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# summary_week_3_4 - Principles of Microeconomics –...

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Unformatted text preview: Principles of Microeconomics – Econ1014 Fall 2008 ‐ Sharon Ryan Summary of Weeks 3‐4 The following is a summary list of the topics covered. Make sure you are comfortable with these topics. Your homework and quizzes will probably be your best guide to how well you understand the material. Review them and practice with them until you understand those problems and can comfortably answer them. 1. Demand and Supply a. What is the demand curve measuring? This measures the relationship between price per unit and the quantity consumers are willing to purchase. This also measures the reservation price or “willingness‐and‐ability‐to‐pay” of the consumer for various quantities. b. What is the supply curve measuring? This measures the relationship between price per unit and the quantity producers are willing to produce. This also measures the reservation price or marginal cost of production (MC) of the producer for various quantities. c. How do we find equilibrium? Where demand and supply intersect. This is the only price that creates no shortage and no surplus. When indicating equilibrium, be sure to tell what dollar value Pe takes and what quantity Qe takes. Don’t just circle the intersection point on the graph. d. What is the difference between change in demand and change in quantity demanded? One indicates a movement along a single demand curve; the other indicates a shift to a brand new demand curve. e. What is the difference between change in supply and change in quantity supplied? One indicates a movement along a single supply curve; the other indicates a shift to a brand new supply curve. f. What happens to Pe and Qe when either demand or supply changes? Try these out on your own by drawing graphs to verify the following outcomes. i. Demand increases (shifts right) → higher price and higher quantity ii. Demand decreases (shifts left)→ lower price and lower quantity iii. Supply increases (shifts right) → lower price and higher quantity iv. Supply decreases (shifts left) → higher price and lower quantity g. What happens to Pe and Qe when both demand and supply change? Try these out on your own by drawing graphs to verify the following outcomes (draw a separate graph for the demand shift and another graph for the supply shift to make the outcome easier to see. If both shifts cause price or quantity to move in the same direction then the outcome for that variable is clear. If the shifts cause opposite movements in price or quantity then the outcome for that variable is unclear.) i. Both demand and supply increase→ we don’t know what happens to price but we know quantity increases ii. Both demand and supply decrease→ we don’t know what happens to price but we know quantity decreases iii. Demand increases and supply decreases→ price increases but we don’t know what happens to quantity iv. Demand decreases and supply increases→ price decreases but we don’t know what happens to quantity 1 2. Elasticity a. What is the price elasticity of demand? This tells us how responsive consumers are to price changes for this good. It is measuring the percentage change in price and the resulting percentage change in quantity demanded. It is a measurement of a movement from one (price, quantity demanded) point on the demand curve to a second (price, quantity demanded) point on the demand curve. Don’t forget that this is always a negative number because of the Law of Demand. Price 8 7 Supply Po=6 5 Pn=4 3 2 1 Demand 2 4 6 8 10 12 14 Qo= Qn= Quantity 2 %∆ %∆ 8 4 6 5 4 6 1.67 b. What is the price elasticity of supply? This tells us how responsive producers are to price changes for this good. It is measuring the percentage change in price and the resulting percentage change in quantity supplied. It is a measurement of a movement from one (price, quantity supplied) point on the supply curve to a second (price, quantity supplied) point on the supply curve. Don’t forget that this is always a positive number because of the Law of Supply. Price 8 7 Supply Po=6 %∆ %∆ 8 16 12 46 5 1.67 5 Pn=4 3 2 1 Demand 2 4 6 8 10 12 14 16 Quantity Qn= Qo= c. What is the income elasticity of demand? This tells us how responsive consumers are to income changes when buying this good. When income increases, demand can either increase (normal good) or decrease (inferior good). This means the income elasticity of demand can be a positive number (normal good) or a negative number (inferior good). The income change causes the demand curve to shift and the income elasticity tells us how far the curve shifts and in which direction it shifts. The following example is an inferior good; income rises by about 9.5% and the demand curve shifts left so that at the original equilibrium price, the quantity demanded is about 67% less. This tells us that consumers of this good are very income