds of decisions: short run, long run o How long is long run? Long enough that any combination of inputs can be selected; all contracts are negotiable o How long is short run? Not long run; some inputs cannot be changed o Generally, K, Land, E.T. are fixed in short run o Model: Q on Y axis, L on X axis, TP increases at a decreasing rate o Model: Change in Q on Y axis, L on X axis, MP (Marginal Product) decreases at increasing rate) o Possible for MP to be negative o Diminishing Marginal Product MP decreases at fixed rate o MP = (Change in Q)/(Change in L) o AP (Average Product) = Q/L

o Maximum of AP must be on MP o Model: ($/Q) on Y-axis, Q on X-axis, upside down average product curve is the MC cruve Based on assumption that all workers have same wage and as many people can be hired as desired; supply curve in labor market is infinitely elastic o Duality 1:1 correspondence between product curves and cost curves If production process is known, so are costs of firm MC = (Change in TC)/(Change in Q) x (Change in L)/(Change in L) = (Change in TC)/(Change in L) x (Change in L)/(Change in Q) = wage x (Change in L)/(Change in Q) = wage/(Change in Q/Change in L) = wage/MP October 13, 2010 - Marginal cost rises because marginal product is falling - MC = (Change in TC)/(Change in Q) = (Change in VC)/(Change in Q) = wage/MP - Marginal product rises because of specialization of labor (graph above) - Marginal product falls because of diminishing returns (graph above) - TC/Q = VC/Q + FC/Q

ATC = AVC + AFC

October 18, 2010 - Long Run Average Total Cost curve is tangent to several short run average total cost curves - Short run curves always include MC and ATC - Increasing returns due to specialization (on left) - Decreasing returns to scale on right - Model of Perfect Competition is based on five assumptions: 1) Goal is to maximize economic profit (TR-TC; Change in TR/Change in TQ Change in TC [Marginal Revenue]/Change in Q [Marginal Cost]) Maximum profit is achieved at the Q where MR = MC 2) Standardized Product (perfect substitutes within the market) 3) Many Firms Many = so many firms that the behavior of one of those firms does not impact the market 4) Equal access to resources Only draw 1 set of cost curves o In perfect competition, because of standardized product and many firms, the price = marginal cost because firm chooses output quantity o Output level is found through price = MC 5) Free Entry & Exit in the long run o Difference between ATC and the amount being produced (average revenue) = area of profit October 20, 2010 - Firms short run equilibrium quantity is when price = marginal cost

If MC, ATC, and P intersect, profit = 0 o Entrepreneur is making just enough to pay for all costs and nothing more; just enough that he has no incentive to do something else When ATC is above 0, profit is negative Profit is always comparing Marginal Revenue with Marginal Total Cost When AVC, MC, and price meet, only enough money is made to pay wages; not enough funny for other fixed costs Supply curve displays the relationship between the price of the good and the quantity the firm is willing and able to bring to market, everything else held constant Without specialization, MC = S Supply = Sum of all MCs for all firms in market Low point on S means small number of firms have lowest AVC so they are still able to sell at low prices Perfect competition in long run

October 25, 2010 - LRAC is U-shaped because of: o Initially, specialization of K and bulk discounts lead to Economies of Scale o Eventually, organization costs & information problems lead to Diseconomies of Scale - LRAC comes from outlining several sets of short run cost curves - Supply curves come from MC curves - Demand curve for individual firm (Df) comes from where MC hits MR o MR = Df o MC = MR represents short run equilibrium for firm o If MC = ATC, firm is breaking even o If AR stays the same and economies of scale says average total costs go down, profit must go up o Price stays the same because of many firms o In long run, if firms can change scale and increase profit, they have an incentive to change behavior o If incentive exists to change behavior, we are not in equilibrium yet o Free entry and exit more firms want to convert to where the profit is S increases in short term due to more sellers Q falls because D stays the same Df=MR=AR decreases to minimum LRAC quantity no profit no incentive to enter o When no one has any incentive to change behavior (long run equilibrium) LRAC = ATC = MTC = Df o If in long run, D falls, S will fall due to fewer sellers because firms will leave due to free exit until equilibrium in long run is reached o Long run supply curve: horizontal line at equilibrium price on short run D/S Market Firms entering market will not shift Slr

November 1, 2010 - Allocative efficiency final product goes to consumers that value them the most - Productive efficiency when only lowest cost units get produced - Combine to form economic efficiency - Market Failure o Monopoly or Market Power o Externalities Factors that dont show up in supply/demand curve o Public Goods/Commons o Asymmetric Information - Non-rivalrous providing the good to an additional consumer has zero additional cost; doesnt get used up when consumed - Model of Monopoly o Assumptions: Maximize Profit MR = MC 1 firm (firm is the entire market) 1 product Barriers to entry/no entry Firm in market has control of important resource Increasing returns to scale/small market size Private/secret technology Legal Barriers (patents, copyrights, ) o Cost curves dont change; same MC, ATC, AVC as in previous units o Because firm is market, the demand curve is the demand curve in monopoly Downward sloping o MR starts at same place as D, but is steeper o Quantity label = Qm (m for monopoly); Price label = Pm November 3, 2010 - In monopoly, MR =/= P - MR = P (P/Price elasticity of demand) = P(1-1/Price elasticity of demand) - P > MC - Market can create deadweight loss because of the monopoly - Profit exits when AR > ATC - Natural Monopoly if more firms were in the market, none of them would be able to cover their costs - Legal Monopoly LOOK AT PICTURE IN BOOK - Nationalization/government ownership gov. can take over firm November 8, 2010 - Natural monopoly if firm produces above monopoly price (Qm), would make a profit (P above ATC); would lose money if operating at competitive price quantity (Qpc) (P below ATC)

