Econ 201 Microeconomics

What is Economics and why study it?

The What
Economics is choice under constraint
Scarcity is how to describe economics in one word
The Traditional Definition of Economics is:
Economics is a social science concerned with use of scarce resources in the
production and distribution of goods and services to satisfy the unlimited human
wants.
Positive vs. Normative Economics
Positive economics is descriptive; it describes the facts as they are. Positive
Economics is concerned with what is.
Normative Economics, on the other hand, tells us what the world should be. It is
prescriptive" rather than descriptive. Normative Economics is concerned with
what should be."
The Why
Economics gives you a different perspective on things
A different tool to make decisions
Thinking analytically is valued in the real world
The Resources
There three types of resources we will deal with
Land (T) Terra
Raw materials (gold, petroleum, etc) and real estate
Capital (K) Cost but K
Goods that are used in production of other goods.
Roads, machines, infrastructure
Labor (L) Labor
The skills and abilities and the time that people are willing to spend in gainful
activities

Microeconomics
Microeconomics is the branch of economics that is concerned with entities such as
markets, individuals, and firms.
Adam Smith (1723-1790)
1

Major work An Inquiry into the Nature and Causes of the Wealth of Nations
(1776)

1
Information on the tests regarding Important People will deal primarily with Name and Theories/Ideas
Theories/Ideas the invisible hand, laissez-faire, specialization
Invisible Hand Leave the market to operate by themselves. Everyone should
work for their own best interests.
Laissez-faire No government supervision
Specialization Good at something? Focus on it and specialize on it.

Macroeconomics
Macroeconomics, on the other hand, is concerned with the overall performance of the
economy.
John Maynard Keynes (1883-1946)
Major Work The General Theory of Employment, Interest and Money (1936)
Theories/Ideas slumps are due to a lack of demand, government should interfere
Government should stimulate the economy is a recession to get it back on track.
When the economy strengthens the government should back off.
Friedrich August von Hayek (1899-1992)
Major Work The Political Order of Free People (1979)
Theories/Ideas criticized socialism, Noble Prize winner (1974), argument with
Keynes
See Keynes vs Hayek rap battle "Fear the Boom and Bust" on youtube.com
Socialism was considered anything other than free market.
Big on laissez-faire, government intervention will make it worse by creating debt.

Scientific Theory in Economics
Observation
Study a phenomenon that you will to make predictions about
Make Assumptions
Generalizations Impossible to capture everything so try to capture the spirit
Build a Model
Mathematical models lots of graphs and equations
Make Predictions
Testing
How did the model match up against what actually happened?
Failed? Either start from scratch or try to fix whats wrong

Three Common Fallacies/Pitfalls
The Fallacy of Composition
Draw general conclusions from individual circumstances
Excellent growing season Lots of crops from many growers Supply exceeded
demand Low profits
The Post Hoc Fallacy (Post hoc ergo propter hoc)
Because something happened before an event you cannot assume the first event
caused the second event.
The Ceteris Paribus Fallacy (All else equal)
Failure to keep other things constant
Moving to city and assuming the higher wages will make you better off. However,
everything is more expensive. Not everything is equal.
Changing one thing can change the result

The Three Major Economic Questions
What and How much/many to produce?
How to produce?
For Whom to produce?

Command Economy vs. Market Economy
Command Economy Government the government makes all the important decisions
about production and distribution. Government owns the resources and the means of
production and it determines who will consume the outputs of production.
Communism
Market Economy Firms and individuals make the economic decisions. Individuals,
firms, and the interaction between the answer the three questions.
Capitalism
Most market economies are in reality a mix between command and market.

Major Components of Market Economies
Money
All types of money currencies, bank notes, checks, etc.
Transactions, bartering
A barter system is a market system in which goods or services are traded directly
for other goods or services. Relies heavily on wants
Specialization
Can apply to individuals and countries and everything in between
Very important to the market system
Trade
Capital and Investment

Markets, Prices, and Market Equilibrium
Market a mechanism which brings buyers" and sellers" together.
Price is the exchange value of goods and services at the market in terms of money
Market Equilibrium the balance between all the buyers (the demand) and the sellers
(the supply) in an economic system.








