AP Microeconomics: Master Notes UNIT 1: FUNDAMENTALS OF ...

[Pages:20]AP Microeconomics: Master Notes

UNIT 1: FUNDAMENTALS OF ECONOMIS Key Terms Economics: The study of how limited resources are

allocated. Microeconomics: Study of how individuals (firms or

households) make choices and are influenced by economic forces. Macroeconomics: Looks at the economy as a whole, focusing on issues such as growth, unemployment, inflation, and business cycles. Scarcity: material wants are unlimited and economic resources are limited or scarce.

Factors of Production o Land: Any productive resource existing in nature, Ex. water, wind, mineral deposits. o Labor: Physical and mental effort of people. Ex. Teacher o Capital: Manufactured goods that can be used in the production process Ex. tools, buildings, machinery Human Capital: Knowledge and skills acquired through training and experience Ex. College or Technical School. o Entrepreneurship: Ability to identify opportunities and organize production, risk taker. Ex. Elon Musk

Economic Reasoning Given limited resources (SCARCITY), there are

opportunity costs for every choice Trade-offs- All the possible options given up when you

make a choice The opportunity cost of an action is the benefit missed by

not choosing the next-best alternative. An action should be chosen only if the expected benefit is greater than the opportunity cost. Implicit Cost: Forgone benefits of any single transactions. Ex. time and effort an owner puts into maintaining a company, rather than expanding it. Explicit Cost: Expenses that are paid with cash or equivalent. Ex. Wages to workers, electricity bill Individuals attempt to maximize utility by allocating and spending their resources according to their preferences. Individual consumption and production options are expanded through the market, where goods and services are exchanged for mutual benefit. Economic Systems All economic systems must answer three basic economic questions o What goods and services to produce? o How to produce those goods and services? o Who consumes those goods and services? Types of Economic Systems o Command Minimize imbalance in wealth via the collective

ownership of property Lacks incentives for extra effort, risk taking, and

innovation Wages determined by the gov. Particularly vulnerable to corruption as the gov. plays

the central role in allocating resources; only one political party

Economic goal emphasized: Price stability, equity, full employment, security

Economic goal deemphasized: Efficiency, freedom, growth of consumer goods/services

o Market Pursuit of individual profit Private individuals control the factors of production Wages determined by negotiations between trade unions and managers Market forces of supply and demand determine the allocation of resources Gov. can regulate business and provide tax-supported social benefits Economic goal emphasized: Efficiency, freedom, price stability, growth Economic goal deemphasized: Equity, security, fullemployment

o Mixed- Both market and command together, reality Production Possibilities Model (Curve) Identify the Points on the PPC

o The A, B, and C represents: Attainable and efficient with these resources

Allocative vs. Productive Efficiency Productive Efficiency: Products are being produced in the least costly way (any point on the curve) Allocative Efficiency: The products being produces are the ones most desired by society. (optimal point depends on the desire of society)

o The X represents: Inefficiency o The Y represents: Not Attainable/Unattainable with these

resources o Movement from A to B is an increase or decrease in

consumer demand.

Production Possibilities Model (Curve)

Reasons for Economic Growth/Contraction o Technology (Quality of Resources) o Land (Quantity of Resources) o Population (Quantity of Resources) o Education (Quality of Resources)

Production Possibilities Model: Economic Growth

Constant Opportunity Cost Graph

Other Shifts: Contraction to just Butter

Trade (Absolute and Comparative Advantage) Absolute advantage describes a situation in which an

individual, business, or country can produce more of a good or service than any other producer with the same quantity of resources. o Just because a country has an absolute advantage, it

doesn't mean that the country necessarily benefits the most from producing that good. Comparative advantage describes a situation in which an individual, business, or country can produce a good or service at a lower opportunity cost than another producer. o Countries will benefit from specialization if one country has a comparative advantage in one good, and the other country has a comparative advantage in the other good.

Example

Increasing Opportunity Cost Why does the graph curve? Resources are not easily

adaptable between products- GUNS VS BUTTER) Explain opportunity cost of curve: The opportunity cost of

the 4th Butter is small (1 Gun), as we go to the 6th, 7th or 8th butter, the opportunity of Guns will go up (2 Guns).

Increasing Opportunity Cost Graph

o Which nation has the absolute advantage in producing corn? Dallas

o Which nation has the absolute advantage in kiwi? Dallas o Which nation has the comparative advantage in corn?

