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1 1 of 25 5/1/2014 4:28 PM Any point on the budget constraint Gives the consumer the highest level of utility. Represent a combination of two goods that are affordable. Represents combinations of two goods that yield the same utility. Reflects the price of one good divided by the price of another good. Any point on the budget constraint line represents a combination of the two goods that are affordable. Any point beyond the budget constraint line is unaffordable. Learning Objective: How consumers maximize utility. The slope of the budget constraint, when a consumer has reached optimal consumption of two goods, is equal to the Marginal rate of substitution. Cross-price elasticity of the two goods. Total utility for the two goods. Marginal rate of indifference. The marginal rate of substitution is the rate at which a consumer is willing to exchange one good for another the slope of the indifference curve. Because the optimal consumption combination is at the point where the budget line is tangent to (just touches) an indifference curve, the slopes will be equal at that point. Learning Objective: Why demand curves are downward sloping.

2 2 of 25 5/1/2014 4:28 PM Which of the following is used to depict all combinations of goods that are affordable with a given income and given prices? An indifference curve. An indifference map. A demand curve. A budget constraint. Consumption possibilities are limited by available income. The budget constraint illustrates this limitation. Learning Objective: Why demand curves are downward sloping. Rosa is willing to pay \$200 for the iphone, but the actual price is \$400. This means Rosa will enjoy a consumer surplus of \$200 if she buys the iphone. Rosa will not enjoy any consumer surplus from purchasing the iphone. Rosa will buy this product. The iphone is overpriced. Rosa will not purchase the iphone because she is not willing to pay the \$400 price. If she were willing to pay \$500 for the iphone, she would buy it and enjoy \$100 of consumer surplus. Learning Objective: The nature and source of consumer surplus. The of the demand curve corresponds to the idea that the marginal utility for the first few goods is. top; lower bottom; lower top; higher bottom; higher The first few goods consumed have a higher marginal utility. This corresponds to the top of the demand curve, where consumers are willing to pay a higher price if a good has a higher marginal utility. Learning Objective: Why demand curves are downward sloping.

3 3 of 25 5/1/2014 4:28 PM The law of diminishing marginal utility suggests that People are willing to buy additional quantities of a good only if its price falls. People will substitute lower-priced goods for more expensive goods, ceteris paribus. Price and quantity demanded are directly related. As marginal utility decreases, the willingness to pay increases. The more marginal utility a product delivers, the more a consumer will be willing to pay for it. Marginal utility diminishes as increasing quantities of a product are consumed; therefore consumers are willing to pay progressively less for additional quantities of a product. Learning Objective: Why demand curves are downward sloping.

4 4 of 25 5/1/2014 4:28 PM Refer to Figure The total consumer surplus in this market is equal to \$950. \$900. \$850. \$800. The total consumer surplus is the total of the differences between each individual's maximum willingness to pay and the actual price. The total for the three consumers is (\$600 - \$100) + (\$400 - \$100) + (\$200 - \$100) = \$900. Learning Objective: The nature and source of consumer surplus.

5 5 of 25 5/1/2014 4:28 PM If a successful advertising campaign increases brand loyalty, the Supply of the advertised good will become less elastic. Demand for the advertised good will become less elastic. Supply of substitutes for the advertised good will increase. Total level of consumption will decrease. Increasing brand loyalty will reduce consumer responsiveness to price increases, which allows a firm to increase prices and revenues. Learning Objective: How consumers maximize utility.

6 6 of 25 5/1/2014 4:28 PM Complete Table 19.2 below: In Table 19.2, the total utility when two units are consumed is The total utility when one unit is consumed is 15 and the second unit adds 9 additional utils, which causes total utility to increase to 24. Learning Objective: How consumers maximize utility.

7 7 of 25 5/1/2014 4:28 PM The four determinants of demand that are held constant when we consider a movement along a demand curve include all of the following except Price. Income. Tastes. Availability and price of substitute goods. A movement along a demand curve corresponds to a change in price only, holding income, tastes, and the availability of substitutes constant. Learning Objective: Why demand curves are downward sloping. Sociopsychiatric explanations of consumer behavior include the Desire for ego and status. Level of income. Level of wealth. Prices of other goods. Sociologists offer explanations for our consumption behavior not just to "keep up with the Joneses" but to surpass them. Learning Objective: Why demand curves are downward sloping. Total utility is The additional utility from consuming one more unit of a good. The sum of the marginal utilities from the consumption of good. A function that always falls as a buyer enjoys more units of a good. How much utility a seller gets from producing a good. Total utility can be calculated by summing up all of the marginal utilities that the buyer has enjoyed from each subsequent unit of a good. Learning Objective: Why demand curves are downward sloping.

