Economics: Microeconomic Analysis Flashcards
1
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Demand and Supply: Types of Market
A
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Factor markets: Factors of production
- Raw materials, labor, etc.
- Firms are buyers
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Product Markets: Services and Finished Goods
- Firms are Sellers
- Intermediate Markets: One firm’s finished products (components) used in the production of another firm’s output.
2
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Demand and Supply: The Demand Curve
A
QDX = f (Px, I, Py,…)
Quantity demanded is a function of:
- Price of Px
- Individuals income i
- Price of related products (Py)
- Many other factors may be added
Law of Demand: Typically, quantity increases as price decreases
3
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Demand and Supply: The Supply Function
A
QSX = f (Px, Cx, …)
Quantity supplied is a function of:
- Price of good Px
- Cost of production Cx
- Labor cost
- Material cost
- Production overheads
- Technology
- Many other factors may be added
4
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Demand and Supply: Shifts and Movements
A
Changes in price (Px) cause movements along the supply and demand curves.
5
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Demand and Supply: Aggregating Demand and Supply Curves
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Market supply = aggregate of the supply functions of the firms in the market
The same approach can be used to formulate market demand
Example: 50 firms in the market
- Supply function: Qs = -250 +2.5Px
- Market supply = Qs = -(50 x 250) + (50 x 2.5 Px)
- Qs = -12,50 + 125Px
- Invert function: Px = 0.008Qs + 100
- 0.008 = slope coefficient of supply curve
6
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Demand and Supply: Equilibrium Quantity and Price
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7
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Demand and Supply: Movement to Equilibrium: Supply > Demand
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8
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Demand and Supply: Movement to Equilibrium: Demand > Supply
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9
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Demand and Supply: Stable and Unstable Equilibria
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- Stable: Market forces move price and quantity back to equilibrium.
- If downward sloping, supply curve must cut demand curve from above to reach stable equilibrium.
10
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Demand and Supply: Calculation of Equilibrium
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- Supply function: Qs = -600 + 10Px
- Demand function: Qd = 3,000 - 15Px
- Equilibrium: Supply = Demand
-600 + 10Px = 3,000 - 15Px
Solve for Px Qs = -600 + 10 (144) = 840
3600 = 25Px Qd = 3,000 - 15(144) = 840
Px = 144
11
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Demand and Supply: Excess Demand and Supply
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Supply function: QS = -600 +10Px
Demand function: QD = 3,000 - 15Px
12
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Demand and Supply: Auctions: Common and Private Value
A
Alternatives to markets for establishing equilibrium prices
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Common value auction
- Value of items same for all bidders
- Bidders do not know value at time of auction
- Beware: Winner’s curse
- (e.g. mining rights)
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Private value auction
- Value of item different for all bidders
- Maximum bid is that value the item has for the bidder
- (e.g. antiques auctions)
13
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Demand and Supply: Auctions: Ascending Price and Sealed Bid
A
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Ascending Price Auction (English Auction)
- Bidder must bid higher than previus bid
- Bids publically disclosed
- Process continues until no one is willing to bid higher
- Highest bidder wins and pays bid price (last bid made_
- (e.g. automobile auctions)
-
Sealed bid auction
- Each bidder provides one bid
- All bids remain unknown to other bidders (concealed)
- Highest bid wins and pays bid price
- Optimal bid < reservation price
- (e.g. government contracts)
14
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Demand and Supply: Auctions: Second Price Sealed Bid and Descending Price
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Second price sealed bid auciton (Vickrey auction)
- Each bidder provides one bid
- All bids remain unknown to other bidders (concealed_
- Highest bid wins and pays price of second highest bidder
- Optimal bid = reservation price
- (e.g. stamp collecting [apparently]
-
Descending price auction (Dutch auction)
- Starts with a price > bidders are willing to pay
- Reduces price until bidder agrees to pay
- Bidder normally states quantity
- Price is then further reduced until all is sold
- Bidders pay price bid
15
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Demand and Supply: Auctions: Descending Price Auction modified and Noncompetitive bid
A
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Descending price auction modified (Modified Dutch Auction)
- Starts with a price > bidders are willing to pay
- Reduces prices until bidder agrees to pay
- Bidder normally state quantity
- Price is then further reduced until all is sold
- All bidders pay price of the bidder who wins the last units offered. Single price to all.
