Econ 120 - Microeconomics Notes Daniel Bramucci December 1, 2016 1 Section 1 - Thinking like an economist 1.1 Definitions • Cost-Benefit Principle — An action should be taken only when its benefit exceeds its cost. • Economic Surplus — The net gain from an action. • Opportunity Cost — Implicit + Direct Costs. • Positive Economics — How people do behave • Normative Economics — How people should behave 1.2 Formulas Economic Surplus = Benefit of an action − Opportunity cost of the action Opportunity Cost = Direct Costs + Opportunity cost of the action Opportunity Cost = Direct Costs +Benefit of next best action − Direct cost of next best action 1.3 Three pitfalls to using cost-benefit principle 1. Measuring cost benefits as proportions not absolute values 2. Ignoring implicit costs 3. Failure to think at the margin 1 2 Section 2 — Supply and Demand Price is on the vertical axis. Demand is on the horizontal axis. 2.1 Definitions • Demand Curve — A curve representing the quantity that would be bought in a market for a given price. • Supply Curve — A curve representing the quantity that would be sold for a given price. • Buyer’s reservation price — The maximum price that a buyer would pay to take an action. • Seller’s reservation price — The minimum price that a seller would pay to take an action. • Market Equilibrium — The point where all buyers and sellers are sat- isfied. No one has an incentive to change. This is located at the inter- section of the demand and supply curves. • Shift in Demand — A shift in the demand curve itself; a change in the amount purchased for a given price. • Shift in Quantity Demanded — A shift along the demand curve; a change in the amount purchased for two different prices. • Shift in Supply — A shift in the supply curve itself; a change in the amount sold for a given price. • Shift in Quantity Supplied — A shift along the supply curve; a change in the amount sold for two different prices. • Complements — Two goods are complements if an increase in demand for one good increases demand for another; the two goods are typically used together (e.x. Peanut butter and jelly) • Substitutes — Two goods are substitutes if an increase in demand for one, decreases demand for the other; these two goods usually replace each other (e.x. Coke and Pepsi) 2 • Normal Goods — An increase in consumer income increases demand for the good (e.x. gas) • Inferior Goods — An increase in consumer income decreases demand for the good (e.x. Ramen Noodles) • Economic Efficiency — The sum of buyer and seller surplus1 • Buyers Surplus — The difference between the buyers reservation price and the price he pays • Sellers Surplus — The difference between the sellers reservation price and the price he receives 2.2 Shifts in the Demand Curve 1. Change in price of related good Type of Relationship Price decreases Price Increases Complement Demand Shifts Right Demand Shifts Left Substitute Demand Shifts Left Demand Shifts Right 2. Changes in consumer income Type of good Income Increases Income Decreases Normal Demand Shifts Right Demand Shifts Left Inferior Demand Shifts Left Demand Shifts Right 2.3 Shifts in the Supply Curve 2.4 Shifts in the Demand Curve 1. Change in cost to make Good becomes cheaper to make Good becomes more expensive to make supply shifts right supply shifts left 3 Section 3 - Elasticity Market demand is sum of all individual demand curves. At each price add up the demand of each individual buyer 1Review this definition 3 3.1 Definitions • Price Elasticity of Demand — The Percentage Change in the Quantity Demanded that results from a 1% change in the price. • Perfectly Inelastic Demand — A change in price won’t change demand (0 = ǫ) • Inelastic Demand — Percentage quantity demanded changes slower than percentage price (0 ≤ ǫ< 1) • Unit Elastic Demand — Percentage quantity demanded changes at the same rate as percentage price (ǫ = 1) • Elastic Demand — Percentage quantity demanded changes faster than percentage price (ǫ> 1) • Perfectly Elastic Demand — Quantity demanded drops to 0 for any increase in price (ǫ = ∞)2 • Income Elasticity of Demand — The Percentage Change in the Quan- tity Demanded that results from a 1% change in income. • Cross-Price Elasticity of Demand — The Percentage Change in the Quantity Demanded that results from a 1% change in the price of another good. 3.2 Notation • P1 — Price of good 1 D • Q1 — Quantity Demand of good 1 • ǫ — Elasticity • QD — Quantity Demanded • %∆QD — Percentage Change in Quantity Demanded • %∆P — Percentage Change in Price 2This isn’t completely mathematically rigorous 4 3.3 Formulas Formula for Price Elasticity %∆QD ǫ = %∆P 3 Formula for Price Elasticity with Slope 3.3.1 Derivations Deriving Formula for Price Elasticity with Slope from Formula for Price Elasticity ∆Q ∗ 100 %∆QD Q P ∆QD P 1 P 1 ǫ = = = ∗ = ∗ = ∗ %∆P ∆P QD ∆P QD ∆P QD Slope ∗ 100 P ∆QD 4 Let Q(P ) be the quantity demanded for a given price. Q(1.01P ) − Q(P ) D dQ %∆Q Q(P ) Q(P ) P 1 P 1 ǫ = = ≈ = ∗ = ∗ %∆P 1.01P − P dP Q(P ) dP QD Slope Let|{z}h → 0 P dQ P 3.4 Determining factors of price elasticity 1. Elasticity is inversely proportional to the availability of substitutes. 