8 8 of 25 5/1/2014 4:28 PM The point where the budget constraint and an indifference curve are tangent Represents maximum total revenue. Indicates the optimal level of production. Represents the optimal consumption point. Indicates profit maximization. The objective is to reach the highest indifference curve that is compatible with our budget constraint. We can afford only those consumption combinations that are on or inside the budget line. Therefore, the optimal consumption combination the one that maximizes the utility of spendable income lies at the point where the budget line is tangent to (just touches) an indifference curve. Learning Objective: Why demand curves are downward sloping. Which of the following is most likely an inferior good? Rolex watches. Nike running shoes. Generic canned food. A custom-built mansion. With low incomes, people buy discount clothes, used textbooks, and generic brand items, and they eat at home. Learning Objective: What the income elasticity of demand tells us. Which of the following products will have more inelastic demand? New cars. Fresh flowers. Fast food. Medicines. Demand is more inelastic if there are fewer substitute goods; medicines are necessities and will have more inelastic demand. Learning Objective: How to compute price elasticity of demand.

9 9 of 25 5/1/2014 4:28 PM In Figure 20.1, at what price is the elasticity of demand unitary? \$40. \$100. \$160. \$200. At a price levels less than \$100, a decrease in the price causes revenue to decrease, which implies that demand is inelastic. At price levels greater than \$100, a decrease in the price causes revenue to increase, which implies that demand is elastic. Therefore, demand must be unitary elastic at a price of \$100. Learning Objective: The relationships between price changes; price elasticity; and total revenue.

10 10 of 25 5/1/2014 4:28 PM Sam owns a taco restaurant, and he conducted a consumer survey that indicates that the price elasticity of demand for his restaurant is 3.5. You would advise Sam to Raise his price to increase revenues. Keep his price the same to maximize revenues. Lower his price to increase revenue. Offer more high-priced products. If the elasticity of demand is 3.5 (in absolute value), it indicates that demand is very elastic. Consumers have a lot of substitutes available. Therefore Sam should lower his price to increase total revenue because the quantity demanded will increase. Learning Objective: The relationships between price changes; price elasticity; and total revenue. If incomes fall by 5 percent and the quantity demanded for new cars falls by 10 percent, New cars are a normal good, and the income elasticity is +.5. New cars are an inferior good, and the income elasticity is New cars are a normal good, and the income elasticity is New cars are an inferior good, and the income elasticity is The formula for income elasticity is the percentage change in quantity demanded for new cars divided by the percentage change in income. So 10%/5%= +2, which indicates that new cars are a normal good; the demand for them rises when incomes increase. Learning Objective: What the cross-price elasticity of demand measures. If demand is perfectly elastic, The demand curve is vertical. The demand curve is very steep. The demand curve is horizontal. The demand curve has a zero slope. A perfectly elastic demand curve is horizontal, which means that any increase in price causes quantity demanded to fall to zero. Learning Objective: How to compute price elasticity of demand.

11 11 of 25 5/1/2014 4:28 PM Maximum total revenue occurs when Total revenue is The absolute value of the price elasticity of demand is 1.0. Price multiplied by quantity is 1.0. The absolute value of the price elasticity of demand is 100. Higher prices result in higher total revenue only if demand is inelastic. If demand is elastic, lower prices result in higher revenues. Therefore, to maximize revenue, a firm should charge the price at the point where elasticity goes from elastic to inelastic in other words is equal to 1. Learning Objective: The relationships between price changes; price elasticity; and total revenue. Technically the elasticity number is negative because When price falls quantity demanded will rise, but for simplicity economists take the absolute value of the elasticity number. When price falls quantity demanded will fall, but for simplicity economists take the absolute value of the elasticity number. When price rises quantity demanded will rise, but for simplicity economists take the absolute value of the elasticity number. The demand curve is always upward-sloping. If there is a percentage change increase in price, the percentage change in quantity demanded will fall, so the elasticity number is always negative. For simplicity, economists take the absolute value of the elasticity number (they drop the negative sign). Learning Objective: How to compute price elasticity of demand. When demand is price-inelastic, ceteris paribus, an increase in Price leads to lower total revenue. Total revenue means quantity rises. Total revenue indicates a reduction in price. Price leads to greater total revenue. Higher prices result in higher total revenue only if the price elasticity of demand is inelastic (price elasticity is less than 1). Learning Objective: How to compute price elasticity of demand.