- (e.g. U.S. Treasuries)
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Noncompetitive bid
- Bidders state quantity not price
- Pay the single price from modified Dutch auction
- (e.g. U.S. Treasuries)
16
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Demand and Supply: Consumer Surplus
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17
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Demand and Supply: Marginal (Opportunity) Cost and Producer Surplus
A
.
18
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Demand and Supply: Competitive Equilibrium
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- Equilibrium in a competitive market occurs at the intersection of the industry suply and demand curve
- The quantity supplied at the equilibrium price equals the quantity demanded at that price.
19
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Demand and Supply: Efficient Resource Allocation
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- Efficient resource allocation occurs at the quantity for which marginal benefit equals marginal cost for the last unit produced and consumed
- The sum of producer surplus and consumer surplus is maximized at that quantity.
20
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Demand and Supply: Underproduction
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Underproduction means producing at a quantity less than equilibrium. Consumers are willing to pay more than the cost to supply. MB > MC
21
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Demand and Supply: Overproduction
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Overproduction means producing at a quantity greater than equilibrium. Consumers are willing to pay less than the cost to supplu. MB < MC.
22
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Demand and Supply: Deadweight Loss
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- Both overproduction and underproduction are examples of inefficient allocation of resources
- The scale of inefficiency is measured by deadweight loss
- Deadweight loss is the decrease in total surplus that results from an inefficient level of production
23
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Demand and Supply: Calculating Surplus
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24
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Demand and Supply: Price Ceiling (e.g., Rent Ceiling) Chart
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25
Demand and Supply: Price Ceiling
Long-run impact:
* Long waiting period to purchase
* Sellers discriminate
* Sellers take bribes
* Sellers reduce quality
* Black market develops (Black market prices **\>** ceiling prices)
26
Demand and Supply: Price Floors (e.g. Minimum Wage) Chart
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Demand and Supply: Price Floor
**Long-run effects**
* Excess supply of the good
* Substitution in consumption away from price of controlled good
**Mimumum wage** is an example of a price floor
* Excess supply of labor increases unemployment
* Producers substitute capital for labor
* Non-monetary benefits, working conditions, on-the-job training all decrease.
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Demand and Supply: Effect of Taxes
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Demand and Supply: Actual Incidence of a Tax is Independent of Who Must Pay
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Demand and Supply: Actual Incidence of a Tax: Inelastic Demand
* Inelastic demand: **Buyer** suffers great burden
* Actual incidence depends on _both_ the elasticities of supply and demand.
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Demand and Supply: Actual Incidence of a Tax: Inelastic Supply
* Inelastic supply: **Seller** suffers great burden
* Actual incidence depends on _both_ the elasticities of supply and demand.
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Demand and Supply: Subsidies Lead to Overproduction
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Demand and Supply: Quotas Lead to Underproduction
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Demand and Supply: Price Elasticity of Demand
As the price of a normal good increases, **quantity demanded** decreases
* **Elastic demand:** Percentage increase in price leads to a larger percentage decrease in quantity demanded
* **Inelastic demand:** Percentage increase in price leads to a smaller percentage decrease in quantity demanded
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Demand and Supply: Price Elasticity of Demand Charts
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Demand and Supply: Factors That Influence Elasticity of Demand
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Demand and Supply: Elasticity on a Straight-line Demand Curve
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Demand and Supply: Price Elasticity of Demand and Total Revenue
* Greatest total revenue (P x Q) at the point where elasticity = -1
* **Inelastic range**: Price increase will **increase** **total revenue**; percentage decrease in quantity demanded \> percentage increasei in price
* **Elastic range**: Price increase will **decrease total revenue**; percentage decrease in quantity demanded \> percentage increase in price.