Profit represented by is total revenue minus total cost
Three Questions revisited and why government is needed
What? How Much? Good and Services need some oversight or else crazy ones may
grow in size (mercenaries and WMDs)
How? Firms seek maximum profits which can be problematic. Child labor is a good
way to reduce cost and maximize profit but is unscrupulous.
For Whom? Market may shift causing a 99% vs. the 1% scenario.

Conditions under which the Market System will work by itself
Economic agents are rationale
Economic agents know what they want and act accordingly
Markets are perfectly competitive
When there is no single buyer/seller that can affect the market price, markets are
competitive
Monopolies are the exact opposite of a competitive market
There are no negative externalities
A situation in which economic agents who are not part of a specific market are
negatively affected by what is happening in this market.
Example is living next to an airport. They may not be traveling much or at all but
they have to deal with the noise, planes, etc
Positive externalities are when economic agents are positively affected by a market
they are not a member of.
This is rare because most of the time the firm will attempt to internalize the profit.
A metro stop is built near your house Price of your house increases
(positive) Taxes go up on house because of its new cost (internalized)
Income distribution is fair and just
Perceived as fair
Goods and
Services Market
$$$
Individuals
How?
For Whom?
Firms
Factors Market
$$$
G & S G & S
$$$
L,T,K
L,T,K
What? How Much
Circular Flow
Model
Not everyone makes the same amount, but that there are boundaries.
The system is stable and growing
Not the Boom Bust cycle
Great Depression
The Role of the Government
Economic agents are rationale
Very little control over this
Markets are perfectly competitive, and There are no negative externalities
Improve efficiency
The reason mergers are carefully monitored
Do not want to give excessive market power to any one player.
Income distribution is fair and just
Promote fairness
One way is progressive taxation. Progressive taxation is setting a higher tax rate
to those who make more money.
Another way is setting minimum wages.
The system is stable and growing
Monetary and Fiscal policies
Monetary policies include money supply and interest rates.
Fiscal policies include taxation and spending.

Production Possibility Frontier (PPF)
Definition of PPF (See Here)
The PPF represents all possible combinations of Goods and Services that can be
produced in an economy with a given amount of resources that are fully and
efficiency employed

Properties of PPF
Downward sloping
The only way to produce more of one good is to produce less of another.
Concave (bowing out)
0
5
10
15
20
0 2 4 6
Guns (10
3
)
Roses (10
6
)
PPF Example
PPF
This captures the Law of Increasing Opportunity Cost.
Opportunity Cost is the value of the best forgone alternative (the alternative
given up).
Each million of roses produced cost more and more guns.
Assumes full and efficient employment
If you are under the PPF curve then there is unemployment and/or inefficient
employment.
Represents efficient allocation of resources
Efficient, Inefficient, & Unattainable Production
Applications of PPF
The PPF can expand outward or shrink down. This is caused by something that
causes an increase in productivity (technology, increased land or work force,
investment). This shift does not need to happen evenly between the outputs



Frontier vs. Urban Society
Production of capital goods (goods used to produce more goods) allows for the
PPF curve to grow outward (at the cost of immediate product from producing less
consumer goods).
Think delaying gratification
In a Frontier society, the focus is more on producing the consumer goods,
whereas, the Urban society focusing on capital goods.
Public goods and services are goods and services that nobody can be excluded
from consuming.
Private goods and services which can be used only by certain individuals.

Demand Schedule
Demand Schedule definitions
Demand schedule is defined as the relationship between prices and quantity
demanded at a given point of time, ceteris paribus (all else equal)
Demand curve is a graphical representation of [demand schedule definition].
Law of Downward Sloping Demand when the price of a good increases the price of
this good/service decreases, ceteris paribus (all else equal).

