ECN 2020 LECTURE NOTES

Chapter 7 (20) Supply and Demand: Elasticities and Legal Prices

Welcome to Microeconomics!

Price Elasticity of Demand:

• this section deals with Ch 3 principles in more detail (not just the demand curve, but its slope and other aspects)
• think of underwear, Hanes inspector #12!, like new and old underwear - elasticity of demand of products works the same way over time - starts out tight (inelastic) and ends up loose (elastic)
• floor and ceiling price example - see impact on size of surpluses or shortages from changes in elasticity (end of chapter)

Price Elasticity of Demand is the extent to which consumers alter the quantity of a product purchased when its price changes (price change sensitivity):

• Q responsiveness to changes in P
• price is the external force (independent variable)
• quantity demanded is the dependent variable

Simply the ratio of %chg in qty demanded to the %chg in price, or:

E_d = %chg Q ignore (-), use absolute value

%chg P

= q₁-q₂ ) p₁-p₂ see p119 midpoints formula

(q₁+q₂)/2 (p₁+p₂)/2

• don't worry too much about math - worry more about the concept!

Extremes of Elasticity (fig 7.1):

• completely/perfectly inelastic is vertical (D₁)
• completely/perfectly elastic is horizontal (D₂)

Rules (table 7.2):

E_d > 1 relatively elastic: numerator (Q) changes more than denominator (P)

= 1 unitary elastic: both numerator and denominator change equally

< 1 relatively inelastic: numerator (Q) changes less than denominator (P)

Determinants of Elasticity:

• substitutability: availability of substitutes (perfect competition vs monopoly)
• proportion of income (don't think about 10% price change in chewing gum)
• luxuries vs necessities (novel vs textbook)
• time (like underwear)

Price Elasticity and Total Revenue:

• very important to firm's/industry's pricing
• Total Revenue (TR) = P x Q
• as long as TR increases with price cut (or decreases with price increase), then in elastic range of demand curve (see tab 7.1, fig 7.2)
• demand is typically elastic in high-price (low qty) range - upper left (NW), and inelastic in low-price (high-qty) range - lower right (SE)
• examples include airlines fare-wars in inelastic range (reducing industry TR, thus profits)
• see other examples pp124-5, especially excise "sin" taxes levied on 'gotta have it' (inelastic) goods: alcohol, tobacco, gasoline, firearms, newspapers, snack foods - just about anything in a convenience store - sure revenue maker but note failed 1990 "luxury tax" on relatively elastic goods

Elasticity of Supply (E_s):

• how responsive producers are to changes in price (from changes in demand)
• %chgs in Price/%chgs in Qty Supplied
• time is main determinant of elasticity of supply
• market periods: immediate, short-run, long-run (e.g., restaurant, tomato farm, Christmas tree farm)

Other Elasticities:

Cross-Price Elasticity (E_xy) = %chg Q_x/%chg P_y:

• gauges sensitivity between price of one good and demand for another (ignore calculations):

(+) substitute goods (Coke and Pepsi)

(-) complementary goods (cameras and film)

(0) independent goods "price of tea in China…"

Income Elasticity (E_i) = %chg in Q/%chg in income

• gauges sensitivity of income chgs to product demand: normal (+) vs inferior (-) goods
• ignore calculations

Government-Set Prices

• Price Ceilings/Controls: below equilibrium price, meant to protect consumers (Demand), results in shortages
• Price Floors/Supports: above equilibrium price, meant to protect producers (Supply), results in surpluses
• See black markets and examples (esp Last Word on rent controls)

Review EOC questions 2, 4, 5, 6, and 11.

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Chapter 8 (21) Consumer Behavior and Utility Maximization

Marginal means extra (one more) vs total or average, marginal is concerned with change, such as marginal tax rates or MPC (marginal propensity to consume)

Why Law of Demand?

Income and Substitution effects combine to increase a consumer's ability and willingness to buy more of a specific good when its price falls.

Law of Diminishing Marginal Utility:

• why we buy (or don't buy): review determinants of demand
• utility is economist's term for satisfaction: consumer's goal is to maximize satisfaction or maximize utility
• marginal utility declines as consumer acquires additional units of a given product
• thus price must drop to attain same utility/$ ratio: we seek the most "bang for the buck"
• how many own a TV set? 2? 3? 4? 5?
• evidence: popularity of dollar stores, thrift shops, yard sales, clearance tables, bargain basements, etc
• also all-you-can-eat restaurants
• effect on elasticity of demand: if marginal utility falls sharply as successive units of a product are consumed, demand is inelastic

Utility Theory of Consumer Behavior:

• marginal vs total utility (fig 8.1), note diminishing marginal utility
• discuss tables 8.1 and 8.2, show MU/P comparison
• Utility-maximizing rule: consumer's limited money income should be allocated so the last dollar spent on each product purchased yields same amount of extra (marginal) utility:

MU_A = MU_B

P_A P_B

• review homework problem #5
• emphasize maximizing total utility
• ignore appendix on Indifference Curves

Examples:

• Water-Diamond Paradox (water high total utility but low marginal utility, diamonds vice-versa)
• Culture and Values differences: Americans are goods-rich (wasteful) and time-poor (overly-sensitive), whereas developing countries (Somalia) are time-rich and goods-poor
• health care payment system, cash gifts, etc

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Chapter 9 (22) The Costs of Production

The "heart" of microeconomics: theory of the firm

• this chapter starts the "thick" part of the course (Chp's 9-12), lots of graphs, math tables, etc - doing EOC assignments will greatly assist in understanding this material

Economic vs Accounting Costs (see fig 9.1, EOC #2)

• economic cost = explicit costs + implicit (opportunity) costs:
• explicit costs = expenditures or out-of-pocket costs
• implicit costs = non-expenditures or opportunity costs
• normal vs economic profit:
• economic profit = total revenue - economic cost
• short- vs long-run production decisions:
• short run assumes fixed plant, thus fixed cost
• long run: all costs are variable
• example: your kitchen in the production of the family meal

Production Function:

• output (Q) is a function of varying quantities and combinations of factor inputs (resources)
• labor vs capital (see assignment Ch4 EOC #7 p71)
• productivity (average product): output per unit of input
• assumes technical efficiency: maximum output attainable from a given level of factor inputs
• short-run constraints (fixed plant can't be changed - land and capital)

Marginal Productivity:

• marginal product (MP) = chg in output (TP)

chg in inputs

• see tables 9.1, 9.2; fig 9.2 and EOC #4
• marginal product (output) vs average product (productivity)
• law of diminishing marginal returns (like diminishing marginal utility, but supply oriented)
• example: successive units of a variable resource (i.e., study time) added to a fixed resource (i.e., brain capacity) will eventually produce less and less marginal results (increased test grade)
• state-road crew: specialization of flagman, truck driver, laborers, backhoe operator, etc. first increases output (marginal returns) but eventually decreases output (shovel leaners)
• MP curve intersects productivity curve at its highest point (same will be true for costs, but reverse) - the "pulling up or down" function that marginal results (next exam score) has on overall average (semester grade)

Production Costs:

• marginal cost (MC) per unit = chg in total cost

chg in output (Q)

• diminishing MP implies rising MC and vice versa (see fig 9.6), inverse relationship (very important!)
• on per unit basis, more inputs per output (lower MP and productivity) means higher unit (marginal) cost
• total cost = fixed cost + variable cost (see fig 9.3)
• average (per unit) total cost (ATC) = AFC + AVC (see fig 9.4)
• U-shaped ATC (bathtub curve):
• falling AFC
• rising AVC
• minimum AVC and ATC intersected by MC (see fig 9.5), same principle as "pulling up or down" MP curve
• MC curve is key: will use to determine output levels
• cost summary (see handout)
• see assignment EOC #7, will be the basis for assignments in next two chapters

Long-Run Production Costs:

• long-run implies no fixed costs (can buy, sell, or lease plant and equipment)
• long-run costs with various plant sizes (see fig 9.7)
• LATC is an U-shaped curve, a composite of all possible short-run ATCs (fig 9.8)

Economies of Scale (see fig 9.9):

• economies vs diseconomies of scale vs constant returns to scale
• chart b: economies of scale/increasing returns (Wal-Mart effect)
• will also see later argument for natural monopoly (SMECO)
• chart c: (incorrect) diseconomies of scale (small producer)

Improving Productivity:

• shifts TP and MP curves up, ATC and MC curves down

Interesting Last Word on sunk costs (remember article from first class re: value of old bottle of wine or lost ticket to a show).

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Chapter 10 Pure Competition

The business of business is maximizing profits

· we are concerned solely with economic or "pure" profits

Market Structure:

The four market models are the heart of microeconomics - the study of price and output (Q) determination in perfect competition (1) vs imperfect competition (2,3,4) markets, primarily distinguished by number of sellers (see tab 10.1):

1. perfect competition (most)

2. monopoly (one)

3. oligopoly (few), duopoly (two)

4. monopolistic competition (many, but different)

Most U.S. sellers operate in monopolistic competition (70-75%), followed by oligopoly (20%), but we study monopoly (2-3%, e.g., USPS, utilities) and perfect competition (4-5%, e.g., agriculture) to develop a better theoretical understanding of revenues, costs, and profits

Basic differences:

· Perfect Competition (#1)

- horizontal demand curve

- perfectly elastic demand

- D (or P) = MR

- standard product (many substitutes)

- no control over price (price taker), thus no market power

- example: cord of firewood (u-pick up)

· Imperfect Competition (#2,3,4)

- downward-sloping demand curve

- inelastic demand

- D > MR

- unique or different product

- some/complete control over price (price maker), thus some/complete market power

- example: everything else

The Production Decision (Q output):

· market vs firm demand curves (see handout)

Profit-Maximizing Rule:

· total: TR - TC = TP (see tab 10.3, fig 10.1), at output 9, maximum profit = 1179-880 (299 profit)

· MR (marginal revenue) = chg in TR

chg in Q

· MR = price (p) since competitive firm's price never changes

- thus, in perfect competition: p = D = MR

- not the case in imperfectly competitive markets

- average/marginal: MR = MC or p = MC (tab 10.4, fig 10.3)

· short-run profit-maximization rules (see various figures and tables):

- price > MC: increase output

- price = MC: maintain output (profit-max)

- price < MC: decrease output

· objective is maximum total profit, not maximum unit profit (lowest ATC)

Shutdown Decision (p = min AVC) - see fig 10.6:

a. >P₄: profit-maximizing (MR/p > ATC)

b. P₂ < P₄: loss-minimizing (ATC > MR/p > AVC)

c. <P₂: shutdown (min AVC > MR/p)

Determinants of Supply (see Ch 3):

· MC curve above min AVC represents competitive firm's short-run supply curve (fig 10.6)

· supply/MC shifts also shift ATC

· impact of taxes:

- property tax affects fixed cost, thus ATC - doesn't chg AVC and MC

- payroll, excise and similar "per unit" taxes affect variable costs, changes MC, ATC

- profits (corporate income tax) - no immediate effect on costs

Investment Decision (to change fixed cost) - long-run vs short-run

· zero profits in the long-run competitive markets (fig 10.12)

· long-run rules for market entry and exit:

p > ATC (profits mean market entry)

p < ATC (losses mean market exit)

p = ATC (breakeven means equilibrium, market at rest)

· note "triple equality" MR/p = MC = ATC where both allocative efficiency (right mix of output where p = MC) and productive efficiency (least cost output where p = min ATC) are satisfied

this is Adam Smith's definition of efficiency in competitive markets, invisible hand, etc

See last word on consumer surplus from pure competition

EOC #4 Key Question

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Chapter 11 Pure Monopoly

Monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes (Ford Model T, MLB, electricity, Girl Scout "Samoa" cookies)

Market Power:

· ability to alter the market price of a product

· exists at all levels in the economy (from school's bookstore to industrial giant)

Major difference with purely competitive firm:

· monopolistic firm is the industry (demand curves are one in the same), other monopoly characteristics:

- single seller

- no close substitutes (buyer must buy or do without: inelastic demand)

- price maker (vs price taker)

- blocked entry (licenses, patents, location, technology, economies of scale, ownership of raw materials)

- nonprice competition (PR, heavy advertising)

· monopolist's demand curve relatively inelastic:

- downward sloping

- D/p > MR (see fig 11.3), produces two curves

- MR curve lies below D (price) curve at every point but first

- compare with purely competitive firm

Profit-Maximization (see fig's 11.4, 11.5):

· MR = MC rule (also applies to monopolists) determines output

· see tab 11.2 p213, good step-by-step procedure

· price is demand (travel "north" at MR = MC to demand curve (point D)

· remember profit-maximizing monopolist (or anyone) will prefer elastic over inelastic segment of its demand curve

· monopolies tend to increase price and restrict output compared with competitive markets (see fig 11.6 and assignment)

- marginal cost pricing (D/p = MC) not probable

The monopolist has no supply curve. Unlike competitive firms, no unique relationship exists between price and quantity supplied - instead, prices and quantities depend on the demand (and MR) curves

Price discrimination: takes place when a given product is sold at more than one price and these price differences are not justified by cost differences (more common than you think, e.g., movie theater tickets)

· results in D/p = MR (similar to competitive firms, but a little different)

· see fig 11.8 and assignment

Regulated Monopoly (fig 11.9):

· socially optimal/, marginal cost price (p = MC) vs fair-return/ breakeven price (p = ATC)

· thus, policy dilemma of regulation

Pros and Cons of Market Power:

· R&D and innovation (is bigger necessarily better?)

· economies of scale

· natural monopolies: downward-sloping ATC (see regulation Ch19)

· antitrust laws (see tab 9.1), AT&T and IBM

· see De Beers cartel breakup in last word (nothing lasts forever, even diamonds)

EOC #5 Key Question