Principles of Microeconomics

Transcription

1 David C. Broadstock Principles of Microeconomics Lecture notes December 27, 2011 RIEM

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3 Contents 1 Course overview Course outline Contents and objectives Grading and exams Homework Homework Homework Presentations Class 1 (Room C407) Class 2 (Room C201) Introduction and main principles The demand curve The core principles of economics How individuals make decisions How groups of individuals make decisions Hoe the economy as a whole works Thinking like an economist The economist as a scientist Why economists disagree Problems Gains from trade The gains from trade Production possibilities The principles of advantage Supply and Demand What is a market? What is competition? Demand v

4 vi Contents Supply Supply and demand together Problems Elasticity Price elasticity of demand The midpoint method Problems Final homework Problems A Chapter Heading A.1 Section Heading A.1.1 Subsection Heading Solutions

5 Chapter 1 Course overview Instructor: David Broadstock Teaching assistant: Diane, tzdai@yahoo.com.cn, phone: Time and location (depending on allocation): Tuesday (14:50-17:35) room:c407 Tuesday (18:30-21:05) room:c Course outline Contents and objectives The course is designed to introduce to the student the principles of microeconomics and to critically analyze these principles in the context of public policy issues. The foundations of microeconomics are the logic of decision-making, leading to supply and demand or the market system. The course will introduce tools to explore the fundamentals of the market system, examine the behavior of consumers and firms in alternative market models, and consider public policy issues such as public goods. The major purpose of the course then is to help students understand how economic concepts can be applied to a variety of problems. You will have many opportunities this semester to practice and make progress toward achieving these objectives. Quizzes and homework assignments will be used to assess your performance in achieving the course objectives. 1

6 2 1 Course overview Grading and exams The grades for the course will be determined by the student s performance on quizzes, exams, and homework problems. Grades are determined by a percentage of the total score. No makeup exams. You can use a calculator during the midterm and final. The scores for each of the elements of work are summarized in the following table, noting that the exact score are still under review and hence subject to small change - these changes will be notified as soon as agreed. Event Percentage Pop quizzes 10 Homework 20 Midterm exam 25 Presentation 10 Final exam 35 The following provides a more complete description on the topics that will be covered on a week by week basis, including the relevant reading within the course text. Week 1 10 Principles of Economics (Ch1) Thinking Like an Economist (Ch2) Week 2 National Holiday Week 3 Interdependence & the Gains from Trade (Ch3.) The Market Forces of Supply & Demand (Ch4) Week 4 The Market Forces of Supply & Demand (Ch4) Elasticity of Demand & Supply (Ch5) Week 5 Elasticity of Demand & Supply (Ch5) Supply, Demand, and Government Policies (Ch6) Week 6 Supply, Demand, and Government Policies (Ch6) Consumers, Producers, and the Efficiency of Markets (Ch7) International trade (Ch9) Week 7 Midterm Exam Week 8 Presentations Week 9 The Costs of Taxation (Ch8) Externalities (Ch10) Week 10 The Costs of Production (Ch13) Week 11 The Costs of Production (Ch13) Firms in Competitive Markets (Ch14) Week 12 Monopoly (Ch15) Week 13 Oligopoly (Ch15) Monopolistic Competition (Ch17) Week 14 Final Exam

7 1.2 Homework Homework Homework words on your favorite/least favorite 1 of the 10 principles of economics Homework 2 Complete Problem sets for Chapter 4 and Chapter 5. To be handed in on the day of the mid-term exam. Please write answers in the notebook provided in class, this homework is to be submitted by hand and not by . 1 Depending on which class you were in.

8 4 1 Course overview 1.3 Presentations The groups for presentations are given in the following. If you find that your student number is not in the list, please me or talk to me in class as soon as possible Class 1 (Room C407) Group Group members Group , , , Group , , , Group , , , Group , , , Group , , , Group , , , Group , , , Group , , , Group , , , Group , , , Class 2 (Room C201) Group Group members Group , , , , Group , , , Group , , , Group , , , Group , , , Group , , , Group , , , Group , , , Group , , , Group , , ,

9 Chapter 2 Introduction and main principles Abstract Each chapter should be preceded by an abstract (10 15 lines long) that summarizes the content. The abstract will appear online at and be available with unrestricted access. This allows unregistered users to read the abstract as a teaser for the complete chapter. As a general rule the abstracts will not appear in the printed version of your book unless it is the style of your particular book or that of the series to which your book belongs. Please use the starred version of the new Springer abstract command for typesetting the text of the online abstracts (cf. source file of this chapter template abstract) and include them with the source files of your manuscript. Use the plain abstract command if the abstract is also to appear in the printed version of the book. 2.1 The demand curve 2.2 The core principles of economics This section is closely based on Chapter 1 of Mankiw. The purpose of this chapter is to introduce the reader to some of the key principles of economic reasoning and thinking. While the term economist is wide reaching, and can cover a huge range of interests and approaches to analysis (as you will see in the coming years) there are a number of principles which remain core to the subject as a while. Mankiw distills these into ten core principles, which are discussed below, while some of these are arguably more founded in macroeconomics than microeconomics, it serves a purpose to gain an appreciation of them now. Some of these principles may not seem so obvious at present, but their understanding will be clarifies throughout the course of the module. In many ways this list of principles serves as an introduction to the insights and understandings you 5

10 6 2 Introduction and main principles will have achieved by the end of the course. It is useful to keep these principles in the back of your mind as you study for the rest of the semester. The principles can be classified into three categories: How individuals make decisions How groups of individuals make decisions How the economy as a whole works How individuals make decisions Principle 1: People face trade-offs Economics is in many ways the study of choice. The process of making a choice implicitly involves making a decision between two or more alternatives based upon what we think they are worth, and so we often need to compare values. One example is the decision over how much time to spend studying microecomics relative to the other modules you are likely to be taking at the same time as this one. You could either choose to spend an extra hour studying microeconomics, or perhaps watching the news on TV instead, or resting. As another example, when in the supermarket you may choose to but either more meat or more vegetables, but you may only have enough money for one or the other. Both of these examples involve some kind of binding constraint insofar as the time allocation problem is bound by the fact that there are only 24 hours in a day, and the shopping problem is bound by an income constraint. That is to say that resources in these examples are finite (sometimes in economics we refer to this as scarce). Society faces trade-offs as much as individuals do, and one key problem is the trade-off society faces between efficiency and equity where: Efficiency is where the main pursuit of society is in achieving the most it can from its scarce resources Equity is where the main goal is to distribute economic prosperity fairly among the members of society Principle 2: The cost of something is what you give up to get it This is the main principle that differs the economic definition of cost from the pure accounting definition of cost. It is our first introduction to the concept of opportunity cost, a key concept in microeconomics. As suggested by Principle 1, people face decisions, and in order to make those decisions people need to be able to value alternatives. This is not so straightforward

11 2.2 The core principles of economics 7 as it may sound. A simplistic approach might be to consider the costs. Mankiw cites an example of a student going to college, and the rent they will pay for living. The pure money cost is not enough as there are other factors we need to consider. For example, the rent outside may have cost more, and so in relative terms, the cost of accommodation may have become less, meaning that this could be considered a benefit as it has induced an implicit saving in the cost of living. Opportunity cost something else The opportunity cost is whatever must be given up to obtain Principle 3: Rational people think at the margin Rational people are people who systematically and purposefully do the best they can to achieve their objectives The notion of rationality is another core concept in economics and one that often raises significant debate, particularly among those on lightly read in the subject. A large body of economics works on the premise of looking into the behaviour of rational people (who we often refer to as rational agents). As you study through your courses in economics you will come across many instances where this will prove to be a valid generlisation too. 1 For instance you will see examples of (i) people who choose to allocate their time and money and (ii) firms who choose to invest in different raw materials to transform into value-added goods. One important thing that rational agents understand is that decisions do not need to be made on an all or nothing basis. For instance, there are 16 hours in a day (excluding 8 hours assumed to be used for sleeping), so if we reconsider the example given in Principle 1 of studying microeconomics or resting (including watching TV), a rational agent realises that their choice is not between using the whole 16 hours studying or not studying it all. Rather their choice is often how many more (or less) hours to spend studying. Economists refer to these types of incrmental decisions as marginal changes where; Marginal changes refer to small incremental adjustments to a plan of action In economics, it often proves highly instructive and useful to consider these types of marginal changes, as they are particularly useful for considering the impacts of potential policies in terms of welfare gains. 1 Noting that in economics, where we often use this is a start point for analysing problems, we are often interested in (and sometimes more interested in) looking at the behaviour of seemingly irrational agents also. It is worth noting that almost all agents act rationally, what seems at times to be irrational behaviour is due to differing objectives in decision making.

