Microeconomics Cheat Sheet

1 January 2017

Price regulation — Marginal cost pricing is one form of price regulation, where the monopolist’s price is set equal to marginal cost at the quantity of output at which demand intersects marginal cost. The problem with marginal-cost pricing is that it usually results in the monopolist suffering a loss—a result that cannot be sustained for long. Profit regulation — A second possibility is to limit the monopolist to zero economic profit, either by taxing all economic profits away or by using average-cost pricing, which requires the monopolist to charge a price equal to average total cost.

The problem here is that the monopolist has no incentive to minimize costs, since it will be allowed to pass all costs on to customers and gains no additional benefit by being cost-efficient. Output regulation — The third possibility is for government to mandate a quantity of output it wants the natural monopoly to produce. — The government can assure a particular level of output, and the monopolist can gain additional economic profits by lowering its costs. Briefly discuss the Capture, Public Interest, Public Choice theories of regulation.

The Capture Theory of Regulation—This theory states that no matter what the motive for the initial regulation, eventually the agency responsible for the regulation will be “captured” (controlled) by the industry that is being regulated. As a result, the regulatory measures enacted will be affected by this relationship. Four points that support this theory are presented. The Public Interest Theory of Regulation—This theory holds that regulators are seeking to do, and will do through regulation, what is in the best interest of society at large. ————————————————-

The Public Choice Theory of Regulation—This theory predicts that the outcomes of the regulatory process will tend to favor the regulators instead of either business interests or the public. Elastic Demand (Ed > 1)—If the percentage change in quantity demanded is greater than the percentage change in price, demand is said to be elastic, and a change in price will cause a larger opposite change in quantity. Inelastic Demand (Ed < 1)—If the percentage change in price is greater than the percentage change in quantity demanded, demand is said to be inelastic, and a change in price will cause a smaller opposite change in quantity.

Unit Elastic Demand (Ed = 1)—If the percentage change in quantity demanded equals the percentage change in price, demand is said to be unit elastic, and a change in price will cause a proportional change in quantity. Perfectly Elastic Demand (Ed = ? )—If quantity demanded changes dramatically in response to a change in price—indeed, in the purest sense, if quantity demanded drops to zero in light of a price change—demand is said to be perfectly elastic. Perfectly Inelastic Demand (Ed = 0)—If quantity demanded is completely unresponsive to a change in price, demand is said to be perfectly inelastic.

Market Structure| Short-Run Tendency of Price and MR| Short-Run Tendency of Price and MC| Long-Run Tendency of Price and ATC| Short Run Supply Curve| Long Run Supply Curve| Resource Allocative Efficient? | Productive Efficient? | Perfect Competition| P = MR| P = MC| P = ATC| MC above AVC| MC above ATC| Yes| Yes| Monopoly| P > MR| P > MC| P > ATC| Undefined| Undefined| No| No| Monopolistic Competition| P > MR| P > MC| P = ATC| Undefined| Undefined| No| No| Oligopoly| P > MR| P > MC| P > ATC| Undefined| Undefined| No| No| Determinants of Price Elasticity of Demand . Number of Substitutes—The more broadly defined the good, the fewer the substitutes; the more narrowly defined the good, the greater the substitutes. The more substitutes that are available for a good, the higher its price elasticity of demand; the fewer substitutes, the lower the price elasticity of demand. 2. Necessities versus Luxuries—The more a good is considered a luxury, the higher the price elasticity of demand. The more a good is considered a necessity, the lower will be its price elasticity of demand. 3.

Percentage of One’s Budget Spent on the Good—The greater the percentage of one’s budget that goes to purchase a good, the higher the price elasticity of demand; the smaller the percentage of one’s budget that goes to purchase a good, the lower the price elasticity of demand. 4. Time—The more time that passes (after a price change), the higher the price elasticity of demand for the good; the shorter the time span, the lower the price elasticity of demand. That is, price elasticity is higher in the long run than in the short run. A. Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of the quantity demanded of one good to a change in the price of another good. Cross elasticity of demand (EC) is defined as: Percentage Change in Quantity Demanded of One Good Ec =————————————————————————— Percentage Change in Price of Another Good We use cross elasticity to determine whether two goods are substitutes, complements, or unrelated. If EC > 0, the two goods (X and Y) are substitutes; if EC < 0, the two goods are complements; and, if EC = 0, the two goods are unrelated. B. Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in income. Income elasticity of demand (EY) is defined as: Percentage Change in Quantity Demanded EY =——————————————————— Percentage Change in Income We use income elasticity to distinguish between normal and inferior goods. If EY > 0, X is a normal good; if EY < 0, X is an inferior good. We also look at the degree of income elasticity. If EY > 1, demand is income elastic; if EY < 1, demand is income inelastic; and if EY = 1, demand is income unit elastic.