12 12 of 25 5/1/2014 4:28 PM When demand is inelastic The percentage change in price is greater than the percentage change in quantity demanded. Buyers are very sensitive to changes in price. The product in demand has many substitute goods. The percentage change in quantity demanded is greater than the percentage change in price. When demand is inelastic, the percentage change in price is greater than the percentage change in quantity demanded. Learning Objective: How to compute price elasticity of demand.

13 13 of 25 5/1/2014 4:28 PM What is the marginal cost of the 120 th unit of output in Figure 21.2? \$1.20. \$ \$ \$ According to the graph, marginal cost is equal to \$288 at the quantity 120. Learning Objective: How the various measures of cost relate to each other.

14 14 of 25 5/1/2014 4:28 PM When the size of a factory (and all its associated inputs) doubles and, as a result, output more than doubles, The law of diminishing returns must not apply in the smaller factory. Economies of scale must exist. The short-run ATC curve must be declining. Marginal costs must be declining. Economies of scale (or increasing returns to scale) exist when all inputs double but output more than doubles, which implies that the average costs have decreased. Learning Objective: What (dis)economies of scale are. If a fifth unit of labor was added to Table 21.1, its MPP would most likely be Zero. 7. Less than 7. Greater than 7. The MPP of the fifth worker would likely be less than 7 because diminishing marginal returns have already set in and the MPP of the fourth worker is 7. Learning Objective: How the various measures of cost relate to each other.

15 15 of 25 5/1/2014 4:28 PM Complete Table 21.3 below: What is the marginal physical product of the second unit of labor in Table 21.3? The marginal physical product is the difference in total output associated with one additional unit of input, which is 33 (66-30). Learning Objective: How the various measures of cost relate to each other.

16 16 of 25 5/1/2014 4:28 PM Which of the following costs do not change when output changes in the short run? Average variable costs. Variable costs. Average fixed costs. Fixed costs. Fixed costs such as the cost of the basic plants and equipment do not vary with the rate of output. Learning Objective: How the various measures of cost relate to each other. The marginal cost curve intersects the minimum of the curve representing TC. ATC. AFC. MPP. The MC curve will always intersect both the ATC and AVC curves at their lowest. Learning Objective: How the various measures of cost relate to each other. Average total cost is equal to Total cost divided by fixed cost. Total cost multiplied by quantity. The sum of average variable cost and marginal cost. Total cost divided by quantity produced. Average total cost or unit cost per item is total cost divided by the quantity produced. Learning Objective: How the various measures of cost relate to each other.

17 17 of 25 5/1/2014 4:28 PM Average total cost is important to a business because It tells the firm what the profit per unit produced is. It always declines as more output is produced. It tells the firm what its fixed costs are. It is an indicator of the production function. The initial dominance of falling AFC, combined with the later resurgence of rising AVC (due to increasing MC), is what gives the ATC curve its characteristic U shape. Learning Objective: How the various measures of cost relate to each other.

18 18 of 25 5/1/2014 4:28 PM Refer to Figure The vertical difference between the total cost curve and the total fixed cost curve represents Total variable costs. Total marginal costs. Average fixed costs. Average variable costs. Total cost minus total fixed cost is total variable cost. Learning Objective: How the various measures of cost relate to each other.

19 19 of 25 5/1/2014 4:28 PM Normal profit implies that Economic profit must be positive. Economic profit must be negative. The factors employed are earning as much as they could in the best alternative employment. Firms will expand their scale of production. Normal profit is the profit made that covers all explicit costs and implicit costs but does not include any profit above and beyond what could have made with those resources used elsewhere. Learning Objective: How profits are computed. If a perfectly competitive firm wanted to maximize its total revenues, it would produce The output where MC equals price. As much as it is capable of producing. The output where the ATC curve is at a minimum. The output where the marginal cost curve is at a minimum. If a competitive firm wanted to maximize its total revenue, it would always produce at capacity because the individual firm is so small relative to the market that it will not impact market price. Learning Objective: How profits are computed. A perfectly competitive firm will maximize profits by choosing an output level where Price is greater than marginal cost. Price equals marginal cost. Price equals total cost. Price is greater than total cost. A competitive firm maximizes total profit at the output rate where MC is equal to price (which is the same as MR in perfect competition). If MC is less than price, the firm can increase profits by producing more. If MC exceeds price, the firm should reduce output. Learning Objective: The characteristics of perfectly competitive firms.