Dallas o Which nation has the comparative advantage in kiwi?

Montezuma o Should Dallas specialize in corn or kiwi? Corn o Should Montezuma specialize in corn or kiwi? Kiwi

Constant Opportunity Cost o Why does the graphs curve remain straight? Resources are easily adapted between products (PIZZA VS CALZONE) o Explain opportunity cost of the curve: As more calzones are made, resources that are easily adapted to produce either good are moved away from pizza and toward calzones. Opportunity cost for each calzone is constant at 2 bicycles.

UNIT 2: SUPPLY, DEMAND AND CONSUMER CHOICE Demand (CONSUMERS, BUYERS, INDIVIDUALS) Law of Demand: if Price goes , the Quantity goes, or if

Price goes , the Quantity goes

Reasons for Law of Demand (DOWNWARD SLOPING CURVE)

o Substitution Effect: At a higher price, consumers are willing to and able to look for substitute (COKE or PEPSI). The substitution effect suggest that at a lower price, consumers have the incentive to substitute the cheaper good for the more expensive service.

o Income Effect: A decline in the price of a good will give more purchasing power to the consumer and he/she can buy more now with the same amount of income.

o Law of Diminishing Marginal Utility: This law states that as we consume additional units of something, the satisfaction (utility) we derive from each additional unit (marginal unit) grows smaller (diminishes)

Changes in Quantity (MOVING ALONG THE CURVE)

o What changes quantity demanded: A change in the price of the good/service

Changes in Demand (SHIFTING THE CURVE) o What shifts the demand curve? o Change in income: Normal goods: an increase in income leads to a rightward shift in the demand curve

Income goes , Demand goes Income goes , Demand goes Inferior goods: an increase in income leads to a

leftward shift since these are usually low-quality items people will avoid when the have more to spend

Income goes , Demand goes

Income goes , Demand goes o Change in taste/preferences o Change in price of complementary goods: the linkage of

products' demand because the work with each other can affect demand for each (Milk and cookies) Price of A Demand for B goes Price of A Demand for B goes o Change in price of substitutes: When the prices of or preference for a substitute changes, demand for both products will change. Price of A Demand for B goes Price of A Demand for B goes o Change in number of buyers o Change in price expectation of buyers Supply (SELLERS, FIRMS, PRODUCERS) The Law of Supply: If price goes , the quantity produced goes or if the price goes , the quantity produced goes

Reasons for Law of Supply (UPWARD SLOPING CURVE)

o Opportunity cost: At a higher prices, profit seeking firms have an incentive to produce more.

o Law of Diminishing Marginal Returns: Since the additional cost of each unit will eventually increase, the firm must increase the price to increase quantity supplied

Changes in Supply (SHIFTING THE CURVE) o What shifts the supply curve? o Price/Availability of inputs (resources) o Number of sellers o Technology o Government Action: taxes and subsidies o Change price expectation o Expectations of future profit

Equilibrium Market Equilibrium: A market is in equilibrium when the

price and quantity are at a level at which supply equals demand. The quantity that consumers demand is exactly equal to the quantity that producers supply. o Equation for Equilibrium: Qd = Qs Market Disequilibrium: Quantity demanded doesn't equal quantity supplied. Creates shortages and surpluses o Shortage: The price is below equilibrium, the amount

demanded will be greater than the amount supplied Equation for Shortage: Qd > Qs o Surplus: The price is above equilibrium, the amount

demanded will be less than the amount supplied Equation for Surplus: Qd < Qs Double Shift in Supply and Demand Double shift rule: If two curves shift at the same time, either price or quantity will be indeterminate. Example below: Demand and supply are increasing, so Price is INDETERMINATE and Quantity has INCREASED

Double Shifts in Supply and Demand Curve

Elasticity Elasticity: Is the responsiveness of consumer to a change in

the price of a product. Equations for elasticity:

Be sure to use absolute values and ignore the --------sign; useful for comparing different products.

