Lesson 1

v Building Blocks of Economic Thinking

• Types of Questions Answered by Economists

• Assumptions in Economics

– Rationality

– Maximization

– Scarcity

– Economic Goods

– Opportunity Costs

Basics of Course

What is economics about? Micro economics.?

• Current def: whatever economists study - not a very useful definition of a discipline.

• Historical and more useful definition: allocation of scarce goods for competing ends.

• In reality, it focuses mainly on how free markets, consisting of voluntary participants, operate.

• It can also be used to analyze other non-market forms of production and distribution.

What Types Of Questions Do Micro-economists Try To Answer?

• What pricing strategies allow firms to maximize profits?

• When should a firm produce a product in house, and when should it purchase from outside vendors?

• Can a firm pass on a tax? What is the effect of taxes on the profit maximizing behavior of firms?

• What is the impact of airline deregulation?

• What is the optimal amount of pollution?

• Do women get paid less then men? Why?

Assumptions In Economics

Ø Major actors: consumers and producers.

Assumptions: Economic Actors Are Rational

u Voluntary actions are only undertaken when they are expected to make people better off.

u Even people in asylums act economically rationally in most instances, according to experiments.

Assumptions: People Try to Maximize Happiness (Utility)

u This does not imply selfish behavior.

u If giving to others is what makes you happy, that is what maximizes your utility.

u Rationality in this case implies that you wish to maximize your giving to others, not to just have the money wasted.

Assumptions: Firms Try to Maximize Profits

u Private for-profit firms are supposed to work for their shareholders, who usually are interested in stock price appreciation, which results from profit maximization.

u But, many organizations are not for-profit firms – clubs, government, charities, and so forth. But even if they don’t maximize profits, they still should be interested in efficiency, and also in what happens to the demand for their product when conditions change.

u This assumption leads to good predictions about firms behavior, so it doesn’t need to be always true.

Assumptions: Scarcity

u Our wants are greater than our abilities to fulfill them (scarcity). Factually correct throughout history.

u If we do not have scarcity, then everyone has as much of all products as they want. There would be no trading, no markets, and no prices.

u The problem of scarcity could in principle be ‘solved’ either by increasing output or decreasing wants. Some religious or philosophical movements work on decreasing wants; Capitalism tends to go the increasing output route. ‘Problem’ will never be solved.

Some Basic Definitions

u Goods: things people want :

u Economic goods: goods that are scarce.

• Question- must goods have a positive price? Are all positive priced items economic goods?

u Opportunity cost: what you give up when you engage in an activity. Measured as the value of your next best activity (the activity you would have engaged in if you didn’t choose the first activity). Example: opportunity cost of going to college.

Production Possibility Curves.

• Illustrates concepts of efficiency, scarcity, opportunity cost.

• Assumes society with two goods (perhaps Robinson Crusoe with fish and fruit).

• Indicates combinations of each good that can be produced.

• Example for farmer: amount of two possible commodities he might grow.

Production Possibility Curve

No Specialized Resources-PPC Straight

Specialized Resources- PPC Curved Line

Lesson 2

u Supply and Demand

• Demand

– Law of Demand.

– Movement of Curve vs. movement along curve.

– Ceteris Paribus assumption.

• Supply

– Upward Sloping.

• Equilibrium (competitive)

– Shortages and Surpluses.

– Using supply and demand to predict prices and quantities.

Demand

u Defined for a single market – particular product and particular consumers.

u Each unit of the good is identical to all other units.

u Represents highest price consumers are willing to pay, and quantity they want at a given price.

u Time dimensions

u Holds everything but price and quantity constant (income, tastes, price of other goods, gravity, Y2k problems….)

u law of demand – demand slopes down – based on empirical observation.

u movement along versus movement on

Demand

u Defined for a single market – particular product and particular consumers.

u Each unit of the good is identical to all other units.

u represents highest price consumers are willing to pay.

u Holds everything but price and quantity constant (income, price of other goods, gravity, Y2k problems….)

u time dimensions

u law of demand – demand slopes down – based on empirical observation.

u movement along versus movement on

Demand for WLM*

Shift in Demand for WLM

Price Elasticity Of Demand

u def: percentage change in quantity divided by percentage change in price

u (ÄQ/Q)/(ÄP/P) or (ÄQ/ÄP) (P/Q)

u measure of responsiveness

u If Elasticity is >1 known as elastic (responsive customers)

u If Elasticity is =1 ; unit elastic

u If Elasticity is <1; inelastic (less responsive customers)

u Infinite and zero elasticity

Illustrations of elasticity

Elasticity and TR

u When elasticity is greater than 1 (elastic) increases in price lead to decreases in revenue and vice-versa

u When elasticity is equal to 1, changes in price lead to no change in revenues

u When elasticity is less than 1 (inelastic) increases in price lead to increases in revenue.

