Economics 310 Handout 1 Professor Tom K



Economics 310 Handout 1 Professor Tom K. Lee

Section I: Review of basic economic concepts

Part 1: Prices, concepts of demand and demand elasticities

(1.5, 2.1, 2.5, 4.1, 4.4, 4.5)

Absolute price is the exchange rate of goods and services for

money.

Relative price is the exchange rate of goods and services for goods

and services.

Market price is the price determined by the actions of all the

buyers and sellers of a market.

Demand price of a product is the maximum amount a consumer is

willing to pay for the last unit of a product.

Two views of a demand curve: positive vs normative views

Consumer surplus is difference between the maximum amount that a

consumer is willing to pay for the quantity demanded and the

actual payment of the purchase.

The First Law of Demand states that as the market price of a

product increases the quantity demanded of the product

decreases.

Own-price demand elasticity is the percentage change in the

quantity demanded of a product per percentage change in the

market price of the product.

The Second Law of Demand states that the own price demand

elasticity is higher in the long run than in the short run.

Change in demand vs change in quantity demanded

Determinants of demand: Income

Prices of substitutes & complements

Advertising

Preferences

Interest rate

Gov't taxes, subsidies & regulation

Expectations

Number of buyers in the market

Income demand elasticity is the percentage change in the

quantity demanded of a product per percentage change in

income.

Cross-price demand elasticity is the percentage change in the

quantity demanded of a product per percentage change in the

price of another product.

Market demand is horizontal summation of buyers' demand curves.

Part 2: Concepts of supply and supply elasticities

(10.1, 17.5)

Supply price of a product is the minimum that one has to pay to

induce a seller to produce and supply the last unit of a

product.

Two views of a supply curve: positive vs normative views

Economics 310 Handout 2 Professor Tom K. Lee

Producer surplus is the difference between the actual amount a

seller receives and the minimum that a seller is willing to

accept for the quantity supplied.

Economic rent is producer surplus with supply price being zero.

The First Law of Supply states that as the market price of a

product increases the quantity supplied of the product

increases.

Supply elasticity is the percentage change in quantity supplied of

a product per percentage change in the market price of the

product.

The Second Law of Supply states that the supply elasticity is

higher in the long run than in the short run.

Change in supply vs change in quantity supplied

Determinants of supply: Technology

Input prices

Joint product prices

Interest rate

Gov't taxes, subsidies & regulation

Expectations

Number of sellers in the market

Market supply is horizontal summation of sellers' supply curves.

Part 3: Partial equilibrium analysis and applications

(2.2-2.4, 10.2, 10.5, 18.1, 18.2)

Equilibrium price is that price where quantity demanded equals

quantity supplied.

Equilibrium price and quantity determination

The Law of Supply and Demand states that, whenever the market price

deviates from the equilibrium price, there are market forces

that would bring the market price back to the equilibrium price

so that transactions take place at the equilibrium price.

The equivalence of excise tax on production vs consumption

Price ceiling is the maximum price that a market is allowed to

operate at.

Price floor is the minimum price that a market is allowed to

operate at.

Agricultural price support

Agricultural target price & deficiency payment

International trade and tariff

Pricing of exhaustible resources

Economics 310 Handout 3 Professor Tom K. Lee

Section II: Consumer theory and applications

Part 4: Consumer theory

(3.1-3.3)

A consumer budget line is the combinations of products that the

expenditures on these products will exhaust a consumer's

income.

An indifference curve is the combinations of products that give a

consumer the same level of satisfaction.

Marginal utility is the incremental amount of satisfaction due to

the last unit of a product consumed.

Marginal Rate of Substitution is the compensation of the

consumption of one product in sacrifice of the consumption of

another product while holding a consumer's satisfaction level

constant.

The Law of Diminishing Marginal Rate of Substitution states that

the marginal rate of substitution gets less and less as we gain

more and more of a product while holding utility constant.

Utility maximization subject to a consumer budget constraint

Optimality condition for consumption choice: incremental

satisfaction from the last dollar spent on each product should

be the same across all products.

The Composite-good Convention

Part 5: The decomposition of price effect into income effect and substitution effect

(3.4, 4.2-4.3, 4.6)

An income-consumption curve is the combinations of products that

are utility maximizing at different levels of income while

holding all prices constant.