12 8 2 Introduction and main principles Principle 4: People respond to incentives Incentives are critical to understanding how markets work. An incentive is broadly defined as: Incentive something that induces a person to act While seemingly broad in its definition, it is largely self explanatory. Many policies introduced by governments seek to alter the balance of incentives on offer to all or some members of society, and in so doing alter the decision that rational agents make in economic decisions. One example of this is the demand for transport energy. If the government introduces a policy that requires cars to be more fuel efficient this will reduce the energy impact of travelling, which would likely be the intended result. However, by making travelling cheaper, they are letting people save money, which they can then use for other things. They may use some of that money for travelling, and therefore increase their overall use of transport as a result of a policy that was intended to reduce it. As such the policy aimed at reducing energy use has the primary effect of causing a direct reduction How groups of individuals make decisions The principles above refer to the way in which individuals make decisions, the next few look into the way in which individuals make decisions within groups and how they are able to co-ordinate behaviour to mutually beneficial gain Principle 5: Trade can make everyone better off Not all individuals have the same resources or expertise, or the same desires. This is true also of countries. Take for instance China and France. The appetite for wine in China is fairly small, while in France it is large. As a result the French have invested a lot of effort in learning to make good wine. If China now wants (more) good wine it has two choices, rapidly develop the domestic market at a large cost, or trade with France. For China trade is probably the best option for now, as the market is probably too small to make a large investment worthwhile, and obviously the trade with France benefits them also. Hence, the trade makes everyone better off.

13 2.2 The core principles of economics Principle 6: Markets are usually a good way to organize economic activity Market economy A description for an economy that allocates resources through the decentralised decisions of many firms and households as they interact in markets for goods and services. The proposition is based on the wisdom of the free-hand economy which stretches back to 1776 and a famous economist named Adam Smith, From Scotland in the UK. The forces of the market are essentially controlled through price effects which affect the quantity of a good demanded. If the price is too high (that is, higher than individuals are willing to pay), then demand will be low. As a result that good will either become cheaper (meaning lower profit to the producer) or disappear from the market if it is no longer economically viable. As such, a market has the potential to self-regulate and form its own stable level, without necessarily needing support from anybody. However as will be discussed in the following principle, sometimes this is not the case, and the government can step in to help Principle 7: Governments can sometimes improve market outcomes There are situations in which the free-hand economy fails to work effectively. These can be a result of a number of things including: Property rights which are the ability of an individual to own and exercise control over scarce resources Market failure a situation in which a market left to its own devices fails to allocate resources efficiently Externalities the impact of one persons actions on the well being of a bystander Market power the ability of a single economic agent (or small group of agents) to have a substantial influence on market prices All of the above can cause the market to act in abnormal ways, and may be reasons for the government to intervene in markets, depending on their position in the efficiency versus equity trade-off Hoe the economy as a whole works The following three principles are concerned with the workings of the economy as a whole. In some ways these are an allusion to some of the things you will study in your Principle of Macroeconomics, though they have strong microeconomic foundations too, hence their inclusion here

14 10 2 Introduction and main principles Principle 8: A country s standard of living depends on its ability to produce goods and services This is a simple point: The more productive a country s people are, the better off that country is. Where productivity is defined as: Productivity the quantity of goods and service produced from each hour of a workers time The interesting notion that this principle raises is that, when attempting to define a new policy the government is able to focus on doing things that will raise productivity of local workers as doing so will automatically increase the quality of life of people too Principle 9: Prices rise when the government prints too much money The change in the price of a good is known as inflation. In most cases, the cause of inflation is increased supply of money. As more money becomes available, the value of the money falls. As its value falls, nominal prices rise to compensate Principle 10: Society faces a short-run trade-off between inflation and unemployment Inflation can be undesirable, but at the same time it can have some interesting short term implications. Increasing the money supply can stimulate demand, which in turn may over time cause firms to increase their prices (hence inflation). In addition it also encourages them to produce more goods so that they can sell them at the higher price, to do which they may need to increase the size of their workforce. Therefore although increasing the money supply can cause inflation, it can help to reduce unemployment.

15 2.3 Thinking like an economist Thinking like an economist This section is largely based on Chapter 2 of Mankiw s text book. The purpose of this chapter is to add to the 10 core Principles by considering the way that economists aim to percieve the world, and it covers: The economist as a scientist The economist as a policy maker Why economists disagree The importance of graphing The economist as a scientist The scientific method: Observation, heory and more observation Economics prides itself on its scientific approach to analysis, and in terms of the technical merit of its approach to analysis, it is every bit as thorough and complex as other (physical) sciences. 2 The process is simple, we observe real world behaviour to attempt to distill some persistent happenings (or sometimes we refer to them as stylized facts). Once we observe such a phenomena we then seek to try to explain it using some theoretical model. Following this we continue to observe reality and see whether or not the proposed theory worked, if not we revise the theory and observe further. As economists, people often specialise in one or another area, either creating a theory, or observation of the real world, these two types are normally referred to as theorists and empirical economists. In addition there is a growing branch of economics looking into controlled experiments, though this is much more difficult in economics than it is in physical sciences The role of assumptions Scientific approaches to analysis are often underpinned by assumptions. In the first section we saw one such assumption, the assumption that people act in a rational way. In Economics, in order to create economic models that are capable of representing large amounts of behaviour in a fairly simple way, we often need to have a few assumptions. Like rationality, these assumptions are normally very sensible assumptions that do not need to be explained in too much detail. We will see alternative assumptions such as that when our income rises we spend more money, or 2 Compare for instance articles in Biometrika, the leading Biological statistics magazine with Econometrica, the leading Economic statistics magazine.

16 12 2 Introduction and main principles that as prices rises, demand will fall. Assumptions like these latter two are easy to support with evidence too Economic models A key role of economics is to be able to understand what causes people to make the choices they make. It is not enough to be able to say that for instance a person will choose to buy a second car, what we want to be able to illustrate is what will cause a person to buy a second car. The answers to this may be complex, for instance involving the persons working status, family status, age and many other things. We aim to simplify complex behaviour into simpler models, that are able to closely model reality, but without needing to be so complex that they are too difficult to use. The following two subsections describe two common models in microeconomics, the circular flow diagram, which illustrates how markets interact with each other and how individuals interact with households. The second model is one called the production possibilities frontier (PPF) and represents the choices that the economy faces in allocating its resources into different products it could make. The descriptions are deliberately short as they are covered in detail later in the course/notes, this section is only to give you an introductory awareness of their existence and importance Our first model: The circular flow diagram Fig. 2.1 The circular flow of the economy The circular flow diagram is the first example of a model that we introduce. This model is very instructive as it provides a succinct way of summarising how the economy works. In this diagram the important features are; there are two type of people in the economy, households (which includes individuals and firms There are two markets (i) the market for finished goods and services and (ii) the market for factor of production. Factors of production, such as land, labour and money (capital) are used by firms to turn into finished goods and services Households supply factors of production, through labour and the land that they own etc. In return, firms pay rent and wages households purchase finished goods and services, causing firms to generate revenue

17 2.3 Thinking like an economist 13 Money and goods (including factors of production) essentially flow around the economy in a circular way This is a simple model, but for instance excludes the role of international trade which can cause extra money to enter into the economy, or to leave it. However, you will see this in next semester s course on macroeconomics Our second model: The production possibilities frontier The second model that we wish to introduce is known as the production possibilities frontier (see figure), which reflects the following characteristics; The graph shows all possible combinations of goods (or services) that can be produced using the resources available in the economy Any point on the frontier, or within the frontier is a possible manufacturing combination Points within the frontier are inefficient, as the frontier shows the most efficient combination of goods and services that can be produced. any combination of goods and services that lies outside of the frontier is not possible to achieve using current technology The example provided shows the output combinations that an economy has in terms of producing either cars or computers. Four points are given A, B, C and D. D represents the only point that is not possible. B represents a point that is not the most productive use of the resources available. Points A and C represent alternative production choices that both lie on the frontier. These alternative choices result in different amounts of cars and computers. The PPF is a very powerful tool, and is widely used in large areas of economics. What is presented here is only a very cursory (brief) introduction. Fig. 2.2 Production possibilities frontier (PPF) Why economists disagree Economics is still a very young discipline. Adam Smith, the founder of the invisible hand, was one of the fathers of economics, and wrote his seminal work in That is to say his work is only a little over 200 years old. On the other hand, philosophy has a deep heritage in ancient Greece some 2000 years ago and more (noting that while markets and economic behaviour have been around every bit as long, the

