Microeconomics

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Economics: Study of choice under conditions of scarcity Opportunity Cost: what you give up when making a choice Society Resources: o Land (natural resources) o Labor: time spent on production o Capital: long-lasting tool that labor uses to produce goods/services Physical Human o Entrepreneurship: Resource Allocation What is produced? .. Opp cost How to produce? How much of the four resources are used Who gets it? Distribution? 3 Methods of Resource Allocation Command who gets what (communist central gov.) Tradition resources allocated the way theyve always been o Adv: Stable, no unemployment, primitive societies o Disadv: no growth no change in standard of living Market everyone does what they want with what they have

Day 2

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Model: abstract representation of reality. ie graphs, functions. Simple as possible to accomplish purpose Assumptions Simplifying doesnt affect conclusions that would be reached (lack of trees on roadmap) makes model simple as can be to get the gist of it Critical affects conclusions of model (open roads on map in places of construction in reality) Supply/Demand model of how prices are determined in many markets (group of buyers and sellers with potential to trade with each other) (can be broad or narrow) movement of prices affects resource allocation Ex. Market for gasoline Quantity demanded (QD) number of gallons buyers in market would choose to buy given constraints they face QD = D(Price) Law of Demand: as price rises, QD down o D(Income) gross income, Positive Relationship Normal good: rise in income increases demand for that good. House, car, health club membership, food Inferior good: rise in income decreases demand D(Wealth) net worth. Direct relationship D(Substitutes) similar good Direct relationship D(Complement) second good bought along with first good D(Population) positive relationship D(Expected Price)- price ppl expect in future Positive relationship

o o o o o

o D(Preference) Positive relationship

o Demand Curve movement along vs shift of curve change in price of good causes quantity of demand to change movement along curve when anything else other than price of good causes quantity demanded to change demand curve shifts 2

QD

Increase in income causes curve to shift right, etc.

D2 D1

Supply: QS Quantity supplied - # of gallons gas suppliers would like to sell in the US each month given their constraints QS= S(price) higher price, more supply Law of Supply S(inputs) labor, resources. Higher, less supply S(Alternate) alternative good that producer can easily produce or at alternative locations. More/higher price of alternative, less supply of original good S(Technology) advancements improvement shifts right S(Weather) etc. 3

S(Expected Price) POV of producer, higher expectation of price less supply S(# Firms) more industry, higher supply S P

Q P B A S
Prices go down QS decreases, QD increases: Excess Supply

excess demand D Q Equilibrium set of values for endogenous variables that wont change unless an exogenous variable changes o Endogenous Prices and Quantity; determined inside model o Exogenous A given Excess Supply less demand than supply - prices decrease Excess demand prices increase to get back to equilibrium Short side rule: difference between QS and QD, the lesser one wins Comparative Statics change one or more of exogenous variables and observe change that it causes in endogenous variables Price of input goes up - Supply shifts left, equilibrium price increases and quantity demanded decreases

ex. Price of electricity drops ie Demand decreases shift left. Equilibrium and quantity demanded decreases

Day 3

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Government Intervention change prices to make economy more fair Price Floor: When market price is too low and sellers are unhappy o a minimum price set by Gov. has to be set above the equilibrium price, causing an excess supply which would force the price back dowb.

o Agricultural Price Floors As technology increases, supply keeps shifting right, the prices keep decreasing, hurting farmers o Excess supply is temporary. When its more long-lasting, its called a Surplus caused by price floors o How to maintain the price floor 1. Government buys up the surplus to ensure that the price doesnt decrease not best alternative 2. Artificially shift demand curve to the right to eliminate the surplus gov. funds advertising on surplus items such as milk. TELL CADY. Food stamps to get rid of extra food 3. Artificially shift supply curve leftward in order to get equilibrium at price floor price done by paying farmers to not grow crops ewg.org

Price Ceilings: maximum allowable price. Only impacts market if below equilibrium price when price is too high P2 o If gov. enacts a price ceiling, theres an excess demand a long term excess demand, its called a shortage if scalpers by all tickets they will try to sell at price P2 Total Revenue of tix before ceiling would be PexQe When ceiling is enacted, the new price decreases the total revenue 6

The difference between Pc and P2 x number of tix = scalpers revenue When supply curve keeps shifting left, price keeps rising So, a price ceiling can reduce the amount of people seeing plays due to increase in prices demanded by scalpers Rent Control Taxes o Doesnt matter who gov. taxes (buyers or sellers) o Ex. Quantity supplied at specific price? Or what must the minimum price be to supply X quantity. o Gov collects Tax on sellers: Ex. $100 tax on airlines ie suppliers will increase ticket prices by 100, so the supply curve shifts up ie left But at the new price ($300 from $200), there will be an excess supply forcing the price to decrease to new equilibrium ($260) this price is what buyers will pay to the airline Airlines have to pay $100 tax ie they only get what buyers pay minus $100 - $160 o Tax incidence who is really paying Look at what buyers pay and sellers pay before tax. Buyers pay $60 and sellers sell $40 the new difference between each and the original equilibrium Ex. If buyers are taxed $100 If you want to keep quantity the same, then the 100 is deducted from the original 200$ ie $100 Demand curve shifts down, so theres an excess demand which would force the price up until the new equilibrium ($160) $160 is how much buyers pay to the airline without tax. So they really are paying $260 o Tax incidence what buyers pay - $60 Sellers - $40 o IE. The tax will be split the same way 7

