Table of Contents
Unit 1
Fundamental Concepts ........................................................... 1
Unit 2
Supply and Demand ............................................................... 7
Unit 3
Elasticity .............................................................................. 17
Unit 4
Business Production Behavior .............................................. 21
Unit 5
Cost Functions and Utils....................................................... 25
Unit 6
Profit Maximization of a Purely Competitive Firm................ 31
Unit 7
Monopoly............................................................................. 39
Unit 8
Monopolistic Competition and Oligopoly ............................. 43
Unit 9
Distribution of Wealth and Incomes...................................... 47
Unit 10
Factor prices......................................................................... 53
Unit 11
International Trade ............................................................... 55
Appendix A
Practice Problems ................................................................. 59
iii
About This Workbook
Over the years I have given my Microeconomics and Macroeconomics students a variety
of handouts containing my class notes and practice problems. Upon recommendation
from a colleague, I chose to organize and refine these handouts so they could be available
for publication and used by students from other courses as well. This workbook serves to
supplement the use of other principles texts, readers, telecourse lessons, or classroom
lecture/discussions.
The practice problems included in this book are directly related to the corresponding text
section. Instructors who wish to obtain answers to these problems or have any other
questions about this workbook may write to:
John Bouman
Howard Community College
Social Sciences Division
10901 Little Patuxent Parkway
Columbia, Maryland 21044
[email protected]
Acknowledgments
This workbook was prepared with much help form several outstanding Howard
Community College individuals, in particular Dawn Malmberg, Megan Arnold, Terry
Kirchner, Hildegard Deatherage and Karen Evans. Special thanks to my wife, Sharrie,
who has allowed me to work many hours on this book during the summer hours.
I also wish to express a great deal of gratitude to several economists whose thoughts are
reflected in this book (but because of the workbook format, does not do full justice to
their comprehensive ideas). Professor Bob Miller from the Johns Hopkins University in
Baltimore, Maryland provided me with valuable insights via a recent course. He
prescribed a then, not yet officially published text by George Reisman, titled
"Capitalism". This text is the most powerful text on capitalism I have read and brilliantly
synthesizes the ideas of the Austrian economists as well as defends most of the significant
contributions of the classical and Austrian economists since Adam Smith.
Unit 1
Fundamental Concepts
1.
Economics
What is economics about? Many people relate it to anything having to do with money and how to
make as much of it as possible. Others claim that it deals with making choices and facing tradeoffs. Still others associate it with government fiscal and monetary policies and how they can best
help a country’s economic health.
The real purpose of economics research is its ability to explain how we can most optimally
achieve the highest standard of living possible. A good definition therefore is: economics is the
study of how we can best increase a country’s wealth with the resources that we have available to
us. Wealth in this definition includes tangible (cars, houses, etc) as well as intangible (more
leisure time, cleaner air, etc.) products.
As you may know, there is quite some disagreement over how a country should go about
achieving the optimum amount of wealth. Some economics advocate a great amount of
government involvement, price controls, active monetary policy, etc. Others believe that
government involvement should be minimal and limited to tasks related to defending individual
rights, defense, police and fire protection, etc. And many believe that a combination of moderate
government involvement and private initiative is ideal in achieving the highest standard of living.
There are also various opinions about the role of profits, consumer spending, saving, capital
formation, unions, etc. in our economy. Should we tax profits to more equally distribute the
wealth in our country? Should we encourage spending (and discourage saving) to stimulate
economic growth? Do unions raise real wages? We will touch on this and other important
economic issues in this workbook.
2.
The Role of Government
The United States is currently a mixed economy with a substantial amount of government
involvement in the form of direct government spending, taxation, regulations, price controls, and
monetary policies. Economic conditions were not always like this though.
During the latter part of the 19th century and the beginning of the 20th century, the United States
economy was primarily a “laissez-faire” (“let do, or allow them, i.e., households and businesses
(the private sector) to do”) economy with very little government involvement, minimal
regulations, and free banking. Prices, wages, interest rates and other economic variables were
determined by economic conditions of private businesses and households.
Then, in part due to influences from, among others, Karl Marx, Friedrich Engels in the late 19th
century and John Maynard Keynes (pronounced to rhyme with “rains”) in the 1920s and 1930s,
the country experienced a dramatic change in economic beliefs about the role of the private sector
and a country’s government. Subsequently, the role of the government in this country as well as
Unit 1 – Fundamentals Concepts
1
many other industrialized countries has increased considerably particularly since the Great
Depression of the 1930s. Central banks took control of the monetary system; labor unions,
supported by government legislation gained in influence; regulations about worker safety, antidiscrimination and anti-trust (against big businesses) multiplied; social programs, such as social
security, unemployment compensation, and subsidies to farmers were deemed necessary; new
deal types of government spending (Tennessee Valley Authority) to artificially create jobs
became commonplace; and to fund the direct government expenses and the exponentially
growing number of government employees, taxes to individuals and businesses skyrocketed.
Before we delve into the question as to whether the increased role of the government in the
United States and other industrialized countries has been beneficial, let’s take a look at some
fundamental concepts about the economy and the way it works.
3.
The Production Possibilities Curve
A production possibilities curve represents outcome or production combinations that can be
produced with a given amount of resources. For instance, let’s say that a (very small) country
currently availing itself of 100 acres of land, 20 machines, and 50 workers, is able to produce
maximally 500 machines and 350 units of consumer goods with these resources. However, it
could also, with the same resources, produce 400 machines and 500 units of consumer goods. Or
it could produce 300 machines and 580 unit of consumer goods. Numerous other combinations,
producing fractions of capital goods or consumer goods, are possible. A curve representing all
possible combinations is graphed in Figure 1.3, where “Guns” represents capital goods, and
“Roses” represents consumer goods.
Figure 1.3
Any point on the curve (for example, 500 guns and 350 roses) illustrates an output combination
that is produced with all available resources and as efficiently as possible. A point inside the
curve, for example 300 guns and 350 roses, represents an output combination that is produced
with less than the available resources (unemployment), or with all the resources, but with the
resources used inefficiently (underemployment). Point F is currently unattainable, because our
resources are fixed. In the future as the curve shifts outward, because of technology advances
and/or production of more resources, it is possible to be at point F.
2
Essential Principles of Microeconomics
4.
Economic Growth
If an economy is operating at a point on the production possibilities curve, it means, by
definition, that all resources are used and they are utilized as efficiently as possible. It is, in other
words, the maximum that can be produced with the existing resources and technology. It follows
then that output cannot increase if resources and technology remain constant. When economists
discuss the concept “scarcity,” they refer to the economic reality that resources are limited and
that at any given point in time, output is limited. The production of one particular good or a
category of goods (consumer goods) can increase, but only at the expense (opportunity cost) of
decreasing production of another good or category of goods.
Over time, economic growth occurs when the economy realizes greater production capabilities to
produce capital and consumer goods. For this to happen, resources (land, labor or capital) must
increase and/or technology must improve. Most countries experience economic growth because
of advances in technology and increases in a country’s capital stock (machinery, equipment,
assembly lines, office buildings, etc.). In a graph, economic growth can be illustrated by an
outward shift of the production possibilities curve.
The United States and other industrialized countries such as Hong Kong, Chile, Japan and
Germany, have experienced significant economic growth during the recent past. The production
possibilities curve has shifted out considerably, primarily because of increases in these countries’
capital stock and advances in technology. On the other hand, communist (or command economy)
countries, such as the former Soviet Union, and Cuba, have experienced significantly less
economic growth, if any, than industrialized, more capitalist countries.
5.
Reasons for Economic Growth
We know that increases in a country’s capital stock and advances in technology equate to
economic growth. How does a country achieve significant increases in capital goods and
advances in technology though? Let’s take a look at increases in capital goods first.
Capital goods (machinery, equipment, etc.) are produced just like other goods such as cars,
televisions, or food. At one point in time (i.e. given fixed amounts of resources and technology),
assuming full employment, more capital goods can be produced only at the expense of producing
fewer consumption goods. Thus more capital goods are produced when fewer consumption
goods are produced. On the curve, we are moving from the lower right to the upper left (for
example, from point A to point C).
Advances in technology occur because of inventions and improvements in producing goods and
services. Inventions and improvements take place when entrepreneurs have incentives to produce
more efficiently and lower their costs. When lower costs lead to higher profits and greater
rewards, entrepreneurs are motivated to continue to improve the production process. Countries
which allow entrepreneurs to keep all or most of these rewards (by limiting taxation and
government involvement) have been shown to experience greater rates of technological growth.
Unit 1 – Fundamentals Concepts
3
6.
Important Concepts and Definitions
It is helpful at this point to clarify a few concepts which are important in our economic analyses
later in the course.
I.
Nominal and real values
When we refer to nominal values, such as nominal prices, earnings, wages or nominal
interest rates, we refer to the dollar value of the prices, earnings, wages, or the numerical
value of the interest rates. A person earning $10 per hour in today’s dollars is said to be
earning a nominal wage of $10.
Real values are always values in comparison, or relative, to other related economic
variables. Thus a person earning a nominal wage of $10 in 1996 may only be earning a
real wage of $5 relative to today’s doubled prices since, say, 1986. Applying the concept
to interest rates, a 12% nominal interest rate is only a 2% real interest rate if prices are
rising by 10%.
II.
Positive and normative economic statements
Positive economic statements are facts or relationships which can be proven or disproven.
A normative economic statement is someone’s opinion or value judgment about an
economic issue. Such a statement can never be proven. Au contraire (as the French
would say), a normative statement is one which people commonly argue about. Note that
a positive statement does not have to be a true statement; the statement could be
disproven. It would be a false positive statement. Also keep in mind that predictions,
such as “The Orioles should win the World Series this year,” or “The ‘skins will be in the
Super Bowl again this season,” are not considered normative statements, but predictions
or hopes (or wishful thinking…) unrelated to facts or value judgments.
Examples of positive economic statements are:
1.
2.
3.
The federal deficit this past year exceeded $250 billion.
When the value of the dollar falls, Japanese products imported into the United
States become more expensive.
Legalizing drugs will lower the price of drugs and reduce the crime rate among
drug users.
Examples of normative economic statements are:
1.
2.
3.
4
The government should raise taxes and lower government spending to reduce the
budget deficit.
We need to try to lower the value of the dollar in order to discourage the
importation of Japanese goods into this country.
Our government should legalize the use of drugs in this country.
Essential Principles of Microeconomics
III.
The fallacy of composition
A common error in the thinking of economists, politicians or even “normal” people, is
that if something happens to one person or a group of people, the same will happen to
society at large. For example, if one farmer increases his production, this will increase
his revenue, because he will sell more products. Because one farmer is only a small part
of the whole industry, additional production by this one farmer will not significantly
lower the price of the commodity. A constant price times a greater quantity sold leads to
an increase in revenue.
However, if all farmers were to raise production, the price of the farmed good would
significantly fall and revenue may not necessarily increase. Indeed, it may decrease if the
relative drop in price is greater than the relative rise in production. Thus, what may be
beneficial for one farmer, is not necessarily beneficial for all farmers combined. This is
an example of the fallacy of composition.
George Reisman, in his book Capitalism, discusses that an increase in demand for a good
leads to a higher price and more of the good sold. Therefore, revenue increases. Based
on this, many economists and politicians conclude that an increase in aggregate demand
(an increase in demand for most products) necessarily leads to greater profits for many
businesses. However, Reisman also points out that because households and other
purchasers of products have a fixed amount of real spending (purchasing power), an
increase in spending on one good or category of goods must necessarily lead to a
decrease in spending on other goods or categories of goods. So what is beneficial for the
producer of one good is likely to be economically harmful to producers of other goods.
An important implication of this realization is that if the government decides to
“stimulate” the economy by encouraging people to spend more on consumer goods (it
usually does this by practically giving the money away through social programs, creating
public works jobs and printing more money), it does not really increase total aggregate
demand. The demand for one particular good or category of goods (those bought by the
elderly, for example, in the case of higher social security paychecks for the elderly) may
rise, but the real demand for other goods will have to fall. Nominal (the monetary
amount of) spending may increase, but real spending will not. Thus, aggregate real
earnings of business will not improve at all.
The economist Henry Hazlitt, in his book Economics in One Lesson, applies a similar
concept. If a hooligan throws a brick to break a grocery store’s window, many people
will argue that this stimulates the economy. They hold that the grocery storeowner will
need to replace the window and thus generate additional work and earnings for glass and
window businesses. However, they forget that the additional expenditures on the
replacement of the window decreases the grocery store owner’s purchasing power and
lowers his spending on other goods and services. The tailor will not be able to sell his
suit.
IV.
Cause and effect
It is tempting to conclude that if one event occurs after another, that the first occurring
event caused the second event. After winning its first three games while you were out
with an injury, you conclude that it was your fault that your baseball team lost its fourth
game as you regained your position in the starting rotation. Of course, your presence
could have something to do with it, but you can not necessarily conclude this. Other
Unit 1 – Fundamentals Concepts
5
variables may have played a role: the weather, the umpire, the opponent, your other
teammates’ performance that day, etc.
Similarly, in economics, people sometimes conclude that if one event follows another,
the other must have caused the one. The period following World War II has seen a rising
standard of living in industrialized countries around the world. This period has also been
accompanied by much greater government involvement in these countries. Can we
conclude that greater government involvement causes higher standards of living?
6
Essential Principles of Microeconomics
Unit 2
Supply and Demand
1.
The Law of Demand
The law of demand states that buyers of a good will purchase more of the good if its price is
lower (and vice versa). If the price of strawberries decreases from $2.00 per pound to $1.00 per
pound, consumers will buy more strawberries.
The law of demand holds, as economists say, “ceterus paribus”, or: “assuming other relevant
variables remain constant.” It would be possible, for example, that as the price of strawberries
decreases from $2.00 per pound to $1.00 per pound, fewer pounds of strawberries are purchased.