Implications of Elasticity

u If Elasticity is <1, firm can always increase Profit by increasing price (revenues increase and costs decrease because output decreases)

u If Elasticity =1, firm can always increase profit by increasing price

u If Elasticity>1 firm can not necessarily increase its profits by a change in price.

u Thus firms that maximize profits must have elasticities >1.

u Example of VideoTape Sales Demonstrates Importance of knowing elasticity.

Long Run and Short Run Elasticities

u Elasticity is greater in the long run

• consumers have more time to react to price changes

• For example, if the price of gasoline goes up, consumers at first can try to reduce the amount they drive, but this is often difficult. Over time, they can by more fuel efficient cars or move closer to their work.

Supply:

u Represents minimum price sellers require to voluntarily provide the product.

u assume it slopes up for now. In reality it depends on the cost conditions of the firm.

u Same assumptions as with demand: everything else is held constant.

Meaning of Supply

Meaning of (Stable) Equilibrium

u A situation such that the variables of interest remain at rest until disturbed by some outside force. For stability, the variables must return to the equilibrium after being disturbed by some force.

u Gravity and the resting place of tennis balls.

u We assume many producers and consumers to start the analysis.

u Surplus and shortages take the place of gravity in these markets.

Illustration of Supply Demand Equilibrium

Examples of changes in Equilibrium

u Supply and Demand analysis assumes that market moves from one equilibrium position to another.

u Shifts in D or S alter equilibrium. For example, how would you expect the price and quantity of Pepsi Cola to change when:

• Price of Coca Cola falls.

• Price of fructose goes up

• Surgeon general warns of soda threat to health.

• Winter changes to summer.

• TV ads for cola banned

• Answers on next slide.

Changing Equilibrium

Lesson 3

Area under demand = total value of that output

Area under supply = total cost (net of fixed costs)

Role of Price

u Mechanism for Allocating Goods in Markets: willingness to pay.

u What are alternative mechanisms?

• First come, first served

• Strongest and most Powerful

• Random Selection

• Friends and relatives

Meaning of Price

u What is the meaning of price when it is used to allocate goods? What does a high, or a low, price tell us about the product?

u Diamond-Water paradox: why are diamonds expensive when water is so cheap?

Meaning of Price (diamond-water Paradox

Meaning of Price in Markets

u Price Measures the value of the last unit sold, or marginal unit.

u Price, therefore, is unrelated to average or total value of a product.

u Salary, which is the price of labor, need not be related to the “value” of the worker or the work.

u How can one group of workers generate higher wages for themselves?

Consumer and Producer Surplus

u Consumer surplus is the difference between the price paid and the higher price that consumers would have been willing to pay for the product.

u Producer surplus is the difference between the payment received and the minimum payment that producers would have accepted.

Consumer and Producer Surplus

Price Controls

u Artificial Government Restraint of Price

u Can be a floor, or a ceiling

u Popular during wars, or in non-market economies

u Simple view: distortion in output

u More complete view: wrong consumers get product.

Price Floor at P₁

Price Floor at P₁ AND wrong producers

Rent Control (Price Ceiling)

Government guarantees price at P₁ and and sells output at market clearing price

Government guarantees price at P₁ and burns any output it can not sell at that price

Who Pays For A Tax?

u Terminology in Book is not exactly correct.

u Two forms of analysis: decreasing supply or decreasing demand.

u Tax burden is shared depending on slope of both curves.

Tax from consumer’s vantage

Tax from producer’s vantage

Distortion from Tax

Instance of Tax borne by Producer

Instance of Tax borne by Consumer

Instance of Tax borne by Consumer

Instances of Tax borne by producer

Lesson 4

u Firms

• Definitions.

• Firm’s Production.

• Profit Maximization and Marginal Analysis.

• Fixed and Variable Costs

• Economies and Diseconomies of Scale

Firms: Legal Forms

u Corporation and Proprietorships.

u Corporations which use stock have two advantages: limited liability and transferability of ownership. Disadvantages: the corporate income tax and costs of incorporation.

u Proprietorships have unlimited liability and can not be transferred. They do not have to pay corporate income tax, however. (New hybrid forms).

u Firms in our theory produce output in order to maximize profit. Marginal Analysis will help us understand profit maximization.