Subsidies Gov. pays either buyers or sellers o Ex. Subsidy of $10,000 per student per year given to the students o Tuition of $40,000 will attract Q1 students o If gov. gives $10,000 subsidy, students will be willing to pay $50,000 - increasing the number of students attending college o The demand shifts up Incidence: look at new equilibrium - $47,000 what students pay to the college, theyre really paying $37,000 with the subsidy Buyers benefit: Look at what they paid before and after subsidy: B:40,000 A:37,000 so $3000 Sellers benefit: $7,000

Day 4

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Elasticity compares % change in a variable caused by % change in another variable Sensitivity of quantity to changes in price Steep demand curve not too sensitive to price, opposite to a flat curve Depends on type of good Price Elasticity of Demand - % change in quantity demanded/% change in price of the good absolute value Price per gallon $3 $3.30 $3.60 # of gallons per week demanded 10,000 8,000 6,000

% change in quantity demanded the normal way = 2000/10,000 = 20% OR from $3.30 to $3.00 = 2,000/8,000 = 25% - Dont do this way Midpoint Rule: when calculating elasticities: % change in quantity demanded = change in quantity demanded/ Average Quantity demanded The average stabilizes the quantity from low to high or high to low % change in price change in price/ average price Elasticity of demand = change in quantity = 2,000/9,000 = 22.2% Change in price = .30/3.15 = 9.5% ED = 2.34 for going from 3 to 3.30 or vice versa Estimate for % change in quantity demanded caused by 1% change in price Even though line is straight line, the price elasticity changes along the line - % change in price decreases as % change in quantity demanded is increasing so Q/P increases Elasticity is 0 in the middle and greater above, lower below

Elasticity Continued

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Categories of Demand Elastic Demand: Price elasticity is larger than 1 ie % change in quantity > than % change in price. Price sensitive. Price up by 1%, Quantity down by more than 1% Inelastic Demand: Price elasticity is less than 1. Insensitive Unit elastic Demand: Price elasticity = 1. Ex. Price up by 1%, Quantity down by 1% Perfect Elastic Demand: Price elasticity is infinitive horizontal line Perfect Inelastic Demand: Price elasticity = 0: Undefined Quantity wont change even if price does Determinants of Elasticity Ease of substitution Nature of product: Necessity (Inelastic) or Luxury (Elastic) good ie movies. Ex. Ed for movies = 3.7. 10% rise in price = 37% decrease in quantity demanded Narrowness of Definition: easier to find substitutes for goods outside of the narrow market (specific categories) = more elastic. Ex. Food price increases = less substitutes (inelastic). Fruit increases = more subs. (elastic) Time Horizon: Short run (few months) ED = .25 for gas ie inelastic. Long Run changes in lifestyle (yr or longer) ED = .60 still inelastic, but larger. Demand for most goods is more elastic the longer we wait Importance in buyers budget: Demand is more elastic when a good is a bigger part of buyers budget Elasticity and Total Expenditure (Total Revenue). Expenditure = Revenue Price x Quantity (Area) = Total Expenditure/Revenue If demand is inelastic, we know total expenditure increases Demand Inelastic Demean Elastic IF price up TE increases TE decreases

10

If price decrease

TE decreases

TE up

Mass Transit: Demand is inelastic. A price increase will cause quantity demand to decrease less than the price rose ie TE/revenue increases Microsoft Anti-Trust Case ED for windows was .5 - inelastic If Price increases, quantity dropped, Total Revenue increased ie Total Cost would have decreased and profit would increase Profit = total revenue total cost if elastic and price decrease/quantity increases, TR increases, but total cost increases too. Profit is dependent on which one increases more Ex. War on Drugs Inelastic.

Qi Q1

small decrease in quantity demanded

Supply curve shifts left due to more risk in supplying illegal drug Increase in crime with increase in Price Ie Total Expenditure increase = crime by drug users increase & Total Revenue increase = crime by drug suppliers increase Focus more on demand shift curve left - TE and TR decrease, so crime by users and suppliers decrease Elasticity of demand for oil = .06 11

Price of oil - $100/barrel Quantity 88 million barrels/day Iran exports 2.5 million barrels/day 2.8% of world oil Straits of Hormuz 17 million.. 19% Embargo would cause a 2.8% increase in demand. What price will adjust the demand and supply back to equilibrium? Percentage change in Quan. Dem. = 2.8 2.8/percentage change in price = .06 % change in P = 46.7% ie A 46.7% increase in price will get the market back to equilibrium ie price of oil would be $146 same thing: 19/x = .06. X = 316.7% increase in oil price. New price would be $416.7

12

Consumer Theory

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Giffen: found Law of Demand to work backwards Person 1: wont spend more than $25. Goes out 10 times if $15 Person 2: will go out twice at meals of $30, 3x if $25, 5 times if $15 Market Demand (1+2): 2 meals at $30, 3 at $25, 15 at 15$ As-If Theory: peoples behavior conceptualized on point of what they would do Indifference Curve Approach: Assumptions about consumer preferences: 1. Rational Preference Comparability: consumer is able to choose between 2 goods Transitivity: consumer is able to use transitive property in choosing goods 2. More is better (non-satiation):

Q of movies

B region depends on consumer preference

7 Q of rest. meals A is preferred to B and B to C, so A to C Purple Line indifference Curve: Change in one will cause what kind of change in the other? If on same curve they are indifferent to each other Marginal Rate of Substitution (MRS) MRS = change in quantity of movies/ change in quantity of restaurant meals - slope of the line = MRS gets smaller as you move rightward along the curve willingness to trade one for the other decreases too much of one, not enough of other 13

A point on indiff curve willing to trade the amount X of one for one of the other Any point above indiff curve will be preferred to any point on the curve. Each point is indifferent to one another.Any point to the right of the curve is preferred, Left is dis-preferred Indifference Map: combination of various indifference curves. Higher ones are preferred by consumers they have higher utility (how well off consumer is). Curves cannot cross each other

