Review of Economic Concepts

AREC 365: Natural Resource

Economics

Douglas Mugabe
[email protected]
Outline
● Economic Concepts

○ Circular Flow Model;

○ Supply and Demand  Elasticity of Demand/Supply

○ Choices with Scarcity  Marginal decision making;

○ Costs (TC, AC, MC), Revenue (TR, AR, MR) and Profit

 Profit Maximization (Marginal Revenue = Marginal Cost)

○ Market equilibrium

○ Welfare measures and Market Failures

Circular Flow Model/Diagram
Circular flow model
• Shows how households & firms interact in
markets

Product market (market for goods &

services)
• Firms provide goods and services
• Households pay for goods and services

Resource/factor/labor market
• Households provide factors of production
• Households receive payment
Demand
● We would expect the demand curve to be
downward sloping:

○ the lower the price, the greater the

quantity demanded;

○ the higher the price, the smaller the

quantity demanded.

● This inverse relationship  law of demand

● Differentiate Individual vs market demand?

Supply
● We would expect the supply curve (MC curve) to be
upward sloping:

○ the higher the price, the greater the quantity

supplied;

○ the lower the price, the smaller the quantity

supplied.

● This positive relationship is called the law of supply

● What factors affect supply?

● Differentiate Individual vs market supply?

Price Elasticity of Demand/Supply
• The % change in quantity brought about by 1% change in price

Q / Q0
A) 
P / P0 B)

● What about cross Price elasticity od demand?

● The % change in quantity of product Y in response to a 1% change in the price

of product X:
𝛥𝑄𝑦 /𝑄𝑦
𝜂𝑦𝑥 =
𝛥𝑃𝑥 /𝑃𝑥

○ If 𝜼𝒚𝒙 >0, X and Y are substitutes & If 𝜼𝒚𝒙 <0, X and Y are complements
Cross Price Elasticity of Demand-Example
● It is estimated that a 10% rise in the price of juice would lead to a 1.5% increase in
the demand for coke

● What is the cross-price elasticity? Are these products substitutes or complements?

1.5%
𝜂𝑦𝑥 = = 0.15
10%

○ Since 𝜂𝑦𝑥 > 0, juice and coke are substitutes

• Discuss the following terminology & highlight the magnitude of the elasticity (η)
• Elastic, inelastic; Unitary elastic, Perfectly elastic & inelastic
Class Activity: Price Elasticity of Demand

• Calculate own price elasticity of demand when price changes from $3 to $4.
• What category of elasticity does the result fall into?
Discuss the following cost terms
● Explicit vs Implicit Costs

● Total Costs; Fixed Costs and Variable Costs

● Average Fixed and Average Variable Costs

● Marginal Costs

● Economic vs Accounting Cost

○ Explicit cost vs implicit cost

● Opportunity Cost
Cost and Cost Curves

● Example: 𝑇𝐶 = 10 − 5𝑄 + 2𝑄 2

● Find Average Cost (AC) and

Marginal Costs (MC)

𝑇𝐶(𝑄)
● 𝐴𝐶 =
𝑄

𝑑𝑇𝐶(𝑄)
● 𝑀𝐶 =
𝑑𝑄

● AC and MC curves?
Average Cost and Marginal Costs
Profit and Marginal Revenue Functions
● Total Revenue (TR) = P(Q)*Q

𝑑𝑇𝑅(𝑄)
● 𝑀𝑅 =
𝑑𝑄

TR(Q  Q)  TR(Q)

MR(Q) 
Q
 1
MR  P 1  
 

● Profit = TR-TC

● Profit Maximization

○ MR=MC
 Class Activity: Profit, MR, MC calculations
• Use these equations to answer questions 1 and 2 below: Total cost is represented by

𝑇𝐶 = 40 + 8𝑞 + 4𝑞 2 and demand is expressed as 𝑃 = 80 − 2𝑞 where P=price

1. Find the following

i. Average Cost equation

ii. Marginal Cost expression

iii. Marginal Revenue expression

iv. Output (q) that maximizes profits

2. Determine the numerical value of TC, TR, Price, and profits at the profit maximization quantity

level
 Choices with Scarcity
• Economic entities tend to want more than they can get, but factors of production are always
limited, therefore CHOICES should be made.