Affected the Quantity Demanded
The factor that will affect the quantity demanded is the price of the good.
Gets too high and no one will buy it.
Demand Curve Shifts
Factors
Income
Win the lottery buy more luxury goods
Market size
Economy is good more people willing to spend
Price of related goods
Complementary goods (coffee & cream, cars & tires, milk & cornflakes)
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Price ($)
Quantity Demanded (10
6
)
Quantity Demanded
Demand
If the price of one complementary good (milk) increases, it will affect the
quantity demanded of the other good (cornflakes)
This does not change the curve!!! Only your location on it.
Symbiotic relationship
Substitute goods (Coke & Pepsi)
If the price of one competing good increases people will consume less of it
and consume more of the cheaper alternative.
Tastes and Preferences
New inventions
Think of the demand for CD players after the iPod caught on
Expectations
Think snow storm predicted so everyone stocks up on milk so the demand of
milk increases
Special factors
Most important special factor is the weather
Demand for sandals in the winter is low but in the summer is high.

Supply Schedule
Definitions
Supply schedule is the difference between prices and quantity supplied at a given
time, ceteris paribus (all else equal).
The supply curve is the graphical representation of [supply schedule definition]
Supply Curve
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5 10 15 20 25 30 35
Original
Shifted

Shifts along the Curve vs. Shifts of the Curve.
The only factor that cause movements along the supply curve are caused by a change
in price.
Factors that Affect the Supply Curve
Production costs
If something becomes more expensive to produce then it shifts to the left
increasing the price of the quantity supplied
Drought causes bad harvest price of crop in question increase
Prices of related goods
Products produced by the same technologies (soccer balls & basketballs)
Company that makes basketballs and soccer balls may shift production from
one to the other due to March Madness, World Cup, etc...
Related to Tastes and Preferences
Special Factors
Weather once again
Great harvest of coffee beans will flood the market and cause a shift to the
right on the graph. Meaning that the price will be lower for a given quantity.
Inventions
New invention replaces the old
Expectations
Expecting a hike in gas prices, people will stock up on gas beforehand
Expecting large amount of purchases (new game releases), then company will
produce more anticipating this.

Supply and Demand
Market equilibrium
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Price ($)
Quantity Supplied
Supply
Supply
Equilibrium price is the one at which Demand and Supply are in balance, that is, the
quantity offered for sale is equal to the amount that people wish to buy. This price is
also known as the "market-clearing price"
Excess Supply vs. Excess Demand
When you are above the equilibrium price the difference between the 2 curves at a
given price is called surplus.
The consumers want less then what firms wish to produce at that price.
Conversely if you are beneath the equilibrium point, the difference between the 2
curves at a given price is called shortage.
Consumers wish to buy more than firms are willing to produce at that price

Some Applications
Price ceiling is the maximum price that a producer can legally charge. A price ceiling
only makes sense if it is imposed below the market equilibrium
This will generate a shortage
Price floor will only make sense if it is imposed above the equilibrium price
Minimum wage
This will generate a surplus

Price Elasticity of Demand
The Elasticity of Demand (E
d
) is the absolute value of the percentage change in the
quantity demanded divided by the percentage change in prices.
This captures the sensitivity of quantity of demand to the change in prices

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The change in quantity (Q) divided by the average quantity(Q

m
)

The change in price (P) divided by the average price (P

m
)
Total Revenue is the market-clearing price (equilibrium price) times the equilibrium
quantity.