Budget Constraint Assume: $300/mo to spend on movies and Rest. Price of rest: $20 P of movie: $10

Budget Line. Slope = -2 . change in quantity of movies/change in Q of Rest. AND Price of Rest/ P of movies: Price Ratio

Qr Income falls from $300 to $200. Everything else same Budget line shifts leftward parallel to original line 14

Income remains the same. Price of Rest falls from $20 to $15. Movies the same Line rotates outward due to being able to buy more meals Budget: $300 best possible point on budget line? movie: $10 restaurant: $20 - not on budget line, unaffordable -middle one is best point. Tangent to budget line. i.e MRS = price ratio

other line hits twice along budget line. First point MRS is larger than price ratio and altogether, the indiff. Curve is below the middle one ie worse off If MRS =3 & PR = 2 then Willing to trade 3 movies for meal but able to trade 2 for one meal trading 2 movies for meal means you can be better off Second Point MRS less than price ratio. If MRS = 1 and PR = 2 then willing to trade 1 meal for 1 movie, but able to trade 1 meal for 2 movies. trading 1 meal for 2 movies mean you can be better off If income increases, budget line shift to the right and need new indiff curve to maximize their possessions ie quantity of both can increase thus are normal goods OR income can increase and the quantity of one can decrease ie an inferior good Deriving the Demand Curve

15

Qm 30

Pr 20
-indv. demand curve for R, M

10 5

1415

30

Qr

14

Qr

Giffen good: good that violates law of demand b/c its inferior & income effect dominates substitution effect Q other goods Price of potatoes decreases, rotates out to the right Quantity of potatoes decreases

Q2 Q1

Q potatoes

Income and Substitution Effects of a Price Change Supposed price of X decreases Subs and Income effects on demand If price of X decrease: substitution increases toward X - Law of Demand Like income increases: If good X is normal: increase in demand for good X Law of Demand OR if good X is inferior: quantity demanded decreases violates law of demand has to dominate substitution effect 16

Giffen Good Occurs: Good is very inferior Income effect of a price change must be very large ie beer example already buying a lot of the good Price decrease caused person to change purchasing preferences Studies Devotion of time spent in either French or Econ QF 100 slope= PE/PF ie hours required to get a point ability assume PE/PF = 1. Trade of one point for the other

40

100

QE

MRS: willing to trade X amount of point in one subject for more in the other subj; If it = Price ratio, then best off Assume: addition of outside variable to affect price of econ point (amount of hours for studying) to go down then it rotates out QF 100

40

100

QE

17

PE decreased: substitution effect Q demanded for E would increase Income effect: if normal good QD.E would increase if inferior QD.E would decrease in favor for more QD,F

If Giffen good: so inferior, then QD.E decreases and QD,F increases

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Cost
Firms goals: maximize total profit ()

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Total profit = Total revenue Total cost Basic Principles of Cost Cost relates to a decision: ex. increase/decrease output level. Changing aspects of how things run Cost is opportunity cost: Cost is measured in dollars Cost is a flow variable (for firms): process that takes place over a period of time ex. cost per year/month, profit, revenue o not a stock variable: quantity that can be measured in a moment of time wealth Sunk cost are irrelevant and not considered: cost that has already been paid or must be paid in future regardless of your decision. Ex. nonrefundable ticket cant go to concert Categories of Cost Explicit: opportunity cost where money is exchanged money paid out Implicit: cost where money is not paid out Explicit Labor Costs benefits, taxes Raw materials Rent payments Interest payments Implicit Depreciation value of capital that is lost Forgone interest Foregone rent Foregone salary of owner

Accounting Cost: explicit cost + depreciation Economic Cost (cost, opp. cost): Explicit + Implicit (all of them) Fixed Cost: cost of all fixed inputs; Sunk costs irrelevant for other decisions Variable Cost: cost of all variable inputs 2 inputs: affect Fixed and Variable Cost

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Fixed Input: cannot be varied as output changes ex. space for nyu growth Variable Input: can be varied as output changes ex. more teachers

Short Run: with at least one input being fixed cant be varied Long Run: time horizon long enough to make all inputs variable inputs

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1/24/2012 11:46:00 AM

$ ATC avg. total cost (fixed costs) AVC

Q And LRATC is always less than or equal to ATC in short run Long Run Costs Q per day 0 1 2 3 Quantity per day 0 1 2 3 4 5 o Long Run Total Cost $0 $400 $600 $720 $900 $1200 Long Run Avg. Ttl Cost. LRTC/Q 400 300 240 225 240 Long Run Total Cost

ATC ATC LRATC

21

30 2

Short run costs marginal cost below average cost at A pulls avg down Short run Total Cost (TC) is always greater than Long Run Total Cost except at 2 where theyre equal ie the inputs at that level are the best and there are no other options in the long run to reduce the cost. Takes longer for ATC curve to hit minimum because its declining When it rises above average it pulls avg up If we start at A and want to move 2 units to 4 units in the short run In the long run, you move to C to $225 $

1K

18K

2 reasons for economies of sale: where 1K is 1. Increased opportunities for specialization 22

2. Spreading cost of lumpy inputs - input that a fixed amount of it suffices for a wide range iof output bad Diseconomies of scale: more output produces high cost in long run Reasons for diseconomies 1. Difficulty monitoring production 2.Beauracratic decision making larger the firm more management democracy ie more ppl have to petition Constant Returns to Scale between 1K and 18K Assume: No artificial barriers to entry ie Number of entrants and that all potential firms in an industry are identical MES: minimum efficient scale = lowest output level at which LRATC hits bottom