18 14 2 Introduction and main principles study of them has not). Economists are therefore still testing ideas, and many interested researchers have innovative ideas and approaches that as yet have been neither proved or disproved. The nature of economics is also that much empirical work relies heavily upon computer analysis, and it has not been until recent decades that the power of computers has been enough to undertake such economic analyses Differences in scientific judgements The latter point mentioned above is the root cause of differences in scientific judgements, which in turn is the cause of disagreement. As researchers begin to test different ideas, they form different opinions as they have different results. An example of this might be in the analysis of fuel demand, where one researcher might suggest; demand = f(price, income) That is to say that demand is a function of only price and income, whereas another research might suggest fuel efficiency also affects demand for fuel; demand = f(price,income,e f ficicency) This could cause the two researchers to make different policy recommendations Differences in values The societal trade-off between equity and efficiency is an important example of why sometimes economists disagree. Which is more important? The answer to this depends on who you ask, as some people will always feel that one is more important than the other. That is to say, for whatever reason, they value the same thing in a different way to another person. These differences in values are also one of the reasons for economists disagreeing, as economists given different levels of importance to different features in their models, leading to different outcomes and policy recommendations. Problems 2.1. Describe some of the tradeoffs faced by the following; (a) a family deciding whether to buy a new car

19 2.3 Thinking like an economist 15 (b) a member of Congress deciding how much to spend on national parks (c) a company president deciding whether to open a new factory (d) a professor deciding how much to prepare for class 2.2. You win 100 dollars in a basketball pool. You have the choice between spending the money now or putting it away for a year in a bank account that pays 5 percent interest. What is the opportunity cost of spending the 100 dollars now? 2.3. The company that you manage has invested 5 million dollars in developing a new product, but the development is not quite finished. At a recent meeting, your salespeople report that the introduction of competing products has reduced the expected sales of your new product to 3 million dollars. If it would cost 1 million dollars to finish development and make the product, should you go ahead and do so? What is the most that you should pay to complete development? 2.4. Three managers of the Magic Potion Company are discussing a possible increase in production. Each suggests a way to make the decision; Harry: We should examine whether our company s productivity - gallons of potion per worker - would rise or fall. Ron:We should examine whether our average cost - cost per worker - would rise or fall. Hermione:We should examine whether the extra revenue from selling the additional potion would be greater or smaller than the extra costs. Who do you think is right? Why? 2.5. Explain whether each of the following government activities is motivated by a concern about equity or a concern about efficiency. In the case of efficiency, discuss the type of market failure involved. (a) Regulating cable-tv prices (b) Providing some poor people with vouchers that can be used to buy food (c) Prohibiting smoking in public places (d) Breaking up Standard Oil (which once owned 90 percent of all oil refineries) into several smaller companies (e) Imposing higher personal income tax rates on people with higher incomes (f) Instituting laws against driving while intoxicated

20 16 2 Introduction and main principles 2.6. One common assumption in economics is that the products of different firms in the same industry are indistinguishable. For each of the following industries, discuss whether this is a reasonable assumption; (a) Steel (b) Novels (c) Wheat (d) Fast food 2.7. Imagine a society that produces military goods and consumer goods, which we ll call guns and butter. Part (a) Draw a production possibilities frontier for guns and butter. Explain why it most likely has a bowed out shape. Part (b) Show a point that is impossible for the economy to achieve (label point A). Show a point that is feasible but inefficient (label point B). Part (c) Imagine that the society has two political parties, called the Hawks (who want a strong military) and the Doves (who want a smaller military). Show a point on your production possibilities frontier that the Hawks might choose (label point H) and a point that the Doves might choose (label point D). Part (d) Imagine that an aggressive neighboring country reduces the size of its military. As a result, both the Hawks and the Doves reduce their desired production of guns by the same amount. Which party would get the bigger peace dividend, measured by the increase in butter production? Explain.

21 Chapter 3 Gains from trade 3.1 The gains from trade Production possibilities To understand why people choose to depend on others for goods and services, and how this can lead to them having lives than they would in the absence of trade, it is useful to look at a very simple example where there are two goods traded. We will consider rice and chicken produced by two farmers, one rice-farmer and one chicken-farmer, living in different provinces. The potential gains from trade are best illustrated when each farmer can only produce one good such that; The rice-farmer can only produce rice and The chicken-farmer can only breed chickens 1 while the rice-farmer enjoys rice, and the chicken-farmer enjoys chicken, both realise after a while that rice and chicken are sometimes best eaten together rather than separately. In this case, the gains from trading with eachother are obvious, as both the ricefarmer and the chicken-farmer are able to gain from trading with eachother. However, what of the case where both farmers can produce both rice and chicken? Further, what if the rice-farmer has better land for growing rice than the chicken-farmer? In these more life-lick situations, the potential gains from trading with eachother are less obvious. Let us use an example to consider how to look at this. 1 To keep things simple we ignore the fact that chickens produce eggs which can be eaten also. 17

22 18 3 Gains from trade The rice-farmer and the chicken-farmer Supposing that each farmer works 10 hours per day, and that they can produce both goods, but in different quantities as follows; Rice Chicken Production rate: Rice-farmer 1 hour/kg 0.25 hour/kg Chicken-farmer 0.25 hour/kg 0.2 hour/kg Daily productivity: Rice-farmer 10 kg 40 kg Chicken-farmer 40 kg 50 kg This results in two PPF s as given in Figure 3.1. Fig. 3.1 PPF s for rice-farmer and chicken-farmer We can see that the chicken-farmer has a higher rate of productivity in both rice and chicken, and therefore has a PPF that allows production possibilities that the rice-farmer cannot achieve. Given the the chicken-farmer is more productive in both goods, is there any reason for him to trade with the rice-farmer? The PPF is useful for showing the range of choices that the farmers face, but does not tell us what choices they actually make. In order to support this example, it is useful for us to assume something about the choices they make, and so we assume that; Rice Chicken Production/consumption: Rice-farmer 5 kg 20 kg Chicken-farmer 20 kg 25 kg Therefore, we can add the consumption choices onto the PPF as shown in Figure 3.2; Fig. 3.2 PPF s and consumption choices for rice-farmer and chicken-farmer

23 3.1 The gains from trade 19 Rice Chicken Production without trade: Rice-farmer 5 kg 20 kg Chicken-farmer 20 kg 25 kg Production without trade: Rice-farmer 0 kg 40 kg Chicken-farmer 36 kg 5 kg Gains from trade: Net gains +10 kg - In this situation, with the farmers working together it is possible for them to consume the same amount of rice and chicken that they did without trade, but also to create an extra 10kg of chicken, which they could either choose to eat or to sell for profit. The numbers above are one specific example, but obviously instead of using the spare productivity to produce only chickens, it could on the other hand have been used to produce only rice, or a combination of both rice and potato The principles of advantage Absolute advantage Absolute advantage is defined as: Absolute advantage occurs when one producer has the ability to produce the same quantity of goods as another produce using fewer inputs 2 In the previous example we saw that the chicken-farmer had an absolute advantage in production of both rice and chicken. So while absolute advantage is interesting to know about, by itself it is not enough to explain how and why trade occurs. What we need to understand is the role of opportunity cost and comparative advantage Comparative advantage, opportunity cost and international trade Recalling from previously the definition of opportunity cost, i.e. Opportunity cost whatever must be given up to obtain something We can then look at the previous example in a different way: 2 Or put another way, given the same amount of inputs, the producer with an absolute advantage will be able to produce more goods and services

24 20 3 Gains from trade 1 kg of Rice 1 kg of Chicken Opportunity cost: Rice-farmer 4 kg of chicken 0.25 kg of rice Chicken-farmer 1.2 kg of chicken 0.83 kg of rice : note that this number is rounded off. With this table in mind, comparative advantage is defined as; Comparative advantage is the ability to produce a good or service at a lower opportunity cost than another producer cumulatively, these concepts of opportunity cost and comparative advantage are what determine the amount of gains from trade that exist. That is to say, if producers face the same opportunity costs, there are no obvious gains from trade

