Review
Midterm II
KEY POINTS:
CHAPTER OUTLINE:
I. Controls on Prices
A. Definition of Price Ceiling: a legal maximum on the price at which a good can be sold.
B. Definition of Price Floor: a legal minimum on the price at which a good can be sold.
C. How Price Ceilings Affect Market Outcomes
1. There are two possible outcomes if a price ceiling is put into place in a market.
a. If the price ceiling is higher than or equal to the equilibrium price, it is not binding.
b. If the price ceiling is lower than the equilibrium price, the ceiling is a binding constraint and a shortage is created.
2. If a shortage for a product occurs (and price cannot adjust to eliminate it), a method for rationing the good must develop.
3. Case Study: Lines at the Gas Pump
a. In 1973, OPEC raised the price of crude oil which led to a reduction in the supply of gasoline.
b. The federal government put price ceilings into place and this created large shortages.
c. Motorists were forced to spend large amounts of time in line at the gas pump (which is how the gas was rationed).
d. Eventually, the government realized its mistake and repealed the price ceiling.
4. Case Study: Rent Control in the Short Run and the Long Run
a. The goal of rent control is to make housing more affordable for the poor.
b. Since the supply of apartments is fixed (perfectly inelastic) in the short run and upward-sloping (elastic) in the long run, the shortage is much larger in the long run than in the short run.
c. Rent controlled apartments are rationed in a number of ways including long waiting lists, discrimination against minorities and families with children, and even under-the-table payments to landlords.
d. The quality of apartments also suffers due to rent control.
6. In the News: Rent Control in New York City
a. Rent control is a policy that has few supporters (other than those living in a rent controlled apartment).
b. This is an article from The New York Times describing the possibility of the end of rent control in New York City.
D. How Price Floors Affect Market Outcomes
1. There are two possible outcomes if a price floor is put into place in a market.
a. If the price floor is lower than or equal to the equilibrium price, it is not binding.
b. If the price floor is higher than the equilibrium price, the floor is a binding constraint and a surplus is created.
2. Case Study: The Minimum Wage
a. The market for labor looks like any other market: downward-sloping demand, upward-sloping supply, equilibrium price (called a wage), and equilibrium quantity of labor hired.
b. If the minimum wage is above the equilibrium wage in the labor market, a surplus of labor will develop (unemployment).
c. The minimum wage will be a binding constraint only in markets where equilibrium wages are low.
d. Thus, the minimum wage will have its greatest impact on the market for teenagers and other unskilled workers.
E. Evaluating Price Controls
1. Because most economists feel that markets are usually a good way to organize economic activity, most oppose the use of price ceilings and floors.
2. Price ceilings and price floors often hurt the people they are intended to help.
a. Rent controls create a shortage of quality housing and provide disincentives for building maintenance.
b. Minimum wage laws create higher rates of unemployment for teenage and low skilled workers.
KEY POINTS:
CHAPTER OUTLINE:
I. Definition of Externality: the uncompensated impact of one person’s actions on the well-being of a bystander.
A. If the effect on the bystander is adverse, we say that there is a negative externality.
B. If the effect on the bystander is beneficial, we say that there is a positive externality.
C. In either situation, decisionmakers fail to take account of the external effects of their behavior.
II. Externalities and Market Inefficiency
A. Efficiency: A Recap
1. The demand curve for a product reflects the value of that product to consumers, measured by the price that buyers are willing to pay.
2. The supply curve for a product reflects the cost of producing the product.
3. In a free market, the price of a good brings supply and demand into balance in a way that maximizes total surplus (the difference between the consumers’ valuation of the good and the sellers’ cost of producing it). This is the efficient allocation.
B. Negative Externalities in Production
1. Example: an aluminum firm emits pollution during production.
2. Social cost is equal to the cost to the firm of producing the aluminum plus the external costs to those bystanders affected by the pollution. Thus, social cost exceeds the private cost paid by producers.
3. The optimal amount of aluminum in the market will occur where the firm accounts for both their private costs and the cost of the externality.
a. This will occur where the social cost curve intersects with demand curve. At this point, producing one more unit would lower efficiency the value to consumers is less than the cost to produce it.
4. Because the supply curve does not reflect the true cost of producing aluminum, the market will produce more aluminum than is optimal.
5. This negative externality could be internalized by a tax on producers for each unit of aluminum sold forcing them to clean up.
