Economics 120 CRAM SESSION

1. Economics 120CRAM SESSION Instructors: Paul and Ashwin

2. Review of Major Concepts from 1st Midterm • Opportunity Cost • PPC Curve • Demand and Supply Curve

3. Opportunity Cost Definition: The cost of using resources for a certain purpose, measured by the benefit given up by not using them in their best alternative use. “The foregone benefits by the next best alternative” Example: Suzie has two options work at job that pays $6/hour for 8 hours or run her own business which pays $100/day. What is the opportunity cost of running her own business????

4. Production Possibility Curve The negatively sloped boundary shows the combinations that are just attainable when all of society’s resources are efficiently employed.

5. Basic Overview of Supply and Demand Price Quantity Demand: total amount of any particular good or service that consumers wish to purchase in some time period. Quantity Supply: total amount of any particular good or service that suppliers wish to supply in some time period. Demand Pe Supply Quantity Qe

6. Four Laws of Demand and Supply • An increase in demand causes an increase in both the equilibrium price and the equilibrium quantity exchanged. • A decrease in demand causes a decrease in both the equilibrium price and quantity exchanged.

7. Four Laws of Demand and Supply Continued….. 3. An increase in supply causes an increase in both the equilibrium price and the equilibrium quantity exchanged. 4. A decrease in supply causes a decrease in both the equilibrium price and quantity exchanged.

8. Elasticity of Demand/Supply The price elasticity of demand is the measure of responsiveness of quantity of a product demanded to a change in that product’s price. = Percentage change in quantity demanded Percentage change in price

9. Elasticity of Demand/Supply Inelastic Demand: a situation in which, for a given percentage change in price, there is a smaller percentage change in quantity demanded; elasticity is less than one. Ex: Pace Maker, certain drugs… Elastic Demand: the situation in which for a given percentage change in price there is a greater percentage change in quantity demanded. Ex: blue ink pen These same concepts can be applied to supply curves.

10. Chapter 7 Producers in the Short Run

11. Goals of the Firm • 1) To maximize profits • 2) Every firm is a single, consistent, decision-making unit

12. Profit – Maximizing Output • ∏ = TR – TC = (P x Q) – (C x Q) = Q (P – C) - therefore a firm’s profits are effected by both revenue and cost

13. Costs and Profits • Costs: economics – “opportunity cost:” the benefit foregone by not using an input a certain way • Types of Cost: • 1) inputs – costs you can place a dollar value on. eg) rent • 2) imputed – costs you cannot place a dollar value on. eg) goodwill

14. Types of Imputed Costs • 3 categories: • 1) the “useful economic life” of long lived capital assets. eg) building • 2) Cost of employing capital in the firm eg) machinary • 3) cost of risk • #1 and 2 are use depreciation

15. Economic vs. Accounting Profit • Economic profit takes into account implicit costs (costs that we cannot put an actual dollar value on) • Economic profit takes into account opportunity cost and the cost of risk • Therefore: • economic profits < accounting profits • If economic profit is positive, the owners capital is earning more than it could in its next best alternative use • Zero accounting profit does not mean zero accounting profit. i.e. the company is not making any money

16. Production Function • A production function describes the relationship between the inputs that a firm uses and its outputs • Q = f ( L, K ) where Q = output K = capital L = labour

17. Time Horizons for Decision Making • Short Run - In terms of time it is the length of time over which some of the firms factors of production are fixed • Long Run – factors of production are variable, technology is fixed • Very Long Run – length of time over which all factors are variable

18. Short Run Production • Total Product (TP): amount of output produced during a given period of time • Average Product (AP): TP / # of units of variable factor used to produce it. Labour is the most common • Therefore: AP = TP / L • Marginal Product (MP): change in total product resulting from the use of one more variable factor; • MP = ∆ TP / ∆ L • ∆ TP / ∆ L

19. Law of Diminishing Returns • States that if you keep increasing your variable factors, eventually MP will decline

20. Costs in the Short Run • TC = TFC + TVC • ATC = AFC + AVC • MC = ∆ TC / ∆ Q = ∆ TFC / ∆ Q + ∆ TVC / ∆ Q Because fixed costs do not vary with output MC = ∆ TVC / ∆ Q

21. Chapter 8Long Run Production

22. Chapter 8Producers in the long Run…. • In the short run, the only way to produce a given level of output is to adjust the input of variable factors. • In the long run “ALL INPUTS ARE VARIABLE,” and there are numerous ways to produce any given output. • We need to produce goods without wasting society’s scare resources and produce the chosen output at least cost.

23. What does Economically Efficient mean? Economic Efficiency is achieved by a firm choosing from among the many technically efficient options and finding the one that produces a given level of output at the lowest possible cost.

24. Cost Minimization • Firms in the long run should select the economically efficient method of production, which is the method that produces its output at the lowest possible cost. • Cost Minimization: an implication of profit maximization that firms choose the production method that produces any given level of output at the lowest possible cost.

25. Principle of Substitution • Implies that a firm ‘s method of production will change if the relative prices of factors change. Relatively more of the cheaper factor and relatively less of the more expensive factor will be used. MPK = MPL P K = P L

26. Long Run Cost Curves • The long run average cost (LRAC) curve is the boundary between cost levels that are attainable (with given technology and factor prices) and those that are unattainable. • For Low rates of output, it makes little sense to use a lot of capital because of high fixed cost. • For higher rates of output, fixed cost of larger amounts of capital can be spread (averaged) over more units, and lower labour costs per unit.