25 Chapter 4 Supply and Demand What is a market? Market a group of buyers and sellers of a particular good or service What is competition? A Competitive Market is defined as a market in which there are many buyers and sellers so that each has a negligible impact on the market price In such markets firms will often charge the same price, as any firm that charges less will gain an advantage and all other firms will lower their price to avoid losing market share. On the other hand, any firm that raises it s price will not be able to sell goods, as customers will buy from the cheaper retailers. In the text in this section, we will assume that firms are perfectly competitive, which occurs when two conditions are met; the goods offered for sale need to be exactly the same (we call this homogenous); and the buyers and sellers must be so numerous that no buyer or seller has influence over the market price The market for rice is an example of a perfectly competitive market insofar as there are thousands of producers, and millions (if not billions) of customers. Not all markets are perfectly competitive. 21

26 22 4 Supply and Demand Demand The concept of demand is probably the most important concept in economics, and large bodies of economic work are dedicated to it. We define demand as follows; Quantity demanded purchase is the amount of a good that buyers are willing and able to In addition to this the main characteristic of demand has been so widely proven so as to be given the status of a law ; The Law of Demand states that, other things being equal, the quantity demanded of a good (or service) falls when the price of the good (or service) rises The law of demand lends itself to easy graphical analysis, as all we need to understand are the quantities of a good that people are willing and able to buy at any given price of that good. This information, looking at different price combinations, is used to define the demand schedule for an individual; Demand schedule a table that shows the relationship between the price of a good and the quantity demanded For example my demand schedule for pork dumplings can be given as: Price per portion portions demanded 0 yuan 12 1 yuan 10 2 yuan 8 3 yuan 6 4 yuan 4 5 yuan 2 6 yuan 0 Which we can therefore plot as in Figure 4.1. This figure is known as a demand curve which is defined as: Demand curve a graph of the relationship between the price of a good and the quantity demanded Fig. 4.1 My demand curve for pork dumplings Market demand versus individual demand The above illustrated how to take plot the demand curve for an individual. In order to get the market demand, we simply add together the demand schedules of each of

27 4 Supply and Demand 23 the individuals. For example my son Thomas, has a lower demand for dumplings at any given price than I do, as he only has 4 teeth and finds them difficult to eat. His demand schedule is as follows; Price per portion portions demanded 0 yuan 6 1 yuan 4 2 yuan 4 3 yuan 3 4 yuan 2 5 yuan 1 6 yuan 0 This in turn leads to a market demand schedule of; Thomas + Dad = Market demand 12+6 = = = = = = = Shifts in the demand curve The position of the demand curve is not fixed, there are things that can cause it to move. For example: Income Generally speaking, the more money that you have, the more of something you can afford. For a normal product, as income rises, demand also rises. There are some goods that we demand more of as income falls. For example, as our income falls, we may not be able to afford to keep a car, and so our demand for using a bus increases. Goods like this are known as inferior goods. normal goods inferior goods goods that when our income rises we demand more of goods that when our income falls we demand more of Prices of related goods The prices of related goods can influence demand in one of two ways depending on the nature of the other good. Let us consider road transport fuel in the UK, where there are two types of fuel, gasline and diesel. complementary goods A rise in the price of either gasoline or diesel will cause their demand to fall. In addition, it will cause the demand for cars to fall, as fewer people can afford the fuel to run them. Cars are therefore a complementary good to fuel, as the demand for cars is complemented by the demand for fuel. Something that influences the demand for fuel, influences the demand for cars in the same manner.

28 24 4 Supply and Demand substitute goods On the other hand, gasoline and diesel are substitutes for each other, as they are two alternative fuel types that can be used to power a car. A rise in the price of gasoline will cause the demand for gasoline to decrease, but also will cause people to substitute gasoline for diesel and then the demand for diesel to increase. Tastes How much you like one thing compared to another is a very personal thing that is not easy to measure, but it can have clear impacts on demand. The thing you prefer more of, you are more likely to but more of at a given price. For example one brand of phone relative to another. Expectations Your expectations about the future may affect how much you choose to consume now. If you expect the price of something to fall in the future you may be less likely to buy it now. Number of buyers Market price is, in part, determined by the number of buyers. This is because the market demand curve is given by adding up all of the individual demands of the individual buyers Supply The supply curve The concept of supply is as important a concept in economics as demand, although due to difficulties in obtaining firm level data fewer economists are dedicated to it than to demand. We define supply as follows; Quantity supplied is the amount of a good that sellers are willing and able to sell In addition to this the main characteristic of supply has been so widely proven so as also to be given the status of a law ; The Law of Supply states that, other things being equal, the quantity supplied of a good (or service) rises when the price of the good (or service) rises The law of supply, like the law of demand, lends itself to easy graphical analysis, as all we need to understand are the quantities of a good that people are willing and able to sell at any given price of that good. This information, looking at different price combinations, is used to define the supply schedule for an individual; Supply schedule a table that shows the relationship between the price of a good and the quantity sold/supplied Fig. 4.2 A supply curve for pork dumplings

29 4 Supply and Demand Shifts in the supply curve As with demand, there are a number of features that can cause the supply curve to shift. These are: Input prices The costs faced by producers affect the amount of goods that they are able to sell at any given price Technology Improved technology in general means that more can be done with the same amount of inputs. The result of this is that the effective per unit cost of production decreases, and the supply curve can move to the right. Expectations If a firm expects that the price of its factors of production are to increase in the future, then it may choose to store some of the current production, and sell less to the market now. This could cause the price to rise. Number of sellers In the same way that market demand is additive, so is market supply. As such, the number of sellers on the market will affect the shape of the supply curve Supply and demand together Equilibrium a situation in which the market price has reached the level at which the quantity supplied equals the quantity demanded Equilibrium price demanded the price that balances the quantity supplied and the quantity the quantity supplied and the quantity demanded at the equi- Equilibrium quantity librium price Fig. 4.3 Supply, demand and the point of equilibrium. Problems 4.1. Maria can read 20 pages of economics in an hour. She can also read 50 pages of sociology in an hour. She spends 5 hours per day studying. a) Draw Maria s production possibilities frontier for reading economics and sociology. b) What is Maria s opportunity cost of reading 100 pages of sociology?

30 26 4 Supply and Demand 4.2. Suppose that there are 10 million workers in Canada, and that each of these workers can produce either 2 cars or 30 bushels of wheat in a year. a) What is the opportunity cost of producing a car in Canada? What is the opportunity cost of producing a bushel of wheat in Canada? Explain the relationship between the opportunity costs of the two goods. b) Draw Canada s production possibilities frontier. If Canada chooses to consume 10 million cars, how much wheat can it consume without trade? Label this point on the production possibilities frontier. c) Now suppose that the United States offers to but 10 million cars from Canada in exchange for 20 bushels of wheat per car. If Canada continues to consume 10 million cars how much wheat does this allow Canada to consume? Label this point on your diagram. Should Canada accept the deal? 4.3. The following table describes the production possibilities of two cities in the country of Baseballia: Pairs of red socks per worker per Pairs of white socks per worker hour per hour Boston 3 3 Chicago 2 1 a) Without trade, what is the price of white socks (in terms of red socks) in Boston? What is the price in Chicago? b) Which city has an absolute advantage in the production of each colour sock? Which city has a comparative advantage in the production of each colour sock? c) If the cities trade with each other, which colour sock will each export? d) What is the range of prices at which trade can occur? 4.4. An increase in the demand for notebooks raises the quantity of notebooks demanded, but not the quantity supplied. Is this statement true or false? Explain Using supply-and-demand diagrams, show the effects of the following events on the market for sweatshirts. a) A hurricane in South Carolina damages the cotton crop b) The price of leather jackets falls c) All colleges require morning calisthenics in appropriate attire d) New knitting machines are invented The market for pizza has the following demand and supply schedules:

31 4 Supply and Demand 27 Price Quantity Demanded Quantity Supplied Graph the demand and supply curves. What is the equilibrium price and quantity in this market? If the actual price in the market were above the equilibrium price, what would drive the market towards the equilibrium? If the actual price in the market were below the equilibrium price, what would drive the market toward the equilibrium? 4.7. Market research has revealed the following information about the market for chocolate bars: The demand schedule can be represented by the equation Q d = 1, P, where Q d is the quantity demanded and P is the price. The supply schedule can be represented by the equation Q s = 1, P, where Q s is the quantity supplied. Calculate the equilibrium price and quantity in the market for chocolate bars.