Interpreting elasticity o Inelastic Demand Elasticity coefficient less than 1 Few substitutes and necessities Example: Cancer medication o Elastic Demand Elastic coefficient greater than 1 Luxury goods and many substitutes Example: Coke

Inelastic Demand

Elastic Demand

o Elasticity of Supply: Measures seller's responsiveness to changes

Es > 1 Supply is elastic- Producers are responsive to price change

Es < 1 Supply is inelastic- Producers are not responsive to price change

Equation below

Elasticity of Demand Coefficients o Perfect Inelastic= 0 o Relatively Inelastic= Less than 1 o Unit Elastic = 1 o Relatively Elastic= Greater than 1 o Perfectly Elastic = Undefined

Elasticity Varies with Price Range: o More elastic toward to left, less elastic at lower right. o Slope does not measure elasticity--Slope measures absolute changes; elasticity measures relative changes

Elasticity Varies with Price Range

Total Revenue and the Price Elasticity of Demand o Total Revenue: Is the amount paid by buyers and received by sellers of a good. o Equation: TR=P x Q o Total Revenue Test Elastic Demand (EXAMPLE- Coke/Pepsi) Price increase causes TR to decrease Price decrease causes TR to increase Inelastic Demand (EXAMPLE- CANCER DRUGS) Price increase causes TR to increase Price decrease causes TR to decrease Unit Elastic Price changes and TR remains unchanged

Elastic Demand and Total Revenue Graphs

Types of Elasticity

o Cross-Price Elasticity: Measures responsiveness of sales

to changes in price of another good Substitute= Positive sign Complement= Negative sign Independent Goods=zero Equation below

Inelastic Demand and Total Revenue Graphs

o Income Elasticity: Measures responsiveness of buyer to

changes in income Normal Good= positive sign Inferior Goods= negative sign Equation below

Consumer and Producer Surplus at Market Equilibrium Consumer Surplus: Difference between the price a buyer

would have been ready to pay for a good or service (willingness) and the price that he/she actually pays (market price) o Equation for Consumer Surplus: ? Quantity x Price Producer Surplus: Difference between the price that a seller actually receives (market price) and the price at which he/she would have been ready to supply the good or service (willingness) o Equation for Producer Surplus: ? Quantity x Price Total Surplus (SOCIAL WELFARE): The sum of the total consumer surplus and the total producer surplus. o Equation for Total Surplus: ? Quantity x Price CS and PS allows us to access the soundness of economic policies Consumer and Producer Surplus Graph (EFFICENT)

Price Floor/Surplus Graph Price Ceiling/Shortage Graph

Calculate using Consumer and Producer Surplus Graph o Consumer Surplus =$1,250 o Producer surplus=$1,250 o Total Surplus (Social Welfare)=$2,500

Government Effects on Market (DISEQUILIBRIUM AND INEFFICENTCY) Government Price Floors:

o Effective Price Floors, the price is above the equilibrium price

o Example: Minimum wage o Leads to a surplus, because Qs > Qd o Non-effective price floors, the price is below the

equilibrium price

Government Price Ceilings: o Effective price ceilings, the price is below equilibrium price o Example: Rent Control Housing o Provide lower costs for consumers o Leads to a shortage in the market because, Qd > Qs o Can also result in illegal black market activity- selling goods for a higher price

Government Taxes o Indirect Tax: Is one place by the government on the producers of a particular good o Excise Tax: Tax on producers, but the goal is for them to make less of the good (Cigarette, alcohol tax) o For every unit made, the producer must pay o Consumers will pay the tax indirectly through producers o An indirect tax will be shared by both consumers and producers. o Creates disequilibrium and inefficiency in the market, the result is dead weight loss o Dead weight loss: Represents the loss of former consumer and producer surplus in excess of the total revenue of the tax. Transactions that would have taken place in the market if there was not tax. o Tax Incidence: The distribution of the tax burden (WHO ACTUALLY PAYS THE TAX) o Tax Incident (WHO PAYS) If demand is perfectly inelastic: Tax burden paid entirely by consumers If demand is relatively inelastic: Tax burden mostly on consumers If demand is unit elastic: Tax burden shared between consumer and producer If demand is relatively elastic: Tax burden mostly on producers If demand is perfectly elastic: Tax burden paid entirely by producer.