If a flat bottom, the first point is the MES

1000 $ LRATC (typical firm) 30K is the max output ie only 3 firms can survive each could achieve LRATC of 1K 2K 1K 6K 10K (MES) *Natural Oligopoly few # of firms 30K Q

23

*Suppose 5 identical firms instead of 3 thus each producing 6,000 -each has LRATC of $2K -If one firm cuts it price lower than 2K then it moves down the curve toward A ie cost per unit decreases -The other 4 firms would have higher costs per unit thus have to lower their price to the price the first one did. End up at point B, but make less. Those that dont want to lower price have to increase price disadv. Itll keep going until 2 firms go bankrupt leaving 3 firms to survive OR firms will merge

2K 1K

*Only one would survive *Natural monopoly

15K

30K

Many firms - cost per unit would decrease if small number of firms *Perfect competition/monopolistic competition

100

30K

variety of small and big firms no adv/disadv ex. clothing stores 24

*Hybrid

100

15K

30K

25

Profit
Theory of Firm Goal: maximize profit = Revenue Cost Accounting Profit: Total revenue Explicit Costs Economic Profit: Total revenue All Costs Costs per day Explicit $200 Wages $50 raw materials $100 interest payments $400 Rent Total $750 Total $150 Implicit

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$50 forgone interest $100 foregone salary to owner (owner puts in own time)

Suppose TR = $1000 Account Profit (pi) = 1000 750 = $250 Economic Profit = 1000 900 = $100 Or Suppose TR = $850 Acct = 850 750 = $100 Economic = 850 - 900 = $-50 Sacrificing $150 for staying in business Profit Maximizing Output Level Total Revenue & Total Cost (Always use economic def) Approach Q/day 0 1 2 3 4 5 Price on each unit >$1000 1000 800 700 600 400 TR/day 0 1000 1600 2100 2400 2000 TC/day $200 800 1100 1450 1850 2350 Profit/day -200 200 500 650 550 -350

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short term b/c theres a fixed cause of $200 at output of 0 2500 2000 distance b/t curves is profit greatest diff is max. profit 1500 1000 500 0 1 2 3 4 5 *3 profit maximizing output *4 Revenue maximizing output level Marginal Cost and Marginal Revenue Approach MR = change in TR/change in Q MC = change in TC/change in Q Q 0 1 2 3 4 5 *Dont want to move from 3 to 4 or 4 to 5 because MR decreases *If MR>MC firms should increase output *If MR<MC firm should not increase output thats the profit max. output level MR 1000 600 500 300 -400 MC 600 300 350 400 500

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1000 800 600 400 200 0 1 2 3 4 5 Q

*plot in between Q *when MR curve lies above MC curve that change increases output when MR is below MC curve dont increase output The profit maximum output level is the closest Q (output) to the crossing point of MR and MC

100

500

Red is profit max. output level after 500 units, MC is higher increasing after 100 units is still good bc MR curve is higher than MC curve MC curve must cross MR curve and cross MR curve from below

28

120 is max TR

and 100 is max profit

*up to 120, as Q increases, TR rises so MR>0 *after 120 as Q increases, TR falls and MR<0

100 120

100

120

*crosses at 120 b/c MR is going from positive to negative MC and MR should cross where max profit is greatest on top graph

loss minimizing loss

*short run b/c TC doesnt start at 0 *profit max. output at 100

100 29

*no output level where they can earn profit b/c TC>TR

*increase output up to 100 in minimize loss. *lowest possible loss is 100 *loss minimizing output at 100 100 (Q*) Firm A & B at Q* in short run both suffering loss TR Firm A Firm B $5K $5K TC $6K $6K Profit -1K -1K TVC 4K 5.5K TFC 2K .5K
Profit if shut down

-2K -.5K

*Firm A should stay open. Compare Profit to profit if shut down and produce Q* *Firm B should shut down and produce 0 TVC operating costs Shut down Rule (SR): As long as TR > TVC at Q* then firm can stay open, vice versa TR has to cover operating costs Firms can vary on variable and fixed costs affecting their ability to stay open or shut down

30

1/24/2012 11:46:00 AM Long Run Losses there are no costs to pay, everything can be reduced to 0 Exit Rule if TR>TC at Q*, stay in industry. If TR<TC at Q*, exit industry Marginal Analysis additional variables that compares additional marginal revenue to marginal costs Franklin National Bank 74 Output (Q) = $ lent out Cost interest paid on deposits + other marketing costs to attract deposits Revenue interest earned on loans made 1974 prime rate on loans from banks was 10% - to larger corps Sources Checking Acct. Savings Accts Federal Funds Market Cost per dollar to bank 2.25 cents 4 cents 10 cents Total dollars from source $ 2 billion $ 1 billion $1.7 billion

Average costs per dollar = 5.43 cents - they lowered prime rate to 8% so a MR of 8 cents in reality costing them MC of 10cents/dollar from FFM to attract more dollars

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Perfect Competition

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Markets Output market: goods/services that business firms produce & households buy Resource market: trading of resources; business firms buy from households Asset market: things of value that arent goods/services nor resources real estate, stocks/bonds, foreign exchange not in the given year Output markets: Vary in size, forms of advertising, profit margins Market structure: environment in which trading takes place Perfect Competition Reasons for study: point of reference, successful perfect competitive markets, most markets come close enough Assumptions: o Many buyers and sellers each indv. has little impact on market ex. colleges o Standardized product across markets ex. wheat o Easy entry and exiting low barriers o Easily obtained information about product, cost, and cost from other sellers o o *firms are price takers take market price as a given (top two above)