C. Price Elasticity of Supply Price elasticity of supply measures the responsiveness of quantity supplied of a good to a change in the price of that good. Price elasticity of supply (ES) is defined as: Percentage Change in Quantity Supplied ES =—————————————————— Percentage Change in Price If ES > 1, supply is elastic; if ES < 1, supply is inelastic; and if ES = 1, supply is unit elastic. Any of these three conditions can occur on a “normal” upward-sloping supply curve. Two “special” conditions are also possible: if ES = ? supply is perfectly elastic, meaning that the supply curve (or at least the portion we’re observing) is horizontal; and if ES = 0, supply is perfectly inelastic, meaning that the supply curve (or at least the portion of it we’re observing) is vertical. E. Price Elasticity of Supply and Time Over time, as producers are able to adjust their behavior and production patterns, supply becomes more price elastic than it is in the short run. F. The Relationship Between Taxes and Elasticity 1. Who Pays the Tax? —Government can place a tax on whomever it wants, but the laws of supply and demand determine who actually ends up paying the tax. . Elasticity and the Tax—We look at price elasticities of supply and demand to determine who pays a tax. If demand is perfectly inelastic or if supply is perfectly elastic, consumers pay the full tax. If demand is perfectly elastic or if supply is perfectly inelastic, producers pay the full tax. ————————————————- 3. Degree of Elasticity and Tax Revenue—The government can maximize tax revenues by placing the tax on the seller who faces the more inelastic (less elastic) demand curve. discusses the effect on the yacht-building industry of a 10% tax on yachts priced over $100,000 that was passed by the U.

S. Congress in 1990. I. WHY FIRMS EXIST A business firm is an entity that employs resources to produce goods and services to be sold to consumers, other firms, or the government. This section discusses why firms exist. A. The Market and the Firm: Invisible Hand versus Visible Hand The market guides individuals into the activities at which they are most efficient and enables them to express their preferences for goods, instructing producers as to what is wanted and what is not. Managerial coordination guides and coordinates individuals’ actions in a firm. B.

The Alchian and Demsetz Answer Armen Alchian and Harold Demsetz suggest that firms are formed when the benefits that can be gained from working as a team are greater than the sum of the benefits that could be gained by acting individually. C. Shirking in a Team ————————————————- One problem of team production is shirking, which occurs when workers put forth less than the agreed-to effort. Shirking is significant because the individual gains all of the benefits of shirking, while the consequences are spread across the entire team.

The monitor (or manager) plays an important role in the firm by reducing the amount of shirking by rewarding productive workers and punishing shirkers. In so doing, the monitor can preserve the benefits of team production while reducing, if not eliminating, the costs of shirking. Making the monitor a residual claimant of the firm reduces the monitor’s incentive to shirk. Some firms may pay above-market wages to discourage shirking and encourage employees to monitor themselves. The argument is that workers will not want to lose a job that pays them an above-market wage, and they will reduce shirking to ensure this.

Economists who adhere to this theory believe that firms will only pay above-market wage rates if the monitoring costs fall more than wages go up. This is known as the efficiency wage theory. D. Ronald Coase on Why Firms Exist According to Coase, firms exist in order to reduce transactions costs. They make employment contracts with workers so as to eliminate the need to contract every work task out separately. E. Markets: Outside and Inside the Firm Individuals join a firm because they expect to be made better off. Shirking by other members of the team reduces the benefits to nonshirking workers.

Monitors reduce the amount of shirking, thereby increasing the benefits gained from teamwork. Thus, employees submit to the monitor’s commands because they realize that only a well-monitored team will yield the benefits they desire. II. THE FIRM’S OBJECTIVE: MAXIMIZING PROFIT Economists assume that a firm’s objective is to maximize profit. Profit is the difference between total revenue and total cost. Total revenue is equal to the price of a good multiplied by the quantity of the good sold. Economists define total cost as explicit costs plus implicit costs.

An explicit cost is a cost incurred when actual payment is made. An implicit cost is a cost that represents the value of resources used in production for which no actual (monetary) payment is made. A. Accounting Profit versus Economic Profit Accounting profit is the difference between total revenue and explicit costs. Economic profit is the difference between total revenue and total cost (explicit and implicit costs). B. Zero Economic Profit is Not as Bad as it Sounds In economics, a firm that makes a zero economic profit is said to be earning a normal profit.