Triangle closed by D=AR, MC, and Qm deadweight loss; represents amount people are willing to pay that the firm doesnt capitalize on If the price is already greater than marginal cost, anything that moves the price closer to marginal cost reduces the deadweight loss P must equal MC to get rid of deadweight loss completely Natural monopoly doesnt make marginal cost pricing an option because it drives the firm out of business Firm stays in business for any price ceiling at or above where P = ATC o Deadweight loss is not gone; just smaller Average Cost Pricing is the lowest a price ceiling can be without driving the monopoly out of business (best possible price regulation) Pricing as close to average cost pricing as possible is most beneficial Goodwill Ads Price Discrimination o 1st degree charge every buyer a unique price (goal: to charge each buyer the max price they are willing to pay) o 2nd degree bulk discounts o 3rd degree hurdle (firm must separate market into high elasticity and low elasticity as well as seal market against arbitrage) In perfect competition, MR = P In monopoly, MR = P(1-(1/Price Elasticity of Demand)) Arbitrage reselling of a good

November 10, 2010 - Perfect Competition Firm:

Monopoly Firm:

No incentive to advertise in perfect competition Oligopoly more than one firm, but not very many; few firms but each with plenty of influence o Rival firms pay close attention to each other in everything that they do o Industrial Organization o Monopolistic Competition o Brand Mkt vs. Broader Mkt. Every firm is its own brand within the broader market Brand Market looks like a monopoly 1 firm; 1 product No entry; ownership of brand = legal barrier to entry Broader Market Many firms; differentiated product Free entry

November 15, 2010 - Tips for drawing natural monopoly: o Steep demand curve (D=AR) o Much steeper MR curve o Relatively flat MC curve o Creates a lot of room to draw ATC curve - Monopolistic Competition (no perfect substitutes because of brand, comes between perfect Competition (industry advertising, just breaking even in long run, efficiency) and Monopoly (deadweight loss, goodwill advertising)

Deadweight loss because people are willing to pay more than cost Getting rid of trademark gets rid of deadwieight loss and brings closer to perfect competition Standardized product Love of Variety o Paul Krugmans Nobel Prize

November 22, 2010 o Externalities S = MSC D = MSB As long as S/D curve show all possible costs/benefits, equilibrium is most efficient All benefits to market show up in demand curve All costs show up in supply curve Negative externality = external cost = a cost of the market activity that doesnt show up in the supply curve

Deadweight loss in neg. externality = triangle created by D, MSC, and Qo Positive externality MSB=D + externality Deadweight loss Qo, MSB, S Government based solutions Peguvian tax (neg. ext.), Peguvian subsidy (pos. ext.) Market based solutions (Ronald Coase) Coase Theorem Transaction costs (costs to individuals of making the market deals) must be low enough for market to produce efficient outcome Even in presence of externalities, market can still reach a solution if transaction costs are reasonably low

November 29, 2010 - Market Failure o Market Power if firms have monopoly power/influence on price in market, then perfect competition doesnt hold o Externalities benefits/costs that dont affect decision makers in market; supply curve, demand curve dont represent true benefits and true costs o Public Goods/Commons PRIVATE GOODS Excludable (supplier of good can prevent people who dont pay for it from consuming it), rival (good cannot be consumed by more than one person) ARTIFICIALLY SCARCE GOODS (MS Word) Excludable, not rival COMMONS Rival, not excludable (OVERCONSUMPTION OF COMMONS CAUSED BY LACK OF COST) PUBLIC GOODS Not excludable, not rival Free-riders lead to underconsumption of public goods Government provides legal monopolies to encourage creation of new public goods because normally public goods will be under produced and under consumed, moving public goods to artificially scare goods

December 1, 2010 - Fourth type of market failure: asymmetric information o Diminishing marginal utility is the assumption for utility function o Utility function (U on Y axis, Q on X axis):

Expected Value EV = Prob (Outcome 1) x Payoff + Prob (Outcome 2) x Payoff Probabilities can be mapped out on a straight line between point 1 and last point Expected payoff will always be better if we know for certain Consumers are risk averse they dislike having to have to gamble instead of getting a guaranteed number of utils Market failures: failures to reach efficiency Problems of asymmetric information: o How do you insure employees work as hard as they can? Moral Hazard: hidden actions Solutions to Moral Hazard: Commissions Stock options Deductibles o How do you now whether you are hiring good workers? Adverse Selection: hidden info/quality Solution to Adverse Selection must reveal accurate information about good and must be costly to be credible (costly enough that low quality sellers cannot make up difference but high quality sellers will): Signaling test drive Screening