32

qe

market demand curve demand curve for firm Marginal Revenue for firm: same as demand curve. MR = P for a perfectly competitive firm Marginal Cost: profit maximizing output level is where MC and MR cross $ 6 5

q1 q2 q *upward sloping part of MC curve is firms supply curve *As price increases, quantity increases For market graph add all firms quantities at Price X1, X2, etc. to get market supply curve Price dependent on demand curve equilibrium price of market will determine firms pricing

Profit 33

$ ATC 5 d=MR Q* - where MR crosses MC

q*

firm producing at q* - 5$ for each unit sold. Firm economic profit is greater than 0 Cost per unit Revenue per unit Distance between them is profit per unit Total profit = profit per unit times q* Loss - economic profit less than 0 MC ATC AVC

q* cost per unit (where ATC crosses MC) is above 5$ loss per unit Total loss = loss per unit time q * AVC

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continued
Shut down rule at q* Shut down if P (TR/q) < TVC/q (AVC)

1/24/2012 11:46:00 AM

When looking at loss graph firm should stay open (look at loss graph) Firm suffering loss and should shut down ATC $ MC AVC

d=MR 5

q* q shut down because MC>MR and AVC is greater than 5$ (Price) MC AVC

Ps *Ps shut down price

if above shut down price stay open when it drops below shut down price doesnt produce anymore the black portion is the firms supply curve usually stops at AVC curve Adjustment to the Long Run

35

S1

$5 ATC 3

d=MR profit

$5 $3 D Q MARKET q* FIRM q

In Long run , profit >0 attracts entry S1 will move right as more firms come in ie the equilibrium price will start to decrease The demand curve on the firms graph will drop, so the profit will start decreasing Price will fall until Profit = 0 or where MC = MR D=MR will drop to $3 where it crosses the ATC curve & q* will decrease - so the supply curve will keep shifting right until equilibrium price is $3 *If economic loss firms will exit, supply curve shifts left until profit =0 In the long run, firms must also be at the minimum of their LRATC curve $ MC ATC LRATC $3 $1.5 d=MR MC ATC d=MR2

q* q -when q* increases movement along LRATC curve to increase profit 36

but all firms will do this more entry so at lowest possible price/unit (1.50) firms are open at 0 profit Long Run equilibrium of firm in perfect competition MC ATC LRATC P d=MR

q* profit max.: MR = MC perfect competition: MR = P Economic profit = 0: Price = ATC and Price = LRATC Long run economic profit usually = 0 due to easy entry Comparative Statics S P2 P2 P1 D2 D Q1 Q2 Q q* q2 MARKET FIRM If tastes change in favor of good Demand shifts right in short run and Price rises to P2 A = initial long run equilibrium B = new Short run equilibrium q P1 MC ATC L

37

In Long run supply will shift right and Price (d=MR) will shift down until it reaches original P1. New long run equilibrium = A Price are market signals price tells firms to produce more and new firms to enter and produce more -Start at P1 (where demand curve crosses supply curve) -Demand curve shifts right and price rises -Supply curve shifts right to a new point c back to P1 -Long Run supply curve is horizontal line across P1, connecting A and C Constant Cost industry entry doesnt cause input prices to rise Increasing Cost Industry entry causes input prices to rise & exit causes input prices to fall. Ex. Corn

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Monopoly

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Monopoly: Market with a single seller of a good with no close substitutes Barriers to entry: keep others out o Economies of Scale: cost per unit would be higher with more firms - natural monopoly single firm will naturally dominate ex. cable o Legal Barriers: Gov. Declaration only one firm legal Gov. production Gov. produces the good/service itself ex. post office, MTA Gov. Franchise Gov. establishes rights for single company to operate ex. cable Patents/Copyrights Zoning how many sellers allowed in range of distance ex. theaters o Network Externalities: additional members in the network imply greater benefits for each user of the network ex. social networks o Predatory Behaviors: threatening of other firms to exit the market Single Price charges same price on each unit of the product vs Price Discriminating Monopoly: charges different prices to different customers Single Price Demand curve facing monopoly - same for market and firm P $100 $100 $90 $80 $70 Q 0 1 2 3 4 TR 0 100 180 240 280 MR 100 80 60 40

*MR does not equal Price like in Perfectly Competitive markets

39

MR increases less than Price because price has to be lowered each time

Q1 0 to Q1 Profit because MR > MC - where they cross is output level Produces at Q1 where MC crosses MR Price to charge at Q1 units is where Q1 cross Demand Curve Total Profit - Q1 times profit per unit Revenue per unit = P1 Cost per unit = where ATC curve crosses Q1 Profit per unit dist between cost per unit and where demand cross Q1 *make to sure to know how to do monopoly suffering loss in which it stays open and one that shuts down - need to know AVC curve Price setter Monopoly has no supply curve theres only one price that monopolies charge Profit maximizing price

40

Monopoly VS Perfect Competition Perfect Competition: $ 12 10

12 10

80 typical firm

100

8000 10000 Market (100 firms)

Perfectly Competitive Market taken over by Monopoly $ S MC to produce another unit is $10 15 10

D 6000 8000 Q

*Supply curve is the MC in a Monopoly *MR lies below Demand curve in Monopoly *Monopoly charges higher price than perfectly competitive markets & produces less ie charging now $15 and producing 6000 units *Monopoly Power firms have power to raise prices and serve market poorly producing less Monopoly Myths Monopolies have unlimited power to raise the price (only constraint is public outrage) o Monopoly only goes up to Profit Maximizing Price raising price decreases profit because firm is selling less 41