A zero economic profit means the owner has generated total revenue sufficient to cover both explicit and implicit costs, and means that he has “done as well as could have been done. ” III. PRODUCTION Production is a transformation of resources or inputs into goods and services. Economists talk about two types of inputs in the production process—fixed and variable. A fixed input is an input whose quantity cannot be changed as output changes, while a variable input is an input whose quantity can be changed as output changes. The short run is a period in time in which some inputs are fixed, while the long run is a period in time in hich no inputs are fixed. A. Production in the Short Run The marginal physical product (MPP) of a variable input is equal to the change in output that results from changing the variable input by one unit, holding all other inputs fixed. With respect to labor, this would mean that the marginal physical product of labor would be defined as MPP of Labor = ? Q / ? L The law of diminishing marginal returns states that as ever-larger amounts of a variable input are combined with fixed inputs, eventually the marginal physical product of the variable input will decline. B. Marginal Physical Product and Marginal Cost

Fixed costs are the costs associated with fixed inputs. Variable costs are the costs associated with variable inputs. Fixed costs do not change as output changes. Because the quantity of a variable input changes with output, so do variable costs. Total cost is the sum of fixed costs and variable costs. Marginal cost is the change in total cost that results from a change in output: Marginal cost (MC) = ? TC / ? Q The MPP and MC move in opposite directions. Since the MPP curve first rises and then (when diminishing returns set in) falls, it follows that the MC curve must first fall and then rise. C. Average Productivity

Average productivity is the output divided by the inputs, usually labor, or AP = Q / L The average physical productivity of labor is what is meant by labor productivity. IV. COSTS OF PRODUCTION: TOTAL, AVERAGE, MARGINAL A. The AVC and ATC Curves in Relation to the MC Curve The average-marginal rule tells us that when the marginal magnitude is above the average magnitude, the average magnitude rises; and when the marginal magnitude is below the average magnitude, the average magnitude falls. In other words when MC > AVC (ATC), the AVC (ATC) curve rises; when MC < AVC (ATC), the AVC (ATC) curve falls.

Additionally, we can infer from these relationships that the MC curve must intersect the AVC and ATC curves at their respective minimum points. The average-marginal rule does not apply to the AFC curve, since marginal costs do not affect fixed costs. In this case, the AFC curve will decrease continuously as output rises. B. Tying Short-Run Production to Costs In the short run, at least one input is fixed. When we increase production, the MPP of the variable input will eventually fall, increasing marginal costs, which in turn raises AVC and ATC. Thus, the cost of a good is tied to the production of the good.

C. One More Cost Concept: Sunk Cost A sunk cost is a cost incurred in the past that cannot be changed by current decisions and cannot be recovered. In contrast to fixed costs, sunk costs are completely “lost. ” With fixed costs (land, equipment, etc. ), there is at least the possibility of resale in order to recover some of the cost; with sunk cost, there is not even that chance. Since they cannot be recovered, sunk costs should not be considered when making decisions. V. PRODUCTION AND COSTS IN THE LONG RUN In the long run there are no fixed inputs and no fixed costs.

Consequently, the firm has greater flexibility in the long run than in the short run. A. Long-Run Average Total Cost Curve The short-run ATC curve presented earlier assumed a fixed plant size. Each possible plant size has a short-run ATC curve associated with it. The long-run average total cost (LRATC) curve for a given firm combines the short-run ATC curves that represent all possible plant sizes, such that the LRATC curve shows the lowest average cost at which the firm can produce any given level of output. Put another way, the LRATC curve touches each short-run ATC curve at its lowest point. B.

Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale Economies of scale exist if unit costs fall as output increases. Constant returns to scale exist if unit costs remain constant as output increases. Diseconomies of scale exist if unit costs rise as output increases. If economies of scale are present, the LRATC curve is falling; if constant returns to scale exist, the LRATC curve is flat, and if diseconomies of scale are present, the LRATC curve is rising. The minimum efficient scale is the lowest output level at which average total costs are minimized. C. Why Economies of Scale?

Economies of scale exist for two main reasons: growing firms offer greater opportunities for employees to specialize, and growing firms can take advantage of highly efficient mass production techniques. D. Why Diseconomies of Scale? Diseconomies of scale occur because a firm’s size produces coordination, communication, and monitoring problems. Knowing that these problems exist, firms will reorganize, divide operations, hire new managers, and take other measures to reverse the diseconomies of scale. E. Minimum Efficient Scale and Number of Firms in an Industry The minimum efficient scale varies from one industry to another.

We can estimate the number of efficient firms it takes to satisfy U. S. consumption for a particular product by dividing the MES as a percentage of U. S. consumption into 100. VI. SHIFTS IN COST CURVES Several factors shift cost curves A. Taxes- Taxes on the production of a good will increase the perunit costs of production, shifting the MC, AVC, and ATC curves upward. B. Input Prices – A change in input prices brings about a corresponding change in the firm’s MC, AVC, and ATC curves, shifting them upward if input prices rise and downward if input prices fall. C.