6. Definition of Internalizing an Externality: altering incentives so that people take account of the external effects of their actions.
III. Private Solutions to Externalities
A. We do not necessarily need government involvement to correct externalities.
B. The Types of Private Solutions
1. Problems of externalities can sometimes be solved by moral codes and social sanctions.
2. Many charities have been established that deal with externalities.
3. The parties involved in this externality (either the seller and the bystander or the consumer and the bystander) can possibly enter into an agreement to correct the externality.
KEY POINTS:
CHAPTER OUTLINE:
I. What Are Costs?
A. Total Revenue, Total Cost, and Profit
1. Goal of a firm: to maximize profit.
2. Definition of Total Revenue: the amount a firm receives for the sale of its output.
3. Definition of Total Cost: the market value of the inputs a firm uses in production.
4. Definition of Profit: total revenue minus total cost.
B. Costs as Opportunity Costs
1. Principle #2: The cost of something is what you give up to get it.
2. The costs of producing an item must include all of the opportunity costs of inputs used in production.
3. Total opportunity costs include both implicit and explicit costs.
a. Definition of Explicit Costs: input costs that require an outlay of money by the firm.
b. Definition of Implicit Costs: input costs that do not require an outlay of money by the firm.
c. This is the major way in which accountants and economists differ in analyzing the performance of a company.
d. Accountants focus on only explicit costs, while economists examine both explicit and implicit costs.
C. The Cost of Capital as an Opportunity Cost
1. The opportunity cost of financial capital is an important cost to include in any analysis of firm performance.
2. Example: Helen uses $300,000 of her savings to start her firm. It was in a savings account paying 5% interest.
3. Since Helen could have earned $15,000 per year on this savings, we must include this opportunity cost. (Note that an accountant would not count this $15,000 as part of the firm’s costs.)
4. If Helen had instead borrowed $200,000 from a bank and used $100,000 from her savings, the opportunity cost would not change if the interest rate stayed the same (according to the economist). But, the accountant would now count the $10,000 in interest paid for the bank loan.
D. Economic Profit Versus Accounting Profit
1. Definition of Economic Profit: total revenue minus total cost, including both explicit and implicit costs.
2. Definition of Accounting Profit: total revenue minus total explicit costs.
3. If implicit costs are greater than zero, accounting profit will always exceed economic profit.
A. From the Production of Borts to the Total-Cost Curve
1. We can draw a graph of the firm’s total cost curve by plotting the level of output (x-axis) against the total cost of producing that output (y-axis).
a. The total cost curve eventually gets steeper and steeper as output rises.
b. This increase in the slope of the total cost curve is also due to crowding: As we increases the production of borts, I need to hire more labor and the table in the front of the room becomes overcrowded.
III. The Various Measures of Cost
A. Fixed and Variable Costs
1. Definition of Fixed Costs: costs that do not vary with the quantity of output produced.
2. Definition of Variable Costs: costs that do vary with the quantity of output produced.
3. Total cost is equal to fixed cost plus variable cost.
4. Definition of Marginal Cost: the increase in total cost that arises from an extra unit of production.
B. Cost Curves and Their Shapes
1. Rising Marginal Cost
a. This occurs because of crowding.
b. At a low level of output, there are few workers and a lot of idle equipment. But as output increases, the factory gets crowded and the cost of producing another unit of output becomes high.
KEY POINTS:
CHAPTER OUTLINE:
I. What Is a Competitive Market?
A. The Meaning of Competition
1. Definition of Competitive Market: a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker.
2. There are three characteristics of a competitive market (sometimes called a perfectly competitive market).
a. There are many buyers and sellers.
b. The goods offered by the sellers are largely the same.
c. Firms can freely enter or exit the market.
B. The Revenue of a Competitive Firm
1. Total revenue from the sale of output is equal to price times quantity.
2. Definition of Marginal Revenue: the change in total revenue from an additional unit sold.
II. Profit Maximization
1. The profit-maximizing quantity can also be found by comparing marginal revenue and marginal cost.
a. As long as marginal revenue exceeds marginal cost, increasing output will raise profit.
b. If marginal revenue is less than marginal cost, the firm can increase profit by decreasing output.
c. Profit-maximization occurs where marginal revenue is equal to marginal cost.
B. The Marginal-Cost Curve and the Firm’s Supply Decision
1. Cost curves have special features that are important for our analysis.
a. The marginal cost curve is upward-sloping.