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Demand and Supply: Income Elasticity of Demand
The sensitivity of quantity demanded to changes in income
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Demand and Supply: Cross Price Elasticity of Demand
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Demand and Supply: Calculating Elasticities: Price Elasticity of Demand
QDX = 4,000 - 140 PX + .75 I - 300 PY
**Where:**
* QDX = Quantity demanded of good X
* PX = Price of good X
* I = Consumers' average income in $ (normal good; positive coefficient
* PY = Price of complementary product (negative coefficient)
**Assume:**
* I = $40,000 QDX = 4,000 - 140 PX + 30,000 - 4,500
* PY = $15 QDX = 29,500 - 140 PX
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Demand and Supply: Calculating Elasticities: Income Elasticity
**Where:**
QDX = Quantity demanded of good X
PX = Price of good X
I = Consumers' average income in $ (normal good; positive coefficient
PY = Price of complementary product (negative coefficient)
43
Demand and Supply: Calculating Elasticities: Cross Price Elasticity of Demand
**Where:**
QDX = Quantity demanded of good X
PX = Price of good X
I = Consumers' average income in $ (normal good; positive coefficient
PY = Price of complementary product (negative coefficient)
44
Consumer Demand: Utility Theory
Explains consumer choice/behavior
* Preferences based on combination of goods
* Based on satisfaction
* Satisfaction measured by utility
**Utility function:**
* Utility = U(Q1, Q2, Q3,..., QN)
* Variables are quantity consumed of goods 1 to N
* Quantity must be \>= 0 for each good
* Increase in quantity of a good holding all others constant, increae utility (non-satiation)
* Utility is an ordinal measure.
45
Consumer Demand: Indifference Curves
* Consumer is indifference among bundles of goods that lie on the same curve.
* Indifference curves for 2 goods slope downwards
* Indifferrence curves are convex
* Higher indifference curves have more utility than lower ones (ordinal scale)
* Slope at any point is the marginal rate of substitution (MRS), the rate at which the consumer is willing to exchange until of good X for units of good Y
* Indifference curves may not cross
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Consumer Demand: Indifference Curves Chart
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Consumer Demand: Budget Constraints
* Based on consumer income and the price of 2 products
* **Budget line** shows all combinations of both goods that wille exhaust consumer's income.
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Consumer Demand: Consumer's Equilibrium Bundle
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Consumer Demand: Substitution and Income Effects
Price of Good X decreases
* Substitution effect *always* shifts consumption to more of Good X
* Total expenditure on the original bundle is now less than full income (budget line shifts)
* Normal goods: Income effect increases consumption of Good X
* Inferior goods: Income effect decreases consumption of Good X
**Giffen good:** Negative income effect \> positive substitution effect
50
Consumer Demand: Veblen Good
* Higher price increases desirability
* Increase in price: Increase in status
* High end designer / luxury goods
* Positively sloped demand curve for some individuals (within a range)
* Not supported by the rules of consumer choice.
51
The Firm: Economic Profit
* Accounting profit is net income
accounting profit = revenue - explicit costs
* Economic profit = acccounting profit - implicit costs
implicit opportunity costs =
return on owner capital
+ opportunity cost of owner's time
* Normal profil when economic profit = 0
* Effect on equity values.
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The Firm: Economic Rent
Economic rent - when supply is inelastic
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The Firm: Price and Marginal Revenue-Perfect Competition
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The Firm: Price and Marginal Revenue-Imperfect Competition
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The Firm: Factors of Production
* Land
* Labor
* Capital
* Materials
Often we simply use Labor (L) and Capital (K)
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The Firm: Production Function
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The Firm: Total Costs for the Firm
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The Firm: Costs per Unit of Output
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The Firm: Breakeven and Shutdown
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The Firm: Economies and Diseconomies of Scale
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The Firm: Breakeven and Profit Maximization
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The Firm: Profit Maximization - Perfect Competition: P \> ATC
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The Firm: Profit Maximization - Perfect Competition P \< ATC
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The Firm: Profit Maximization - Imperfect Competition
Profit is maximized at the Output for which marginal cost = marginal revenue.
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The Firm: Profit Maximization in the Long Run
* Under perfect competition, the market price will be P2 in the long run as firms move to minimum efficient scale.
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The Firm: Decreasing Cost and Increasing Cost Industries
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The Firm: Total, Marginal, and Average Product
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The Firm: Marginal Product
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The Firm: Marginal and Average Product
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The Firm: Cost and Product Curves
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The Firm: Profit Maximizing Input Amounts
Marginal revenue product (MRP) is the addition to total revenue from selling the addiitonal output (MP) from employing one more unit of input.