1 e ∝ Availability of substitutes 2. Elasticity is inversely proportional to the share of income spent on a good5 1 e ∝ share of income spent on a good 3Note that in this class we always ignore the sign of price elasticity due to the books convention. 4Mathematically, this derivation needs additional rigor but ends up working in the end 5This is because as the share of one’s income spent on a good increases their incentive to change consumption of the good increases 5 3. Time changes elasticity, some things like gasoline prices can’t be reacted to quickly but in the long run will change dramatically. 3.5 Graph Elasticity At middle of graph, elasticity = 1. At bottom of graph elasticity = 0. At Top of graph Elasticity = ∞. Price Change Elastic Demand Inelastic Demand P increase Tot. Exp. Dec. Tot. Exp. Inc. P Dec. Tot. Exp. Inc. Tot. Exp. Dec. 3.6 Income Elasticity of Demand ǫI > 0 for normal goods and ǫI < 0 for inferior goods. 3.7 Cross-Price Elasticity of Demand ǫC > 0 for substitute goods and ǫC < 0 for complement goods. 4 Section 3 - Elasticity 4.1 Definitions • Short Run — period of time short enough that some inputs can’t be changed • Long Run — period of time long enough that all inputs can be changed • fixed — Unchangeable • Fixed Cost — Expenditures on fixed inputs • Variable Cost — Expenditures on variable inputs • Law of Diminishing Marginal Returns — In the short-run, because at least one input is fixed, a firm eventually requires increasing amounts of additional variable input to get additional production. 6 4.2 Notation • q = individual firm’s production • P ∗ = market price • Q∗ = market quantity 4.3 Formulas Profit = Revenue − Cost 4.3.1 Derivations 4.4 In a perfectly competitive market Producers decide how much to produce, they don’t decide the price If they raise the price above market no one will buy their product. If they lower it, everyone will buy their product. Revenue for a firm = P ∗q Cost for a firm = Expenditures on factors of production 4.5 Production in the short-run In the short-run at least one factor of production is fixed. A firm’s sup- ply curve is its marginal cost curve because the firm will produce until its marginal cost is equivalent to its profit.6 A change in fixed input cost does not change the output level or the price. If profit is negative, you stay in business as long as you can pay variable input costs. 4.6 Determinants of Market Supply Changes in technology move the supply curve because they reduce the marginal cost which pushes each firm to make more. 6Danny consider describing how some of these distinctions can be ignored when one thinks about this as a question of not fixed and variable inputs but rather inputs dependent on quantity produced. 7 5 Section 5 - Efficiency, Exchange and the Invisible Hand In Action 5.1 Definitions • The Invisible Hand — Actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resources. • Accounting Profit = Total Revenues − Direct Cost7 • Economic Profit = Total Revenues − Direct Cost − Implicit Cost • Normal Profit = Accounting Profit − Economic Profit = Implicit Cost • Economic Rent — The part of a payment for a factor of production that exceeds the owner’s8 reservation price. • Efficient —- Situation where it is impossible to make some people better off without hurting someone else. 5.2 Implicit cost The implicit cost of using their machinery is due to the depreciation of the equipment and what else it could be used for. We could sell our equipment for its value and invest the money into the best alternative business opportunity. 5.3 The Invisible Hand 5.3.1 Price The Rationing Function of price. Price rations out resources. Changes in price distribute scarce goods to buyers who value it the most. → This means that only the buyers who benefit the most from a good get it. → This maximizes the total buyers surplus. The Allocative Function of Price. Changes in price direct productive resources away from overcrowded markets and towards underserved markets. 8Of that factor of production 8 5.4 Economic Rent In the long-run economic rent will not go to zero in a perfectly competitive market. Economic rent is high when the factors of production are hard to replicate. 5.5 Efficiency Looking at a supply-demand curve pick a price between the curves and both seller and buyer benefit.