Econ 101 Midterm 1 review

Econ 101 Midterm 1 review - Econ 101 – Review...

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Unformatted text preview: Econ 101 – Review Session Midterm 1 Sunday • 1:00 ­3:00PM • Angel Hall D 10 – 10 – 10 GSI: Nico Ravanilla Topics covered in this review 1.  2.  3.  4.  5.  6.  7.  Opportunity costs and the PPF Demand, supply & market equilibrium ShiPs in demand and supply ElasRciRes, total revenue & total expenditure Marginal cost & marginal benefit analyses Consumer surplus, producer surplus & efficiency ExternaliRes & government intervenRons NOTE: PolluRon abatement and tradable permits, informaRon asymmetry and adverse selecRon, distorRonary tax & subsidies are not included in this review BUT are part of the coverage of the exam. This week’s discussion secRons will cover these three remaining topics. 1. Opportunity costs and the PPF •  Opportunity Cost (OC) is the value of the next best good/ service that was not chosen •  Simple formula for compuRng the OC of good X in terms of good Y is: Opportunity cost of X = loss of Y gain of X •  A convenient way of modeling OC is to graph the ProducRon PossibiliRes FronRer (PPF) € •  The PPF represents the maximum combinaRon of two goods that can be produced using all resources and the best available technology 1. Opportunity costs and the PPF hats •  The PPF is downward sloping (i.e. has negaRve slope) because C resources are scarce and there are tradeoffs in producRon D •  The slope of the PPF represents the 25 OC of the good on the X ­axis in terms of the good on the Y ­axis •  The steeper the slope, the greater the OC •  The reciprocal of the slope of the E PPF represents the OC of the good on the Y ­axis in terms of the good on 1 2 3 4 shoes 0 the X ­axis loss of hats 38 − 35 OC of shoes = = = 3 hats/shoes = slope •  If opportunity cost of producing gain of shoes 1−2 more shoes is increasing in terms of loss of shoes 2 −1 1 OC of hats = = = 1 / 3 shoes/hats = hats, then the opportunity cost of gain of hats 35 − 38 slope producing more hats is increasing in Direction of increasing shoes A → B B → C C → D D → E terms of shoes 40 38 35 B B→ C A C→ B € € OC of shoes Direction of increasing hats OC of hats 2 3 10 25 E →D D →C C →B B → A 1 / 25 1 /10 1/ 3 1/ 2 1. Opportunity costs and the PPF hats 2 1 hats 2 1 shoes shoes •  If PPF is bowed ­out, the OC’s are increasing; if PPF is straight line, the OC’s are constant •  Increasing OC of shoes means the more shoes you produce, the more you have to give up producRon of hats. In general, OC is increasing because some resources are befer used in the producRon of one good than in the other •  Technological advancements and increases in resources shiP the PPF out. •  If PPF shiPs ­out in favor of shoes, OC of shoes falls and OC of hats rises at every point on the PPF •  If PPF shiPs ­out in favor of hats, OC of shoes rises and OC of hats falls at every point on the PPF 2. Demand, supply & market equilibrium Price ($) Supply SURPLUS: pressure on price to fall •  Demand VS QuanRty demanded •  PC Supply VS QuanRty supplied –  DEMAND: amount of goods consumers are willing and able to purchase at various prices –  QuanRty demanded: amount of goods consumers are willing and able to purchase at a given price holding everything else constant –  SUPPLY: amount of goods producers are willing and able to sell at various prices –  QuanRty supplied: amount of goods producers are willing and able to sell at a given price holding everything else constant –  Price (PC) and QuanRty (QC) for which quanRty supplied is equal to quanRty demanded (i.e. where there is no pressure for price to adjust) –  If quanRty demanded > quanRty supplied, then there is SHORTAGE –  If quanRty demanded < quanRty supplied, then there is SURPLUS SHORTAGE: pressure on price to rise Demand •  CompeRRve Equilibrium QC QuanRty 2. Demand, supply & market equilibrium Price ($) movement along the demand curve •  Movement along the demand curve •  Shi3 of the demand curve Demand •  Increase in income— P ’ P –  caused by a change in the price of the good –  caused by non ­price factors: –  ShiPs the demand curve to the right IF normal good –  ShiPs the demand curve to the leP IF inferior good Q’ Q Price ($) shiP of the demand curve QuanRty D D’ QuanRty •  Improvement in consumer preference/taste for the good shiPs the demand curve to the right •  Rise (fall) in the price of a complement shiPs the demand curve to the leP (right) •  Rise (fall) in the price of a subsRtute shiPs the demand curve to the right (leP) •  Increase in the number of consumers shiPs the demand curve to the right 2. Demand, supply & market equilibrium Price ($) movement along the supply curve Supply P’ P •  Movement along the supply curve •  Shi3 