Monopoly can pass any cost increases such as taxes onto consumers o Fixed cost (fixed tax) doesnt vary with level of output Wont raise price above P1 because neither Demand, MR, MC are affected ATC is affected curve shifts up lowers profit per unit but will continue to charge at P1 Fixed costs are not passed along to consumers o Variable Costs (tax per unit) ex. tax of $1 per unit shifts MC by $1 which causes output to decrease and

Price to increase Monopoly can only pass some of the variable cost increase onto consumers P2 rises above P1 less than MC increases *all above is in respect to single price monopoly Price Discrimination deals with more than one price - charging different customers different prices for reasons other than differences in cost. Based on differences in willingness to pay. Always helps firm can harm or benefit consumers 3 requirements Downward sloping demand curve facing firm demand is sensitive to price Prevent Resale no one will buy at the higher prices easier for services Identify different groups willingness to pay Assumption: Constant MC $ 175 150 100 50 D MR 42

increase in profit from charging $175 to those willing to pay it

increase in profit from charging $100 to those unwilling to pay $150

MC

80

100 160

found 80 ppl who are willing to pay $175 per unit as compared to the single price monopoly at $150 *increase in profit = (175-150) x 80 found 60 ppl who are willing to only pay $100 profit is $50 20 ppl willing to pay 150 Perfect Price Discrimination -each customer is charged the highest price theyd be willing to pay ex. used cars
each rectangle is an additional unit charging above $150 - the additional profit

150 50 D MR 100 200 MC

intersection of MC and D Additional Revenue additional profit in second triangle by selling more than 100 but less than $150 Demand curve becomes MR ex. tuition FAFSA

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44

Oligopoly

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Requirements 1. few firms that dominate the market (2+) 2. strategic interaction among firms one firm anticipates reactions of others firms when making decisions How oligopolies arise Barriers to Entry Economies of Scale (natural oligopoly) ex wireless phones work at MES Legal Barriers o Gov. franchise o Patents/Copyrights o Zoning Network Externalities Predatory Behavior Reputation

Game Theory Prisoners Dilemma

A & B criminals: committed murder but arrested for dealing heroin Each criminal offered deal confess/not confess AS PAYOFFS - - Bs Actions confess confess Dont confess As actions ^ o Dominant strategy: best strategy regardless of what other player does Strictly Dominant Strategy always gives you better outcome no matter what other player chooses o Weakly Dominant Strategy: at least as good no matter what the other player choose and by at least one choice by the other player, its better 15 yrs 30 yrs

Dont confess 3 months 5 yrs

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 o o

Ex. game show

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1/24/2012 11:46:00 AM Deltas Strategies High Price

Americans strategies

Low Price

High Price Low Price

Amer : 2mil D:2 million A: 3 million D: -1 million

A: -1 million D: 3 million - - 1 Amer: .5 mill D: .5 mill

American strictly dominant strategy is to choose low price no matter what Delta does Delta has the same strict dominant strategy If Delta changes 3 million to 1 million under low price, then delta doesnt have a dominant strategy their strategy depends on what American does but same outcome both choose low price can predict outcome as long as you know dominant strategy of one player Cooperation

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Explicit Collusion (price fixing) companies agree to charge prize that benefits all firms. Ex. OPEC - cartel o Extreme case: cartel work to max total profit by having each cartel produce certain amt. pretend their monopoly Assume: no fixed costs and constant marginal costs $ 20 18 D facing cartel 15 MR MC = ATC

100 150 Q Total Profit = red square o Suppose Quota A = 50 and Quota B = 50 o Each sells 50 units making $5 profit per unit Profit A & B = $250 .. 50 x 5 o Problems with explicit collusion: Illegal in most cases Tendency for cheating: when its hardest to detect more members Suppose B sticks to agreement but A cheats, increasing its own output to 100 so total market output it 150. The profit max falls to $18. Total cartel profit = 3 x 150 = $450 - -profit dec. Player A profit = $3 x 100 = $300 Player B profit = 3 x 50 = $150 Tacit Collusion implicit understanding of prices o Price leadership all oligopolists implicitly agree that one firm is the leader implicit power can raise the price and other firms will follow. Ex. airlines ie American Airlines Incentive to cheat not raise prices to make more profit. Price leaders can enact policies 48

Tit for Tat: If leader raises price and others dont, then the price will be lowered back down Punitive Reaction Leader raises prices, some dont so leader lowers price below original price (price war) Delta Safety Ads No Safety A:Low profits D:Low A: Very low D: Very high A: Very high D: Very low A: Medium D: Medium

Safety A m Safety No e r

American and Delta dominant strategy is to run safety ad, but theyre both collusive at no safety ads Georges Actions Call to check Dont call No job 0 No job 0 No job 0 No job 0

Hire Dont Hire

Show up Job +1 Possible job, poss no job/humiliation 1/2

Dominant strategy is to show up

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Labor Markets

1/24/2012 11:46:00 AM

Households provide resources to firms for resource payments in return (wages, rent) (Perfectly) Competitive Labor Markets Many buyers and sellers - - *Households and firms are wage takers Standardized labor Easy entry and exit Easily obtained information Labor Supply: Quantity of labor supplied = number of qualified people who would like to work in a labor market given their constraints Short Run: not enough time to become qualified (so # of qualified ppl is fixed) Ex. US market for truckers wage rate Ls

#workers Shifts to the right: Number of qualified ppl increases Increase in % of people who want to become truckers Population growth Decrease in wages in alternate labor markets (housing market) Labor Demand

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W 20 B A 10 Ld L2 L1 # workers