As each extra input is added, output increases but at a decreasing rate (diminishing marginal returns)
To maximize profits, use additonal amounts of an input until MRP = unit costs.
Labor: Hire more worker until MRPL = wage.
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The Firm: Minimizing the Cost of Production
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Market Structures: Characteristics of Market Structures
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Market Structures: Perfect Competition
Firms in perfect copetition are **price takers**
* No influence over market price
* "Take" the equilibirum market price given
**Characteristics:**
* Homogenous product
* Large number of independent firms; each small relative to the total market
* Perfectly elastic demand curve
* No barriers to entry or exit
* Supply and demand determine market price
75
Market Structures: Perfect Competition - Short-Run Profit to a Firm
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Market Structures: Perfect Competition - Equilibrium
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Market Structures: Firm vs. Industry Short-Run Supply Curves
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Market Structures: Short-Run Increase in Demand
_In the **long run** new firms:_
Will **enter** the industry when profits \> 0
Will **exit** the industry when profits \< 0
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Market Structures: Effects of a Permanent Increase in Demand
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Market Structures: Costs and Output - Problem
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Market Structures: Monopolistic Competition
* A large number of firms in industry
* Each firm has a small market price
* Concerned about average price
* Collusion not possible
* Firms produce differentiated products (close but not perfect substitutes
* Relatively elastic demand
* Firms compete on price, quality, and marketing
* Low barriers to entry
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Market Structures: Monopolistic Competition Charts
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Market Structures: Monopolistic Competition - Potential Allocative Efficiency
* Firms face downward sloping, highly elastic (flat) demand curves
* Potential allocative efficiency is not clear
* Social cost of not producing where P = MC
* Long-run average cost is not minimized
* Excessive advertising may take place
* Fewer producers could be more efficient
* However, increased product diversity has positive value to consumers
84
Market Structures: Efficiency of Monopolistic Competition
**Brand names** provide signals about quality
**Product innovation** and **differentiation** has value to consumers
**Advertising** provides valuable information to consumers
* High advertising expenditures increase fixed costs and total costs
* If advertising greatly increases sales, ATC can decline because AFC fall
85
Market Structures: Monopolistic Competition vs. Perfect Competition
**Excess capacity:** Q \< efficient quantity
**Markup:** P \> ATC
86
Market Structures: Oligopoly Characteristics
* **Small number** of sellers - downward sloping demand
* Firms' demand curve less elastic than monopolistic competition
* **Interdependence** among competitiors and their deman curves
* Significant **barriers to entry** (e.g. scale of operations)
* Products may be similar or differentiated
87
Market Structures: Kinked-Demand Model - Oligopoly
**_Kinked Demand Curve_**
* Competitors **_will not_** follow a price increase
* Competitiors **_will_** follow a price decrease
* Models gives a discontinuua marginal revenue curve (gap)
* Model does not specify what determines the market price Pk
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Market Structures: Nash Equilibrium
Choices of all firms are such that no choice makes any firm better off (increases profits or decreases loss)
**Strategic games** model the best choice for a firm depending on the actions and reactions of competitors
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Market Structures: Cournot Model
* Duopoly model (Can be extended for more than two firms)
_Assumptions_
* Homogenous product
* Firms have market power (quantity will affect price)
* Both firms determine profit maximizing quantity assuming the other firm will not change its quantity (no retaliation)
* Firms choose quantities simultaneously
* Both firms have identical and constant marginal costs of production
90
Market Structures: Cournot Model Conclusions
* Quantities produced by both firms change each period until they are equal (remember both firms are identical)
* Both firms will choose Nash equilibrium output levels
* Market price will be lower than monopoly
* Market price will be higher than perfect competition (marginal cost)
* As more firms are added, market price moves towards marginal cost
91
Market Structures: Oligopoly Profits with Collusion
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Market Structures: Prisoners' Dilemma and Oligopoly
* Oligopoly firms can earn a greater profit if they **collude**, fix industry output at the monopoly (profit maximizing) quantity, and share the profits.