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33 Chapter 5 Elasticity 5.1 Price elasticity of demand The law of demand gives us the firm knowledge that as prices rise, demand falls. In economics it is important to know this, but furthermore, to be able to show how much demand will change if for instance prices rise by 10%. We refer to this as the price elasticity of demand, which is a measure of how much demand changes in response to changes in price. Economists calculate the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in prices: Price elasticity o f demand = Percentage change in quantity demanded Percentage change in price (5.1) The demand for a good is said to be elastic if the quantity demanded responds substantially to changes in prices. If the demand for a good does not respond to changes in prices the good is said to be inelastic. The purpose of the elasticity is to describe how demand will change if prices move away from their current values. In this regard, the price elasticity must say something about the current prices also The midpoint method If you try calculating the price elasticity between any two points using the simple ratio of percentage changes, it is easy to see that movement between any two given points on the same line can result in different elasticity values, depending on which way you move. We will demonstrate this using an example between point A, with price= 4 and quantity=120 and point B with price= 6 and quantity=80. 29

34 30 5 Elasticity One way to avoid this problem is to use the midpoint method for calculating elasticities. The standard way to compute the percentage change is to divide the change by its initial level. However, the midpoint method instead uses the average between the start point and the end point, or the initial and final levels. For instance 5 is the midpoint of 4 and 6. Therefore, according to the midpoint method, a change from 4 to 6 is considered a 40% rise because [(6 4)/5] 100 = 40. Similarly a change from 6 to 4 is a 40% fall. Because the midpoint method gives the same answer regardless of the direction of change, it is often used when calculating the price elasticity of demand between two points. In our example the midpoint of the price is 5 and the midpoint of quantity is 100. According to the midpoint method, when going from point A to point B the price rises by 40% and the quantity falls by 40%. Similarly, when going from point B to point A, the price falls by 40% and the quantity rises by 40%. In both directions, the price elasticity of demand equals 1. We can express the midpoint method with the following formula for the price elasticity of demand between two points, denote(q 1,P 1 ) and(q 2,P 2 ): Price elasticity o f demand = (Q 2 Q 1 )/[(Q 2 + Q 1 )/2] (P 2 P 1 )/[(P 2 + P 1 )/2] (5.2) The numerator is the percentage change in quantity calculated using the midpoint method, and the denominator is the percentage change in price computed using the midpoint method. Problems 5.1. Suppose that business travellers and vacationers have the following demand for airline tickets from New York to Boston; Price Demand (travellers) Demand (vacationers) $150 2,100 1, , , , Part a As the price of tickets rises from $200 to $250, what is the price elasticity of demand for (i) business travellers and (ii) vacationers? (Use the midpoint method in your calculations.) Part b Why might vacationers have a different elasticity than business travellers?

35 5.1 Price elasticity of demand Price Demand (income=$10,000) Demand (income=$12,000) $ Part a Use the midpoint method to calculate your price elasticity of demand as the price of compact discs rises from $8 to $10 if (i) youur income is $10,000, and (ii)your income is $12,000. Part b Calculate your income elasticity of demand as your income increases from $10,000 to $12,000 if (i) the price is $12, and (ii) the price is $ The New York Times reported (Feb. 17, 1996, p.25) that subway ridership declined after a fare increase: There were nearly four million fewer riders in December 1995, the first full month after the price of a token increased 25 cents to $1.50, than in the previous december, a 4.3 percent decline. a) Use these data to estimate the price elasticity of demand for subway rides. b) According to your estimate, what happens to the Transit Authority s revenue when the fare rises? c) Why might your estimate of the elasticity be unreliable? 5.4. Consider public policy aimed at smoking. Part a Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack of cigarettes currently costs $2 and the government wants to reduce smoking by 20 percent, by how much should it increase the price? Part b If the government permanently increases the price of cigarettes, will the policy have a larger effect on smoking one year from now or five years from now?

36 32 5 Elasticity Part c Studies also find that teenagers have a higher price elasticity than do adults. Why might this be true?

37 Chapter 6 Final homework Problems 6.1. Your Aunt is thinking about opening a hardware store. she estimates that it would cost $500,000 per year to rent the location and buy the stock. In addition, she would have to quit her $50,000 per year job as an accountant. Part a Define opportunity cost. Part b What is your aunt s opportunity cost of running a hardware store for a year? If your Aunt thought thought she could sell $510,000 worth of merchandise in a year, should she open the store? 6.2. Suppose that your college charges you separately for tuition and for room or board. Part a Part b Part c What is a cost of attending college that is not an opportunity cost? What is an explicit opportunity cost of attending college? What is an implicit opportunity cost of attending college? 6.3. A commercial fisherman notices the following relationship between hours spent fishing and the quantity of fish caught: 33

38 34 6 Final homework Hours Quantity of Fish (in pounds) Part a What is the marginal product of each hour spent fishing? Part b Use these data to graph the fisherman s production function. Explain its shape. Part c The fisherman has a fixed cost of $10 (his pole). The opportunity cost of his time is $5 per hour. Graph the fisherman s total-cost curve. Explain its shape Nimbus, Inc., makes brooms and then sells them door-to-door. Here is the relationship between the number of workers and Nimbus s output in a given day: Workers Output Marginal Total cost Average total Marginal product cost cost Part a Fill in the column of marginal products. What pattern do you see? How might you explain it? Part b A worker costs $100 per day, and the firm has fixed costs of $200. Use this information to fill in the column for total cost. Part c Fill in the column for average total cost. (Recall that ATC = TC Q.) What pattern do you see? Part d Now fill in the column for marginal cost. (Recall that MC = TC Q.) What pattern do you see?

39 6 Final homework 35 Part e Compare the column for marginal product and the column for marginal cost. Explain the relationship. Part f Compare the column for average total cost and the column for marginal cost. Explain the relationship Consider the following cost information for a pizzeria: Q (dozens) Total cost Variable cost 0 $300 $ Part a What is the Pizzeria s fixed cost? Part b Construct a table in which you calculate the marginal cost per dozen pizza s using the information on total cost. Also calculate the marginal cost per dozen pizza s using the information on variable cost. What is the relationship between theses sets of numbers? Commnent? 6.6. Healthy Harry s Juice Bar has the following cost Schedules; Q (vats) Variable cost Total cost 0 $0 $ Part a Calculate average variable cost, average total cost, and marginal cost for each quantity Part b Graph all three curves. What is the relationship between the marginal cost curve and the average total cost curve? Between the marginal cost curve and the average variable cost curve? Explain.

40 36 6 Final homework 6.7. Consider the following table of long-run total cost for three different firms: Quantity Firm A $60 $70 $80 $90 $100 $110 $120 Firm B Firm C Does each of these firms experience economies or diseconomies of scale? 6.8. Your roommate s long hours in the chemistry lab have finally paid off! She has discovered a secret formula that lets people do an hours worth of studying in 5 minutes. So far, she s sold 200 doses, and faces the following average-total-cost schedule: Q Average Total Cost 199 $ If a new customer offers to pay your roommate $300 for one dose, should she make one more? Explain The licorice industry is competitive. Each firm produces 2 million strings of licorice per year. The strings have an average total cost of $0.20 each, and they sell for $0.30. Part a Part b What is the marginal cost of a string? Is the industry in long-run equilibrium? Why or why not? Bob s lawn-mowing service is a profit maximising competitive firm. Bob mows lawns for $27 each. His total cost each day is $280, of which $30 is a fixed cost. He mows ten lawns a day. What can you say about Bob s short-run decision regarding shut down and his long-run decision regarding exit? Consider total cost and total revenue given the table below: Quantity Total Cost $8 $9 $10 $11 $13 $19 $27 $37 Total Revenue Part a Calculate profit for each quantity. How much should the firm produce to mazimise profit?

41 6 Final homework 37 Part b Calculate marginal revenue and marginal cost for each quantity. Graph them. (Hint: Put the points between whole numbers. For example, the marginal cost between 2 and 3 should ge graphed at 2 1/2.) At what quantity do these curves cross? How does this relate to your answer to part (a)? Part c Can you tell whether this firm is in a competitive industry? If so, can you tell whether the industry is in a long-run equilibrium? uppose the book printing industry is competitive and begins in a long run equilibrium. Part a Draw a diagram describing the typical firm in the industry. Part b Hi-Tech printing company invents a new process that sharply reduces the cost of printing books. What happens to Hi-Tech s profits and the price of books in the short-run when Hi-Tech s patent prevents other firms from using the new technology? Part c What happens in the long run when the patent expires and other firms are free to use the technology? Suppose the U.S. textiles industry is competitive, and there is no international trade in textiles. In long-run equilibrium, the price per unit of cloth is $30. part a Describe the equilibrium using graphs for the entire market and for the individual producer.