Normal(superior) goods are goods where an increase in income would

increase the demand for the goods.

Inferior goods are goods where an increase in income would decrease

the demand for the goods.

A price-consumption curve is the combinations of utility maximizing

product choices at different price levels of a product while

holding all other prices and income constant.

Price effect is the change in the optimal consumption point as the

price of a product changes while holding all other prices and

income constant

Substitution effect is the change in the optimal consumption point

as the price of a product changes while holding all other prices

and satisfaction level constant.

Income effect is the change in the optimal consumption point as the

income changes while holding all prices at the new price levels.

Price effect = Substitution effect + Income effect

Ordinary goods are goods that satisfy the First Law of Demand.

Economics 310 Handout 4 Professor Tom K. Lee

Giffen goods are goods that violate the First Law of Demand.

Own price demand elasticity and the price-consumption curve

Part 6: Applications of the decomposition of price effect

(5.1)

Excise tax vs lump sum tax

Excise subsidy vs lump sum subsidy

Tax-plus-rebate program

Part 7: Intertemporal consumer theory

(5.5)

An intertemporal budget line is the combinations of consumption

today and consumption tomorrow such that the present value of

consumption equals to the present value income.

An intertemporal indifference curve is the combinations of

consumption today and consumption tomorrow that give a consumer

the same level of satisfaction.

Effect of an interest rate change and savings behavior

Ricardian Equivalence Theorem states that under perfect competition

government budget deficit due to a tax cut has no effect on

intertemporal consumption choices but increases savings.

Section III: Producer theory and applications

Part 8: Producer theory with one input and applications

(1.6, 7.1-7.2, 8.1-8.3, 8.9, 20.5)

Total product, average product and marginal product curve.

The Law of Diminishing Marginal Product states that there exists

a level of input beyond which additional unit of input would

yield a lower marginal product.

Three stages of production

Equalizing marginal product: the case of education

Opportunity cost is the best feasible alternative foregone.

Total cost, total fixed cost, total variable cost and marginal cost

Average cost, average fixed cost and average variable cost

Equalizing marginal cost: the case of pollution abatement

Part 9: Producer theory with two inputs and applications

(7.3-7.4, 8.4-8.6)

An Isoquant is the combinations of inputs that yield the same level

of output.

Marginal Rate of Technical Substitution is the amount of an input

that must be increased in order to maintain a given output level

when the amount of one of the other inputs is reduced.

Economics 310 Handout 5 Professor Tom K. Lee

The Law of Diminishing Marginal Rate of Technical Substitution

states that as we use more and more of an input the marginal

rate of technical substitution of that input decreases.

Decreasing, constant and increasing returns to scale.

An isocost line is the combinations of inputs that have the same

production cost.

Cost minimization subject to an output constraint

Output maximization subject to a cost constraint

Optimality condition for input choices for output-constrained cost

minimization: incremental cost due to the last unit of output

through an increase in an input should be the same across all

inputs.

Optimality condition for input choices for cost-constrained output

maximization: incremental output due to the last dollar spent on

an input should be the same across all inputs.

Effect of input price increases on average(marginal) cost curves

Input choice restriction raises cost of production.

Short-run vs long-run average(marginal) cost curves

Section IV: Profit maximization and perfect competition

Part 10: Short-run vs long-run profit maximization of

a competitive firm

(9.1-9.6)

Perfect competition model: many small price-taking buyers

many small price-taking sellers

no transaction cost (free entry & exit)

perfect information

homogeneous private good

no externality

Short run profit maximization conditions of a competitive firm:

-price equals short-run marginal cost

-short-run marginal cost is increasing

-price is no less than minimum average variable cost

The short-run supply curve

Shut-down decision

Long-run profit maximization conditions of a competitive firm:

-price equals long-run marginal cost

-long-run marginal cost is increasing

-price is no less than minimum long-run average cost

The long-run supply curve

Economics 310 Handout 6 Professor Tom K. Lee

Part 11: Competitive industry equilibrium

(9.7)

Zero profit equilibrium conditions of a competitive industry

-price equals long-run marginal cost

-long-run marginal cost is increasing

-price equal minimum long-run average cost

Efficiency of zero profit equilibrium of a competitive industry

Why do firms exist? -to reduce transaction costs

-economies of scale (and scope)

-diversification of risk

Why do corporations exist? -separation of ownership & management

-limited liability

Section V: The spectrum of market structures

Part 12: Monopoly and market power

(11.1-11.5, 15.1-15.3)

Sources of monopoly power -essential input

-economies of scale

-gov't regulation

-entry barrier

Natural monopoly is a one seller situation where for all relevant

levels of demand the average cost curve is declining.