One reason may be that buyers’ real incomes decline, so that, even though the price of
strawberries is lower, they just can’t afford to buy as many. Does this then violate the law of
demand? The answer is “no”, because the latter example is an instance where another relevant
variable was not held constant. If all relevant variables had remained constant, then we would
have seen an increase in the purchase of strawberries as a result of a price decrease.
2.
The Demand Curve
Demand data can be graphed in a diagram. The two variables to consider are the price of the
product and the amount of the product purchased during a certain period of time. Economists
usually measure the price of the good on the vertical axis and the quantity on the horizontal one.
In the diagram below, two points are plotted for a particular product (for example, watching an
ice hockey game at the US Air Arena). At ticket prices of $7.00, 13 (thousand) tickets are sold.
And at $14.00 per ticket, only 6 (thousand) seats are sold. Other points can be plotted and a line
or curve can be connected through these points to come up with this good’s demand curve.
Individual product demand curves always extend from the upper left to the lower right, i.e., they
are downward sloping.
Unit 2 – Supply and Demand
7
Figure 2.2
Ø The above diagram shows that on demand curve D consumers buy 13 units at a price of $7
(point A) and 6 units at a price of $14 (point B).
3.
The Law of Supply
The law of supply states that product suppliers (firms) offer more of a product at higher than at
lower prices (just the opposite of the law of demand). If the product price is high, the firm can
make greater profits by selling more (assuming the cost of production is constant and the demand
for the product is there). A video game, for which the demand is high and therefore the price as
well, will be supplied at greater quantities because the higher price makes firms want to supply
more.
4.
The Supply Curve
A supply curve is upward sloping from the bottom left of the graph to the upper right of the
graph. This indicates that at higher prices firms supply more than at lower prices and there is a
direct relationship between price and quantity supplied.
Figure 2.4
Ø The above diagram shows that on supply curve S firms supply 6 units of this product when
the price is $7 (point A) and 11 units when the price is $14 (point B).
8
Essential Principles of Microeconomics
5.
Equilibrium Price and Quantity
In a free market (competitive and with no government involvement) the equilibrium price and
quantity occur where the supply and demand curves intersect. At this price consumers are willing
to buy the same amount which businesses are willing to offer. If the price were below this
intersection point, a shortage would exist. If the price were above equilibrium, we would
experience a surplus.
Figure 2.5
Ø In the graph above, this market is at equilibrium at a price of $11 and a quantity of 9. When
the price is set at $7, a shortage of 7 products (13 minus 6) will result. If the price were $14,
there would be a surplus of 5 units (11 minus 6).
6.
Demand Determinants
The demand schedule (curve) does not always stay in the same position. The following are
reasons why it may change, i.e., why demand increases or decreases:
A.
A change in buyers’ incomes and wealth.
The demand for most products will go up if buyers’ real incomes or real wealth, i.e., their
purchasing power, rise. For example, if I manage to earn $50,000 next year instead of
$40,000 this year (and assuming that there is no increase in the price level so that my real
income increases), I will find myself purchasing more clothes, restaurant meals, etc.
Consequently, the demand for these products increases.
Notice that some products or categories of products may experience a decline in demand
as a result of my higher income, because my higher income allows me to purchase more
expensive (“normal”) substitute products. Typical examples of these so-called
“inferior” goods are potatoes, public transportation, spaghetti meals, generic products,
etc.
B.
Buyers’ tastes and preferences.
Because something is in fashion, the demand for the product may increase. Example:
home videos, fat free mayonnaise and ice cream, online products, and virtual reality
games.
Unit 2 – Supply and Demand
9
C.
The prices of related products or services.
Consider the market for potato chips. The demand for it will go down (assuming no
other changes) if the price of a related good, for example, pretzels, decreases. So, if the
price of a substitute falls, then the demand for the product in question drops (and vice
verse). A related good can also be a complement. This is a product consumed not in
place of, but along with another good. A drop in the price of potato chips dip is expected
to increase the demand for potato chips. So if the price of a complement falls, the
demand for the other product rises (and vice versa).
D.
Buyers’ expectation of the product’s future price.
When a supermarket announces that potato chips will become more expensive in the near
future, more people will tend to buy the product now (and vice versa). This would
increase current demand and shift our demand curve to the right. Notice that this will
have the eventual effect of raising the real price and thus fulfilling the expectation.
E.
The number of buyers (population).
If the population of buyers of a certain product increases, we will experience an increase
in the demand for that product. With the aging of the baby boomers we can anticipate a
rise in the demand for products which senior citizens typically purchase (insurance,
health care, travel, nursing care).
7.
Demand versus Quantity Demanded
Economists distinguish between a change in demand and a change in quantity demanded. These
terms may sound similar but they are different in “econobabble.” Demand increases (or
decreases) when the demand curve shifts. This occurs because of the demand determinants (as
described in the previous paragraph) changed.
Quantity demanded increases (or decreases) because the price of the product changed. This can
be illustrated by a movement along (not a shift in) the demand curve.
Consider the market for ice cream. If people decide to consume more ice cream because their
incomes go up, we speak of an increase in the demand for ice cream. If consumers purchase
more ice cream because the price is lower (because the supply has gone up), we call this an
increase in quantity demanded.
Figure 2.7
Ø In the above graph demand increases as D1 shifts to D2. As a result, quantity supplied
increases and the equilibrium point shifts along the supply curve from point A to point B.
10
Essential Principles of Microeconomics
8.
The Effect of a Change in Demand on Equilibrium Price and
Quantity
Figure 2.8a
Ø When the demand curve shifts to the right, i.e., demand increases, then the market price will
go up, as will the equilibrium quantity (in the short run).
Figure 2.8b
Ø When the demand curve shifts to the left, both price and quantity will decline (in the short
run).
9.
Supply Determinants
Four reasons why firms may supply more of a product are:
A.
Advance in technology.
An advance in the technology of making the product will lower the cost of producing it.
This means that firms will want to supply more of the product.
B.
Prices of inputs necessary to make the product.
When input prices (of labor, raw materials, etc.) go down, the firm can make more profit
per product and will want to increase the supply of the product (and vice versa).
Unit 2 – Supply and Demand
11
C.
Taxes and subsidies.
Taxing the manufacturing of a product will lower the supply (it costs more to make it),
and a subsidy does just the opposite.
D.
The number of firms selling the product.
When more firms decide to enter the market the supply of the product increases, and vice
versa.
Note that any of the above changes will bring about a shift in the supply curve.
10.
Distinguish between a change in quantity supplied and a change
in supply
The distinction between supply and quantity supplied is analogous to the difference between
demand and quantity demanded. Can you describe this distinction?
Figure 2.10
Ø The above diagram illustrates that supply increases as S1 shifts to S2 and quantity demanded
increases as the equilibrium point shifts along the demand curve from point C to point D.
12
Essential Principles of Microeconomics
11.
The Effect of a Change in Supply on Equilibrium Price and
Quantity
Figure 2.11a
Ø An increase in supply is illustrated by a rightward (or downward) shift of the supply curve.
This will lower the price and increase the output sold in the market.
Figure 2.11b
Ø Conversely, a decrease in supply (a leftward or upward shift) will raise the price and lower
the equilibrium quantity.
Unit 2 – Supply and Demand
13
12.
Determine how changes in the demand and supply curves affect
equilibrium price and quantity.
Let’s analyze the following examples.
Figure 2.12a: Suppose that you know that consumers’ incomes have gone up, and that an
advance in technology has lowered the cost of making computers. Assuming that a computer is a
normal good, what will happen to the price and quantity of computers as a result of the above two
changes?
Answer: An increase in consumers’ incomes will increase the demand of computers (D shifts to
the right). Consequently, the quantity will rise and price will either rise, fall, or stay the same,
depending on the size of the shifts in the curves (i.e., price is indeterminate). (This is illustrated
below.)
Figure 2.12a
Figure 2.12b: Buyers expect videotapes to be higher; and at the same time the government
decides to tax the production of videotapes (in an attempt to reduce the budget deficit). What
effect does this have on the market price and output of videotapes?
Answer: Demand increases and supply decreases, therefore the price of videotapes will go up;
equilibrium quantity is indeterminate. Note that when both the demand and the supply curve
shift, one variable undergoes a definite change, but the other is always indeterminate (unless you
know the magnitude of the shifts). When only one curve shifts, both the price and amount bought
and sold will experience a definite change. This is illustrated in the next graph.)
Figure 2.12b
14
Essential Principles of Microeconomics
13.
Determination of Prices in our Economic System
Theoretically the laws of demand and supply are well established and few economists disagree
about the basic nature and the relationships between price and quantity on the demand and the
supply side. However, there does appear to be disagreement about the determination of prices of
some categories of goods and services. Controversy exists as well about whether the
determination of prices should be left solely to supply and demand forces, i.e., the free market, or
whether government should have the right to interfere.
Let’s turn to the first question: are prices of all goods and services in a free, laissez-faire market
economy determined by supply and demand?
Prices of goods that are in limited supply, such as factors of productions (land, labor, etc.),
fluctuate much more with changes in demand than goods which are generally abundant
(manufactured goods, such as cars, grocery items, clothes, etc.). If, for example, the demand for
land in a certain area rises because of increased population and housing activity in this area, one
will see the price of the land increase significantly. The price of the land is affected by the
demand and is capable of remaining high for a long period of time. The supply cannot increase to
bring the price down later, because the factor of production, land, is limited and fixed.
Prices of manufactured goods do not respond to demand and supply forces in this way, at least
not in the long run. When the demand for, say, a retail good, such as running shoes, increases, the
price increases. A higher price for the makers and suppliers of the shoes means that profits will
be higher, assuming that the cost of producing the shoes has remained the same. However, in the
long run these profits will not be sustained. Because the profits exceed the average level of
profits in most other industries, other entrepreneurs will want to take advantage of investing in
this industry. This increases supply and brings the price back down. The price will go down to a
level where profits are normal or average (except in cases where a firm has a monopoly, or a
patent, license, etc.). Consequently the price is set such that it covers the cost of producing the
good plus a fair allowance for a profit. In the long run then, prices of manufactured goods, i.e.,
goods that can be produced in practically unlimited quantities (unlike factors of production), are
based on the cost (including an allowance for profit) or producing the good.
14.
Advantages and Disadvantages of a Free Market System
The next few paragraphs will not do enough justice to adequately cover this topic. However, I
will come back to this important theme throughout the book. A free market or laissez-faire or
pure capitalist economy is one where prices of all goods and services, including wages, interest
rates, wages, foreign exchange values, etc., are set by businesses without any interference from
government in the form of price controls, labor laws or other regulations. The most important
advantage of this is that products are always priced according to their true “worth”, which is
based on demand for factors of production, or cost of production for manufactured goods. If a
manufactured good costs $10 per item to produce, it will be sold for $10 plus a little extra to
allow for a profit. Assuming it is a useful and desired product, consumers will buy it and
producers will produce as many products as the demand dictates. Let’s say now that the
government ordered manufacturers of this product to sell the product for $8. Consumers would
have no problem buying the product at this lower price. However, producers, faced with a cost of
making the product of $10 dollars, would lose money every time they produced the good and
would therefore have no incentive to make the product. Some may produce the product with
Unit 2 – Supply and Demand
15
cheaper ingredients or at a much lesser quality to try to bring the cost down to around $8.; the
initial product, produced at a high quality, will not be produced anymore though.
If the government ordered the price of the product higher than the market price, say $14, then
producers would have no problem selling it for that price as they would experience higher profits
per product. However, the higher price would turn away many consumers and they would
demand much less of the product than at the old price. Consequently, less of the product will be
sold in the market and this constitutes an inefficient allocation of resources.
Any time government interferes with the working of the free market, inefficiencies in the market
occur in the form of shortages, surpluses, misallocations of resources, malinvestments, business
losses, etc. From an economic point of view, this is never desired. The government’s purpose for
interfering is to try to remedy certain social problems. In reality it never appears to be successful
though. For instance, in the case of rent controls in large cities, the government dictates to many
landlords to keep the rent of their apartments, houses, etc. below a certain level. The result of this
is that it becomes unprofitable for many landlords to invest in property or build additional
properties to later rent out. Then rent which the government allows them to charge is just not
worth their expenses and investment. Consequently, fewer properties will now be available and
considerable shortages occur. The lucky few who do manage to obtain a place to rent will pay
less than the market price (at least in the short run), but their dwelling will be much less carefully
maintained, because the landlord will not be able to afford it. But more importantly, the rent
control prevents thousands of unlucky homeless people from acquiring anything because the
artificially low rent discourages many potential builders from building additional apartments and
houses.
16
Essential Principles of Microeconomics
Unit 3
Elasticity
1.
Concept of Elasticity
Now that we are familiar with the law of demand, we can discuss the concept of elasticity. We
know that if the price of strawberries decreases, more will be purchased (ceteris paribus) and vice
versa. We don’t know how much though. The elasticity of a product will tell us. Before we
elaborate on this, let’s take a look at a few more characteristics of a demand curve.
2.
The Derivation of Demand Curves
Economists who work for large firms might be asked to estimate the demand curve of a product
the company is producing. Some ways of doing this are:
1.
2.
3.
Look at historical data and see how consumers have responded to changes in the price of
the product. A potential problem with this might be that many other factors in the
economy have changed, too, so that it is hard to isolate the relationship of only these two
variables.
Experiment with a price change and see how consumers respond.
Survey consumers to see how they might respond to a change in the price of the product.
This is not always accurate because consumers don’t always know in advance how they
will respond to a price change. However, estimates of this demand information will
allow us to graph the demand curve and determine its location and slope.
In reality it is very difficult to pinpoint the exact location of any demand curve. This is because
so many variables related to demand (incomes, technology, the supply curve, etc.) change so
frequently and it is difficult to study the relationship between just price and quantity (which is
what a demand curve represents), holding everything else constant. Any picture of a demand
curve for a particular product therefore, is always an approximation.
Unit 3 Elasticity
17
3.