42 38 6 Final homework part b Now suppose that textile producers in other countries are willing to sell large quantities of cloth in the united states for only $25 per unit. Assuming that U.S. textile producers have large fixed costs, what is the short run effect of these imports on the quantity produced by an individual producer? What is the short run effect on profits? Illustrate your answer with a graph. Part c What is the long run effect on the number of U.S. firms in the industry? A publisher faces the following demand schedule for the next novel of one of its popular authors; P Q $ ,000 The author is paid $2 million to write the book, and the marginal cost of producing the book as a constant $10 per book. Part a Compute total revenue, total cost, and profit at each quantity. What quantity would a profit maximising publisher choose? What price would it charge? Part b Compute marginal revenue. (Recall that MR = TR Q.) How does marginal revenue compare to the price? Explain.

43 6 Final homework 39 Part c Graph the marginal revenue, marginal cost, and demand curves. At what quantity do the marginal revenue and marginal cost curves cross? What does this signify? Part d In your graph, shade in the deadweight loss. Explain in words what this means. Part e If the author were paid $3 million instead of $2 million to write the book, how would this affect the publisher s decision regarding the price to charge? Explain. Part f Suppose the publisher was not profit maximising but was concerned with maximising economic efficiency. What price would it charge for the book? How much profit would it make at this price? Johnny Rockabilly has just finished recording his latest CD. His record company s marketing department determines that the demand for the CD is as follows: P Q 24 10, , , , , ,000 The company can produce the CD with no fixed cost and a variable cost of $5 per CD. Part a Find total revenue for quantity equal to 10,000, 20,000, and so on. What is the marginal revenue for each 10,000 increase in the quantity sold?

44 40 6 Final homework Part b What quantity of CD s would maximise profit? What would the price be? What would the profit be? Part c If you were Johnny s agent, what recording fee would you advise Johnny to demand from the record company? Why? A company is considering building a bridge across a river. The bridge would cost $2 million to build and nothing to maintain. The following table shows the company s anticipated demand over the lifetime of the bridge: P Q $ Part a If the company were to build the bridge, what would be its profit maximising price? Would that be the efficient level of output? Why or why not? Part b If the company is interested in maximising profit, should it build the bridge? What would be its profit or loss? Part c If the government were to build the bridge, what price should it charge?

45 6 Final homework 41 Part d Should the government build the bridge? Explain Larry, Curly, and Moe run the only saloon in town. Larry wants to sell as many drinks as possible without losing money. Curly wants the saloon to bring in as much revenue as possible. Moe wants to make the largest possible profits. Using a single diagram of the saloon s demand curve and it s cost curves, show the price and quantity combinations favoured by each of the three partners. Explain Explain why a monopolist will always produce a quantity at which the demand curve is elastic. (Hint: If demand is inelastic and the firm raises its price, what happens to total revenue and total costs?) The New York Times (Nov. 30, 1993) reported that the inability of OPEC to agree last week to cut production has sent the oil market into turmoil...[leading to] the lowest price for domestic crude oil since June Part a Why were the members of OPEC trying to agree to cut production? Part b Why do you suppose that OPEC was unable to agree on cutting production? Why did the oil market go into turmoil as a result? Part c The newspaper also noted OPEC s view that producing nations outside the organisation, like Norway and Britain, should do their share and cut production. What does the phrase do their share suggest about OPEC s desired relationship with Norway and Britain? A large share of the world supply of diamonds comes from Russia and South Africa. Suppose that the marginal cost of mining diamonds is constant at $1,000 per diamond, and the demand for diamonds is described by the following schedule:

46 42 6 Final homework Price Quantity $8,000 5,000 7,000 6,000 6,000 7,000 5,000 8,000 4,000 9,000 3,000 10,000 2,000 11,000 1,000 12,000 part a If there were many suppliers of diamonds, what would be the price and quantity? part b If there were only one supplier of diamonds, what would be the price and quantity? Part c If Russia and South Africa formed a cartel, what would be the price and quantity? If the countries split the market evenly, what would be South Africa s production and profit? What would happen to South Africa s profit if it increased its production by 1,000 while Russia stuck to the cartel agreement? Part d Use your answer to part (c) to explain why cartel agreements are often not successful Consider trade relations between the United States and Mexico. Assume that the leaders of the two countries believe the payoffs to alternative trade policies are as follows: Part a What is the dominant strategy for the United States? For Mexico? Explain.

47 6 Final homework 43 Part b Define Nash Equilibrium. What is the Nash equilibrium for trade policy? Part c In 1993 the U.S. Congress ratified the North American Free Trade Agreement (NAFTA), in which the United States and Mexico Agreed to reduce trade barriers simultaneously. Do the perceived payoffs shown here justify this approach to trade policy? Part d Based on your understanding of the gains from trade (discussed in chapter 3 and 9), do you think that these payoffs actual reflect a nation s welfare under the four possible outcomes Sparkle is one firm of many in the market for toothpaste, which is in long-run equilibrium.

48 44 6 Final homework Part a Draw a diagram showing Sparkle s demand curve, marginal revenue curve, average total cost curve, and marginal cost curve. Label Sparkle s profit maximising output and price. Part b What is sparkle s profit? Explain. Part c On your diagram, show the consumer surplus derived from the purchase of Sparkle toothpaste. Also show the deadweight loss relative to the efficient level of output. Part d If the government forced Sparkle to produce the efficient level of output, what would happen to the firm? What would happen to sparkles consumers? For each of the following pairs of firms, explain explain which firm would be more likely to engage in advertising: a b c A family owned farm or a family owned restaurant. A manufacturer of forklifts or a manufacturer of cars. A company that invented a very reliable watch or a company that invented a less reliable watch that costs the same amount to make.

49 Appendix A Chapter Heading All s well that ends well Use the template appendix.tex together with the Springer document class SVMono (monograph-type books) or SVMult (edited books) to style appendix of your book in the Springer layout. A.1 Section Heading Instead of simply listing headings of different levels we recommend to let every heading be followed by at least a short passage of text. Furtheron please use the LATEX automatism for all your cross-references and citations. A.1.1 Subsection Heading Instead of simply listing headings of different levels we recommend to let every heading be followed by at least a short passage of text. Furtheron please use the LATEX automatism for all your cross-references and citations as has already been described in Sect. A.1. For multiline equations we recommend to use the eqnarray environment. a b=c a b=c (A.1) A Subsubsection Heading Instead of simply listing headings of different levels we recommend to let every heading be followed by at least a short passage of text. Furtheron please use the 45

50 46 A Chapter Heading Fig. A.1 Please write your figure caption here LATEX automatism for all your cross-references and citations as has already been described in Sect. A.1.1. Please note that the first line of text that follows a heading is not indented, whereas the first lines of all subsequent paragraphs are. Table A.1 Please write your table caption here Classes Subclass Length Action Mechanism Translation mrna a 22 (19 25) Translation repression, mrna cleavage Translation mrna cleavage 21 mrna cleavage Translation mrna mrna cleavage Translation mrna Histone and DNA Modification a Table foot note (with superscript)

51 Solutions Problems of Chapter Part a A family faces a tradeoff between the cost of a car and and other things they may wish to purchase e.g. a holiday abroad. The real cost of the car represents the opportunity costs that the family faces, as it represents the value of all other things foregone in order to afford that car. Part b In deciding whether or not to increase spending on national parks, Congress must first consider the sources of the funding. In this instance two sources are considered; 1. Redirected funds 2. Increased taxes Congress can either reduce spending on other parts of the budget, for instance lowering the defence budget or investment in education. Alternatively government could increase taxes to cover the proposed increase in expenditure on national parks. If it is assumed that the funding is already in place, then Congress must decide whether to continue to increase investment in National Parks, or simply to let the level of investment remain the same and lower the general tax level. 47

52 48 Solutions Part c In deciding whether to invest in a new company, the company president must assess if the returns of the project (profits) exceed the returns of other alternatives for the money. For example is it more cost effective to expand the workforce, or to invest in new technology? Part d In deciding whether to prepare these notes or not I face a trade off between the benefits offered to you, the students, and the other things I could be doing with my time, for example preparing for my next paper. 2.2 An opportunity costs exists between what is spent now, and what is foregone in the future. The individual can either spend their money now or in a years time, where the future value of the money will be the current value plus any interest earned over the year. With an interest rate of 5 percent (per annum), the opportunity cost of spending $100 now, is the ability to spend $105 in the future i.e. opportunity cost= $100+($ ) 2.3 The five million pounds already invested holds no value without the investment of another million pounds, as the incomplete project will return no revenues. Furthermore, this money is non-retrievable and is therefore regarded as a sunk cost. As a result of this, the decision to invest a further 1 million is then directly weighed against the expected returns of three million. The expected returns exceed the proposed cost e.g. 3,000,000> 1,000,000, such that the marginal returns are two million pounds. What is more, any proposed level of costs would be acceptable up to and including three million pounds. Investment therefore continues up to the point where marginal costs equal marginal returns. 2.4 Hermione takes the correct approach, considering both the extra revenues and the extra cost, thus focussing on the returns at the margin. Harry is not wrong to consider productivity, as this will affect the costs a firm faces. However, Harry fails to consider the relative change in revenues, and is therefore overlooking a key aspect of the investment decision. Ron makes a similar mistake by looking into the average cost per unit produced. This is once again an incomplete suggestion as there is no mention of returns.