of the supply curve Q Q’ S Price ($) QuanRty S’ –  caused by a change in the price of the good –  caused by non ­price factors: shiP of the supply curve QuanRty •  Technological improvements shiP the supply curve to the right •  Decrease (increase) in cost of inputs shiPs the supply curve to the right (leP) •  Increase in the number of firms in the market shiPs the supply curve to the right 3. ShiPs in demand & supply •  SINGLE SHIFTS: Price ($) S Increase in DEMAND Price QuanRty Total Revenue/ Expenditure (PxQ) RISE RISE INCREASE Decrease in DEMAND FALL FALL DECREASE Increase in SUPPLY FALL RISE Decrease in SUPPLY RISE FALL Depends on demand elasRcity Price ($) S D’ D QuanRty Price ($) S S’ Price ($) D’ D QuanRty S’ S Prac5ce drawing graphs! DON’T MEMORIZE D QuanRty D QuanRty 3. ShiPs in demand & supply •  DOUBLE SHIFTS: P ($) S 2 1 D 3 ’ D P ($) S 1 3 D D’ Q Q S’ P ($) S’ Increase in DEMAND P: ? Q: RISE P: RISE Q: ? Decrease in DEMAND P: FALL Q: ? P: ? Q: FALL Increase in SUPPLY Decrease in SUPPLY Prac5ce drawing graphs! DON’T MEMORIZE S’ S P ($) 3 1 2 D’ D S’ Q S 3 1 D D’ Q 2 2 4. ElasRciRes, revenue & expenditures •  ElasRcity – a measure of the sensiRvity/responsiveness of demand or supply to changes in price •  Midpoint formula for compuRng elasRcity: –  Example: Price elasRcity of demand QNew − QOriginal % ΔQ Q εD = = New , where Q are P the averages − P Original % ΔP P P if ε D > 1 ⇒ % ΔQ > % ΔP ⇒ demand is ELASTIC € if ε D = 1 ⇒ % ΔQ = % ΔP ⇒ demand is UNIT ELASTIC if ε D < 1 ⇒ % ΔQ < % ΔP ⇒ demand is INELASTIC 4. ElasRciRes, revenue & expenditures P ($) P ($) P ($) P ($) Demand 0 Q 0 Demand Q 0 Demand Q 0 Demand Q perfectly elas5c  ­  Think of this as the extreme scenario of elasRc demand A very small price increase causes quanRty demanded to drop to zero (highly sensiRve to price) (rela5vely) elas5c  ­  QuanRty demanded is very sensi7ve to price changes Many close subsRtutes Luxury goods Accounts for large fracRon of income Long Rme frame (rela5vely) inelas5c  ­  perfectly inelas5c QuanRty demanded is not responsive to price changes at all Ex. Life ­saving meds, highly addicRve goods  ­   ­   ­   ­   ­   ­   ­   ­   ­  QuanRty  ­  demanded is only slightly sensiRve to price changes No close subsRtutes  ­  NecessiRes Accounts for small fracRon of income Short Rme frame 4. ElasRciRes, revenue & expenditures P ($) 6 elasRc unit elasRc •  IF demand is a straight line, then we have the following results: 3 inelasRc Demand 0 3 6 Q Total revenue/Total expenditure (PxQ) ($) 9 8 5 –  Exactly halfway between 0 and the highest price the consumers are willing to pay for a unit of the good is where demand is unit elasRc –  Above the unit elasRc point, demand is elasRc –  Below the unit elasRc point, demand is inelasRc –  Total revenue/total expenditure is highest at the unit elasRc point –  At the elasRc porRon of demand, TR/TE is decreasing when price is increasing –  At the inelasRc porRon of demand, TR/TE is increasing when price is increasing 0 3 6 Q 5. Marginal cost and marginal benefit •  MARGINAL BENEFIT (MB): the addiRonal benefit to the consumer of consuming the next unit •  MARGINAL COST (MC): the addiRonal cost to the producer of producing the next unit •  MB & MC are measured in dollars •  OpRmal behavior of CONSUMERS: –  Taking the market price as given, conRnue to buy an addiRonal unit of the good for as long as MB ≥ P –  Don’t buy the next unit for which MB < P •  OpRmal behavior of PRODUCERS: –  Taking the market price as given, conRnue to produce € an addiRonal unit of the good for as long as MC ≤ P € –  Don’t produce the next unit for which MC > P € € 5. Marginal cost and marginal benefit •  MARGINAL BENEFIT (MB): the addiRonal benefit to the consumer of consuming the next unit •  MARGINAL COST (MC): the addiRonal cost to the producer of producing the next unit •  Do not confuse MARGINAL benefits/costs with TOTAL benefits/ costs! Servings of rice Amy’s addiRonal benefit from consuming the 4th serving of rice Amy’s MB Amy’s Total Benefit Servings of rice Ed’s MC Ed’s Total Cost 1 2 3 4 5 6 7 5 5 5 4 3 0 0 5 10 15 19 22 22 22 1 2 3 4 5 6 7 4 4 5 6 8 16 26 4 8 13 19 27 43 69 Ed’s addiRonal cost of producing the 3rd serving of rice Amy’s total benefit from consuming 4 servings of rice Ed’s total cost of producing 3 servings of rice 5. Marginal cost and marginal benefit •  Market demand is derived from individual MB schedules •  Market supply is derived from individual MC schedules •  CompeRRve equilibrium (PC, QC) is found where quanRty supplied is just equal to quanRty demanded Servings of rice Amy’s MB Ben’s MB Charlie’s MB Danielle’s MB 1 2 3 4 5 6 7 Servings of rice 5 5 5 4 3 0 0 Ed’s MC 9 9 5 4 2 0 0 Frank’s MC 5 4 4 2 0 0 0 Grant’s MC 10 10 10 10 8 5 1 Herb’s MC P 0 1 2 3 4 