Marginal Analysis

u Relationship between Total, Average, and Marginal Magnitudes?

u You already have experience – you have been calculating your ‘average’ since elementary school. Each test is a ‘marginal’ score.

u Useful in Understanding Profit Maximization.

u Total Revenue is defined as Price multiplied by Quantity.

u MR is the change in TR when another unit is sold.

Marginal Analysis - Demand

More Marginal Analysis

Marginal Costs and Profit

Profit Maximization

u Marginal Analysis

u TR= PxQ

u Calculus leads to MR=MC conclusion;

u Alternatives to Calculus

u AR = demand curve; marginal revenue curve must lie below demand curve

u Profit maximized when TR-TC is greatest (vertical difference)

u this implies slope of TR = slope of TC which means that MR=MC

Some simple Calculus

The Intuition

Profit Maximization

Another Angle

The Firm's Inputs And Costs

u Fixed And Variable Costs.

• Fixed Costs: Costs that do not change when output changes.

• Variable costs: Costs that do change when output changes.

u Long Run and Short run.

• Long Run: A long enough period of Time such that all costs are variable

• Short Run: A period of time such that at least one input (cost) is fixed.

TC=FC+VC; TC/Q = FC/Q +VC/Q which is ATC= AFC +AVC

Irrelevance of Fixed Costs if you stay in Business

u Changes in Fixed costs don't alter profit maximizing P and Q because fixed Costs don’t impact Marginal Costs.

u Fixed Costs do impact profits, and may cause firm to decide the leave industry.

u Same with lump sum taxes.

Economies and Diseconomies of Scale

u What does this imply about the AC curve?

u defined simply as whether or not AC rises or falls

u long run AC Vs. short run AC

u Distinguishing between economies of scale and improvements in technology very important.

u Can firms have diseconomies of scale but industries have economies of scale?

Long Run AC

Can firms have diseconomies of scale but industries have economies of scale?

u External Effects – Industry output effects the costs of individual firms.

u Positive External Effects can cause AC for industry to fall even though each firm has upward sloping AC curve.

u Used to explain apparent decreasing costs but multiple firms in industry.

Module 5

perfect competition

u Many participants, buyers and sellers.

u Sellers are infinitesimally small.

u Homogeneous products.

u Free entry and exit.

u Perfect information.

1. Competitive Firms

u a. In the short run almost horizontal demand.

u b. supply curve of firm is the MC above AVC.

u c. Industry supply horizontal sum of firms mcs (the sum of their output at a price).

Competitive Equilibrium

u a. fixed number of firms in SR!! no entry or exit allowed; therefore, industry supply can not change

u b. for firm: d=mr=p=mc

u c. In longer run, profits draw entry of firms, increasing industry supply, lowering price and profits down to zero; negative profits cause exit, decreasing supply, raising price and bring profit back to zero.

Efficiency of Competition

u a. no deadweight losses-- i.e. on prod poss frontier

u b. each firm at bottom of ac--- seems good, but actually irrelevant for economic efficiency

u c. consumers vote with dollars. Popular products make money, drawing entry until enough of the product is produced. The drive for profits makes firms efficient and efficient firms drive out inefficient firms (Darwin and Economics).

Efficiency of Competition (rpt)

u a. no deadweight losses-- i.e. on prod poss frontier

u b. each firm at bottom of ac--- seems good, but actually irrelevant for economic efficiency

u c. consumers vote with dollars. Popular products make money, drawing entry until enough of the product is produced. The drive for profits makes firms efficient and efficient firms drive out inefficient firms (Darwin and Economics).

Competitive Markets that aren’t

u Example of taxi-cab medallions

u Television station licenses.

u Medical doctors

u Many, many, more.

Long Run Supply: No External Effects

u Competitive industry must have constant costs in this case.

u Long run industry supply must be horizontal at the bottom of the AC of representative firm.

u Long run industry output changes only through entry and exit of new firms.

Long Run Supply with External Effects

u Competitive industry may have increasing or decreasing costs in this case.

u Long run industry supply changes only as the bottom of the AC of representative firm changes.

AC for representative firm as industry output Q increases.

Long run supply in decreasing cost competitive industry

Module 6

Monopoly Vs. Competition

u Monopoly versus competition (smaller q, higher p)

u Imposing a tax on a monopolist similar to competition in that producer still bears part of it.

u Price controls and monopoly ...a case where controls may increase efficiency.

u Price discrimination.

u The tradeoff associated with patents and copyright - deadweight loss in consumption versus possible new products.