Price Elasticity of Demand
From the chapter on supply and demand we already learned that as the price of a product rises,
the amount of people buy of it falls. Elasticity measures exactly how much less people buy of
that product when the price rises, or vice versa.
For example, if the price elasticity of demand for soap is 3, then when the price of soap goes up
by 10% people will buy 30% (3 times 10%) less soap.
Price elasticity of demand is defined as:
the percentage change in quantity demanded divided by the percentage change in the
price of the product.
OR:
(change in quantity purchased/average quantity) divided by (the changed in the
price/average price).
This latter formula is called the “arc” price elasticity of demand. There are other ways to
calculate elasticity, but we will restrict ourselves to the formula above.
4.
A Numerical Example
Let’s compute the price elasticity of demand for Mariah Carey concert tickets. Suppose that for
one of her concerts the price of a ticket is $15.00 and that 25,000 people attend it. For another,
similar concert the organizers charge $17.00 and 24,000 fans show up. What is the price
elasticity of demand for tickets in this instance?
Answer:
Using the formula in the previous objective we get:
(1,000/24,500) / (2/16) = .0408/.125 = .3264
So the elasticity in this example is about .33 or 33%. This means that if concert tickets increased
in price by 100% then 33% fewer people would show up.
The true value of the above elasticity is -.33 (minus .33). However, because price elasticity of
demand is always negative, the minus is assumed and left off.
5.
Determinants of Price Elasticity of Demand
What makes people more sensitive to one product’s price change than another product’s price
change? For example, some people will give up buying a car if its price increases by 10%, but
are unaffected by an increase of 50% in the price of a pound of salt.
Three determinants of price elasticity of demand are:
1.
The availability of close substitutes. If a product has many close substitutes, for
example a certain brand of cereal, then people tend to react strongly to a price increase,
i.e. the price elasticity of this product is high.
2.
The importance of the product’s cost in one’s budget. If a product is very
inexpensive, such as salt, consumers could care less whether the price of salt goes up by
10, 20, or even 50%. Salt therefore has a very low price elasticity of demand.
18
Essential Principles of Microeconomics
3.
6.
The period of time under consideration. If you’re looking at the demand for gasoline
over only one day, people will react less strongly to a price increase than if you studied
the effect of a price increase in gasoline over a period of two years. This is because
people have much more time to adjust their consumption in two years than in one day.
Over the course of two years you have the ability to move closer to work or school;
arrange to carpool; buy a more fuel efficient car, etc.
Elasticity, Inelasticity, and Unit Elasticity
There is a simple agreement to distinguish between the above:
A product is price elastic when the elasticity is greater than 1. A product is priced inelastic when
the elasticity is less than 1. A product is unitary elastic when the elasticity is equal to 1.
Note that if elasticity is greater than 1 (elastic), the % change in quantity is greater than the %
change in price (numerator bigger than denominator). For example, if a product’s price rises by
13% and the quantity demanded goes down by more than 13%, then this product is elastic (and
vice versa).
7.
Elasticity
Let’s look at the three cases: elasticity, inelasticity, and unit elasticity.
When a product is elastic, and its price rises, then we expect to see a fall in the sales revenue for
that product. To explain this, note that a firm’s total revenue equals Price times Quantity or P x
Q. In the above case ,P rises but Q falls. Which one changes more?
Answer:
Q, because the product is elastic. So the decrease is bigger than the increase and
P x Q = TR will fall. For similar reasons:
When a product is elastic and its price falls, we will see an increase in TR.
When a product is inelastic and its price rises, we will see a rise in TR.
When a product is inelastic and its price falls, we will see a decrease in TR.
When a product is unit elastic and its price changes ,we will see no change in TR.
8.
Perfect Elasticity and a Competitive Firm’s Demand Curve
The demand curve for a firm in perfect competition is horizontal, or perfectly elastic, because the
output which the firm produces is insignificant compared to the total market size. Thus, the firm
is able to sell any number of products at the same price. It must adhere to the market price
though. If it charges a higher price customers will buy the product from a competitor down the
road (note that in this industry firms sell identical products). The more substitutes, the higher the
elasticity and the flatter the demand curve. A firm cannot sell the product at a lower price either
because then it will lose money and go out of business.
Unit 3 Elasticity
19
9.
Income Elasticity of Demand
Income elasticity of demand measures the change in people’s purchase of a product or service as
a result of a change in their income. For example, if your income rises by 10% and you decide to
buy 20% more bananas, we can conclude that the income elasticity of demand is 2. (% change in
Qd/% change in income). Or in the case of an inferior good, if your income rises by 50% and you
buy 25% fewer hamburgers, the income elasticity demand is –1/2.
Be sure not to leave off the minus sign in the above example. Because income elasticity of
demand can be either positive (in the case of a normal good), or negative (with an inferior
product), the sign must be indicated.
Note that the concept elasticity in general refers to a change in one variable as a result of a change
in another variable. Thus we also have a measure for how much the demand for one product
changes as a result of a change in the price of a competing good (how much will demand for
Pepsi decrease if the price of coke goes down?). This kind of elasticity is called “cross price
elasticity of demand.”
10.
Cross Price Elasticity of Demand
In the case of a product which has a substitute (Coke or Pepsi), the price change of one product
affects the quantity demanded of the other. Cross price elasticity of demand measures this effect.
The formula for cross price elasticity of demand is:
cross price elasticity of demand of product A =
the percentage change in the quantity demanded of product A divided by the percentage
change in the price of substitute product B.
20
Essential Principles of Microeconomics
Unit 4
Business Production Behavior
1.
Production Functions
A production function is a relationship between inputs and outputs. It illustrates how may
workers and machines it might take to produce, for example, one car, two cars, etc. The table
below contains a hypothetical firm’s total production data for cars during a certain period of time.
# of Workers
0
1
2
3
4
5
6
Production of Cars
0
3
7
15
19
22
23
As you can see, total production rises with additional workers. The rise in production is not
proportionate though. The first few workers contribute more per worker than the last few. The
drop in additional production after a certain number of workers (in this example the third worker)
is known as the Law of Diminishing Marginal Product (see also objective on the next page).
2.
Short Run versus Long Run
The short run is a time period in which a business has at least one fixed input (for example, the
production space (building) is fixed).
The long run is a time period in which the firm has the flexibility to change all inputs (buy more
or bigger machines, hire more workers, expand the building, etc.).
How long this is depends on the nature of the business. For a small business long run might be
three months; for a larger, more inflexible business it might be three years.
Unit 4 -- Business Production Behavior
21
3.
Fixed and Variable Inputs
Fixed inputs are resources which the firm keeps constant in the short run. Variable inputs may
increase or decrease as production increases or decreases. Examples of resources that are
typically fixed in the short run: land, heavy machinery, buildings. Resources that are usually
variable in the short run: energy, raw materials, supplies.
4.
Average Product and Marginal Product
Average product is production per worker. Example: if three workers produce 15 cars, average
product is 5. Marginal product is how much an extra worker adds to the output. Example: a
fourth worker joins the company; total production rises to 19; marginal product of this fourth
worker is 4. (Question: What is the average product of four workers? Answer: 4.75)
Calculating marginal and average product from the production function in objective 1 we get:
# of Workers
0
1
2
3
4
5
6
Total Production
0
3
7
15
19
22
23
Avg. Prod.
3
3.5
5
4.75
4.40
3.83
Marg. Prod.
3
4
8
4
3
1
In general, the definition of marginal product is: the change in total production/the change in the
number of workers. In the above table, we have data for each worker from 1 through 6. If we do
not have data for each worker, the table may look as follows, including new values for marginal
product using the definition above.
# of Workers
0
2
4
6
Total Production
0
7
19
23
Avg. Prod.
0
3.5
4.75
3.83
Marg. Prod.
3.5
6
2
Note that in the above table the values for average product have not changed. Only the marginal
product values have because the number of workers for whose production was known skipped by
2 and the general definition had to be applied.
22
Essential Principles of Microeconomics
5.
The Law of Diminishing Marginal Product
The law states that when a firm uses a variable input, such as labor, the productivity of workers
who are hired at a later stage is less than the additional productivity of workers who were hired
first. In the table above the firm can hire form 0 to 6 workers. The additional production of the
second and third workers increases. This occurs because two and three workers are in a position
to specialize and work more efficiently. The specialization opportunities diminish for workers 4,
5 and 6 though.
Because of the fixed inputs, there are not enough machines and offices to comfortably
accommodate these employees. Subsequently, these workers are not as productive as the third
worker. Additional output of the fourth worker is 4 products, the fifth brings in 3 and the sixth
employee only contributes an extra one product. Diminishing marginal product takes affect after
the third worker.
Keep in mind that this law applies to production behavior of a firm in the short run, i.e. one or
more factors of production are fixed (in most cases land or machinery are fixed inputs). In the
long run it is possible to add machines and increase the size of an office, etc., so the reasons for
diminishing returns are non-existent. It is possible, in the long run, that marginal production
declines, but it is for different reasons. In the next unit this concept, called diseconomies of scale,
is explained.
Unit 4 -- Business Production Behavior
23
Unit 5
Cost Functions and Utils
1.
Explicit Costs and Implicit Costs
Economists classify these types of costs: explicit (=accounting) costs, and implicit costs.
Explicit costs are out of pocket, obvious kinds of costs, e.g. expenses on books, tuition, gas, etc..
Implicit costs are not really expenses you incur, but involve income or values you are giving up
by not doing something that you could have chosen to do. For instance, if you decide to go to
school full time instead of working a $20,000 job, you are giving up earning $20,000. This is
your implicit cost. Sample problem: Suppose you are running a small business and incur the
following expenses: labor = $80,000; raw materials = $30,000; finance charges on a loan =
$3,000. You are not paying explicit rent, because you own the building you are operating in. If
you would rent it out, however, you could be earning $12,000. You also estimate your own time
to be worth $25,000. What are your expenses?
Answer:
2.
Explicit costs = $80,000 + $30,000 + $3,000 = $113,000.
Implicit costs = $12,000 + $25,000 = $37,000.
Total economic costs = explicit + implicit costs = $150,000
Accounting versus Economic Profits
To calculate accounting and economic profits we need to know the company’s total revenue.
Let’s suppose it is $140,000. Then, accounting profits are: total revenue minus explicit costs or:
$140,000 - $113,000 = $27,000. Economic profits are: total revenue minus total economic costs
or; $140,000 - $150,000 = -$10,000 (i.e. a loss of $10,000).
The above firm reaps a positive accounting profit; but the negative economic profit indicates that
from an economic point of view, the owner should discontinue the operation.
Unit 5 -- Cost Functions and Utils
25
3.
Total and Per Unit Costs
Seven cost functions which we will discuss are:
1.
Total Variable Cost (TVC) – The cost of all variable resources
Examples: Cost of labor, materials, office supplies
4.
2.
Total Fixed Cost (TFC) – The cost of all fixed inputs
Examples: Cost of the building, large pieces of machinery, certain taxes
3.
Total Cost (TC) – This the sum of TVC and TFC.
4.
Average Variable Cost (AVC) – This is variable cost per product.
5.
Average Fixed Cost (AFC) – This is fixed cost per product.
6.
Average Total Cost (ATC) – This is total cost per product.
7.
Marginal Cost (MC) – This is the cost of producing an additional unit of the product.
Cost Calculations
Using the above abbreviations and Q for the quantity of output:
ATC = TC/Q
AFC = TFC/Q
AVC = TVC/Q
MC = change in TC/change in Q
Example: Let’s suppose you are making 50 bottles of wine each week. You know that your
fixed costs add up to $300, and your variable costs amount to $900. You also know that if you
were to make an extra 5 bottles, your total cost would rise by $60. What is your total cost;
average total cost; average total cost; average variable cost; average fixed cost; and marginal
cost?
Answer:
Total cost = $300 + $900 = $1200
ATC = $1200/50 = $24
AVC = $900/50 = $18
AFC = $300/50 = $6
MC = $60/5 = $12
A table with cost data might show the following:
Q
45
50
55
60
26
TC
1150
1200
1260
1380
TFC
300
300
300
300
TVC
850
900
960
1080
ATC
25.55
24.00
22.91
23.00
AFC
6.66
6.00
5.45
5.00
AVC
18.88
18.00
17.45
18.00
MC
10
12
24
Essential Principles of Microeconomics
5.
Cost Curves
Fig. 5.5a
Fig. 5.5b
The curves above show typical shapes of a firm’s total cost, total variable cost and total fixed cost
curves. Total fixed cost is constant at $50 for all levels of production. Total cost and total
variable cost increase with higher levels of output. Note that total fixed cost and total variable
cost always add to total cost.
The data used in these graphs (figures 5.5a and 5.5b) is taken from the table in Unit 6,
objective 5.
Unit 5 -- Cost Functions and Utils
27
6.
The Long Run Average Cost Curve
The long-run average cost curve is derived from a number of short-run average cost curves. For
each fixed plant size (short run), you look at the lowest costs for that size plant. These bottom
portions of the different short run cost curves make up the long run average cost curve.
Fig. 5.6
â
7.
A firm’s long run average cost curve is the “envelope” of many short run average cost
curves. All inputs are variable and the firm has the choice of building or changing to a
variety of plant or facility sizes. A small operation (SRAC1) which wants to produce 300
units will have average costs of $26. A larger one, which produces 700 units, can
produce each product for $17 (economies of scale). When the firm gets too large
(SRAC6), average costs rise to $20 (diseconomies of scale).
Increasing, Decreasing, and Constant Returns to Scale
Note that increasing returns to scale is closely associated with the concept economies of scale (the
downward sloping part of the long run average total cost curve.) Decreasing returns to scale
relates to diseconomies of scale (the upward part of the curve).
Increasing returns to scale occurs when a firm increases its inputs, and a more than proportionate
increase in production results. For example, one year a firm employs 200 workers and 50
machines and produces 1000 products. A year later it increases the number of workers to 40 0and
the machines to 100 (inputs doubled) and the output rises to a level of 2500 (more than doubled).
