ECON 101 KONG Midterm 2 CMP Review Session

Midterm 2
CMP Review Session
Chapter 5 Efficiency and Equity
Benefit, Cost, Surplus – Consumers (1)
A consumer benefits from the consumption of a product
• this benefit determines Willingness to Pay
• graphically represented by the Demand Curve
Demand Curve:
• x-axis shows units of the product, i.e. quantity
• y-axis shows the Marginal Willingness to Pay, in $
• marginal -> for 1 MORE unit, what is the max the
consumer is willing to pay
The more you have, the less you value a thing
• demand curve slops DOWN
Benefit, Cost, Surplus – Consumers (2)
Market Demand Curve:
• adding up all consumers’ demand curve HORIZONTALLY
Consumer Surplus:
• big idea: area under the demand curve = the total $ that
consumers are Willing to pay for a given number of units
• CS = the area under the demand curve and above the price line
Benefit, Cost, Surplus – Producers
Producer must sell to cover the cost of making a product
Marginal Willingness to Sell:
• to deliver 1 more unit, the price producers must charge
• equals the cost to produce that unit = Marginal Cost
• graphically represented by the supply curve
Market Supply Curve:
• adding up all suppliers’ supply curve HORIZONTALLY
• big idea: area underneath the supply curve = total cost of
producing a given number of units
Producer Surplus:
• area below the price line and above the supply curve
Efficient Market – p* & q*
Equilibrium price (p*) and quantity (q*) is where market
supply curve and demand curve crosses.
• price > p*: producers want to sell more than consumers
are willing to buy
• producers will drop price due to competition for
customers until price = p*
• price < q*: consumers want to buy more than producers
are willing to sell
• consumers bid up price until p = p*
Efficient Market – Total Surplus
Total surplus = CS + PS
• CS + PS = total area under the demand curve and above
the supply curve
• maximized when market is Efficient
Deadweight Loss
• occurs when price ≠ p*, quantity ≠ q*
• when market isn’t efficient
• lost benefit that should have been available to society if
market was Efficient
• … or harm done to society when more than efficient
quantity is produced (wasteful use of resources)
Chapter 6 Government Actions
KEY: don’t memorize, draw graphs
Ways government can “mess with” a market
• Price ceiling (e.g. rent ceiling)
• Price floor (e.g. minimum wage)
• Taxes
• Subsidy
• Quota
When a policy forces the market equilibrium AWAY from the
efficient price and quantity, it always leads to inefficiency
and DWL
Price Controls
Price ceiling/cap: maximum price producers can charge
• no effect if ceiling ≥ p*, otherwise shortage occurs
• rent ceiling leads to less than efficient quantity of houses,
longer Search Time, black market and DWL
Price floor: minimum price that must be paid to producer
• no effect if floor ≤ p*, otherwise excess of supply
• minimum wage leads to unemployment (i.e. quantity of
labour available in excess of the quantity demanded)
• effects: increased job search, DWL
1. Tax on consumers, demand curve shifts down by per unit tax
2. Tax on producers, supply curve shifts up by per unit tax
Big idea: consumers and producers want to be able to recreate
their original condition before taxes
Taxes create a NEW equilibrium that is NOT efficient
Tax Incidence: how much of the tax Ultimately falls on
consumers vs producers; careful! doesn’t matter who is taxed,
results are the same
Effect of taxes given different elasticity? Draw graphs to find
Production Quota
Production quota: the max the producers can make
• no effect if quote ≥ q*, otherwise underproduction
• leads to (don’t memorize!):
• decrease in supply
• higher price
• lower Marginal cost
• company wanting to cheat and produce more than quota
Subsidy: government gives monetary aid to firms to help with
• opposite of taxing the producer
• encourages over production and DWL
Chapter 10 Organizing Production
Firms want to maximize Economic Profit
Economic Profit: total revenue minus total cost, this is the
opportunity cost of production
Opportunity Cost: value of the best option NOT chosen
Total cost INCLUDES Normal Profit – the amount the owner
earns on average from starting a business
Constraints that limit a firm’s profitability:
• Technology: a WAY of producing a product
• Information: conformation is costly
• Market: consumers have a limit to their budget!
