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# ch02 - Basic Microeconomic Tools Chapter 2 Basic...

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Chapter 2: Basic Microeconomic Tools 1 Basic Microeconomic Tools

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Chapter 2: Basic Microeconomic Tools 2 Efficiency and Market Performance Contrast two polar cases perfect competition monopoly What is efficiency? no reallocation of the available resources makes one economic agent better off without making some other economic agent worse off example: given an initial distribution of food aid will trade between recipients improve efficiency?
Chapter 2: Basic Microeconomic Tools 3 Focus on profit maximizing behavior of firms Take as given the market demand curve Equation: P = A - B.Q linear demand Importance of: time short-run vs. long-run willingness to pay Maximum willingness to pay \$/unit Quantity A A/B Demand P 1 Q 1 Constant slope At price P 1 a consumer will buy quantity Q 1

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Chapter 2: Basic Microeconomic Tools 4 Perfect Competition Firms and consumers are price-takers Firm can sell as much as it likes at the ruling market price do not need many firms do need the idea that firms believe that their actions will not affect the market price Therefore, marginal revenue equals price To maximize profit a firm of any type must equate marginal revenue with marginal cost So in perfect competition price equals marginal cost
Chapter 2: Basic Microeconomic Tools 5 MR = MC Profit is π (q) = R(q) - C(q) Profit maximization: d π /dq = 0 This implies dR(q)/dq - dC(q)/dq = 0 But dR(q)/dq = marginal revenue dC(q)/dq = marginal cost So profit maximization implies MR = MC

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Chapter 2: Basic Microeconomic Tools 6 Perfect competition: an illustration \$/unit Quantity \$/unit Quantity D 1 S 1 Q C AC MC P C P C (b) The Industry (a) The Firm With market demand D 1 and market supply S 1 equilibrium price is P C and quantity is Q C With market price P C the firm maximizes profit by setting MR (= P C ) = MC and producing quantity q c q c D 2 Now assume that demand increases to D 2 Q 1 P 1 P 1 With market demand D 2 and market supply S 1 equilibrium price is P 1 and quantity is Q 1 q 1 Existing firms maximize profits by increasing output to q 1 Excess profits induce new firms to enter the market The supply curve moves to the right Price falls Entry continues while profits exist Long-run equilibrium is restored at price P C and supply curve S 2 S 2 C
Chapter 2: Basic Microeconomic Tools 7 Perfect competition: additional points Derivation of the short-run supply curve this is the horizontal summation of the individual firms’ marginal cost curves Example 1: Three firms Firm 1: MC = 4q + 8 Firm 2: MC = 2q + 8 Firm 3: MC = 6q + 8 Invert these Aggregate: Q= q 1 +q 2 +q 3 = 11MC/12 - 22/3 MC = 12Q/11 + 8 Firm 1: q = MC/4 - 2 Firm 2: q = MC/2 - 4 Firm 3: q = MC/6 - 4/3 Firm 1 Firm 3 Firm 2 q 1 +q 2 +q 3 \$/unit Quantity 8

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Chapter 2: Basic Microeconomic Tools 8 Example 2: Eighty firms Each firm: MC = 4q + 8 Invert these Each firm: q = MC/4 - 2 Aggregate: Q= 80q = 20MC - 160 MC = Q/20 + 8
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ch02 - Basic Microeconomic Tools Chapter 2 Basic...

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