Increasing returns to scale is often accompanied by decreasing long run average costs (economies
of scale). A firm which gets bigger may experience this because of increased specialization,
more efficient use of large pieces of machinery (for example, use of assembly lines), volume
discounts, etc.
Decreasing returns to scale happens when the firm’s output rises by less than the percentage
increases in inputs. In the last example, had the firm’s output risen to 1500, we would experience
decreasing returns to scale.
28
Essential Principles of Microeconomics
Decreasing returns to scale can be associated with rising long run average costs (diseconomies of
scale). An organization may become too big, thus creating too many layers of management, too
many departments, and too much red tape. This lead to a lack of communications, inefficiency,
and delays in decision making.
Constant returns to scale occurs when the firm’s output rises proportionate to the increase in
inputs. What would output have to be for this to take place?
8.
Marginal Utility
Marginal utility is the additional satisfaction one gets from consuming one more item of a good or
service. Satisfaction is measured in utils (use your imagination). Let’s say that you are about to
eat a pizza consisting of 6 slices. The first piece might give you 140 utils of satisfaction (you
were starving!). The second slice, your hunger somewhat satisfied after the first, yields you only
60 utils. The third’s down to 20 utils and a possible fourth, if forced upon you, could produce
negative additional utils (your total would drop.)
9.
The Law of Diminishing Marginal Utility
Referring back to the example in the previous objective, you can see that the marginal utility
declines as the person consumes more slices. This is typical of almost all (beer and other
substances known to be harmful to body and soul may be sole exceptions…) consumption: the
more you have of something the less the additional unit is worth to you.
This phenomenon explains why if you are shopping in a supermarket you only buy a limited
quantity of goods. As the marginal utility of, for example, the fifth orange declines, you may
decide that this orange is not worth your additional expense.
Unit 5 -- Cost Functions and Utils
29
Unit 6
Profit Maximization of a
Purely Competitive Firm
1.
Categories of Industries
A firm can be classified in one of four market types:
competition; oligopoly; and monopoly.
perfect competition; monopolistic
These range from most competitive to least competitive respectively. Perfect competition and
monopoly are the two extremes and very few firms can be said to be either purely competitive or
purely monopolistic. However, to better understand the more realistic industry types it is
important to learn about the two extremes first.
Perfect competition is a market structure in which there are many competing firms selling
identical products or services.
Monopolistic competition is a market structure in which there are many firms selling slightly
differentiated products or services. Be sure not to confuse this market with the monopoly market.
They are actually quite different. The emphasis in monopolistic competition should be on
“competition.”
An oligopoly market contains a few firms who dominate the industry and one firm’s actions is
known to very much affect another’s.
A monopoly is an industry with only one seller. The product which the firm sells typically has
no close substitutes. Most monopolies in the United States are regulated by our governments
(state and local).
2.
Characteristics of a Purely Competitive Firm
Characteristics of a purely competitive industry are:
1.
There are many sellers and many buyers
2.
It is relatively east to start a business in this industry
3.
One firm’s product is identical to a competitor’s product (homogeneity)
4.
Buyers of the product have complete knowledge of the price and the quality of the
product
Unit 6 -- Profit Maximization of a Purely Competitive Firm
31
3.
Total Revenue and Profit
A firm derives revenue from selling a product or service. The total sales revenue (TR) is equal to
the number of products sold times the price of the product (Q x P). For example, if a firm sells
100 newspaper subscriptions at $1 per newspaper, its total sales revenue would be 100 x $1 =
$100.
A firm’s profit is its total revenue minus its total cost, or TR – TC. For instance, if the above
firm’s total costs amount to $80, then its profit would be $100 - $80 = $20.
4.
Average Revenue and Marginal Revenue
The marginal revenue and average revenue (demand) curves are horizontal and identical to each
other. To illustrate this, let’s take a look at the following example:
Firm A sells 100 books for $5 each. The next day it sells its 101st book and the following day its
102nd. Both additional books are sold at $5 each. What is marginal revenue and average
revenue?
Total revenue at 100 books is $500; at 101 revenue is $505 and at 102 it is $510. The difference
in revenues per book (=marginal revenue) is $5. Average revenue is also $5. ($500/100;
$505/101; $510/102).
Because the average and marginal revenues are constant at $5, we can see that the average
(=demand) and marginal revenue curves in this purely competitive market are all the same. The
“curve” is drawn as a straight horizontal line.
Fig. 6.4a
â
The marginal and average revenue (=demand) curves for a typical firm in pure
competition are identical: a horizontal line originating from the equilibrium price of the
product.
32
Essential Principles of Microeconomics
Fig. 6.4b
â
5.
The demand curve for all firms combined (i.e. the industry) is still downward sloping, as
illustrated above.
Profit Maximization for a Purely Competitive Firm
The table contains cost data for a firm in perfect competition. Application A assumes that the
market price of economics textbooks is $31.00. What is the best output which this firm should
produce, i.e. at which output is it most profitable?
A quick way to determine this is to compare the values in the marginal cost column with the
marginal revenue (equals the price of $31.00 identifies the output at which profits are maximized.
In table 1 this occurs at output level 7 (marginal cost is $30 at this output). To verify, you can
compute the profit amounts at each output. For example at output 3, total profit is total revenue
minus total cost, or: $93-$110 = -$17. At output 8, profit is $248 - $215 = $33. At output 7 (the
profit maximizing quantity) profit is $37.
Important: When you research for the marginal cost value which comes closest to the marginal
revenue, two further conditions need to exist:
1.
2.
The marginal cost must not be falling (at output 1 marginal cost is also $30, but it
declines thereafter)
Average variable cost must be less than the price; otherwise produce zero output (shut
down).
Unit 6 -- Profit Maximization of a Purely Competitive Firm
33
â
â
â
6.
Output
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
Margina
l Cost
0
1
2
3
4
5
6
7
8
9
$50
50
50
50
50
50
50
50
50
50
0
30
50
60
68
80
100
130
165
220
$50
80
100
110
118
130
150
180
215
270
$30
20
10
8
12
20
30
35
55
Averag
e
Variable
Cost
$30
25
20
17
16
16.67
18.57
20.63
24.44
Average
Total
Cost
$80
50
36.67
29.50
26
25
25.71
26.88
30
Application A: Let’s suppose the above illustrates data for a company selling economics
textbooks in a perfectly competitive market. The current market price is assumed to be
$31. What is the output the firm should produce in order to gain the largest profit?
Answer: Output = 7 textbooks (this is where the firm’s marginal revenue [price] most
closely approaches the marginal cost.)
Corresponding profit: TR-TC = $217 - $180 = $37
Application B: If the market price drops to $21, which output should be produced?
Answer: Output = 6; profit = $126 - $150 = -$24
Application C: Same question if the price plummets to $15.
Answer: Close down (Q = 0), as the price is less than any average variable cost value.
Loss: $50.
Profit Maximization: A Graphic Illustration
A firm maximizes its profits at the output which corresponds to the point where the marginal cost
curve intersects the marginal revenue curve.
The following conditions must also exist: the marginal cost curve must be rising at the point of
intersection. The price of the product must be greater than the average variable cost at the profit
maximizing (or loss minimizing) output.
34
Essential Principles of Microeconomics
Fig. 6.6
In the above example the firm maximizes its profits when it produces 7 units because it is where
MC equals MR; ATC at that output is $25.71. The profit area is the rectangle from the price
($31.00) down to the ATC ($25.71) and across to the vertical axis.
The firm should shut down at least temporarily if the price drops below the shut down price of
$16.00. At a price below $16.00 the firm not only loses money on its fixed costs, but also on its
variable costs. In other words, if it did operate at a price below $16.00, its loss would be worse
than if it produced a quantity of zero (shut down).
7.
The Profit Area
Please refer again to the graph in Fig. 6.6.
At any output, the vertical distance from the demand curve to the average total cost curve
represents the firm’s average profit (price minus average total cost). Multiplying this by the
number of products sold will get you total profit. This is equal to the shaded area (length x width,
or Q x Avg. profit).
8.
The Golden Rule of Profit Maximization (or Loss Minimization)
A firm maximizes profits where its marginal revenue is just equal to its marginal cost.
Graphically this occurs where the MR and MC curves intersect. In a table the MR and MC may
not always be exactly equal. In that case the firm maximizes profits where MC is as close as
possible to MR without exceeding it. Remember that we pointed out that two other conditions
must be satisfied: the price of the product must always be greater than average variable cost
(otherwise the firm must shut down), and when you look for the intersection of MC and MR,
make sure MC is upward sloping.
32
Essential Principles of Microeconomics
9.
Long Run Output and Profit Determination
Because of the relative ease with which new firms can enter industries in which existing firms are
small, economic profits are never exorbitant. If in the short run a competitive firm is reaping
above normal economic profits, venture capitalists (investors) from outside the industry will
become attracted to the profit potential and enter the industry. This increases the supply of the
good and lowers the price of the product. The lower price will lower the existing firms’ above
normal profits.
The reverse is also true: if firms in the industry are incurring losses, then some will eventually go
out of business. The lower supply will raise the price and increase the profits for the surviving
businesses until the profits approach normal levels again. If there is not enough demand for any
businesses to survive, the industry will cease to exist and resources will be allocated into other,
more profitable investments.
Fig. 6.9a
â
Let’s assume that for the perfectly competitive industry above, the equilibrium price is
$31.00 and at that price firms are making positive economic (above normal) profits.
However, this profitable price attracts other firms into this market and shifts the market
supply curve to the right to establish a long run equilibrium price of $25.00 (minimum
ATC value):
Unit 6 -- Profit Maximization of a Purely Competitive Firm
33
Fig. 6.9b
â
Firms are making zero economic profits at this price, as illustrated for a typical firm in
the long run in perfect competition:
Fig. 6.9c
â
At the profit maximizing quantity of 6 the firm’s average total cost equals the price. This
means that economic profits are zero.
34
Essential Principles of Microeconomics
Unit 7
Monopoly
1.
Monopoly Characteristics
A monopoly industry is defined as an industry with only one seller. Typically a monopoly firm is
a large company which sells a product for which there are no close substitutes. Utility
companies, such as BG & E, sell electricity to customers within a certain region. There are
alternative ways to generate electricity, but for all practical purposes, BG & E is the only
company in the Baltimore metropolitan area people can turn to for electricity. Other examples of
monopolies are the U.S. Postal Service (first class letters), local telephone companies, cable
service providers, and the major professional sports leagues. Microsoft holds a near monopoly
position in the software manufacturing market. The DeBeers company has for a long time near
monopolized the diamond industry.
Reasons why monopolies exist range from government restrictions to prevent competitors (Postal
Service, utilities, etc.) from entering the market, to economies of scale allowing a firm to
maintain a competitive position and economically discouraging competitors from entering. In the
former case, the governmental controls the entry to and exit from the market through licenses,
restrictions, and other government laws. This monopoly situation is harmful to the economy,
because it provides a disincentive to the monopolist to be efficient, keep prices low and provide
high quality service. The U.S. Postal Service, gas and electric companies, local telephone
companies, and cable companies are prime examples of companies who, because of their secure
government backed and license protected economic positions, have little incentive to innovate
and provide the best and most efficient service to their customers. Professional occupations such
as doctors, dentists, and lawyers have also received the help from government legislation to
restrict entry into their profession by making it more difficult for newly aspiring doctors, dentists
or lawyers to obtain licenses.
Monopolies arising out of economies of scale are very different from the ones just described.
Whereas the government protected monopolies don’t have to work hard to maintain their
monopoly positions, the companies which have earned their monopoly status through efficient,
low cost operations and by implementing constant innovations (Microsoft), have to constantly
remain on their toes to fend off competitors and to protect their share of the market. Ironically,
these firms get most criticized by economists and politicians (and the small business competitors,
of course) and are often subject to anti-trust investigations by the government.
Unit 7 – Monopoly
39
Frequently, these anti-trust cases are unwarranted and a waste of taxpayer and corporate money.
The mere size of the near monopoly’s operations makes people suspicious that the company
obtained its position in an illegal and unethical way, whereas this is often not the case. Usually
large, successful corporations have become that way because of hard work, outstanding service to
their customers, and a perpetual emphasis on innovation and higher quality products.
2.
The Monopolist’s Demand Curve
Because the monopolist is the industry, the monopolist’s demand curve is the industry demand
curve. This demand curve, as we saw in the chapter on supply and demand, is downward sloping.
Also, because there are no close substitutes for this product, the demand curve is relatively steep,
or inelastic.
Fig. 7.2
â
3.
Typical demand (AR) and marginal revenue curves of a monopolist.
The Monopolist’s Average Revenue and Marginal Revenue
Curves
Average revenue, by definition, is equal to the price of the product, so the AR revenue curve is
the same as the demand curve. The MR curve is in a different location, however. It is downward
sloping and lied below (it’s steeper) than the demand curve.
The following example shows that in a monopoly market the MR is always less than price.
A monopolist produces 100 newspapers (sometimes a newspaper firm can hold a local monopoly)
at a price of $.50. It can also sell 120 newspapers at $.45 per paper; or 140 at $.40. Notice that
when the price changes to $.45 and $.40, the marginal revenue drops to $.20 (4/20) and $.10
(2/20) respectively. To check this, calculate the total revenue at output 100: TR = PxQ = $.50 x
100 = $50. At output 120, TR is: $.45 x 120 = $54. So the marginal revenue equals $4 (the
increase in total revenue) divided by 20 (the increase in output) or $.20. Similarly, the marginal
revenue from output 120 to 140 equals $2 divided by 20 or $.10.
40
Essential Principles of Microeconomics
4.
The Monopolist’s Profit Maximizing (Loss Minimizing) Situation
Similar to the pure competition case, a monopolist maximizes profits by finding out where MC
and MR are equal or almost equal (still contingent upon MC not exceeding MR; MC must not be
falling; and price must be at least as great as AVC).
Remember that profit is TR – TC and average profit is price (AR) minus ATC.