Price Discrimination is the practice of charging different customers different prices for
the same good or service.
This is possible because different customers have different sensitivity to price
changes
Elastic, Inelastic, Unitary Elastic Demand
A product is ELASTIC (or sensitive) if the E
d
> 1
If the price changes it greatly changes the quantity
A product is INELASTIC if the E
d
< 1
A change in price effects the quantity on to a smaller degree
Unitary elastic demand when the E
d
= 1
Elasticity is NOT slope generally, however there are two exceptions (extreme cases)
Perfectly inelastic
Perfectly inelastic means that the quantity demanded does not change regardless
of any price change.
Think medication
This will be represented by a perfectly vertical quantity demanded curve.
Perfectly elastic
Perfectly elastic means that any change in prices will change the quantity demand
infinitely.
This will be represented as a perfectly horizontal quantity demand curve.
A list of something?
Necessary vs. Luxury
Necessities are things we cannot live without.
Inelastic Demand
Luxuries are wants not needs
Share in Budget
The larger the budget share the more elastic the demand.
Milk becomes a dollar more expensive no response Price triples then
there will be a response.
Substitutes
The more substitutes available the more elastic
Prices rise at one store, demand shifts to a competitor at a lower price.
Time
As time passes the demand becomes more responsive
Gas prices go up but the response is not immediately felt till you go back
to the pump.

Bumper Harvest Paradox
Brazil produces 70% of the worlds coffee. Had an incredible year of weather, producing
a huge harvest. They ended up losing money.

Elasticity of Supply
Elasticity of Supply is the percentage change between quantity supplied and percentage
change in price.

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----------------------------END OF MIDTERM 1 MATERIAL----------------------------
Utility
Definitions
Utility is a scientific concept used in Economics to explain how rational consumer
divide their resources between different goods and sources that bring them
satisfaction
In one word it is satisfaction
Rational Consumers are:
Non-satiated
Always prefer more than less
Given a choice between one of a good or two of the same good, they take
the two of a good.
Transitive
Likes good A more than good B, and likes good B more than good C,
therefore they like A more than C
Chocolate > Cereal > Fruit
Complete
That when you offer the consumer a bunch of choices the consumer is able to
compare. (?)
Cardinal or Ordinal Utility
Cardinal Utility means measureable utility
Ordinal Utility (more important of the two) means able to order/rank the satisfaction
You dont have to be able to know how much you like something; you just need
to be able to know if you like it more or less than something else.
Total vs. Marginal
Definition
Total Utility is the total satisfaction that we derive from the choices that we make
Total Utility = Marginal Utility
Marginal (= additional) Utility is the additional satisfaction that we derive from
consumer one more unit of a good or service, ceteris paribus.
This is how much satisfaction you get from each individual unit
Law of Diminishing Marginal Utility
After some point each additional unit of a good/service that we consume will
bring us less and less satisfaction (becoming jaded).
Thirsty so you drink a bottle of water (+ 10 Happiness). Still a little thirsty so
you drink another bottle (+ 7 Happiness).
Prices reflect Marginal Utility not Total Utility.
This explains why water (a necessity of life) is less expensive than diamonds
(a want).
Applications
Consumer Surplus and Producer Surplus
Consumer Surplus is the difference between how much we value a product
and how much we pay for it.
The bigger the consumer surplus the happier the consumers are

Producer Surplus is the additional value that producers get above what they
are willing to sell for.
The sum of Consumer Surplus and Producer Surplus is defined as Welfare



Production Theory
Firm is a business organization devoted to managing the process of production and
supply
Three major types of Business Organizations
Individual Proprietorships Partnerships Corporations
Scale small medium Large
# of Firms 72% of all US firms 8% 20%
Sales 5% in the US 15% 80%
Liability Full / Unlimited Full / Unlimited Limited
Ownership Owner Owners Shareholders
Control Owner Owners Board of Directors
Individual Proprietorship
Think lunch trucks
Partnerships
Partners are responsible for each other (one disappears, the other inherits all the
debts)
This is why they are not popular and people prefer Individual Proprietorship
Corporations Owned by shareholders who appoint a Board of Directors to run the
corporation. Due to the limited liability if the company fail is does not affect the
shareholders as much as if it was a Individual Proprietorship or Partnerships. Major
downside is taxes (35%)
Production Function specifies the maximum output that a company can produce with a
given amount of resources and technologies.
Production Relationships
Total Product (Output)
Total amount produced
Marginal Product of an Input
The additional output produced by one more unit of the input, ceteris paribus.
Marginal Product =