Pure monopoly model -many small price-taking buyers

-one price-setting seller

-no substitutes and no entry

-homogeneous private good

-perfect information

-no externality

Total revenue, average revenue and marginal revenue curves

A monopolist never operates in the inelastic region of a demand

curve.

A monopolist has no supply curve.

Short-run profit maximizing conditions of a monopoly:

-marginal revenue equals marginal cost

-change in marginal cost exceeds change in marginal revenue

-price is no less than average variable cost

Social cost of a monopoly –Harberger triangle (DWL)

-rent-seeking cost

-dynamic cost

Economics 310 Handout 7 Professor Tom K. Lee

Part 13: Price discrimination

(12.1-12.3, 12.5)

Conditions of price discrimination

-market power

-ability to separate consumer groups

-no resale

1st degree price discrimination is the charging of different prices

for different units of a product to each consumer.

2nd degree price discrimination is the charging of different prices

for different blocks of units of a product to each consumer.

3rd degree price discrimination is the charging of different prices

to different consumers(possibly in different markets).

The inverse demand elasticity rule: a monopolist will charge a

higher price in a market with a lower demand elasticity.

Uniform pricing is the charging of the same price to different

consumers.

Welfare comparison of 3rd degree price discrimination vs uniform

pricing

Two-part tariffs is a form of pricing charging buyers an entry fee

plus a per unit price.

All-or-nothing contract is a form of pricing where a buyer can buy

a fixed quantity of a product at a fixed price per unit or

nothing.

Part 14: Peak load pricing

(12.4)

Peak-load pricing is the pricing of a service when the demand of

the service varies over time, with the peak users charged the

marginal cost and the marginal capacity cost while the off-peak

users are charged only the marginal cost.

Reverse-peak problem arises from implementing peak-load pricing

when the peak users are charged the marginal cost plus a high

marginal capacity cost but the off-peak users are only charged

the marginal cost and the demand for peak users and off-peak

users differ so little that peak users end up consuming less

than the off-peak users.

Solution to reverse peak problem: vertical summation of demands

Part 15: Monopolistic competition

(13.1)

Monopolistic competition model

-many small price-taking buyers

-many small price-setting sellers

-product differentiation

-no transaction cost(free entry & exit)

-perfect information

-no externality

Economics 310 Handout 8 Professor Tom K. Lee

Profit maximization conditions of a monopolistic competitive firm:

-marginal revenue equals marginal cost

-change in marginal cost exceeds change in marginal revenue

-there exists an output such that demand price is no less than

average variable cost

Zero profit equilibrium of a monopolistic competitive industry:

-marginal revenue equals marginal cost

-change in marginal cost exceeds change in marginal revenue

-price equals average cost

Inefficiency of monopolistic competition

Excess Capacity Hypothesis states that at the zero profit

equilibrium of a monopolistic competitive industry, average cost

is not at the minimum average cost, that is further increase in

output will lower average cost.

Part 16: Models of oligopoly and game theory

(13.2-13.4, 14.1-14.5)

Dominant-firm price-leadership model and residual demand

Cartels as multiplant monopoly

Oligopoly: Cournot(quantity) vs Bertrand(price) rivalry

Game theory -number of players

-information sets of players

-preferences of players

-strategy sets of players

-equilibrium concepts, e.g. Nash equilibrium

Prisoners' dilemma game has unique Pareto-dominated Nash

equilibrium.

Battle-of-sexes game has two nonequivalent Nash equilibria.

Repeated games and reputation

An isoprofit curve of a firm is the combinations of outputs of

firms that give a firm the same level of profit.

A best response function is the profit maximizing output choices of

a firm at various output levels of the other firms.

Cournot-Nash duopoly equilibrium: incentive compatibility

individual rationality

Instability of cartels

Information asymmetry: adverse selection and moral hazard

Section VI: The study of input market and intermediate good market

Part 17: The demand and supply of labor

(16.1, 16.6, 17.1, 17.2)

The value marginal product of an input is the competitive price

of a product times the marginal product of the input.