Also note that even though monopolists often make profits, there is no guarantee that they always
do.
Output
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
Average
Variable
Cost
Average
Total
Cost
Marginal
Cost
Price
Total
Revenue
Marginal
Revenue
0
100
200
300
400
500
600
700
800
900
$5000
5000
5000
5000
5000
5000
5000
5000
5000
5000
$0
3000
5000
6000
6800
8000
10000
13000
16500
22000
$5000
8000
10000
11000
11800
13000
15000
18000
21500
27000
$30
25
20
17
16
16.67
16.67
20.63
24.44
$80
50
36.67
29.50
26
25
25.71
26.88
30
$30
20
10
8
12
20
30
35
55
$38
37
36
35
34
33
32
31
30
29
$0
3700
7200
10500
13500
16500
19200
21700
24000
26100
37
35
33
31
29
27
25
23
21
â
Application: Given the above demand and cost data for a monopolist who sells
economics textbooks, what are the profit maximizing output, price, and profit for this
form?
Answer:
Unit 7 – Monopoly
Output
Price
Profit
Average Profit
=
=
=
=
600 units
$32
$19,200-$15,000 = $4,200
$7
41
Unit 8
Monopolistic Competition and
Oligopoly
1.
Characteristics of a Monopolistically Competitive Industry
Four characteristics of monopolistic competition are:
1.
There are many sellers in this industry (lots of competition)
2.
It’s easy for firms to enter this industry and for existing firms to exit
3.
Firms in this industry sell differentiated products
4.
Firms in this industry frequently advertise (usually on a local level).
Characteristics 1 and 2 are the same as in perfect competition. Characteristic 3 means that firms
in this industry sell products that are similar but slightly different. The difference may lie in the
packaging of the product, the ingredients, the service associated with the product, the name of the
product, or the difference may even be only perceived by consumers.
The advertising (characteristic 4) helps to emphasize these differences to consumers. These last
two characteristics also mean that firms in this industry do not all have to charge the same price
for the product. Since the products are slightly different they can change different prices. The
demand curve is therefore downward sloping.
These are good examples of monopolistically competitive industries:
a.
Retail clothing stores
b.
Retail shoe stores
c.
Gas stations
d.
Fast food restaurants
e.
Car dealers
f.
Pizza restaurants
g.
Financial consulting services
h.
Legal services
i.
Video rental stores
Unit 8 -- Monopolistic Competition and Oligopoly
43
2.
Long Run Price and Output Equilibrium in Monopolistic
Competition
Because there are no barriers to entry into this type of industry a firm will not be expected to
make economic profits in the long run. If (for a short while) a firm is making above normal
(=economic) profits, then other firms would quickly enter this industry in order to share in the
profits. The profitable firm’s sales would suffer and in the long run its economic profits would be
zero. The reverse occurs when firms lose money.
Graphically, the long run equilibrium shows the average total cost curve just touching the demand
curve above the output where MC = MR.
The monopolistically competitive firm makes no economic profits (only an accounting profit) in
the long run, so the ATC curve just touches the demand curve (i.e. P = ATC). Profits are zero for
firms in monopolistic competition because there are no barriers to entry. If profits exist in the
short run, new firms would enter the industry to increase supply, lower the price and reduce
economic profits.
3.
Monopolistic Competition as a More Realistic Model
As you can judge from the characteristics, the model of monopolistic competition is more
realistic than the purely competitive one. All firms, small or large, differentiate, if not through
different ingredients, certainly in the way that they package, name, distribute, or service their
products. Advertising is also very common; it benefits the firm because of the greater exposure
to a larger market and often benefits the consumer by informing her/him of the choices available.
Monopolistically competitive firms earn “normal” accounting or so-called “zero” economic
profits. Firms look at their cost of production and then mark up their prices to obtain a reasonable
percentage profit. If any firm marks up its prices too much, another firm will take advantage of it
by changing a slightly lower price. This will cause the first firm to lose market share and the
mark-up will be adjusted accordingly. This competitive process occurs in any industry,
monopolistic competition, oligopoly or monopoly, as long as there is free, unrestricted (from
government legislation) competition. It is rare therefore to see a firm in any unrestricted industry
experience exorbitant, above normal economic profits for an extended, long term period of time.
4.
Characteristics of an Oligopoly Industry
Oligopoly industries are characterized by:
1.
Few (two, three, four, …) sellers who control all or most sales
2.
Barriers to entry (it is difficult to start a new company in an oligopoly industry)
3.
Firms in this industry are interdependent (one firm’s actions very much affect a rival
firm’s well being)
4.
Advertising is prevalent (firms frequently advertise on a national scale).
Oligopoly firms are usually large relative to the market in which they operate. Consequently, if
one oligopoly firm changes its product price or alters another part of its marketing strategy, it will
significantly impact the rival firm(s).
44
Essential Principles of Microeconomics
For instance, if Pepsi lowers its prices to 50¢ per can, Coke will be affected. Coke most likely
will lower its price, too. If this happens neither company will gain a competitive advantage.
These markets are good examples of oligopoly industries:
a.
The automobile industry
b.
The steel industry
c.
The photographic equipment industry
d.
The aircraft manufacturing industry
e.
The beer (wholesale) industry
f.
The cereal (breakfast) industry
g.
Infant formula makers
h.
The oil industry (OPEC)
i.
The airline industry
5.
Collusion and Barriers to Collusion in Oligopolies
When firms collude and behave in a monopoly like fashion they will be able to restrict output and
charge a higher price. Each firm will see its profits increase in the short run as companies engage
in price setting (fixing) and cooperate to keep out competitors.
Collusion and cartels are not legal in the United States. In contrast, legal cartels abroad are fairly
common. The most famous example of an international cartel is OPEC (Oil Producing and
Exporting Countries).
Collusion among producers and retailers may occur legally (outside the U.S.) or covertly.
However, cartels frequently run into problems for the following reasons:
1.
Cartel members’ interests and goals may differ. This makes it very hard to reach an
agreement between members. For instance, in the case of OPEC, Saudi Arabia, Iran,
Iraq, Kuwait and other nearby countries have long fought (recently very literally) about
how much to produce and what price to charge. The fierce disagreement between Iraq
and Kuwait in July of 1990 triggered the war which broke out the following month.
Another OPEC country, Venezuela, is interested in maintaining a high price and
restricting output to preserve its smaller holdings of oil for a longer time.
2.
Even if an agreement has been reached it is tempting for members to secretly cheat and
supply more at the very high monopoly price in order to increase revenue. Of course if
all countries cheat and increase supply the effect of a cartel is completely lost.
3.
At the very high cartel price it becomes increasingly attractive for new producers to enter
the market. In the oil market this has indeed occurred. After the price of a barrel of oil
reached $34 in the late ‘70s, other countries found it profitable to drill and export oil.
England, Mexico, Norway, the United States, and Russia entered the market and through
their competition drove down the price of oil. During the 1980’s and early ‘90s the
average price of a barrel of oil has indeed come down and it has made OPEC’s life a lot
more difficult.
The above examples illustrate that, in the long run, given free and unrestricted
competition, no firm, whether oligopolistic or monopolistic, can be expected to earn
above normal profits. Competitive market forces prevail and ensure a fair price to
consumers.
Unit 8 -- Monopolistic Competition and Oligopoly
45
Unit 9
Distribution of Wealth and
Incomes
1.
United States Income Distribution
How much income inequality is appropriate is a hotly debated topic in this country. That we
should have at least some inequality, nearly everyone, especially after learning from the Soviet
economic failure, agrees on. The current degree of inequality is depicted in the table below.
Inequality has widened recently with the top quintile earning 48 percent of the total earnings and
the bottom 20 percent receiving 4 percent. The long term trend has seen an increasing gap: in
1971 the top twenty percent earned 43.5 percent and in 1981 it was 44.4 percent. Note that this is
not necessary a bad development, because whereas the percentage of some income groups has
declined, the absolute amount of real earnings of all groups has increased.
In other words, even though the income inequality in this country is widening, the overall
standard of living for the large majority of people in this country is rising. In comparison some
people might feel worse off because the wealthy acquire more and higher quality gods, but in an
absolute sense most people can afford to buy more and enjoy much higher quality products than
thirty or forty years ago.
The ability to earn more than others helps inspire people to work harder and strive to innovate
and produce more and better products. Without greater incentives for successful work there
would be dramatically less production, innovation and wealth. If people who did not work, or did
not work hard, would receive the same or similar rewards as people who labored, researched and
invested significant time and resources to produce, the latter would soon lose any motivation to
be productive. The result would be that everyone would work considerably less and few people
would be inspired to innovate. This is what happened in the former Soviet Union and led to its
economic demise. In industrially developed countries, on the contrary, entrepreneurs such as
Henry Ford and John D. Rockefeller helped advance the industrial world through their inventions
in the automobile and oil and petroleum industries in large part because of the rewards associated
with their efforts. In turn they helped many other thousands of people obtain jobs, earnings and
wealth.
A diagram illustrating the extent of a country’s income inequality is drawn in figure 9-1. This socalled “Lorenz Curve” indicates that the further the curve bows outward, the greater the country’s
inequality.
Unit 9 -- Distribution of Wealth and Incomes
47
Percentage Distribution of Households, by Income
INCOME AMOUNT
PERCENT OF ALL
PERCENT OF ALL
FAMILIES
INCOME RECEIVED
(rounded to whole #’s)
Under $17,000
20
4
$17,000 - $30,000
20
10
$30,000 - $45,000
20
15
$45,000 - $65,000
20
23
$65,000 - $110,000
15
28
$110,000 and over
5
20
â
Source: Department of Commerce
Fig. 9.1
â
The Lorenz Curve illustrates the extent of a country’s income inequality. The United
States distribution shows the Lorenz curve traveling through Point A at which 20% earn
only about 4% of all income; and point B where 60% of income earners receive
approximately 30%. The straight line indicates total equality.
48
Essential Principles of Microeconomics
2.
Progressive, Regressive, and Proportional Taxes
A progressive tax is one in which you pay a higher tax rate (percentage) as your income goes up.
A person with $80,000 in income might pay 33% in taxes. A person with only $8,000 might pay
15%
A proportional tax is one where both high and low income earners pay the same rate.
In a regressive tax the low income earner pays a higher rate than the higher income earner.
The following are examples of the various categories of taxes:
Progressive: the federal and state individual income tax (not counting loopholes); the
corporate income tax (ditto).
Proportional: the social security tax, up to a certain level of income; after about $55,000
(1992) it becomes regressive
Regressive: the state sales tax; keep in mind that regressiveness is based on income. 5%
of a poor person’s income may go to state taxes (assuming that a poor person consumes
all of his/her income), while only 2 or 3% of a wealthy person’s income is spent on taxes
(because the rich person doesn’t spend his/her entire income).
3.
Marginal and Average Tax Rates
To illustrate this difference, let’s take a look at this example.
Suppose a person earns taxable income of $40,000 and faces a marginal tax of 28%. What is this
person’s average tax rate?
If, for example, the brackets are:
$0 – 5000
=0%
$5000 – 25,000 =15%
over $25,000 =28%
Then (s)he will pay $0 + $3000 (.15 x $20,000) + $4200 (.28 x $15,000) = $7200 in tax. As a
percentage of his/her total income this is 18.0% (=average tax).
4.
Arguments For and Against Income Inequality
People who favor inequality claim that:
1.
Inequality leads to incentives to work harder
2.
It permits greater savings (rich people save more) and therefore higher investment
3.
Wealthy persons stimulate the production of new, high quality products
4.
If everyone were equal then poor would be helped very little because there are so few
rich to begin with.
People who favor equality believe so because:
1.
Equality leads to more equal opportunities and fewer wasted resources (less conspicuous
consumption).
2.
It increases total consumer satisfaction ($1 – provides more utils to a poor than it does to
a rich person; so take from the rich and give to the poor).
3.
Economic inequality may lead to political inequality.
Unit 9 -- Distribution of Wealth and Incomes
49
5.
Poverty
The poverty cut off amount for a family of four, as determined by the Social Security
Administration, currently stands at around $16,000 (for a single person it is around $9,000). The
Administration uses as a guide the amount an average family spends on necessary food expenses
and multiplies this by three to allow for expenditures on housing, clothing, insurance,
entertainment, etc.. As you can imagine, $16,000 (or $9,000) will not take a family (or person)
very far financially. However approximately 15 percent, or about 38 million Americans currently
earn this amount or less. While keeping in mind that many of America’s poorest still live far
better than many of the wealthiest people in non-industrialized countries, it is nevertheless
disturbing to observe that a country as well as ours should have this much poverty. The next
objective discusses reasons why so many people in our country are poor.
The poverty cut off amount is used by the government to determine who receives financial
handouts and in-kind assistance. Many poor qualify for programs such as AFDC (Aid to Families
with Dependent Children), housing subsidies, food stamps, Medicare or Medicaid, social security
and disability benefits, school lunch vouchers, child care assistance, and a host of other state or
federal programs.
Median United States household income is approximately $34,000. This number varies
significantly across the different racial groups. Blacks and Hispanics on average earn
significantly less than households headed by white income earners.
6.
Causes of Poverty
While some causes of poverty relate to factors beyond a family’s immediate control (economic
depressions, death of a bread winner), most of today’s poverty can be prevented by eliminating
the myriad of government programs which currently exist to sustain and encourage people’s
financial hardships. It is no secret that in industrialized countries, welfare recipients are often
financially better off continuing to receive the government handouts than if they would get off
welfare and work. In other words, there is a strong disincentive to work and be productive.
Some programs encourage families to bear more children as handouts go up with the addition of
dependents and similar programs make it more financially attractive for the husband to leave the
family, as certain programs only target single or divorced mothers for financial assistance.