27. SRATC and LRAC

28. Increasing and Decreasing “Returns to Scale” • If the change in the output is proportionally less than the change in the use of all the inputs, we have decreasing returns to scale. • If the change in the output is proportionally more than the change in the use of all the inputs, we have increasing returns to scale.

29. Example of Returns to Scale

30. MES • Any output level that can be produced at the lowest LRAC is characterized as an efficient scale of output. • The smallest of these flow rates of output at which the firm attains minimum LRAC is called the firm’s Minimum Efficient Scale (MES) of output.

31. Chapter 9Perfect Competition

32. Perfect Competition • Basic Assumptions 1. Homogeneous (i.e. identical) products. 2. Buyers know prices charged by each firm. 3. MES is small relative to market size. 4. Freedom of entry and exit in long-run.

33. Important Formulas • Total Revenue = price x quantity • Average revenue (AR) = TR/Q • Marginal revenue (MR) = ΔTR/ΔQ • We maximize profits where MR = MC • In the short run we shut down where Price < Average Variable Cost…….. • If Price is equal to AVC we can either shut down or not

34. Firm and Industry Graphs

35. Short Run Assumptions 1. Firms are price-takers & maximize profits 2. Number of firms and plant size is given. 3. Input prices are given 4. Price equates QD and QS

36. Long Run Perfectly Competitive Firm

37. Assumptions in the Long Run in a Perfectly Competitive Industry • 1. Firms are price-takers & maximize profits. • 2. Firms choose plant size & entry or exit. • Implications of Assumptions 1 - 2 • Economic profits are zero. • Each firm operates at MES. • P = min LRAC. • 3. Input prices (let n = number of firms) • …don’t depend on n (constant cost industry) • LR industry supply curve is horizontal. • 4. Price equates QD and QS

38. Chapter 10 Monopoly

39. Market Structure • Output All firms seek to produce and sell a quantity of output at which MR = MC in order to maximize profits Price Monopoly seller will try to charge the maximum buyers are willing to pay. B/C monopolist is sole producer, its demand curve is the market demand curve. Monopolist charges the price where equilibrium hits the demand curve

40. Market Structure • Remember: • Monopolist faces a negatively sloped demand curve • it charges the highest possible price • The monopolists MR is less than the price at which it sells output • Therefore the monopolists MR curve is below its demand curve

41. Marginal Revenue – Monopoly vs. Perfect Competition • In perfect competition; if firm increases quantity it increases revenue gain = price x additional quantity - For a monopoly, additional revenue is equal to: new (lower) price x quantity – “spoilage”

42. Profit – Maximizing Output • Profit maximizing quantity for a monopoly is where MR = MC • This only determines our quantity • Price is equal to where it hits the demand curve • Price is always greater than MC

43. Monopolies and Supply Curves • There is no such thing as a supply curve for a monopoly • Once the monopoly determines its optimal quantity (where MR = MC), monopoly uses knowledge of the demand curve to determine the price that it will charge

44. Entry Barriers • Unlike perfectly competitive markets, there are entry barriers in a monopolistic market • 2 classes of barriers • 1) Natural Barriers: arise from economies of scale. There is always a huge initial cost involved. Eg) electrical power • 2) Created Barriers: eg) Microsoft. Company that either owns a patent to a certain technology or has a lot of “brand loyalty”

45. Price Discrimination • Occurs when producer charges different prices for different units of the same product sold for reasons not related to cost differences • Eg) senior’s discounts for movie tickets • Price discrimination is possible when: • 1) Firms have market power; i.e. not price takers • 2) Consumers different valuations can actually be identified • 3) No arbitrage opportunities exists (the process of purchasing a product at a lower price and re-selling it for a higher one • When a firm uses price discrimination it is trying to capture consumer surplus

46. Cartels • When firms get together and act as a monopoly by controlling and reducing supply in order to raise prices and increase profits eg) OPEC • Normally the firm would set D = MC (=S) • With a cartel, they reduce supply to where MR = MC (like a monopoly) and charge the price where it hits the demand curve

47. Problems That Cartels Face • Whenever quantity is reduced and price rises there is always an incentive for forms to take advantage of the higher prices and produce more quantity since no one is policing how much they are producing • If enough firms decide to cheat and produce more quantity, eventually price will fall to where it originally was where the firms were in competition against each other

48. Chapter 11 Imperfect Competition and Strategic Behaviour

49. Oligopoly • Has characteristics somewhere between a perfectly competitive firm and a monopoly • Firms in an oligopoly market have “identical products” but have barriers to entry and a few number of sellers • Eg) toothpaste – Crest, Colgate, Aquafresh • Each firm faces a negatively sloped demand curve that is highly elastic b/c other firms have close substitutes • Freedom of entry and exit • Output is determined where MR = MC and price is determined where it hits the demand curve (same as monopoly)

50. Predictions of Theory • b/c there is an ease of entry with oligopolies, short run profits provide an incentive for new firms to enter the industry • As new firms enter, each firms demand curve shifts to the left until profits are eliminated