5 6 7 8 9 10 QD 28 21 20 18 17 13 7 7 7 6 4 QS 0 0 4 5 9 13 16 16 19 19 20 1 2 3 4 5 6 7 4 4 5 6 8 16 26 2 2 2 4 5 5 12 6 6 8 10 12 16 22 2 3 4 5 8 15 24 CompeRRve equilibrium: PC = 5 QC = 13 6. Consumer & producer surplus Price ($) Supply = MC CS PC PS •  For every unit of the good consumed, CONSUMER SURPLUS is the difference between the marginal benefit from consuming that unit of the good and the price they had to pay: Consumer SurplusPER UNIT = MB − P •  For every unit of the good produced and sold, PRODUCER SURPLUS is the difference € between the price producers received from selling that unit of Demand = MB QuanRty the good and the marginal cost of producing that good. 18 TOTAL SURPLUS = CS + PS Producer SurplusPER UNIT = P − MC 6. Efficiency •  Efficiency means all and only units for which M B ≥ are MC traded in the market •  In other words, efficiency is where Total Economic Surplus is € highest •  In the absence of externaliRes (and other market failures), the compeRRve equilibrium quanRty is also the efficient quanRty: QC = Qeff •  Efficiency does not imply EQUITY (i.e. equality). Efficiency means you cannot make improvements. It does not mean that the allocaRon is “fair” and “equal” –  Helpful way to think about this: EFFICIENCY is about making the biggest pie out of the available ingredients. EQUITY is about dividing the pie among the people 7. ExternaliRes •  NEGATIVE EXTERNALITIES – addiRonal costs of consuming and producing a good, borne by the rest of the society –  Example 1: Consuming cigarefes (i.e. smoking) creates polluRon and health hazards that are costly to the rest of the society –  Example 2: Producing electricity from coal plants causes carbon emissions that are costly to the rest of the society (environmental costs) •  POSITIVE EXTERNALITIES – addiRonal benefits of consuming and producing a good, enjoyed by the rest of the society –  Example 1: Keeping the front yard clean and beauRful gives addiRonal saRsfacRon to neighbors who gets to enjoy the front yard –  Example 2: Bee farms (apiaries) near an apple orchard helps in pollinaRon and increases producRon of the apple orchard 7. ExternaliRes •  In the presence of NEGATIVE externaliRes, the compeRRve Social MC = Private MC + Marginal External Cost equilibrium quanRty QC is no longer equal to the efficient quanRty Qeff P ($) Social MC •  Because individual consumers and producers do not take into account the external costs to Private MC DWL the society, the equilibrium quan5ty is higher than the efficient quan5ty (that is, too PEff much of the good is bought C Marginal P external cost and sold) •  In effect, a deadweight loss (DWL) from overproducRon is Marginal Benefit created QEff QC QuanRty 7. ExternaliRes •  Similarly, in the presence of POSITIVE externaliRes, the Social MB = Private MB + Marginal External Benefit compeRRve equilibrium quanRty QC is no longer equal to the efficient quanRty Qeff P ($) •  Because individual consumers and producers do not take into DWL Marginal Cost account the external BENEFITS to the society, the equilibrium quan5ty is lower than the PEff efficient quan5ty (that is, too lifle of the good is bought and Marginal PC external sold) benefit Social MB •  In effect, a deadweight loss (DWL) from underproducRon is Private MB created C Eff Q Q QuanRty 7. CorrecRve taxes & subsidies •  In the presence of NEGATIVE externaliRes, the efficient quanRty Tax revenue + reducRon in external costs Qeff may be achieved by imposing = reducRon in CS + reducRon in PS + DWL a TAX •  A TAX shiPs the Private MC to the P ($) Social MC leP at every price •  To find the correct tax, look for the Private MC DWL efficient quanRty and set the tax equal to the marginal external cost at that efficient quanRty PD •  A tax creates a wedge between tax PC the price that consumers pay, and the price that producers receive PS Marginal Benefit QEff QC QuanRty 7. CorrecRve taxes & subsidies •  In the presence of POSITIVE externaliRes, the efficient quanRty Subsidy payment + DWL = increase in CS + increase in PS + increase in external benefits Qeff may be achieved by imposing a SUBSIDY •  A SUBSIDY shiPs the MARGINAL P ($) COST to the right at every price •  To find the correct subsidy, look DWL Private MC for the efficient quanRty and set the subsidy equal to the marginal external benefit at that efficient PS quanRty subsidy PC •  A subsidy creates a wedge Social MB between the price that consumers D P pay, and the price that producers Marginal Benefit receive QC QEff QuanRty ...
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This note was uploaded on 01/23/2011 for the course ECON 101 taught by Professor Gerson during the Fall '08 term at University of Michigan.

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