Because of the size of our population and the variety of program with their numerous restrictions
and conditions, it is often difficult for government welfare inspectors to determine who truly
deserves the handouts and who doesn’t. This flagrant abuse, along with the social and economic
losses caused by broken families and unemployed fathers and mothers, is draining this country of
valuable resources. Taxes which are being paid by entrepreneurs and the working class to
subsidize the handouts discourage these workers from being more productive. Without these
taxes businessmen and women would have considerably more funds to invest and create jobs for
the currently employed. Poor people unable to work (because of a disability) should rely on
private charity (which there would be an abundance of without high government taxation; Henry
Ford, John D. Rockefeller and other successful entrepreneurs donated millions of dollars to
charity). Individuals donating to charity are in a much better situation to assure that the funds are
spent properly without any of the time consuming politics and bureaucratic red tape which
accompanies government programs. It is also very likely that because the money is given freely
and voluntarily that the truly needy will receive more help than they are getting from current
inefficiently run government programs.
50
Essential Principles of Microeconomics
7.
Government Welfare Programs
Social Security
Social Security is a mandatory retirement program in which all United States workers participate.
Of a salaried employee’s gross pay, 7.65% goes to Uncle Sam and the employer contributes a
matching amount as well. A cap of approximately $65,000, beyond which no social security, or
“FICA” contributions are paid, makes the tax regressive. About one and one-half percent of this
contribution goes to paying for Medicare expenditures (see objective 10).
At around age 65 (and older in the near future) a person is eligible for social security income.
Benefits depend on how many years one has worked and the amount of the total contribution. A
person who chooses to work between the ages of 65 and 70 will still receive benefits, but receive
less if (s)he earns more than approximately $12,000 per year. This provides a disincentive for
the recipient to earn additional income.
Many people feel that the system provides a false sense of security. Workers are led to believe
that they will be secure in their retirement days because there is social “security.” Because past
administration have used surplus social security funds to help pay for the deficit, and with many
baby boomers ready to retire in a few years, social security may only serve to provide minimal
benefits to those reaching the “golden years.”
In addition to retirement payments, the program pays funds to other groups in our society, such as
spouses of deceased workers, dependent parents, children whose parents have died and disabled
wage earners and their dependents.
An increasing number of politicians and economists favor phasing in a privatized retirement
program, which allows people to choose their retirement options and guarantees significantly
higher longterm returns.
Medicare, Medicaid, and Unemployment Insurance
Medicare is medical assistance for people over 65.
Medicaid is medical assistance for families and individuals who are poor.
Medicare and Medicaid have cost taxpayers hundreds of billions of dollars during the past years.
The inefficiency with which these programs are run as well as the fraud which is commonplace,
provide reasons to eliminate these programs.
Unemployment compensation includes benefits to people who have lost their job. Employers
bear the brunt of the tax for this fund. Benefits vary per state and individual (depending upon
previous salary) but average around $225 per week and are taxable.
Average length of the duration of benefits is 26 weeks, but recently Congress passed several bills
allowing an extension of benefits for most unemployed.
Unit 9 -- Distribution of Wealth and Incomes
51
Food Stamps and AFDC
The food stamp program provides coupons to needy families, which allows them to purchase
grocery store items. The program costs the federal government roughly $17 billion per year.
AFDC (Aid to Families with Dependent Children) is what people most often refer to when they
discuss welfare. It provides cash payments to families with children whose supporting parent
(usually the father) has left the house.
As is true for the other government welfare programs, AFDC is poorly managed and actually
adds to our country’s poverty because of the disincentives it creates for people to advance
themselves. I recommend that it be phased out and replaced with a system of private charity.
8.
The Negative Income Tax Program
A characteristic of the current welfare programs is that many welfare recipients are better off
receiving the various welfare handouts (AFDC, housing subsidies, food stamps, medicaid, etc.) as
opposed to holding a job. To eliminate this disadvantage, some economists, most notably Milton
Friedman, have suggested a “negative income tax program.”
The negative income tax plan proposes to establish an income level (for instance $10,000) above
which one would pay taxes (as is the case now), but below which one would “pay” negative
taxes, i.e. receive a subsidy from the government. The greater the difference between someone’s
income and this level, the more the subsidy. Advantages are that this system is much simpler and
easier to administrate and that workers always take in more money as their work earnings
increase. A serious disadvantage of this program remains that it is a government administered,
non-voluntary program, which, even though it provides somewhat more incentive to obtain a job,
still enables people to receive financial help without having to work for it. A significant degree
of abuse will still take place.
52
Essential Principles of Microeconomics
Unit 10
Factor Prices
1.
Factors of Production
The three factors of production are land, labor and capital goods. Land includes land and other
natural non-man made materials, such as raw materials, energy sources, and trees. Labor includes
all forms of human productive effort, from blue collar to white collar to professional athletes. We
will refer to all payments for labor as wages (even though it conventionally also includes salaries,
bonuses, etc.). Capital goods represent the man-made machines, equipment, buildings and other
capital goods used to produce consumer goods and other capital goods. Capital is the money
often used to enable businesses to finance the purchase of capital goods. When businesses
borrow money to purchase capital goods they pay interest to financial intermediaries or lenders.
2.
Factor Prices in Free Markets
Without government interference, prices of labor and land are determined by the supply and
demand of these factors available in the market. The less land available, i.e. the less supply, the
higher the price of the land, given a certain amount of demand. The more a certain labor is in
demand, for instance, the talent of a highly skilled tennis player, the higher his or her wages.
Changes in wage rates and prices of natural resources, such as land and raw materials behave
according to price and quantity changes as depicted in the demand and supply diagrams in Unit 2.
3.
Real versus Nominal Prices
Someone’s wages may rise by 10 percent. However, if the general price level rises by 15 percent,
he is worse off measured in terms of purchasing power. In other words, nominal wages (the
dollar amount) may rise; while at the same time real wages (purchasing power) fall.
Nominal interest, as received by bank or any other lender, may be 7 percent. However, if prices
rise by 89 percent, the lender will have lost 1 percent purchasing power. In other words, nominal
interest is 7 percent, but nominal interest is minus 1 percent.
In both of the above cases, the real factor payment is the nominal payment minus the percentage
rise in the price level.
4.
Factor Prices Interferences
The economy functions most efficiently and leads to the fastest accumulation of real wealth if it is
subject to the least amount of government interference. Unfortunately when it comes to factor
prices, there is a significant degree of government interference. The establishment of a minimum
wage means that in many labor markets the wage is higher than the free market price.
Consequently, many people who other wise could have worked and would have worked at the
Unit 10 – Factor Prices
53
lower free market rate, are now excluded from the labor market and find themselves unemployed.
Additionally, the cost of producing is higher, because of the higher minimum wage.
Labor unions, supported by the government and its many pro-union labor laws, also artificially
inflate wage rates. Their collective bargaining powers and strike threats push rates well above
free market rates, raise prices and place companies at an internationally competitive disadvantage.
Furthermore, unions’ restrictions about what workers are allowed to do and how much they are
allowed to work, lead to tremendous inefficiencies in production and significantly raise
businesses’ cost of production. These inefficiencies not only aggravate the firm’s customers
(because service is jeopardized), but also lead to higher prices and unemployment. Not
surprisingly, the industrialized world’s worst economic depression was accompanied by the labor
unions’ greatest rise in power. It is mistake to think that unions are responsible for the better
working conditions and higher wages of the past six decades. Only when unions have suggested
measures which have led to productivity improvements, have they been beneficial. But most of
the time, technological advances and greater profits made possible by business investments and
entrepreneurial efforts have been the real cause of improvements in working conditions and better
wages and benefits. This is because the greater profits have over time enables businesses to
afford these luxuries. Union efforts may have raised workers’ nominal wages. However, real
wages have suffered as a result of union activities.
The real key to improving one’s standard of living is to raise real wages. Real wages rise with
increases in a firm’s productivity. Productivity is a function of technological advances and the
efforts of hard working men and women who are inspired by a just reward system, which
includes few (only necessary) regulations and low taxes.
54
Essential Principles of Microeconomics
Unit 11
International Trade
1.
United States International Trade
In an increasingly international world, the United States is forced to become more sensitive to
trade with other countries. The United States, which relative to other countries is somewhat less
dependent upon imports and exports, is wise to expand its trade horizons and remain globally
competitive if it is to avoid future economic hardship.
Exports in the U.S. currently amount to 10% of our GDP and over half of all imports into the
United States is manufactured products, such as TVs, computers, cars, etc. (in the past over half
of all imports were raw materials).
The United States’ strongest export items include food, high technology products, software, and
services (consulting, insurance).
2.
Absolute and Comparative Advantages
There is one important reason why nations, or for that matter, people trade: trade allows people
to specialize and make those goods they can best produce. Read Adam Smith’s “Wealth of
Nations”! (It’s only about 1100 pages….)
When a country produces a product more efficiently than another country, it has an absolute
advantage in producing that good. It should therefore specialize and trade with another country in
exchange for a product which the other country has an advantage in.
But what if one country is better at making all products? Should it make all products and the
other country nothing? Or is there still an advantage for each country to specialize?
The well known economist, David Ricardo, who lived in the 19th century, concluded and
provided proof that it does pay for each country to specialize in this situation. He suggested that
each country manufacture the produce which it is comparatively (relatively) best at.
For example, let’s consider only two countries, England and France, and let’s suppose that
production consists of only 2 products: wine and cloth. England produces one unit of cloth in 2
hours and one bottle of wine in 20 hours. France produces one unit of cloth in 1 hour and one
bottle of wine in 5 hours. France is better at making both products. However, it is best, i.e. it has
a comparative advantage at making the wine. If France specializes in making wine and chooses
to make, for instance, 10 more bottles it must give up 50 units of cloth. If England produced 60
more units of cloth it would give up 6 bottles of wine. Total production increased!
Unit 11 – International Trade
55
3.
Tariffs and Quotas
A tariff is a tax imposed by the federal government on an imported product. It raises the price of
the imported product and thus lowers the amount people buy of it. A quota is a limit on the
amount which can be sold of an imported product. Because of this cutback in supply, the price
rises. Note that both tariffs and quotas usually lead to an increase in the domestic sales of the
competing U.S. products. As the price of the foreign product rises, the domestic firm will tend to
raise its price as well. Consumers and businesses purchasing the product suffer because they pay
the higher price and face a limited quantity of goods to choose from.
Quotas and tariffs are alike in that they both lower the quantity sold and raise the price of the
foreign good sold in this country. The difference is that in the case of a tariff, the U.S.
government keeps a part of price increase and thus increases its revenue, whereas in the case of a
quota, the higher price goes in its entirety to the foreign manufacturer. No wonder that the
Japanese auto makers were not too unhappy with the quotas on their car sales to the U.S. Yes,
they sold fewer cars, but they also received much higher prices for them. Total revenue declined
very little. Tariffs is what foreign manufacturers definitely do not like. In general, economists do
not favor any form of protectionism as it frequently leads to less competition (and thus les
efficiency), higher prices and retaliation by other countries which eventually lowers our exports.
4.
Protectionist Arguments
The five most common arguments brought forth by economists and politicians in favor of
protectionism (against free international trade) are:
A.
The infant industry argument -- In a country where an industry is just beginning to
develop, it may need to be protected from other countries whose industries are fully
developed. After a few years of protection the industry should be mature and ready to
compete and the protectionist measures (usually tariffs and quotas) should be lifted.
B.
Counteracting dumping and/or foreign subsidies – Japan recently “dumped” its micro
chips in the U.S. as well as other countries, i.e. it sold these chips at prices below what it
costs to make them. It did this, according to the United States, to eliminate the
competition and to establish a monopoly position (after which it of course would be able
to increase the price). To retaliate against this kind of behavior and against unfair
subsidies to foreign producers by their governments, domestic industries may be
protected.
C.
National Security – If a product is used in the manufacturing of military goods or other
security sensitive products, it would not be wise to import it from another country. A
domestic industry may need to be protected to make sure that this industry continues to
supply enough of this product.
D.
Protecting U.S. jobs – Foreign competition may mean that certain domestic businesses
loose sales to foreign companies and will have to lay off workers (steel industry, textile
industry, etc.). To protect these industries and to prevent lay offs, tariffs and quotas may
be imposed.
E.
Improving the trade deficit – A trade deficit is when imports exceed exports. By
cutting back on imports through quotas and tariffs a country might be able to improve or
eliminate the trade deficit.
56
Essential Principles of Microeconomics
As mentioned in the previous objective, most economists do not support the above arguments
other than in exceptional circumstances. Many agree with Adam Smith that free trade, if
practiced fairly by all countries, leads to increased production and a higher standard of living.
Please refer to your copy of the PowerPoint slides for a critique of the above five arguments.
Unit 11 – International Trade
57
Appendix A
Practice Problems
Appendix A Practice Problems
59
Unit 1
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
The best definition of economics is:
monetary policy.
2.
T or F
The United States economy is currently a pure capitalist or a so-called laissezfaire economy.
3.
T or F
Karl Marx and John Maynard Keynes were economists who advocated against
the existence of a free market economy in which economic decisions are made
solely by households and businesses.
4.
T or F
A production possibilities curve represents combinations of output among
which people are indifferent.
5.
T or F
A point on the production possibilities curve illustrates an economic production
combination of maximum efficiency or at a macro economic level, full
employment.
6.
T or F
An increase in its macro economic demand, i.e. when a government increases
the money supply and total spending, leads to higher economic growth.
7.
T or F
The production possibilities curve shifts out as a result of advances in
technology and increases in the countries capital stock.
8.
T or F
Given a fixed stock of resources and technology, additional capital goods can
be produced by producing fewer consumption goods.
9.
T or F
Advances in technology are common occurrences in our country because of our
government’s industrial policy and our advanced system of social welfare.
10.
T or F
If prices increase by 25 percent from one period to another, and nominal wages
have gone up by 20 percent, then real wages have risen.
11.
T or F
The following is an example of a positive economic statement: “If the Fed
increases the money supply, the countries price level rises.”
12.
T or F
The following is an example of a positive economic statement: “The Fed’s
increase in the money supply is desirable to allow consumers to purchase
additional goods and services each year.”
13.