Tax (EXCISE or INDIRECT) Graph

Calculate using Tax Graph o Before Tax PS before tax: EFG CS before tax: ABCD o After Tax Tax per unit: $4 per unit tax (vertical distance between two supply curves) PS after tax: G CS after tax: A Dead weight loss: DF Total tax revenue to gov't: BCE Total spending by buyers: BCEGH Total revenue to sellers: GH Amount of tax buyers pay: BC Amount of tax sellers pay: E

International Trade o World Trade Price: If the world price of good is lower than the domestic price, the country will import the good. If the world price of a good is higher than the domestic price the country will import the good. o Subsidy: tax on imports o Quota: a limit on import

Identify using International Trade Graph o Consumer Surplus with no trade: P o Producers Surplus with no trade: IDA o Amount we import and world price(Pw): KLMN or Q5Q1 o Producers Surplus if we trade at world price (Pw): I o Consumer Surplus if we trade at world price (Pw): PABCDEFGH o If government tariff leads to a world price of Pt, how much is imported and what is the Consumer Surplus and Producers Surplus: LM or Q4-Q2, PS is I, PC is PABC o If government tariff leads to world price of Pt, what is the deadweight loss and tariff revenue? DW is EH, TR is FG

Utility Maximization and Consumer Behavior Total Utility (TU): This is the total happiness a consumer

at a particular level of consumption. Total utility will generally increase as total consumption of a particular good increases, until the consumer has "had too much" of a good, when total utility will begin to decline. Marginal Utility (MU): This is the increase in total utility resulting from the consumption of each additional unit of a good. Equation for Marginal Utility (MU): MU=TU/Q Reasoning: Since MU measures the change in TU, as long as MU is positive at a particular level of output, TU will be increasing. But if MU becomes negative, TU will decrease. Law of Diminishing Marginal Utility: The greater the levels of consumption of a particular good, the les utility consumers derive from each additional unit of the good. Point of Satiety: The point where marginal utility of a good is zero.

Total Utility and Marginal Utility Graph

International Trade Graph

Graph Explained: o Point A: A total utility increases, marginal utility increases. o Point B: Point of satiety, total utility is maximized and marginal utility is zero. o Point C: Consumer Dissatisfaction, total utility starts to diminish and marginal utility becomes negative.

 Maximizing Utility Rule: To maximize your total utility,

you should instead consume the combination of good that

maximizes your marginal utility per dollar spent, so that:

Equation: MUgood A/PgoodA=MugoodB/PgoodB

Calculate Maximizing Utility

o Assume the following

You have a budget of $20 that you wish to spend

entirely on Good A and Good B.

The price of Good A is $5 and the price of Good B is

$2.

o Calculate the following

If you have $20, what combination maximizes your

utility? 2 of Good A and 3 of Good B

o Reasoning (USING THE GRAPH) You should first buy 1st of Good B because MU/P is

2.5, you have $18 remaining.

You should then buy 2nd of Good B because MU/P is

2, you have $16 remaining.

You should then buy 1st of Good A because MU/P is 2,

you have $11 remaining

You should then buy 2nd of Good A because MU/P is

1.6, you have $6 remaining.

You should then buy 3rd of Good B because MU/P is

1.5.

NOW based on utility maximizing rule, you should buy

2 widgets and 3 robots or where MUgood

A/PgoodA=MugoodB/PgoodB

Quantity

TU

MU

MU/P

(Good A) (Good A) (Good A)

1

10

10

2

2

18

8

1.6

3

24

6

1.2

4

28

4

.8

5

30

2

.4

Quantity

1 2 3 4 5

TU (Good B)

5 9 12 14 15

MU (Good B)

5 4 3 2 1

MU/P (Good B)

2.5 2 1.5 1 0.5

UNIT 3: COST CURVES AND PERFECT COMPETITION Cost of Production Profit Maximization: The goal of most firms is to

maximize their profits. To do so, they must produce at a level of output at which the difference between their revenue and their costs is maximized Total Revenue: The amount a firm receives for the sale of its output or Price x Quantity Total Cost: The market value of the inputs a firm uses in production Economic Profit = Total Revenue (TR) ? Total Cost (TC)

Economic Cost or Cost of Production: Payments a firm must make, or income it must pay to resources suppliers to attract those resources from alternative uses. This would mean all the opportunity costs.

Economic Profit vs Accounting Profit Explicit Costs: Payment to outsiders for labor, materials,

service, fuel Implicit Costs: Cost of self-owned, self-employed

resources. The opportunity cost that firms "pay" for using their own resources. Accounting Profit Equation: Total Revenue ? Accounting Cost (EXPLICIT ONLY) Economic Profit Equation: Total Revenue- Economic Costs (Explicit + Implicit) Accounting profit must be larger than economic profit because there is always an opportunity cost.