* **Game theory** suggests that if competitors cannot detect cheating, they will choose to _violate the collusion agreeement_ and increase output
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Market Structures: Nash Equilibrium and Oigopoly
_Collusion will be more successful with:_
* Fewer firms
* Homogenous products
* Similar cost structures
* Certain and severe retaliation for cheating
* Little competition from firms outside the agreement
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Market Structures: Dominant Firm Oligopoly
* One dominant firm is the low cost producer
* Dominant firms produces most of the output
* Dominant firm essentially **sets market price P**
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Market Structures: Monopoly Characteristics
_Barriers to entry_
* Economies of scale (natural monopoly)
* Government licensing and legal barriers
* Resource control
A _single price monopolist_ faces downward sloping demand and must reduce price to increase sales; the, marginal revenue is less than price
Price settitng strategies:
* Single-price, price discriminarion
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Market Structures: Monopoly Costs, Price, Revenue
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Market Structures: Price Discrimination
* Must have two identifiable groups with different demand elasticities
* Must be able to prevent resale between groups
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Market Structures: Perfect Price Discrimination is Efficient
* Charge each consumer the maximum the consumer is willing to pay for each unit
* No deadweight loss
* Produce same quantity as perfect competition
* No consumer surplus; entire surplus goes to producer
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Market Structures: Monopoly vs. Perfect Competition
100
Market Structures: Natural Monopoly
**Significant economies of scale**
ATC declines as output increases
Often high fixed costs industries
Marginal cost tends to be low
*Example:* Utilities
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Market Structures: Regulating Monopolies
* **Average cost pricing** → reduce price to where ATC intersects the market demand curve
* Increases output and social welfare
* economic profit = 0
* **Marginal cost pricing →** reduce price to where MC intersect the demand cure (MC = price)
* May lead to a loss, require a government subsidy if MC \< ATC
102
Market Structures: Natural Monoplies
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Market Structures: Monopoly Market - Problem
104
Market Structures: Firm's Supply Function
**Perfect Competition:**
* MC Curve above average variable cost
* Market supply - sum of suppply of market participants
**Monopolistic Competition, Oligopoly, Monopoly:**
* No well defined supply function (can't construct quantity supplied as a function of price)
* Supply driven by intersection of MR and MC; price is then determined by the demand curve
105
Market Structures: Pricing Strategy
* **Perfect Competition:** Price = MR = MC at profit maximizing output quantity
* **Monopoly, Monopolistic Competition:** MR = MC at profit maximizing output quantity; price determined by downward- sloping demand curve; P \> MR
* **Oligopoly:** Optimal pricing stategy depends on how other firms are expected to react
* Kinked demand curve
* Dominant firm
* Game theory
* Collusion
106
Market Structures: Identifying Market Structure
* **Regression analysis: Cross sectional**
* **Requires substantial data gathering**
* **Using slightly different measures of the independent variables yield dramatically differing results**
**Price Elasticity of Demand**
* Inelastic may indicate market power (monopoly)
* Analyst must estimate both demand and supply functions
**Estimating Price Elasticity**
* Regression analysis : Time series
* Rquires a large number of observations
* Market structure may have changed significantly over the period (coefficient instability)
107
Market Structures: N- Firm Concentration Ratio
Sum of the percentage market shares of the N largest firms in an industry. **Advantage:** Simple
Market share = firms sales/total market sales
* N-firm ration near 0% **perfect competition**
* Lower ration indicate competitive market; higher ratios indicate oligopoly
* N-firm ratio = 100% for **monopoly**
**Disadvantages**
* Ignores barriers to entry
* Largely unaffected by mergers
108
Market Structures: Herfindahl-Hirschman Index (HHI)
HHI = sum of _squared market shares_ of N largest firms in a market
* Very low in a market with perfect competition
* approx = .1 to .18 moderately competitiove; .18+ uncompetitive market
* 1 = 100% for a monopoly
_Advantages_
* More sensitive to mergers than N-firm ratio
* Widely used by regulators
_Disadvantages:_
* Ignores barriers to entry
* Ignores demand elasticity
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Market Structures: Types of Markets Problem