53 Solutions 49 It is commonly assumed in the analysis of firms that they wish to maximise their profits a Efficiency Market failure attributable to monopoly of cable TV provider b Equity Resources more evenly redistributed across society b Efficiency Externality arises from unavoidable passive smoking by non-smokers d Efficiency Increased competition negates Market failure from the monopoly power Standard Oil had e Equity Resources more evenly redistributed across society f Efficiency Accidents from drunk drivers are an externality Part a It is quite reasonable to assume that steel producers produce a uniform product. Some firms may produce steel of an inferior quality to other firms, however it is still quite distinguishably steel. Part b Novels are highly individualised and consequently very distinguishable. It is easy for instance to tell the difference between a J. K. Rowling book and one by Stephen King. Part c Wheat produced by a farmer in the North is almost completely indistinguishable from wheat produced in the south. Part d Fast food is generally more distinguishable than for instance steel, but perhaps not as much as books are. Let us consider the difference between McDonald s and Burger King for instance. Although many individuals can tell the difference between the two, it is also clear that each offer very similar products.

54 50 Solutions 2.7 Part a A Production Possibilities Frontier curve shows the tradeoff on the potential allocation of resources in an economy. In particular it shows the possibilities of production that are achievable, given the fixed level of resources in an economy, between two different product markets. The curve is bowed as the when the economies resources are being used to produce butter, the frontier is steep (conversely when the economies resources are being used to produce guns, the frontier is flat). This is primarily a result of mis-allocated resources (in terms of labour), such that workers specialised in making butter are less productive when making guns, therefore at the extremes, productivity increases more rapidly when moving to a point away from the axis. Part b Point A is outside of the Production Possibilities Frontier and is therefore beyond the means of the economy (i.e. to produce at this point requires more resources than the firm has available. Point B on the other hand is situated below the curve and is therefore at a point which is inefficient. Although it is possible to produce this level of output, to do so would be under-utilising the available resources.

55 Solutions 51 Part c The Hawks are likely to produce at a point closer to the guns axis, whilst the Doves are more likely to produce near the butter axis. This represents their respective preferences over each type of good. Part d The Hawks receive a larger peacetime dividend than the Doves, when both parties reduce their desired quantity of guns. This is because the slope of the curve at point H is mush steeper than at point D, therefore a reduction in the number of desired guns from point H yields more butter than the same size reduction in the desire for guns from point D. 4.1 Part a In the course of 5 hours, Maria can either read 100 pages of economics or 250 pages of sociology. These values are the intercepts for the production possibility frontier s vertical and horizontal axis s respectively. Assuming constant time costs, the production possibilities frontier is a straight line. Refer to Figure 2. Economics pages Sociology pages Part b 100 = 0.4 (A.2) 250 Equation (1) shows the opportunity cost in terms of pages of economics foregone for every 1 page of sociology read (based on the number of pages of each that she can

56 52 Solutions read over a five hour period). Given that Maria can read 100 pages of sociology in 2 hours, the opportunity cost in terms of pages of economics is 40 pages i.e.( ). That is to say, in this time she could alternatively read 40 pages of economics. 4.2 part a Since a Canadian worker can either produce two cars a year or 30 bushels of wheat, the opportunity cost of a car is thirty bushels of wheat 30 2 = 15. Similarly, the opportunity cost of a bushel of wheat is 1/15 of a car. The opportunity costs are the reciprocals of each other. part b Cars (millions) A B Wheat (millions of bushels) If all 10 million workers produce two cars each, they produce a total of 20 million cars, which is the vertical intercept of the production possibilities frontier. If all 10 million workers produce 30 bushels of wheat each, they produce a total of 300 million bushels, which is the horizontal intercept of the production possibilities frontier. Since the tradeoff between cars and wheat is always the same (constant), the production possibilities frontier is a straight line. If Canada chooses to consume 10 million cars, it will need 5 million workers devoted to car production. That leaves 5 million workers for the production of wheat,

57 Solutions 53 who will produce a total of 150 million bushels (5,000,000 30bushels). This is shown as point A on figure 5. part c If the United States buys 10 million cars from Canada and Canada continues to consume 10 million cars, then Canada will need to produce a total of 20 million cars. So Canada will be producing at the vertical intercept of the production possibilities frontier. However, if Canada gets 20 bushels of wheat per car, it will be able to consume 200 million bushels of wheat, along with 10 million cars. This is shown as point B on figure 5. Canada should accept the deal as it will result in a level of consumption beyond that which they can achieve without trade. 4.3 Part a In Baseballia, without trade, one pair of white socks trades for one pair of red socks (Liverpool s) in Boston, since productivity levels are the same for the two types of socks. The price in Chicago is two pairs of red socks for every pair of white socks. Part b Boston has an absolute advantage in terms of the production of both types of socks, since a worker in Boston produces more socks per hour than a worker in Chicago, regardless of which colour the sock is. Chicago has a comparative advantage in the production of red socks, since the opportunity cost of producing a pair of red socks in Chicago is half a pair of white socks, as opposed to an opportunity cost in Boston of 1 pair of white socks for every pair of red socks. Similarly, Boston has a comparative advantage in the production of white socks, facing an opportunity costs of 1 pair of red socks for every pair of white socks produced. Chicago s opportunity cost in the production of one pair of white socks is 2 pairs of red socks. Part c If Boston and Chicago initiate trade, Boston will choose to produce and export white socks, since it has a comparative advantage in their production. Chicago will choose to produce and export red socks for the same reason

58 54 Solutions Part d Trade can occur at any price between 1 and 2 pairs of red socks per pair of white sock. At a price lower than 1 pair of red socks per pair of white socks, Boston will choose to produce its own red socks as they would be better off producing their own. At a price higher than 2 pairs of red socks per pair of white socks, Chicago will not wish to trade, as again, they would be better off producing their own. 4.4 In general, the statement An increase in the demand for notebooks raises the quantity of notebooks demanded, but not the quantity supplied., is false. In the standard case (see figure 2a), an increase in the demand for notebooks is results in an increase on the quantity supplied. Price e 2 e 1 D 1 D 2 Quantity This however would not be the case if their was an inelastic supply (i.e. quantity of supply never changes, regardless of the level of demand), this case is shown in figure 2b. In this situation a shift in the demand schedule only raises the price. S

59 Solutions 55 Price S D 1 D 2 Quantity 4.5 Part a When a hurricane in South Carolina damages the cotton crop, it raises input prices for producing sweatshirts. As a result, the supply of sweatshirts shifts to the left, as shown in figure 5a. The new equilibrium has a higher price and lower quantity of sweatshirts.

60 56 Solutions Price S 2 S 1 e 2 e 1 D Quantity Part b A reduction in the price of leather jackets increases demand for them. As leather jackets are a substitute for sweatshirts, this decreases the demand for sweatshirts, resulting in a decline in both the price and quantity, creating a new equilibrium.

61 Solutions 57 Price e 1 e 2 S D 2 D 1 Quantity Part c Compulsory morning calisthenics classes (in appropriate attire) increases the demand for sweatshirts. As shown in figure 5c, this results in an increase in both the price and quantity of sweatshirts. Price e 2 e 1 D 1 D 2 Quantity S

62 58 Solutions Part d The invention of new knitting machines increases the supply of sweatshirts. This results in a reduction in the equilibrium price and in increase in the equilibrium quantity (see figure 5d). Price e 1 e 2 S 1 D S 2 Quantity 4.6 Quantity demanded and quantity supplied are equal when the price is six dollars (with a quantity of 81 pizzas). If the price were greater than six dollars, the quantity supplied would exceed the quantity demanded, so suppliers would reduce their price to gain sales. If price were less than six dollars, the quantity demanded would exceed the quantity supplied, so suppliers would raise their price without losing sales. In both cases, the price would continue to adjust until it reaches six dollars, the only price at which their is neither a surplus nor a shortage.