Monopoly charges higher price, produces smaller quantity.
Monopoly causes Deadweight Loss 1+2. Area 3+4 is transfer to producer from consumer

Tax on Monopoly: price goes up by less than tax, so burden of tax is still shared. Monopolist tends to pay bigger share than would competitors. Deadweight loss grows.

A Price Control on a monopolist. Since p cannot go above P_control the MR is equal to P_control , output may increase (if price control is not too low, and deadweight loss may decrease.

A Price Control on a monopolist. Since p cannot go above P_control the MR is equal to P_control , output may increase (if price control is not too low, and deadweight loss may decrease.

Perfect Price Discrimination

u Theoretical ideal. Cannot be fully achieved.

u Find maximum price that every consumer is willing to pay and charge them that price.

u Requires more information than any firm has, and the prevention of arbitrage.

u Demand Curve becomes MR curve.

u No Deadweight Loss.

u Approximate examples: automobile dealers, doctors in the old days.

Price Discrimination

u If markets for a single product have different MRs, profits can be increased by shifting output from low MR markets to high MR markets.

u Raise price in low MR market and lower price in high MR market.

u High MR market is high elasticity market.

u Need to Prevent Arbitrage.

u Examples: Airlines with business travelers and vacationers. Coupons.

Price Discrimination Rules

u Raise price in market with lower elasticity (lower responsiveness)

u Lower price in market with higher elasticity.

u Do this until MRs are equalized. But prices will not be equalized.

u Examples: Airlines with business travelers and vacationers.

The Causes of Monopoly

u Natural Monopoly

u Government grant (U.S. postal service, electric company),

u Patents and Copyright.

u Control of scarce resource.

u Technical Superiority.

u Network Effects.

Natural Monopoly

u Downward sloping AC curve.

u More efficient to have 1 large firm than many small firms.

u Rate of return regulation is how we regulate these firms.

u Removes incentive to keep costs down.

Natural Monopoly

Patent (copyright) tradeoff

u With no protection, creators do not reap much of the rewards of their creations.

u They are given monopoly protection, which increases their revenues, but raises price to consumers.

u This increases the number of inventions, but decreases the use of each invention?

u We do not know the optimal tradeoff.

Monopsony

u Single buyer instead of single seller.

u Price paid is less than competitive level. Quantity purchased is also less.

u Deadweight loss, similar but inverted compared to monopoly.

Monopsony pays lower price, consumes smaller quantity.
Deadweight Loss 1+2. Area 5+4 is transfer to consumer from producer.

Network Effects

u Increased market size makes product more valuable to consumers.

u This is just like an economy of scale in that it benefits large firms relative to small ones. Leads to natural monopoly.

u It implies that demand increases for large networks, and that prices should rise.

u In Microsoft case, judge decided that they are a barrier to entry.

Antitrust Rules against:

u Monopolization.

u Price Discrimination.

u Predatory Pricing.

u Tie-In Sales.

Monopolization

u If earned through better performance is not illegal.

u Agreements to ‘restrain trade’ are per se illegal.

u Definition of market is often crucial here.

Cartels

Price Discrimination

u Illegal if it gives some firm an advantage over other firms.

u If individuals are consumers, is not illegal.

u Price Discrimination is not likely to harm efficiency. Perfect Price discrimination is perfectly efficient.

u Intention of this rule was to protect ‘mom-and-pop’ stores and grocers from department stores and supermarkets. It was intended to reduce competition.

Predatory Pricing

u Current court-created definition (known as Areeda-Turner rule) : price below average variable cost.

u Also requires that there be a serious likelihood of driving prey out of business and of recouping losses.

u Likely to lose money for the predator, and unlikely to remove the prey.

u Can only succeed if prey is removed.

u Few real world examples. Standard Oil cases are largely fictional.

Predatory Pricing

Resale Price Maintenance

Tie-In sales.

u Generally considered to be an ‘extension of monopoly’ by courts. In other words, courts believed it was an attempt to use one monopoly to create a second.

u Tie-In sales are poorly understood by courts, imperfectly understood by most economists.

u Frequently, tying good is sold very cheaply, while tied good is very expensive. Famous cases: IBM and computer cards, Xerox and toner, Canning machines and tin plate.

u Two monopolies are not better than one if products are used together (in fixed proportions).

Tie In Sale when products used together

PD version of Tie-In Story

Risk Reduction version of Tie-In