T or F
It is beneficial for one farmer to be more productive and be able to supply more
to the market. Therefore it is beneficial for all farmers to do so.
60
the study of government fiscal and
Essential Principles of Microeconomics
14.
T or F
An increase in demand for one category of products will inevitably lead to an
increase in demand for all other categories of products in our economy.
15.
T or F
If one event follows another, the other must have caused the one.
16.
T or F
Government spending in industrialized countries has increased dramatically
during the past sixty years. The standard of living in these countries has also
gone up. We can conclude that the increased government involvement has
contributed to our higher standard of living.
Unit 2
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
The law of demand implies that people will buy more compact disks at higher
prices than at lower prices.
2.
T or F
The law of supply states that at higher market prices less a product or service
will be offered.
3.
T or F
An increase in demand is identical to an increase in quantity demanded.
4.
T or F
When a demand curve shifts to the right, we can say that both quantity
demanded and quantity supplied increase.
5.
Illustrate in a diagram what will happen to the short run equilibrium price and quantity of
jogging shoes, a normal good, if shoe buyers’ incomes fall.
6.
Illustrate in a diagram what will happen to the short run market price and quantity of
automobiles if the auto manufacturers’ costs of production increase.
7.
Explain through supply and demand analysis what will happen to the average, short run
market price of written books, if:
a.
with the rising popularity of “audio books,” fewer people prefer to buy the
written books.
b.
the cost of paper increases.
Appendix A Practice Problems
61
8.
Illustrate in a diagram what will happen to the price and output of public transportation
(economically speaking, an inferior good) if consumer’s personal income falls and the
government increases its subsidies for public transportation.
9.
When the price of strawberries decreases (because of an increase in supply), we speak of
an increase in ?; whereas when higher incomes make consumers buy more strawberries,
we speak of an increase in ? .
a.
quantity demanded; demand
b.
quantity demanded; quantity purchased
c.
demand; normal goods
d.
demand; quantity demanded
10.
Let’s suppose we are looking at the market for United States dollars in comparison to
Japanese yen. The following two changes (and no other ones) takes place:
1.
Interest rates in the United States fall, making it less attractive for Japanese
investors to purchase U.S. stocks and bonds. Consequently the demand for
U.S. dollars declines.
2.
Japan has chosen to open its borders to United States products, thus allowing
greater imports of United States goods. An increase in purchases of United
States products means more need (demand) by Japanese investors for U.S.
dollars.
Which of the following will happen as a result of the above two changes?
a.
the number of dollars exchanged will rise.
b.
the number of dollars exchanged will fall.
c.
the value (price) of the dollar will rise.
d.
the value (price) of the dollar will fall.
11.
T or F
Long run prices of factors of production that are in limited supply such as land
and labor, increase as their demand increases and vice versa.
12.
T or F
Prices of manufactured goods in the long run increase considerably if their
demand rises, (assuming their cost of production remains constant).
13.
T or F
Government price controls are economically efficient and always solve social
inequities in the long run.
14.
T or F
A free market system allocates goods and services according to the true needs
and demands of consumers and businesses who purchase the products.
15.
T or F
A free market system, i.e. one in which the government exerts minimal control
over economic decisions, is unfair, because it leads to inequalities of incomes
and wealth.
62
Essential Principles of Microeconomics
Unit 3
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
Precise and accurate data about a demand curves location and slope can be
obtained from historical price and quantity changes, price experiments, and
consumer surveys.
2.
T or F
Price elasticity of demand measures the % change in people’s buying behavior
as a result of a % change in the product’s price.
3.
T or F
The meaning of the word elasticity refers to the change in the amount (quantity)
of the good (rather than the price) people buy.
4.
T or F
The more substitutes a product has the more elastic it is.
5.
T or F
The longer the time span you consider for the good’s demand curve, the less
elastic the good.
6.
T or F
The more expensive the product, the less elastic the product is.
7.
T or F
A product is elastic when the value of its price elasticity of demand is greater
than 1.
8.
T or F
A product is elastic when the % change in the amount purchased is less than the
% change in the price of the good.
9.
T or F
Shoe polish is inelastic because people will buy about the same amount of it no
matter what the price (within reason).
10.
T or F
For an elastic product, if the price decreases, sales revenues will increase.
11.
T or F
A perfectly elastic demand curve runs parallel to the horizontal axis.
12.
T or F
If a product has an income elasticity of demand of -.50, then if buyers’ incomes
go up by 10%, purchases will fall by 50%.
13.
T or F
The income elasticity of demand for food is relatively low.
14.
T or F
The demand curve of a single firm in perfect competition is horizontal because
the great amount of competition (perfect substitutes) does not allow the firm
control over the price.
Appendix A Practice Problems
63
15.
The Baltimore Spirit is trying to decide at which price they should sell their tickets. In
the past they have found that at $7.00/ticket they could sell 35,000 tickets, while at
$9.00/ticket they sold to 28,000 soccer fans. If the Spirit’s goal is to maximize revenue,
you should recommend the ? price as the product is ?.
a.
$7, inelastic
b.
$7, elastic
c.
$9, inelastic
d.
$9, elastic
e.
$7 or $9, unit elastic
16.
Price elasticity of demand measures:
a.
the % change in how much people buy of the product as a result of a % change
in the product’s price.
b.
how sensitive people are to a price change.
c.
the % change in quantity demanded divided by the % change in the product’s
price.
d.
the % increase in how much people buy of a product because of a % decrease in
the product’s price (and vice versa).
17.
Literally, the meaning of elasticity refers to how much something stretches, or how
flexible something is. Applying this meaning to the concept “price elasticity of demand,”
what is it that is elastic (or inelastic)?
a.
consumer incomes (Y)
b.
firms’ total revenues (TR)
c.
the price of the product (P)
d.
the amount purchased (Q)
18.
Suppose that a “Boyz II Men” concert ticket costs $27.75 and 43,000 fans attend the
concert at this price. A nearby theatre also sponsored a concert by the same artists two
weeks earlier and charged $32.25. Thirty-seven thousand (37,000) fans attended this
concert. The price elasticity of demand for tickets based on this example is:
a.
0.75
b.
1
c.
1.5
d.
6.7
e.
10
19.
In the previous example, price elasticity of demand for the concert tickets is ? and sales
revenue ? as a result of the price decrease.
a.
inelastic; declined
b.
inelastic; increased
c.
unit elastic; remained constant
d.
elastic; declined
e.
elastic; increased
64
Essential Principles of Microeconomics
20.
Gasoline is generally considered to be inelastic, especially in the short run. Which would
be a good reason why gasoline is inelastic in the short run?
a.
It does not have a lot of good substitutes.
b.
It is relatively inexpensive as a portion of one’s total income.
c.
It takes consumers a while to adjust to a gasoline price change.
d.
Firms can sell a lot of gasoline at today’s prices.
21.
Please calculate the following:
a.
A supplier of digital audio tapes finds that if she lowers the price from $13 per
tape to $11 per tape, she can sell 220 rather than 180 tapes per week. What is
this supplier’s price elasticity of demand for DAT’s?
b.
Is this considered elastic, inelastic, or unit elastic?
c.
How did her sales revenue change?
22.
The Baltimore Orioles notice that as they increase their ticket price from an average of
$12 to an average of $16, their revenue rises from $240,000 to $288,000 per game.
a.
What is the price elasticity of demand for a Baltimore Oriole ticket?
b.
Is it elastic, inelastic, or unit elastic?
23.
Let’s suppose that McDonalds has calculated that for every 10% increase in consumer’s
incomes the sales of its cheeseburgers falls by 20%.
a.
What is the income elasticity of demand for McDonalds cheeseburgers?
b.
What kind of economic good is a McDonalds’ cheeseburgers.
24.
Calculate the cross price elasticity of demand for potato chips if, as a result of ten percent
increase in the price of pretzels, the weekly quantity demanded of potato chips increases
from 500 bags to 600 bags.
Unit 4
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
If a business adds more of a variable input (labor for example) to a fixed input
(a certain office space, for example), then its output will continue to increase.
2.
T or F
If a business adds more of a variable input to a fixed input, then the marginal
production of workers who are hired much later is less than the output which
the first few workers contribute.
3.
T or F
A firm’s marginal production typically declines after a certain point in the short
run because of government regulation.
4.
T or F
A production function shows the relationship between inputs and outputs. For
example, it may show that two workers produce 6 computers, whereas, four
workers produce 10.
Appendix A Practice Problems
65
5.
T or F
When a firm can vary the use of at least one input, we speak of a time period
called “the long run.”
6.
T or F
When at least one input is fixed within a certain time period, we are in the short
run.
7.
T or F
Average product of labor is total output divided by the number of workers
divided by two.
8.
T or F
Marginal product of labor is the difference in the quantities produced from one
worker to the next.
9.
Examples of fixed inputs in the short run, typically are:
a.
salaried employees on a five year contract.
b.
raw materials.
c.
the amount of land used for production.
d.
temporary workers.
e.
office supplies.
10.
Please complete the following table:
Number of
Workers
0
1
2
3
4
5
11.
66
Marginal
Production
Average
Production
0
12
14
12
40
2
Please complete the following table: (note that marginal output is the change in output
per (1) worker).
Number of
Workers
0
2
4
6
8
12.
Total Production
Total Production
Marginal
Production
Average
Production
0
60
40
40
300
In the previous table, the law of diminishing marginal returns begins with the ? worker.
a.
second
b.
fourth
c.
sixth
d.
eighth
Essential Principles of Microeconomics
Unit 5
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
Economic costs include a reasonable, estimated salary to the owner(s) of the
business.
2.
T or F
If a company earns economic profits of zero, the owner will have no earnings
that year.
3.
T or F
The implicit cost of going to school is the money you spend on books, paper,
pencils, etc.
4.
T or F
The explicit cost of going to school is all of the out-of-pocket or visible costs
associated with attending school.
5.
T or F
The cost of a building is usually a fixed cost to a company.
6.
T or F
Total Fixed Cost + Total Marginal Cost = Total Cost, and Average Total Cost =
Total Cost Output.
7.
T or F
Average Variable Cost = Total Variable Cost x Total Fixed Cost.
8.
T or F
Average Fixed Cost remains constant as a firm produces more products.
9.
T or F
Marginal cost first increases then decreases as output goes up.
10.
T or F
The MC curve intersects the AFC and the ATC curves at their bottom points.
11.
T or F
Economies of scale can be illustrated by the downward-sloping portion of the
LRAC.
12.
T or F
Large firms can take advantage of economies of scale because they can afford
to buy large pieces of machinery which produce more efficiently, and purchase
large quantities of inputs at volume discounts.
13.
T or F
The big three auto makers (GM, Ford, and Chrysler) can take advantage of
economies of scale because of the efficiencies of mass production.
14.
T or F
The above mentioned car manufacturers also suffer from dis-economies of
scale. These arise when a company gets too large and too many layers of
management cause the channels of communication to break down.
Appendix A Practice Problems
67
15.
A firm finds that 50 workers and 20 machines produce 300 units of output. When it
doubles its inputs to 100 workers and 40 machines, it increases its production to 700.
This is an example of:
a.
law of diminishing marginal returns.
b.
decreasing returns to scale.
c.
constant returns to scale.
d.
increasing returns to scale.
16.
Consider the following weekly costs which Firm R incurs:
Materials, Supplies
$2300.00
Employee Salaries
$6000.00
Utilities and Taxes
$1800.00
Estimated value of the owner’s time
$840.00
Rent (the owner does not own the building)
$800.00
Interest paid on loan
$100.00
Estimated interest foregone on owner-supplied
funds (He used $80,000 of his own money;
the current rate of interest is 10%)
$160.00
Firm R receives revenue from the sale of its micro computer equal to $11,500.00/week.
Answer the following please:
a.
What are Firm R’s explicit costs?
b.
What are Firm R’s implicit costs?
c.
What are Firm R’s economic (total) costs?
d.
What are Firm R’s accounting profits?
e.
What are Firm R’s economic profits?
f.
From a pure economic/financial point of view, should Firm R continue to
operate on the basis of these costs and revenue?
17.
Fill in the missing values in the following table:
Output
0
1
2
3
4
5
6
7
18.
TVC
TFC
ATC
AVC
MC
40
50
30
30
40
260
300
Fill in the missing values in the following table:
Output
0
5
10
15
20
68
TC
30
TC
400
TVC
TFC
ATC
AVC
MC
140
500
1300
140
Essential Principles of Microeconomics
19.
T or F
A util is a measure of a firm’s additional output.
20.
T or F
Marginal utility is the change in total satisfaction from consuming additional
products or services.
21.
T or F
The owner of two identical cars derives a certain amount of satisfaction from
the possession of these cars. If the total amount of satisfaction from the two
cars equals 1000 utils, then we can conclude that each car provides the owner
with exactly 500 utils.
22.
T or F
The law of diminishing marginal returns implies that the owner of an orange
values the possession of one orange (if he purchases only this one) more than
the possession of a second or third orange if he purchases more.
Unit 6
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
Various industries in the United States currently operate under a purely
competitive market structure.
2.
T or F
Firms that are classified as “monopolistically competitive firms” face little or
no competition and often offer a product which is inferior to ones supplied by
purely competitive firms.
3.
T or F
An oligopoly market is one in which a few firms provide the lions share of the
market and firms actions are usually interdependent.
4.
T or F
A single firm in purely competitive market faces a downward sloping demand
curve.
5.
T or F
Average revenue is total revenue divided by output; therefore: AR=TR/Q or
AR = PxQ/Q or AR = P.
6.
T or F
A firm’s total revenue (TR) is equal to the price of the product (P) times the
number sold (Q).
7.
T or F
Total profit can be calculated by subtracting total cost from total revenue, or by
multiplying the amount sold by the average profit.
8.
T or F
A firm’s average profit equals the total profit divided by the amount sold.
9.
T or F
Graphically, a firm’s profit maximizing output can be found by identifying the
intersection of the rising part of the MC curve and the MR curve and making
sure that P<AVC min.