*lower wage rate higher demand for labor Movements along curve: -Output Effect: when W increases MC shifts up (because variable input changes) Q decreases - need less labor ie Ld decreases Substitution Effect: W increases and labor is more expensive relative to other inputs- firms shift to alternative inputs use less of this type of labor Shifts: Change in technology Substitutable new technology that replaces worker shift L Complementary makes labor more productive shift R Price of substitute input increases shifts R - increasing demand Price of complementary input increases shifts L Price of product increases - shift R want more Q, need more labor W W2 W1 W3 Ld L1 52 # attorneys US market for attorneys Ls excess supply

W2: Excess supply causes Wage rate to decrease - Labor supply decreases and labor demand increases W3: Excess demand causes wage rate to increase supply increase and demand decreases Comparative Statics W Ls1

W2 W1

Ld2 Ld1 L1 L2 L3 L Society becomes more litigious - Labor demand curve shifts right A: initial equilibrium long run equilibrium B: new short run equilibrium Labor supply will shift right as wage rate increases causes wage rate to decrease to W3 between W1 and W2 - Long run labor supply curve through A & C increasing cost industry W2 is market signal to increase labor supply

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1/24/2012 11:46:00 AM

W $80 $50

LS

Ld2 Ld1

1.3

#attorneys (mil)

A: initial short run and long run equilibrium Demand shifts right B: new SR equilibrium after Ld2 shift those already qualified enter Supply shifts Right until wage rate decreases til no more entrants C: new long run equilibrium at $60 Why Wages Differ? Imaginary World: All labor markets are perfectively competitive (many buyers and sellers, standardized labor, easy entry and exit, easy info) Except for wage differences, all jobs are equally attractive to all workers All workers equally qualified to do any job All above imply persistent wage difference are impossible Ls2 50 30 Ld Ls 80 50

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Nurses

Engineers

Nurses would rather be an engineer for higher wage rate causes Labor Supply for nurses to shift left and LS for engineers to shift Right continue until at an equal amount - $50 ie real world wage difference has a violation of the assumptions Real World Violation of the Assumptions of Imaginary World Not all jobs are equally attractive o Non-monetary job charac. people like or dislike job for characteristic other than money ex. danger o Different Human capital requirements o Compensating wage differential differences in wages that compensates people for non-monetary and diff human capital requirements ex. Neurosurgeon paid more than general surgeon Not all people can become equally qualified for all jobs: differences in characteristics from job to job Not all people have equal abilities to be productive at their job ex. some bring in more revenue o Economics of Superstars: some making 10 fold of others in same profession. How changes in technology combined with differences in ability lead to soaring incomes at the very top

Minimum Wage Federal minimum wage: $7.25 o Exceptions: disabled, employee that earns tips can earn less State minimum: higher than federal Objections to minimum wage Not well targeted demographics vary Creates winners and losers

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W 7.25 4

Ls1

Ls2

4 3 LD L2 L1 L unskilled, uncovered min.w

unskilled, covered

24 20 Ld2 Ld1

skilled earn higher than min w At 7.25 minimum wage in unskilled/covered, theres an excess supply. LD decreases Those who lost their jobs go to unskilled/uncovered so labor supply shifts right but wage drops Demand for skilled labor increases There is a better alternative o Earned Income Tax Credit if income is low, gov. gives tax credit

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Capital and Financial Markets

present costs vs future revenue

1/24/2012 11:46:00 AM

Present Value (PV) of future payment is that amount of money today that has the same value as that future payment indifference Assume: Can borrow and lend at the same interest rate No uncertainty no risk What is PV of $11,000 to be received in one year from today Suppose interest rate (r) = 10% Can either receive 10K now or borrow 10K PV of $Y in one year = $Y/1+r ex. 11K/ 1 +.1 = 10K If Y/1+r is put in bank for one year, will have (y/1+r) times (1+r) = $Y PV of $Y in two years = Y/1+r^2 *PV of $Y in T years = $Y/(1+r)^t *PV of future payment is lower if 1. $Y is lower & 2. R is higher & 3. T is larger Decision to invest in physical capital Assume: Machine costs 100K It lasts for 3 years It provides net additional revenue of $35K (paid at the end of year) R = 10% PV of net additional revenue = 35K/(1.1) + 35K/(1+1.1)^2 + 35K/(1.1)^3 = 31,818 + 28,926 + 26,296 = 87,040 Do not buy b/c PV of future revenue (87K) < 100K Suppose r = 2% PV = 35K/1.02 + 35K/(1.02)^2 + 35K/ (1.02)^3 = 34,314 + 33,641 + 32, 981 = 100,936 59

Buy machine b/c PV of future revenue > current cost Critical Interest Rate: interest rate that makes one indifferent about purchasing a given physical capital r

10

investment curve 300K

r = interest rate in economy at r = 10%, all investments with critical interest rate >10% will be done if lower than 10% - not made -

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1/24/2012 11:46:00 AM Present Value and Financial Assets (IOU) Financial Assets Bond promise of money in future Stock share of ownership of corp. profits in future Primary Market - sold to original buyer Household/ - - - Financial Asset - - - original lender/ Corporation/ buyer of asset Gov. Agency $ financial asset