2. Marginal and average revenue can be shown by a horizontal line at the market price.
3. To find the profit-maximizing level of output, we can follow the same rules that we discussed above.
a. If marginal revenue is greater than the marginal cost, the firm can increase its profit by increasing output.
b. If marginal cost is greater than marginal revenue, the firm can increase its profit by decreasing output.
c. At the profit-maximizing level of output, marginal revenue is equal to marginal cost.
C. The Firm’s Short-Run Decision to Shut Down
a. A firm will shut down if it does not cover its variable costs.
D. The Firm’s Long-Run Decision to Exit or Enter a Market
1. If a firm exits the market, it will earn no revenue, but it will have no costs as well.
2. Therefore, a firm will exit if the revenue that it would earn from producing is less than its total costs:
4. A firm will enter an industry when there is profit potential, so this must mean that a firm will enter if revenues will exceed costs:
5. In the long-run, a firm will remain in a market only if it is earning at least zero profit.
E. The Long Run: Market Supply with Entry and Exit
1. If firms in an industry are earning profit, this will attract new firms.
a. The supply of the product will increase.
b. The price of the product will fall and profit will decline.
2. If firms in an industry are incurring losses, firms will exit.
a. The supply of the product will decrease.
b. The price of the product will rise and losses will decline.
3. At the end of this process of entry or exit, firms that remain in the market must be making zero economic profit.
4. Because Profit = TR – TC, profit will only be zero when: TR = TC.
5. This implies that the long-run equilibrium of a competitive market must have firms operating at their efficient scale.
8. Why Do Competitive Firms Stay in Business If They Make Zero Profit?
a. Profit is equal to total revenue minus total cost.
b. To an economist, total cost includes all of the opportunity costs of the firm.
c. When a firm is earning zero profit, this must mean that the firm’s revenues are compensating the firm’s owners for the time and money that they have expended to keep their businesses going.
KEY POINTS:
CHAPTER OUTLINE:
I. A competitive firm is a price taker; a monopoly firm is a price maker.
II. Why Monopolies Arise
A. Definition of Monopoly: a firm that is the sole seller of a product without close substitutes.
B. The fundamental cause of monopoly is barriers to entry.
1. Monopoly Resources
a. A monopoly could have sole ownership or control of a key resource that is used in the production of the good.
b. Case Study: The DeBeers Diamond Monopoly – this firm controls about 80 percent of the diamonds in the world.
2. Government-Created Monopolies
a. Monopolies can arise because the government grants one person or one firm the exclusive right to sell some good or service.
b. Patents are issued by the government to give firms the exclusive right to produce a product for 20 years.
3. Natural Monopolies
a. Definition of Natural Monopoly: a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.
b. A natural monopoly occurs when there are economies of scale, implying that average total cost falls as the firm’s scale becomes larger.
III. How Monopolies Make Production and Pricing Decisions
A. Monopoly Versus Competition
1. The key difference between a competitive firm and a monopoly is the monopoly’s ability to control price.
B. A Monopoly’s Revenue
2. A monopoly’s marginal revenue will always be less than the price of the good (other than at the first unit sold). The marginal revenue will slope downward.
C. Profit Maximization
1. The monopolist’s profit-maximizing quantity of output occurs where marginal revenue is equal to marginal cost.
a. If the firm’s marginal revenue is greater than marginal cost, profit can be increased by raising the level of output.
b. If the firm’s marginal revenue is less than marginal cost, profit can be increased by lowering the level of output.
2. Even though MR = MC is the profit-maximizing rule for both competitive firms and monopolies, there is one important difference.
a. In competitive firms, P = MR; at the profit-maximizing level of output, P = MC.
b. In a monopoly, P > MR; at the profit maximizing level of output, P > MC.
A. The typical firm usually has some market power, but its market power is not as great as that described by monopoly.
B. Firms in imperfect competition lie somewhere between the competitive model and the monopoly model.
C. Definition of Oligopoly: a market structure in which only a few sellers offer similar or identical products.
D. Definition of Monopolistic Competition: a market structure in which many firms sell products that are similar but not identical.
II. Markets With Only a Few Sellers
A. A key feature of oligopoly is the tension between cooperation and self-interest.
1. The group of oligopolists is better off cooperating and acting like a monopoly.
2. Yet, because the oligopolist cares about his own profit, there is an incentive to act on his own. This will limit the ability of the group to act as a monopoly.