FOR MICROECONOMICS ALL COST WILL BE ECONOMIC COSTS

Normal Profit: Is zero economic profit. Minimum level of profit needed just to keep an entrepreneur operating in his current market. If firms are not covering their costs they may shut down.

It's important to understand that if a firm ears zero economic profit they are still making money.

Short Run v. Long Run Costs of Production Short Run--Fixed Plant

o Period of time to brief for firms to alter its plant capacity o Output can be varied by adding larger or smaller amounts

of labor, material, and other resources. o Exiting plant capacity can be used more or less intensively

Long Run----Variable Plant o Period of time extensive enough to change the quantity of all resources employed, including plant capacity o Enough time for existing firms to dissolve and exit the industry or for new firms to form and enter the industry

Production Function: The production function shows the relationship between

inputs and outputs in both the short-run and the long-run Inputs: Resources used to make outputs also called factors Outputs: Finished product Marginal Production (MP): The increase in output that

arises from an additional unit of that input (each additional worker) o Equation: MP= Change in Total Product/Change in

Inputs Average Production (AP): Total production/quantity

produced Diminishing Marginal Returns or (Production): If at least

one input is held fixed, while the other inputs are variable, output increases at a decreasing rate. Example: PAPER CHAIN EXPERIMENT- Labor is variable, scissors and staplers are fixed. Fixed Costs: Costs that do not change with the rate of productions. Examples: Rents, salaries, insurance Variable Costs: Costs that change with the rate of production. Examples: Wages, utilities

 Reasoning/Key Concepts for Diminishing Marginal Returns.

o No harvest or production at zero workers o Production from hiring second worker more than

doubles, because of specialization. o From worker 0 to 2, is increasing marginal returns,

marginal product is rising, total product increasing at an increasing rate. o At the third worker or point A on graph below, diminishing returns starts, look a marginal production. o At the fourth worker, decreasing marginal returns because marginal production is falling. Total Production increasing at a decreasing rate. Fixed resources and variable resources (worker) add less production o At the fifth worker or point B on graph below, total product is maximized when marginal product is zero.

# of Workers

0 1 2 3 4 5 6

Corn Harvested (Pounds per

Hour) 0 5

15 20

22 22

18

Marginal Average Production Production

5

5

10

7.5

5

6.6

2

5.5

0

4.4

-4

3

Total Product vs Marginal Product Graphs

Shapes of Cost Curves in Short-Run o Marginal Cost: MC typically falls at first but begins rising due to Diminishing Marginal Returns. MC rises when MP falls (MIRROR IMAGES) o Average Fixed Cost: The fixed costs get spread over a large quantity so they decline throughout o Average Variable Cost: If MC is below AVC, AVC is falling. As MC goes above AVC, AVC is falling. As MC goes above AVC, AVC begins rising. o Average Total Cost: If MC is below ATC, ATC is falling. As MC goes above ATC, ATC begins rising.

Drawing the Cost Curves in Short-Run o MC goes through the bottom of both the AVC and ATC. This is because if the last unit produced cost less than the average, then the average must be falling, and vice versa o ATC= AFC =AVC--Vertical distance between ATC and AVC equals the AFC at each level of production. o Notice that AVC gets closer at ATC as Quantity increases. This is due to AFC falling as Q increases. o As quantity produced increases, fixed costs become a smaller percentage of total cost. This means that the distance between the ATC and AVC curves will get smaller as more is produced. o MC is at the minimum when MP is at its maximum, because beyond that point diminishing returns sets in and the firm start getting less money. (LOOK AT MARGINAL PRODUCTION GRAPH) o MC>AVC is the firm's short-run supply curve o MC> ATC is the firm's long-run supply curve

Cost Curves Graph

Cost of Production Marginal Cost (MC): The additional cost from hiring

each additional unit of labor. (DOUBLE ADDITIONAL) o Equation: MC= Change in Total Cost/ Change in

Quantity Total Cost (TC): Fixed + Variable Cost Averaged Fixed Cost (AFC): Fixed Cost/Quantity Average Variable Cost (AVC): Variable Cost/Quantity Average Total Cost (AVC): AFC+AVC

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