$
somebody else

Secondary Market changing financial assets hand after hand (somebody else) where bonds and stocks exchanged Provides liquidity feasibility of getting cash Price price of selling additional assets in primary market depend on prices in secondary market (high prices better) Bond Corporation promises to pay bearer X amount on date Bearer should pay PV of bond today Suppose r = 10% o PV in a year = 10K/1.1 = 9,090 you shouldnt pay more Suppose r = 5% o PV in yr = 10K/1.5 = 9,524 Inverse relationship between interest rates and bond prices Coupon Bond: Corporation promises to pay X amount on date and coupon payments below o Each coupon had different dates with X amount of $ o Assume r = 10%. PV in a year = 500/1.1 + 500/(1.1)^2 + 500/(1.1)^3 + 10K = 8,757 Stock and The Stock Market Share of Stock: share of ownership (control over board of directors every share owned is a vote & % of future profits) in a corporation Future profits 61

o Dividends paid out to shareholders o Retained earnings corporations holds onto profits (reinvests) if successful, earnings invested leading to higher profits leading to higher share prices and shareholders experience capital gain (buy asset at low price and sell at higher price) o PV of $Y per year forever = $Y/interest rate o Ex. Apple - $35 in profit per share per year Suppose r = 6%. PV = $35/.06 = $583 Where stock comes from o Ex. 2 people A&B each gets half of the profits initially o so they issue new shares of stock with more people profits decreases per each person o profits increase in future and each will gain profits, more than original o *Companies issue new shares of stock if it is advantageous for the company in the future How Stock Prices are determined o Supply & Demand Markey for apple shares S

$ per share

600 560 520 D

932

# of shares

Supply curve - # of shares in existence = # of shares held Demand curve = # of shares ppl want to hold

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IF $600 then demand (how much they want to hold) is less than 932 but actually are holding 932 million - people start selling shares decreasing price and increasing demand for shares IF $520 Demand is above how much is actually being held, increasing price Intersection satisfaction between how much ppl want and how much they hold *stock prices change because demand curve shifts. The supply curve cannot shift P 620 $560 D2 D 932 # of shares S

IF demand increases shift right. Price increases

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1/24/2012 11:46:00 AM Predicting Stock Prices Fundamental Analysis: using basic logic o Interest rates if it decreases, then PV increases o Business cycle: o Industry and Company Specifics Technical Analysis: look at patterns in changing of stock prices. Meta-analysis on previous stock prices from computer data to predict if stock will inc/dec Efficient Markets Hypothesis All publicly available information relevant to a stocks value is already built into the stocks price at every moment in time - - ex. Demand increases because everyone saw good value in new product. Those who already hold stock profit the most. *Patterns can disappear if everyone figures out trend.

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Economic Efficiency

1/24/2012

11:46:00 AM Economic efficiency means we are not wasting opportunities to make people better off Pureto Improvement (PI) any change or action taken in economy that makes at least one person better off and harms no one ex buying lunch Economic efficiency requires tg=gat akk P.I. are exploited *Every pureto imp. must be a potential im=oureto Potential pureto improvement (PPO) o Any change or actions for which the gains to the gamers and greter after than the loses to the losers o Every PPI can become a pureto with an apporopriate side payment Ex. 100 K in gains to gamer

Economic Efficiency requires that every potential pureto improvement be exploited o Gains greater than losses Economic efficiency of a market Reinterpret demand curve 100 99

0123 Either: start with price and see how many units purchased OR look at units and see what maximum price people are willing to pay Ex. Value of first unit = $100 -

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$100 $99

$40

0 123 *$40 market price. Willing to pay 100, but only have to pay 40 Consumer surplus difference between value of good and what you pay for it ie = $60 Area under demand curve = market consumer surplus Area - .5bh = CS

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1/24/2012 11:46:00 AM Producer Surplus: benefits on supplier side; on a unit is the dollars received beyond the minimum necessary to produce that unit P S 16 12 10 1 2 3 4 Q

Supply curve: how much a supplier needs to produce X amt of units Market Price $16. Ex. 1 unit would produce for $10, but market price is $16 so surplus is $6 area of rect. Blue triangle: Market producer surplus aka 1/2 bh or 1/2x4x6 P S

100

2K

Consumer surplus red triangle Producer surplus orange triange CS + PS = Total benefits Competitive markets are efficient 68

150 100 40

1K

2K

Efficient quantity: every pareto improvement taking place - 2K consumer willing to pay $150 and supplier willing to supply at $40 As long as price is between $40 and $150 then both are better off pareto improvement As long as demand curve lies above supply curve efficient 2K is efficient quantity cant produce extra unit and have a gain for both consumer and producer Under perfect competition, market will eventually get to equilibrium Economic efficiency mean total benefits are maximized Price Ceiling Inefficient market S P

100 60 D

900

2K 69

-$60 is price ceiling, 900 units will be bought and sold -Producer surplus = green triangle above supply curve below market price. Worse off -Consumer surplus area under demand curve, above market price blue area - can only buy 900 units. Better off when getting surplus on units theyre buying, but not buying the units they used to buy Putting a restriction on market reduces total benefits Price ceilings can never be a potential pareto improvement Red triangle welfare loss or dead weight loss Total benefits we dont enjoy due to some policy Monopoly Market takes over perfectively competitive market MC becomes supply curve

140 100

MR

800 2K Sets the price at $140, consumer willing to pay but monopoly not exploiting price by charging a lot less have to keep the price the same for everyone loses revenue when price decreases Efficient if monopoly can price discriminate -dead weight loss green triangle all the benefits we could get but not getting b/c monopoly refusing to lower its price Governments Role in Economic Efficiency Legal Infrastructure: 70

o Types of Law Contract Law: specifies what contracts are legal/illegal and law enforces contract penalized. Need this to make deals efficient Tort Law: establishes reasonable standards of reliability, if product produced causes harm to someone else if company is responsible Property Law: establishes procedures to determine ownership of properties and what you can do with the property Criminal Law: prevents transactions that harm others ex. getting jumped Dealing with market failure: market is inefficient despite legal infrastructure needs Gov. intervention o Monopoly power firms raise price, dec output inefficient o Externality: byproduct of a good/service that affects 3rd parties (other than buyer/seller) ex. buying gas that affects env aka other people Negative Ex. overproduce o Pos Ext: benefits others o Public good wont exist if just left up to market Ex. National defense

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