Change in output divided by the change in input
In the graph below the reason for the increase in productivity before the Law of
Diminishing Marginal Productivity is due to specialization.
Firms, in the graph below, will never be located before the local maximum or
after the marginal productivity crosses zero.
Average Product of an Input
The output per unit of input employed, ceteris paribus.
Average Product =

The output divided by the input

Law of Diminishing Returns
Ceteris paribus, after some point adding more units of an input will add less and less
additional output
Also known as the Law of Diminishing Marginal Productivity
Returns to Scale
Production is subject to increasingly returns to scale when doubling all inputs results
in more than double output
Production is subject to decreasing returns to scale when doubling all inputs results in
less than double outputs
Production is subject to constant returns to scale when input doubles results in outputs
doubles
Time and Production
Short-run vs. Long-run
Short-run is a period in which the firm can only change variable costs.
Long-run is a period in which the firm can vary all costs, both fixed and variable.
Production and Technology
Product Innovation
New technology becomes available
Think the Industrial Revolution
Process Innovation
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Output
per Unit
of Input
Input
MP
AP
Existing services or goods become better
Faster computers, smaller cell phones
Economic vs. Accounting: Costs & Profits
Economic costs (EC) Accounting costs (AC)
EC = AC + OC
Opportunity cost (OC) is the value of the best forgone alternative (best thing you
have give up)
Economic costs will always be higher than accounting costs
Having a Profit () of 0 can be considered good if it is based off of the economic
costs. This is because there was no better alternative then what you chose.
Profit () = TR TC = (P)(Q)-EC
Costs
Total Cost (Graph)
the total monetary spending of a company on inputs needed to produce a given
number of outputs
Total cost is the sum of the fixed costs and the variable costs
TC = FC + VC and TC = VC (because FC is constant)
Total cost, as seen in graph below, initially rises with a decreasing slope but
after a certain point rises with an increasing slope.
Fixed Costs (Graph)
Costs that do not change with output (sunk or overhead)
Rent of the building for example
Variable Costs (Graph)
Directly related to output. The more you produce the higher the variable cost.
The price of ingredients for a pizza place
Marginal Cost (Graph)
The minimum cost that a firm has to make to produce one more unit of output.

The shape initially has a negative slop but after a certain point it will switch to a
positive slope.
This shape is a reflection of the graphical representation of Market Production
An increase in Market productivity will result in a decrease in Marginal
Cost, and vice versa.
Average Cost (Graph)
Average Cost is simply the cost per unit of output.

The Average cost is the sum of the average Fixed cost and the average
Variable cost

Graph Analysis
In the short run we distinguish between the fixed and variable costs; however, in
the long run all costs are variable.
The variable cost will be the total cost but offset by the fixed cost. Both total and
variable costs have an S shape. (Explained in total cost)
Because the MC = TC = VC, it is the SLOPE of TC and VC.
Marginal, Variable, and Average Variable costs are always the same for the first
unit.
The MC will intersect the AFC and AVC at their respective minimums.
When MC is below average is pulls it down, when it is above it raises it.


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Costs
Quantity
FC
VC
TC
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Cost
Quantity
AC
AFC
AVC
MC
Perfectly Competitive Markets
Characterizations
Large number of profit maximizing firms
Profit () = TR - TC
Producing identical products
Price takers (relatively small firms)
This means that they cannot affect the price of goods.
Entry and exit are easy (free)
Small firms so start-ups are relatively cheap






Milk 1 Firm
Profit Maximization
The demand faced by a Perfectly competitive firm is perfectly elastic
Marginal Revenue is the additional revenue that the firm will generate by selling one
more unit of its product
Profit () = TR TC
TR = P*Q* & TC = FC + VC
TC = MC & TR = MR = P
Profits will be maximized when the slope of the TC curve is equal to the slope of the
TR curve.
Profit maximization P=MC!!
d
q

TC = FC + VC