63 Solutions 59 Price 9 Supply Demand 81units Quantity 4.7 Equilibrium occurs at the point where demand equals supply. Thus; Q d = Q s (A.3) 1, P= 1, P (A.4) 200 = 1000P (A.5) P= 200 = 0.20 (A.6) 1000 The equilibrium price of a bar of chocolate is 0.20 dollars. The equilibrium quantity is now found by inserting the equilibrium price into the original equations. Note that if the equilibrium price is correct, than both equations will produce the same result. Q d = 1,600 ( )=1,600 60= 1,540 (A.7) Q d = 1,400+( )=1, = 1,540 (A.8) Equation numbers (6) and (7) confirm that the equilibrium price is 0.20, as both equations return the same value for equilibrium quantity. The equilibrium quantity is 1,540 units (chocolate bars). 5.1

64 60 Solutions Part a For business travellers, the elasticity of demand when the price of tickets rises from $200 to $250 is; [ (2,000 1,900) 1,950 ] = 0.05 = 0.23 (A.9) 0.22 [ ( ) 225 ] The elasticity of demand for vacationers, when the price of tickets rises from $200 to $250, is; [ ( ) 700 ] [ ( ) 225 ] = 0.29 = 1.32 (A.10) 0.22 Part b The price elasticity of demand for vacationers is higher than the elasticity for business travelers because vacationers can choose more easily a different mode of transportation (like taking the train). Business travellers are less likely to do so since time is more important to them and their schedules are less adaptable. 5.2 part a If your income is $10,000, your price elasticity of demand as the price of compact discs rises from $8 to $10 is; If your income is $12,000 then the elasticity is; [ (40 32) 36 ] [ (10 8) 9 ] = = 1 (A.11) [ (50 45) 47.5 ] [ (10 8) 9 ] = 0.11 = 0.5 (A.12) 0.22 part b If the price remains at $12, your income elasticity of demand as your income increases from $10,000 to $12,000 is;

65 Solutions 61 [ (30 24) 27 ] [ (12,000 10,000) 11,000 ] = 0.22 = 1.22 (A.13) 0.18 If the price is $16, your income elasticity of demand as your income increases from $10,000 to $12,000 is; 5.3 [ (12 8) 10 ] [ (12,000 10,000) 11,000 ] = 0.40 = 2.2 (A.14) 0.18 Part a With a 4.3% decline in quantity following a 20% increase in price, the price elasticity of demand is only = 0.215, which is fairly inelastic. Part b With inelastic demand, the Transit Authority s revenues rise when the fare rises. Part c The elasticity estimate might be unreliable because it is only the first month after the fare increase. As time goes by, people may switch to other modes of transport in response to the price increase. So the elasticity may be larger in the long run than it is in the short run. 5.4 Part a With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by 20% requires a 50% increase in price, since = 0.4. With the price of cigarettes currently being $2, this would require an increase in the price to $3.33 a packet using the mid-point method. note; = 0.50 (A.15)

66 62 Solutions Part b The policy will have a larger effect five years from now than it does one year from now. The elasticity is larger in the long run, since it may take some time for people to reduce their cigarette usage. The habit of smoking is hard to break in the short run. Part c Since teenagers don t have as much income as adults, they are likely to have a higher price elasticity of demand. Also adults are more likely to be addicted to cigarettes, making it more difficult to reduce their quantity demanded in response to a higher price. 6.1 Part a The opportunity cost of something is what must be foregone to acquire it. Part b The opportunity cost of running the hardware store is $550,000, consisting of the $500,000 to rent the store and buy the stock and a further $50,000 opportunity cost, since your aunt would quit her job as an accountant to run the store. Since the total opportunity cost of $550,000 exceeds the revenue of $510,000, your aunt should not open the store, as her profit would be negative - she would lose money. 6.2 Part a Since you would have to pay for room and board regardless of whether you went to college or not, this is not an opportunity cost. Part b The explicit opportunity cost is the cost of books and tuition fees.

67 Solutions 63 Part c The implicit opportunity cost is the cost of your time. You could work at a job for pay rather than attend college. The wages you give up represent the opportunity cost of attending college. 6.3 Part a The following table shows the marginal product of each hour spent fishing: Hours Fish Fixed cost Variable cost Total cost Marginal product 0 0 $10 $

68 64 Solutions Part b Figure 7 graphs the fisherman s production function. The production function becomes flatter as the number of hours spent fishing increases, illustrating the diminishing marginal product. Figure 7 Part c Figure 8

69 Solutions 65 The table (from part a) also shows the fixed cost, variable cost and total cost of fishing. Figure 8 shows the total cost curve. It slopes up because catching additional fish takes additional time. The curve is convex because there are diminishing returns to fishing time - each additional hour spent fishing yields fewer additional fish. 6.4 Here is the table of costs: Workers Output Marginal Total cost Average total Marginal product cost cost 0 0 $ $15.00 $ Part a See table for marginal product. Marginal product rises at first, then declines because of diminishing marginal product. Part b See table for total cost Part c See table for average total cost. Average total cost is U-shaped. When quantity is low, average total cost declines as quantity rises, when quantity is high, average total cost rises as quantity rises. Part d See table for marginal cost. Marginal cost is also U-shaped, but rises steeply as output increases. This is due to diminishing marginal product.

70 66 Solutions Part e When marginal product is rising, marginal cost is falling, and vice versa. Part f When marginal cost is less than average total cost, average total cost is falling; the cost of the last unit produced pulls the average down. When marginal cost is greater than average total cost, average total cost is rising; the cost of the last unit produced pushes the average up. 6.5 Part a The fixed costs is $300, since fixed costs equal Total cost minus variable cost FC=(TC VC) Part b Marginal costs equals the change in total cost or the change in variable cost. That is because total cost equals variable cost plus fixed cost and fixed cost does not change as the quantity changes. So as quantity increases, the increase in total cost equals the increase in variable cost and both are equal to marginal cost. 6.6 Quantity Total cost Variable cost Marginal cost (using Marginal TC) (Using VC) 0 $300 $ $50 $ cost

71 Solutions 67 Part a The following table shows average variable cost (AVC), average total cost (ATC), and marginal cost (MC) for each quantity; Q (vats) VC TC AVC ATC MC 0 $0 $ $10 $40 $ Part b Figure 10 Figure 10 graphs the three curves. The marginal cost curve is below the average total cost curve when output is less than 4, as average total cost is declining. The marginal cost curve is above the average total cost curve when output is above 4, as average total cost is rising. The marginal cost curve lies above the average variable cost curve. 6.7 The following table shows Quantity, total cost (TC) and average total cost (ATC) for the three firms;

72 68 Solutions Firm A Firm B Firm C Quantity TC ATC TC ATC TC ATC Firm A has economies of scale since average total cost declines as output increases. Firm B has diseconomies of scale since average total cost rises as output rises. Firm C has economies of scale for output 1 to 3, then diseconomies of scale for greater levels of output. 6.8 [note: since we already are given marginal revenue, we need no further information on the revenue s (i.e. we dont need average or total)] Since a new customer is offering to pay $300 for one dose, marginal revenue (MR) between 200 and 201 doses is $300. So we must find out if marginal cost (MC) is greater than or less than $300. To do this calculate total cost for 200 and for 201 doses, and calculate the increase in total cost. Multiplying quantity by average total cost, we find that total cost rises from $40,000 to $40,401, so marginal cost is $401. So your roommate should not make the additional dose. 6.9 Part A Remembering that price equals marginal cost when firms are maximising profit, we know the marginal cost must be 30 cents, since that is the price. Part B The industry is not in long-run equilibrium since price exceeds average total cost Since Bobs average total cost is; ATC= $ = $28 which is greater than the price (28>27), he will exit the industry in the long run. Since fixed cost is $30, average variable cost is; AVC= ($280 $30) 10 = $25 which is less than the price (25<27), so Bob wont shut down in the short run Here s the table showing costs, revenues, and profits;

73 Solutions 69 Quantity TC MC TR MR π 0 $8 $0 $ $1 8 $ Part a The firm should produce 5 or 6 units to maximise profit (π). Part b Figure 3 Marginal revenue and marginal cost are graphed in Figure 3. The curves cross at a quantity between 5 and 6 units, yielding the same answer as in part a. Part c This industry is competitive since marginal revenue is the same for each quantity. The industry is not in long-run equilibrium, since profit is positive. 6.12