Technology Technological changes often bring either (1) the capability of using fewer inputs to produce a good or (2) lower input prices. In either case, technological advances lower variable costs and, consequently, shift the MC, AVC, and ATC curves downward. I. MARKET FAILURE When a market produces more or less than the ideal or optimal amount of a particular good, economists say there is market failure. II. EXTERNALITIES Sometimes, when goods are produced and consumed, side effects, or externalities, occur that are felt by people who are not directly involved in the market exchanges.

These externalities may be negative or positive. A. Costs and Benefits of Activities A negative externality exists when a person’s or group’s actions cause a cost (or adverse side effect) to be felt by others. A positive externality exists when a person’s or group’s actions cause a benefit (or beneficial side effect) to be felt by others. B. Marginal Costs and Benefits of Activities Marginal social costs (MSC) are the sum of marginal private costs (MPC) and marginal external costs (MEC). Marginal social benefits (MSB) are the sum of marginal private benefits (MPB) and marginal external benefits (MEB).

C. Social Optimality or Efficiency, Conditions The socially optimal amount (output), or the efficient amount (output) is the amount at which MSB = MSC. D. Three Categories of Activities Activities may be categorized according to whether negative or positive externalities exist, as follows: 1. If MEC and MEB both =0, there are no externalities. 2. If MEC > 0 and MEB = 0, then MSC > MPC and MSB = MPB, and a negative externality exists. 3. MEB > 0 and MEC = 0, then MSB > MPB and MSC = MPC, and a positive externality exists. E. Externalities in Consumption and in Production

Externalities can arise both from consumption and from production. F. Diagram of a Negative Externality Exhibit 1 in the text shows, as a shaded triangle, the net social cost of moving from the socially optimal output to the market output when the socially optimal output is smaller than the market output. G. Diagram of a Positive Externality Exhibit 2 in the text shows, as a shaded triangle, the net social cost of moving from the socially optimal output to the market output when the socially optimal output is larger than the market output. III. INTERNALIZING EXTERNALITIES

An externality is internalized if the parties that generated the externalities incorporate the external costs and/or benefits of their actions into their own private costbenefit calculations. This can be achieved by several means. A. Persuasion Many negative externalities occur simply because the parties that create them do not consider the effects of their actions on others. By informing the parties responsible for an externality of the consequences of their actions and persuading them to alter their behavior, we may get them to adjust their behavior to take these costs into account.

B. Taxes and Subsidies Taxes and subsidies are sometimes used as corrective devices for a market failure. Specifically, a tax is used to adjust for a negative externality, and a subsidy to promote an activity with positive externalities. If a negative externality exists, the objective of a corrective tax would be to shift the supply curve such that the equilibrium level of output falls from the market output to the socially optimal output. If the government misjudges external costs, it may reduce output more than is socially optimal. C.

Assigning Property Rights Some economists argue that many negative externalities occur because no one “owns” the air, oceans, etc. As a result, there is no one to take action against polluters for infringing on property rights. If we could only assign property rights—that is, determine legal ownership of these natural resources—we could reduce negative externalities. The absence of land ownership on grazing lands in the western United States in the 19th century led to overgrazing that reduced the quality of the land. D. Voluntary Agreements

Externalities can sometimes be internalized through voluntary agreements between the creator(s) of the externality and the third party (-ies) affected by it. In order for such an agreement to be reached, however, the transactions costs associated with making the agreement must be lower than the expected benefits of the agreement E. Combining Property Rights Assignments and Voluntary Agreements The combination of property rights assignments and voluntary agreements can be combined. For instance, if a property right is assigned to one party, that property right may be undone with a voluntary agreement between that party and another one.

This idea led to the Coase theorem, which holds that in the case of trivial or zero transaction costs, the property rights assignment does not matter to the resource allocative outcome. 1. Coase Theorem—The Coase theorem can be expressed in other ways, for example: (1) in the case of trivial or zero transaction costs, a property rights assignment will be undone if it benefits the relevant parties to undo it; (2) in the case of trivial or zero transaction costs, the resource allocative outcome will be the same no matter who is assigned the property right.

The Coase theorem is significant for two reasons: (1) it shows that under certain conditions the market can internalize externalities, and (2) it provides a benchmark for analyzing externality problems. 2. Pigou versus Coase—The text recounts the night when Coase successfully defended his idea that assigning property rights is a more efficient way of dealing with externalities than introducing taxes or subsidies. F.

Beyond Internalizing: Setting Regulations A final way to deal with externalities, particularly negative externalities, is for government to apply regulations directly to the activity that generates the externality. For instance, if steel mills emit air pollutants through their smokestacks, the government may regulate smokestack emissions. Critics of the regulatory approach often complain that regulations, once instituted, are difficult to remove even if conditions warrant removal. Also, regulations are often applied across the board when circumstances dictate otherwise. Finally, regulation entails costs.

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