Production Efficiency
Technologically efficient: when firm can’t produce the
quality with less inputs
Economically efficient: when firm can’t produce the quality
at a lower cost
An economically efficient method has to be technologically
The relative price of inputs determines the economically
efficient method
Businesses & Markets (1)
Types of business: choices of funding
1. Sole Proprietorship: funded by ONE owner
2. Partnership: funded by TWO or MORE owners
3. Corporation: funded by a large number of owners who
will not be liable to pay debt if company goes bankrupt
Types of market: level of competition
1. Perfect competition: large number of firms producing
identical products
2. Monopolistic competition: large number of firms
producing somewhat different products
3. Oligopoly: few firms in the market
4. Monopoly: only one firm
Low barrier to entry can work to keep price down!
Businesses & Markets (2)
Types of market: level of competition
1. Four-Firm Concentration Ratio: percentage of sales
accounted for by the largest 4 firms (0-100)
2. Herfindahl-Hirschman Index: sum of the percentage of
sales accounted for by the largest 50 firms
Careful about limitations of indexes specific to A industry
Production activity of coordinated by
1. firm: lower transaction cost and economies of team
2. market: sellers and buyers of resources uses price to
coordinate production
Usually a mix of the two!
Chapter 11 Output and Costs
1. Short-Run: period of time before the firm can alter ALL
factors of production
2. Long-Run: period of time after the firm CAN alter all
factor of production
Plant (capital) is the building / machines / big investments usually the hardest to alter.
For simplicity: long-run = after a firm can change its plant
An existing plant is considered a sunk cost
Sunk Cost: cost that has already been incurred and can’t be
alter anymore (reduced, reclaimed, etc)
Short-Run Production Behaviour
Product schedule
• Remember short run = plant doesn’t change
• Schedule relates total product to marginal product to
average product
• Total Product: total output given an amount of labour
• Marginal Product: amount of extra output that can be
achieved by using one more worker
• Average Product: total output divided by total labour
1. Increasing Marginal Return at the beginning due to
specialization (division of labour)
2. Decreasing Marginal Return due to crowding and plant
Total Cost: cost of all factors: TC = TFC + TVC
Total Fixed Cost: doesn’t vary by level of production
Total Variable Cost: costs that increases or decreases as
output increases or decreases – costs of labour and capital
Marginal Cost: cost needed to produce 1 MORE unit
Relationships between average and marginal
Marginal > Average: average increase
Marginal < Average: average deceases
Graph tips:
1. vertical distance between ATC and AVC = the height of AFC
2. MC cuts AVC and ATC at their minimum
Cost curves VS Product curves
Costs curves align with product curves
• MP going up -> MC going down
• AP going up -> AVC going down
• AP cuts MP at the output where MC cuts AVC (or the
quantity where AVC is lowest)
Don’t memorize! Think it through, graph on P.260
Long-Run Production Behaviour (1)
Long-run = plant (amount of capital) can change
Long-Run Production Function: shows how output varies with
both labour AND capital
KEY: capital also has increasing and diminishing marginal
Long-Run Average Cost Curve:
• draw all the Short-Run Average Cost Curves, one for each
possible plant, on the same graph
• trace out the lowest segments of the curves to get LRAC
• LRAC curve is the LOWEST average cost to produce a given
a quantity when firm can alter both labour AND capital
Long-Run Production Behaviour (2)
As output increases, firms can decrease ATC by switching to
larger plants – Economies of Sale
There comes a point when more output requires large plants
that raises ATC due to diminishing returns from capital –
Diseconomies of Scale
THE output quantity in the long run when firm achieves the
lowest ATC is called Minimum Efficient Scale

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