Appendix A Practice Problems
69
10.
T or F
Firms in perfect competition are frequently very profitable, even in the long
run.
11.
T or F
Graphically, a firm’s shut down point occurs at the bottom point of the AVC
curve.
12.
T or F
When firms in pure competition earn below normal, or negative economic
profits, in the long-run, some will go out of business. This decreases supply in
the market, and raises the market price.
13.
Let’s suppose that the Baltimore Orioles sold four million tickets last year at an average
price of $10.00 (hypothetical example). Other revenue equaled $45 million. The club’s
operating costs amounted to $77 million. Assuming it had no other costs or revenues,
how much profit did it make?
a.
$7 million
b.
$8 million
c.
$18 million
d.
$27 million
e.
$100 million
14.
T or F
15.
Which of the following is the “Golden Rule” of Profit Maximization?
a.
First make sure that price does not exceed AVC min. (otherwise shut down);
then look for the output for which a rising MC is equal to or comes closest to
(without exceeding) MR.
b.
First make sure that P>AVC min. (otherwise shut down); then look for the
output for which a falling MC is equal to or comes closest to (without
exceeding) MR.
c.
First make sure that P<ATC min; then look for a quantity for which MC=MR.
d.
First make sure that P>ATC min. (otherwise shut down temporarily); then look
for the output for which MC=MR. Make sure that MC is on the rise.
16.
The following is a table with a firm’s Total Variable Cost data:
A price ceiling is a price below the market price and creates a shortage.
0utput
0
5
10
15
20
25
30
TVC
0
300
550
750
1050
1350
1700
The firm’s shutdown point occurs at or near (hint: find AVC):
a.
P = $60
b.
P = $55
c.
P = $50
d.
P = $47.5
e.
P = $45
70
Essential Principles of Microeconomics
17.
Consider the following table with data of a hypothetical Nintendo video manufacturing
business and answer the questions below, please.
Output
0
5
10
15
20
25
30
35
40
45
50
a.
b.
c.
18.
TC
100
180
255
320
395
475
565
660
770
905
1080
ATC
AVC
MC
36
25.5
21.3
19.8
19
18.8
18.9
19.3
20.1
21.6
16
15.5
14.7
14.8
15
15.5
16
16.8
17.9
19.6
16
15
13
14
16
18
19
22
27
35
Let’s assume that the price of a Nintendo Video Game (which is sold in a
perfectly competitive market and for which the cost functions are given above)
is $23. What is the profit maximizing (loss minimizing) output and profit (loss)
of this firm?
Same question if the price of the game drops to $18.50.
Same question if the price of the game falls to $13.00.
Consider the following table with cost an revenue for a firm in pure competition which
sells computer software.
Output
0
10
20
30
40
50
60
70
80
90
a.
TC
1000
1600
2100
2500
2800
3200
3700
4300
5000
5800
ATC
AVC
MC
60
50
40
30
40
50
60
70
80
160
105
83.33
70
64
61.67
61.43
62.50
62.44
60
55
50
45
44
45
47.14
50
53.33
Calculate this firm’s profit maximizing output and quantity when the market
price of the computer software equals $58. What is the firm’s profit (loss)?
Appendix A Practice Problems
71
b.
c.
d.
e.
Answer the same question, but now the price of the software is $66.
Answer the same question. The market price of the software dropped to $42.
Answer the same question. The market price is now $61.43.
Answer the same question for a price of $44.
Unit 7
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
Government created monopoly firms, such as BG&E and the U.S. Postal
Service, exist only by government approval and therefore have little incentive
to be efficient.
2.
T or F
Some firms (for instance, Microsoft) have obtained a significant degree of
monopoly power because they have been most innovative and because they
have been able to achieve lower costs than their competitors.
3.
T or F
All monopolies or near monopolies are socially undesirable because they do not
allow small competitors to participate in the market.
4.
T or F
The true economic loss in the case of monopolies occurs when in industries
where firms have obtained government permission to be the sole producer,
other firms (potential competitors) have been robbed of the opportunity to
produce and provide a more efficient and higher quality good.
5.
T or F
A monopolist’s demand curve is a downward-sloping demand curve.
6.
T or F
A monopolist’s marginal revenue curve is identical to its demand curve.
7.
T or F
A monopolist maximizes profits by choosing that output and price which
correspond to a marginal cost value equal to or as close as possible to (without
exceeding) the marginal revenue value.
8.
T or F
A firm’s average profit is equal to the product’s price minus the ATC at the
output produced.
9.
T or F
Monopolists, because of barriers to entry, always earn an economic profit in the
long-run.
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Essential Principles of Microeconomics
10.
Consider the following table with a monopolist’s cost and revenue data and answer the
questions below:
Output
0
5
10
15
20
25
30
35
40
45
Price
16.00
15.00
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
TR
0
75
140
195
240
275
300
315
320
315
TC
60
120
170
215
250
280
310
360
430
530
MC
12
10
9
7
6
6
10
14
20
a.
Determine the profit maximizing (or loss minimizing) output and price for the
above monopolist.
b.
Calculate the profit (or loss) for the output in a.
c.
Calculate the average profit (or loss) for the output in a.
Appendix A Practice Problems
73
Consider the following table with a monopolist’s cost and revenue data and answer the
related questions.
Output
0
50
100
150
200
250
300
Price
6.50
6.00
5.50
5.00
4.50
4.00
3.50
TR
0
300
550
750
900
1000
1050
TC
150
350
525
675
800
950
1125
MC
4
3.5
3
2.5
3
3.5
11.
In the above table, the profit maximizing output is ? and the price which the monopolist
will charge is ?
a.
50; $6.00
b.
100; $5.50
c.
150; $5.00
d.
200; $4.50
e.
250; $4.00
12.
In the above table, the firm makes a total profit of ? and an average profit of ?
a.
$25; $.25
b.
$50; $.20
c.
$75; $.50
d.
$100; $.50
e.
$125; $.75
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Essential Principles of Microeconomics
Unit 8
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
Most retail stores are monopolistically competitive firms.
2.
T or F
There are significant barriers to enter a monopolistically competitive industry.
3.
T or F
The demand curve of a typical firm in m.c. is downward-sloping and less
elastic (less steep) than a monopolist’s demand curve.
4.
T or F
The firm in monopolistic competition maximizes profits by finding that price
and output at which MC equals MR or where MC comes closest to MR without
being less than MR. (All this, of course, contingent upon the condition that
P>AVC min. and MC must be falling.)
5.
T or F
If a firm in m.c. makes an economic profit in the short-run, new firms will want
to enter. This increases supply in the market, lowers the market price, and
eventually eliminates the economic profit of the company.
6.
T or F
A monopolistically competitive firm’s economic profits are always positive in
the long-run.
7.
T or F
All firms differentiate in one way or another.
8.
T or F
Advertising is prevalent in all structures, but harms the consumer by increasing
the cost to the firm and therefore raising the price of the product.
9.
T or F
Firms in monopolistic competition usually mark up their price well beyond
their cost of production and subsequently often enjoy significant economic
profits for extended periods of time.
10.
T or F
Collusion occurs in oligopoly industries because the few large firms sometimes
agree (implicitly or explicitly) to certain price and marketing strategies.
11.
T or F
Collusion is seldom effective in the long run, because exorbitantly high prices
lead to excessive profits and this attracts outside investors who enter the
industry, provide competition and eventually bring the price back down.
12.
Which one of the following is not a characteristic of a m.c. industry?
a.
There are many firms in the industry.
b.
Firms in the industry sell slightly differentiated products.
c.
Firms in the industry are interdependent.
d.
It is relatively easy to enter this industry.
e.
Firms advertise.
Appendix A Practice Problems
75
13.
Which one or more of the following is not a characteristic of an oligopoly industry?
a.
There are only a few (2, 3, 4, …) firms in this industry.
b.
There are barriers to enter this industry.
c.
Firms in this industry are interdependent.
d.
Firms in this industry are subject to government pricing controls.
e.
Firm advertise, usually on a local scale.
14.
Which one of the following is not an example of an oligopoly industry?
a.
The automobile manufacturing industry (domestic).
b.
The U.S. steel industry.
c.
The U.S. beer industry (wholesale).
d.
The breakfast cereal industry.
e.
The computer retail industry.
15.
Which of the following is a characteristic which distinguishes a perfectly competitive
firm from one in monopolistic competition?
a.
Barriers to entry.
b.
Economic profits in the long-run.
c.
Average total cost in the long-run.
d.
The number of firms in the industry.
16.
Which of the following is(are) characteristic(s) of monopolistic competition?
a.
There are few sellers, who dominate the sales in that industry.
b.
There are barriers to entry.
c.
There is only one seller.
d.
The firm could make economic profits in the long-run.
e.
The product which the firm sells has no close substitutes.
Unit 9
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
Income inequality is economically desirable, because it reflects people’s
different motivations, skills, and ability to innovate. It provides those who are
more productive the ability to reap higher rewards and they would therefore
have the incentive to continue to be productive.
2.
T or F
The Lorenz Curve illustrates a country’s income inequality. The straighter the
curve, the more income inequality exists.
3.
T or F
Because the gap between the higher income groups and the lower income
groups has widened the past several decades, it can be concluded that the rich
have gotten richer and the poor have gotten poorer.
76
Essential Principles of Microeconomics
4.
T or F
Wealth accumulated by entrepreneurs and business owners benefit others in
society because it creates further production and employment, higher quality
products and a greater standard of living.
5.
T or F
Anytime the government redistributes incomes from the higher incomes to the
lower ones, it hurts economic efficiency and leads to malinvestment.
6.
T or F
When someone pays $2,000 on earnings of $20,000 and another person pays
$3,000 on income of $40,000, we are speaking of a progressive tax.
7.
T or F
The individual income tax is a progressive tax.
8.
T or F
The Social Security program discourages persons over 65 and under 70 from
working.
9.
T or F
Medicaid provides medical assistance to the elderly.
10.
T or F
AFDC provides aids to farmers and disabled construction workers; it provides
an incentive for these workers to leave their spouses and collect welfare.
11.
T or F
A negative income tax program would pay a cash subsidy to persons earning
below a certain amount.
12.
T or F
A negative income tax would eliminate the disadvantage that a person would
earn less on the job than on welfare.
13.
T or F
Welfare programs in the United States and other industrialized countries often
are abused and lead to social harm because of the disincentive the programs
create for people to find work and to stay with their spouses.
14.
T or F
Relying on private charity as a system to provide for the truly needy is not
effective because people who are supposed to provide the charity (wealthier
individuals) are known to be greedy and share little with others. Furthermore,
the high taxes these people pay discourages them from giving up even more.
Unit 10
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
Prices of all factors of production are directly determined by the supply and
demand of these factors (in a free market system).
2.
T or F
An increase in a person’s nominal wage is always an increase in that person’s
purchasing power.
Appendix A Practice Problems
77
3.
T or F
If a nominal interest rate is 12 percent, and inflation is 8 percent, then the real
interest rate is 4 percent.
4.
T or F
A government imposed minimum wage leads to unemployment and higher
prices.
5.
T or F
Unions are in great part responsible for the higher real wages many unionized
workers in the United States currently enjoy.
6.
T or F
Real wages, i.e. purchasing power, increase as a result of greater productivity.
Productivity rises mostly because of advances in technology and work efforts
by laborers and entrepreneurs inspired by a just reward system to low taxes and
little regulation.
Unit 11
Please circle the correct response or answer in complete English the following short essay
questions. In the case of a True/False question also explain why the statement is false if you
circled F. Multiple Choice questions may have only one answer.
1.
T or F
The United States has an absolute advantage in producing computers if it can
produce computers with fewer resources than steel of the same height and
weight.
2.
T or F
If a country has an absolute advantage in producing all existing goods and
services, it has no reason to specialize and trade with other countries.
3.
T or F
The law of comparative advantage implies that if a country has an absolute
advantage in producing two goods, it should specialize and trade in that good
in which it is most efficient.
4.
T or F
Belgium produces potatoes at two-man hours per bushel and Chile at four man
hours per bushel. Belgium could also manufacture cloth; it would be produce
one unit of cloth in five-man hours, and it would take Chile six man hours to
make one unit of cloth. According to the law of comparative advantage, Chile
should specialize in potatoes and Belgium in cloth.
5.
T or F
Free international trade is generally beneficial because it raises total world
output and the standard of living of the individual trading countries.
6.
T or F
The infant industry argument is often abused by governments as they protect
industries that (after many years of protectionism) are, or should be, mature
and not in need of protectionism anymore.
7.
T or F
When a country protects certain industries against foreign competition in order
to save domestic jobs, it helps to maintain a low rate of unemployment and
inflation in the country.
8.
T or F
Exports account for about 25% of GDP in the United States.
78
Essential Principles of Microeconomics
9.
T or F
According to Adam Smith, people and nations should not trade because it leads
to self-sufficiency, greater output, and a higher standard of living.
10.
T or F
A tariff is a limit on the number of goods which a country chooses to import.
11.
T or F
Tariffs and quotas raise the price of imported products to the consumer.
12.
T or F
Tariffs and quotas provide a competitive advantage to domestic producers of
the protected good.
13.
T or F
Most economists favor protectionism, not free trade.
14.
Of the following, which is not an argument in favor of protectionism?
a.
the national security argument
b.
the reverse specialization and buyback argument
c.
the infant industry argument
d.
protectionism protects jobs in certain industries
e.
protectionism helps counter foreign subsidies and dumping
15.
The United States can produce one VCR in 8 hours and one bushel of corn in 10 hours.
Canada, on the other hand, produces one VCR in 25 hours and one bushel of corn in 20
hours. According to the law of comparative advantage, the United States would benefit
by specializing in:
a.
both products.
b.
VCR’s.
c.
Corn.
d.
Neither product.
16.
Economics is:
a.
fun.
b.
fascinating.
c.
fantastic.
d.
fabulous.
e.
all of the above.
f.
a. and e. only.
Appendix A Practice Problems
79