• Decisions are based on budget constraints

• Opportunity set  all affordable possible combinations of consumption (to max utility)

• When making choices we have to forego something else  opportunity cost

• Marginal decision making – consider benefits & costs of choosing a little more/less

• The principal of Marginal Analysis is used to answer the “how much” question

• Answer: When Marginal Benefit =Marginal Costs {Marginal Revenue =Marginal Costs}

• Law of diminishing marginal utility - as a person receives more of a good, the additional (or
marginal) utility from each additional unit of the good declines.
Marginal Decision Making
• Marginal Benefits (Demand Curve)

• Maximum amount a consumer is willing to pay for an additional good or service

• Marginal benefit (MB) generally decreases as consumption increases

• MB =change in total benefit divided by the change in the number of units consumed
Δ𝑇𝐵 𝑑𝑇𝐵
• 𝑀𝐵 = Δ𝑞
= 𝑑𝑞

• Marginal Costs (Supply Curve)

• The incremental expense to the business if it produces one additional unit

• Marginal Cost (MC) generally increase as output increases

• MC =change in total cost divided by the change in the number of units produced.
Δ𝑇𝐶 𝑑𝑇𝐶
• 𝑀𝐶 = =
Δ𝑞 𝑑𝑞
Marginal Analysis
● If Marginal Benefit > Marginal Cost
How many hours needed to maximize benefits

○ The activity yields a Net Marginal Benefit

● If Marginal Benefit < Marginal Cost

○ The activity yields a Net Marginal Cost

● If Marginal Benefit = Marginal Cost

○ You have reached the optimal quantity

● How much question: At equilibrium MB = MC

 Class Activity
• Assume a hypothetical market for Q: Total Benefits is given by 𝑇𝐵 = 960𝑄 − 2𝑄 2 and Total Costs
is given by 𝑇𝐶 = 100𝑄 + 3𝑄2 . How much level of quantity (𝑄) should be produced in this market?

d𝑦 d𝑦
• Power Rule: if 𝑦 = 𝑎𝑥 𝑏 then the derivative =𝑎𝑏𝑥 𝑏−1 E.g: if 𝑦 = 3𝑥 5 then the derivative =15𝑥 4
d𝑥 d𝑥

• Step 1: Determine Marginal Benefits • Step 2: Determine Marginal Costs

Δ𝑇𝐶 𝑑𝑇𝐶
• 𝑀𝐵 =
Δ𝑇𝐵 𝑑𝑇𝐵
= = 960 − 4𝑄 • 𝑀𝐶 = = = 100 + 6𝑄
Δ𝑞 𝑑𝑞 Δ𝑞 𝑑𝑞

• Step 3: At equilibrium MB=MC • Using Total Revenue as 𝑇𝑅 = 75𝑄 − 2.5𝑄 2 and

Total Costs as 𝑇𝐶 = 15𝑄 + 5𝑄2 . Determine the
• 960 − 4𝑄= 100 + 6𝑄  𝑄 = 86𝑢𝑛𝑖𝑡𝑠
profit maximising level of quantity (𝑄 ) in this
market?
MARKET EQUILIBRIUM
● Equilibrium: supply and demand intersect

● Consumer surplus (CS)

○ The difference between the willingness to pay and

what is paid for a product.

● Producer surplus (PS)

○ The difference between the market price & the lowest

price a producer is willing to accept to produce a

good

● Economic Surplus= CS + PS+ Tax Revenue

Market Failures

• What is a market failure?

• Market failures results in welfare losses

• Creation of dead weight loss

• Market failure includes;

• Public goods; Externalities; Asymmetric information and Abuse of market power

• Discuss the above market failures

 Any Questions

Next: Introduction to Natural

Resource Economics