20 20 of 25 5/1/2014 4:28 PM Which of the following is the best explanation for why individuals own small businesses? Because they cannot earn a living working for corporate America. To provide a product consumers want. The expectation of profit. To gain experience for their next job. The basic incentive for producing goods and services is the expectation of profit. Learning Objective: How profits are computed. For the perfectly competitive firm, the marginal revenue is always Increasing. Constant. Equal to average total cost. Decreasing. Because a competitive firm can sell all its output at the prevailing price, the marginal revenue will always be equal to price and the MR curve will be equal to the demand curve. Learning Objective: The characteristics of perfectly competitive firms. Which of the following affects the ATC curve for a firm but not the MC curve? A change in property taxes. A change in payroll taxes. A change in profit taxes. A change in the price of the good. Fixed costs such as the cost of the basic plants and equipment and property taxes do not vary with the rate of output and therefore do not affect marginal costs but do affect the ATC. Learning Objective: What shapes or shifts a firm s supply curve.

21 21 of 25 5/1/2014 4:28 PM An investment decision involves choosing A rate of output and is a short-run decision. A rate of output and is a long-run decision. The amount of plants and equipment and is a short-run decision. The amount of plants and equipment and is a long-run decision. An investment decision is the long-run decision to build, buy, or lease plants and equipment, or to enter or exit an industry. Learning Objective: The difference between production and investment decisions. If price is greater than marginal cost, a perfectly competitive firm should increase output because Marginal costs are increasing. Additional units of output will add to the firm's profits (or reduce losses). The price it receives for its product is increasing. Total revenues would increase. If an extra unit brings in more revenue than it costs to produce, it would add to total profit. Hence a competitive firm should expand the rate of production whenever price exceeds MC. Learning Objective: The characteristics of perfectly competitive firms. Suppose a firm has an annual budget of \$200,000 in wages and salaries, \$75,000 in materials, \$30,000 in new equipment, \$20,000 in rented property, and \$35,000 in interest costs on capital. The owner/manager does not choose to pay himself, but he could receive income of \$90,000 by working elsewhere. The firm earns revenues of \$360,000 per year. What are the annual economic costs for the firm described above? \$450,000. \$120,000. \$90,000. \$360,000. Economic costs include both explicit and implicit costs, totaling \$450,000. Learning Objective: How profits are computed.

22 22 of 25 5/1/2014 4:28 PM Refer to Figure 22.3 At quantity level B The company is maximizing profit. Marginal cost is greater than marginal revenue, so it should cut production. The company is minimizing loss. Marginal revenue is greater than marginal cost, so the firm should expand production. Profit maximization occurs where marginal revenue equals marginal cost. At quantity B, marginal revenue is greater than marginal cost, which tells the firm that it should expand production. Learning Objective: How a competitive firm maximizes profit.

23 23 of 25 5/1/2014 4:28 PM In order to sell additional units of their products, competitive firms must Increase their advertising. Lower their price. Cut their expenses. Increase output. An individual firm in a perfectly competitive market is so small relative to the entire market that it confronts a horizontal demand curve (perfectly elastic demand) for its output. It does not need to lower its price to sell more; it can sell as much as it can produce at the market price. Learning Objective: How profits are computed.

24 24 of 25 5/1/2014 4:28 PM Refer to Figure 22.3 for a perfectly competitive firm. At a market price of \$23, total profits are maximized at an output of Total profit is maximized at the output level where price is equal to MC, 39. Learning Objective: How a competitive firm maximizes profit.

25 25 of 25 5/1/2014 4:28 PM Suppose a firm has an annual budget of \$200,000 in wages and salaries, \$75,000 in materials, \$30,000 in new equipment, \$20,000 in rented property, and \$35,000 in interest costs on capital. The owner/manager does not choose to pay himself, but he could receive income of \$90,000 by working elsewhere. The firm earns revenues of \$360,000 per year. What are the annual explicit costs for the firm described above? \$450,000. \$160,000. \$90,000. \$360,000. The explicit costs include wages and salaries, raw materials, equipment, rent, and interests for a total of \$360,000. Learning Objective: How profits are computed.

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