elastic. Even small Income changes have a big impact on their demand for this good. (Note: in this example we are assuming income rises from \$100 to \$110) 3 Price 8 7 Supply 6 %∆ %∆ 4 6 8 110 100 105 5 4 3 2 1 New Demand Demand 2 4 6 8 10 12 14 16 Quantity Qn= Qo= d. What is the cross price elasticity of demand? This tells us how responsive consumers are to price changes of a related good when buying this good. When the price of a related good increases, demand for this other good can either increase (the goods are substitutes) or decrease (the goods are complements). This means the cross‐price elasticity of demand can be a positive number (substitutes) or a negative number (complements). The related good price change causes the demand curve for this other good to shift and the cross‐price elasticity tells us how far the curve shifts and in which direction it shifts. The following example is for substitutes; the price of coffee rises by about 9.5% (we are assuming coffee price rises from \$10 to \$11) and the demand curve for tea shifts right, so that at the original equilibrium price, the quantity demanded is about 22% more. This tells us that consumers consider coffee and tea to be substitutes and fairly strong substitutes. They’ll buy more tea when coffee prices go up. 4 7 Price 8 7 Supply 6 %∆ %∆ 5 4 3 2 1 10 , 9 8 11 10 10.5 2.31 New Demand Demand 2 4 6 8 10 12 14 16 Quantity Qo= Qn= e. If the elasticity number is greater than 1, the good is relatively elastic (consumers or producers are relatively responsive); if the elasticity number is less than 1, the good is relatively inelastic (consumers or producers are relatively unresponsive) f. If the price elasticity of demand is equal to ‐1 (=1 if we use absolute value), this is the price at which the good is unitary elastic; this is the price that will earn the firm the highest revenue. (Remember, every demand curve has a different elasticity at every point on the curve. Try this out on the above demand curve and you’ll see at high prices the elasticity number is big and at low prices the elasticity number is small, and that there must be some price in‐between where the elasticity number is ‐1. This is our unitary elastic price which maximizes revenue for the firm selling the product.) 3. Market Efficiency a. Market Efficiency: In the absence of market failure, the free market system gives us the best allocation of resources. This means it gives us the greatest economic surplus possible. We can show this on the graph by calculating economic surplus (total surplus) at the free market equilibrium (the Pe, Qe point where Demand and Supply intersect), calculating surplus at any production point less than the Pe,Qe point and calculating surplus at any production point greater than the PeQe point. We will see that economic surplus is largest at the free market (Pe,Qe) production level. b. Consumer Surplus: Some of the economic surplus is earned by the consumers whenever they get lucky enough to pay a price which is less than their reservation price. We call this consumer surplus and it is measured as the difference between reservation price and price paid (CS=reservation price – price paid). It is measured as the area under the demand curve and above price paid. c. Producer Surplus: Some of the economic surplus is earned by the producers whenever they get lucky enough to sell for a price which is greater than their reservation price. We call this producer surplus and it is measured as the difference between price received and reservation 5 price (which is also MC). (PS=price received – reservation price) It is measured as the area above the supply curve and below the price received. d. Deadweight Loss: This is the amount of surplus lost to society whenever we don’t produce and consume the most efficient amount. It arises due to resource misallocation. To locate it graphically, first find the resource misallocation, then go straight up and find the area between the demand and supply curve. This area will be the lost economic surplus due to the resource misallocation. This area is the DWL. e. Resource Misallocation: When we do not produce and consume the most efficient amount. Resources get wasted and we lose the chance to earn economic surplus. Price 8 7 Supply 6 CS 5 Pe= 4 PS 3 2 1 Demand 2 4 6 8 10 12 14 16 Quantity Qe= Price 8 7 Supply 6 CS 5 DWL Pe= 4 PS 3 2 1 Demand RM 2 4 6 8 10 12 14 16 Quantity Q 6 CS=(1/2)x(8)x(4)=\$16 PS=(1/2)x(8)x(2)=\$8 TS=CS+PS=\$24 or TS=(1/2)x(8)x(6)=\$24 CS={(1/2)x(6)x(3)} + 6x1 =\$15 PS={(1/2)x(6)x(1.5)} + 6x0.5 =\$7.5 TS=CS+PS=\$22.5 RM=8‐6=2 units too few bought and sold DWL=(1/2)x(2)x(1.5)=\$1.5 Price 8 7 Supply 6 CS 5 DWL Pe= 4 PS 3 2 1 RM Demand 2 4 6 8 10 12 14 16 Quantity Q 7 CS={(1/2)x(8)x(4)} –{(1/2)x(2)x(0.5) =\$16‐\$0.5=\$15.5 PS={(1/2)x(8)x(2)} –{(1/2)x(2)x(1)} =\$8‐\$1=\$7 TS=CS+PS=\$22.5 RM=10‐8=2 units too many bought and sold DWL=(1/2)x(2)x(1.5)=\$1.5 ...
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