The average revenue product of an input is the average revenue

of a product times the average product of an input.

Economics 310 Handout 9 Professor Tom K. Lee

Profit maximizing input choice conditions for a competitive firm:

-input price equals value marginal product of the input

-value marginal product of the input is declining

-maximum average revenue product is no less than input price

The marginal revenue product of an input is the marginal revenue of

a product times the marginal product of an input.

Profit maximizing input choice conditions for a monopolist:

-input price equals marginal revenue product of the input

-marginal revenue product is declining

-average revenue product is no less than input price

Income-leisure tradeoff and backward bending labor supply curve

Part 18: Other forms of market structure of the labor market

(16.7, 17.6)

Monopsony is a one price setting buyer but many price taking

sellers market.

Monopsonist has no demand curve.

Labor union as -workers' welfare maximizer

-union due maximizer

-membership maximizer

Part 19: The market for intermediate goods and transfer pricing

Transfer pricing is the pricing of an intermediate good by

one division of a firm to another division of the firm.

Transfer pricing with no intermediate good market

Transfer pricing with a competitive intermediate good market

Section VII: General equilibrium analysis

Part 20: General equilibrium of an exchange economy

(19.1, 6.1-6.3)

Exchange economy & Edgeworth exchange box

Consumption contract curve is the combinations of consumption

points where the marginal rates of substitution of the two

consumers are equal.

Pareto optimality is the condition where one cannot increase the

well being of one individual in an economy without hurting the

well being of another individual in the economy.

Offer curve is the combinations of utility maximizing consumption

choices at various price levels for a given endowment point.

The First Fundamental Welfare Theorem states that every general

competitive equilibrium is Pareto efficient.

The Second Fundamental Welfare Theorem states that every Pareto

efficient outcome can be achieved by income redistribution

followed by a competitive market process.

Pure monopoly vs discriminating monopoly in an exchange economy

Economics 310 Handout 10 Professor Tom K. Lee

Part 21: General equilibrium of a production economy

(19.2-19.5, 19.7)

Edgeworth production box

Production contract curve is the combinations of input choices

where the marginal rates of technical substitution for the two

products are equal.

Production possibility frontier is the combinations of products

that an economy can produce when it uses all its resources

efficiently.

Marginal rate of transformation is the reduction in the output of

one product when there is an increase in output of another

product while using all resources efficiently.

Gains from international trade:

-the case of differences in technology

-the case of differences in taste

Efficiency conditions for general competitive equilibrium

-equality of marginal rate of technical substitution across

products

-equality of marginal rate of substitution across consumers

-marginal rate of transformation equals relative prices

General equilibrium with product market monopoly

General equilibrium with input market monopoly

Section VIII: Miscellaneous topics of economics

Part 22: Public goods and demand revelation

(20.1-20.2)

Pure public goods -nonrivalry in consumption

-nonexclusion

Excludable public goods e.g. membership social clubs

The free-rider problem occurs in the provision of a pure public

good where each consumer has an incentive not to buy the pure

public good in hope that the other consumers would buy it so as

to free ride on their consumption of the pure public good, but

then no consumer would buy the pure public good leading to

underprovision of the pure public good.

Vertical summation of the demand curves for a pure public good

Demand-revelation mechanism is the process through which truthful

information on the demand of a public good would be voluntarily

revealed by the consumers.

Groves-Ledyard mechanism is an example of demand revelation

mechanisms where each buyer's contribution to the payment of

a public good is dependent only on the information supplied

by the other buyers on their demand for the public good.

Economics 310 Handout 11 Professor Tom K. Lee

Part 23: Externality, common property and Coase Theorem

(20.3-20.4)

Externality is the situation where the act of consumption or

production of one individual affects the well being of another

individual.

Positive externality and excise subsidy

Negative externality and excise tax

Tax vs quota in negative externality

Marketable pollution license

Property rights -rights of ownership

-right to use

The common-property problem arises when property rights are

allocated on a first-come first-serve basis, leading to

excessive usage of the resource.

The Coase Theorem states that if property rights are well defined

and enforced, and there are no transaction costs, then no matter

how property rights are allocated the outcome would be

efficient.

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