ECON 102 Tutorial: Week 2 Ayesha Ali www.lancaster.ac.uk/postgrad/alia10/econ102/ [email protected] office hours: 8:00AM – 8:50AM tuesdays LUMS C85 Additional Resources Videos that explain the basics of many of the ideas, terminology, and theories that we will learn in both micro and macro economics: https://www.khanacademy.org/economics-financedomain/microeconomics It’s not compulsory to review them. They are just an additional resource that explain the same concepts in a slightly different way and use slightly different examples. Note that the ordering of topics is not the same as what we are following, so you’ll have to look around to find the topic that you’d like more help with. Four important mistakes in decision-making We learned that people are rational decision makers. But sometimes people make mistakes or don’t follow the rules of rational behavior. There are four important mistakes (pitfalls) that people often make when making decisions. What are they? Four important mistakes in decision-making Measuring costs and benefits as proportions rather than absolute money amounts Would you walk 30 minutes to save £10 on a £1000 laptop? Would you walk 30 minutes to save £10 on a £40 videogame? The absolute value is important here -- £10 is £10 either way. Ignoring Opportunity Costs Many people fail to consider what they give up by taking a particular action Failure to ignore sunk costs A sunk cost is a cost that is non recoverable at the moment a decision is made – it doesn’t matter what you chose, you lose the sunk cost either way. Failure to understand the average vs. marginal distinction When deciding how much of an activity to undertake, the focus should always be on the cost and benefit of one additional unit of an activity. Question 1(a) Mike is currently a taxi driver in Manchester. Each hour Mike operates his taxi costs him £5 in petrol. The total revenue that Mike expects to bring in from operating his cab for h hours is given in the following table: If Mike is trying to maximize his profit (i.e. total revenue minus total costs), how many hours a day should Mike spend operating his cab? What information do we need to know if we want to find out how to maximize profit? What is the Cost-Benefit Principle? Number of Hours Operating Cab 0 1 2 3 4 5 6 7 8 Total Revenue 0 £25 £45 £60 £70 £75 £79 £83 £85 Cost-Benefit Principle: The level of an activity should be increased if, and only if, the marginal benefit exceeds the marginal cost. So, in our case as long as MR>MC. Later on in the course, we’ll actually learn that profit is maximized where MR = MC. Question 1(a) Each hour Mike operates his taxi costs him £5 in petrol. So, his MC = £5. How can we find Mike’s MR? Marginal Revenue is the change in Total Revenue that results when we change the number of hours worked. Number of HoursTotal TotalMarginal Revenue Number of So, using that definition, we can fill in the Marginal Revenue column in the table. If Mike is trying to maximize his profit (i.e. total revenue minus total costs), how many hours a day should Mike spend operating his cab? Hours Operating CabRevenue Operating 0 Cab 1 0 0 2 1 £25 2 3 £45 3 4 £60 4 5 £70 5 £75 6 6 £79 7 7 £83 8 8 £85 Revenue 0 £25 £45 £60 £70 £75 £79 £83 £85 Using the Cost-Benefit Principle, we will keep on increasing the number of hours until MR becomes less than MC. So, MC becomes > MR if Mike chooses to go from 5 to 6 hours. So, Mike would choose to drive his taxi for 5 hours. Question 1(b) Now suppose that Mike rents his taxi from Dave. Mike has agreed to pay Dave £5 per day for the next 5 years. Does your answer from part a change? Explain This does not change the answer from part a. The £5 rental fee is unavoidable by Mike (hence that cost is sunk) and should not affect Mike’s decision making. Question 1(c) Instead of the agreement described in part b, now assume that Mike has agreed to pay Dave £5 for each hour he operates his cab, for the next year. Does your answer from part a change? Explain. Essentially, the marginal cost of operating the cab has increased by £5 per hour. We can use the same methods as we did in part (a) to find that Mike should now operate his cab for only 4 hours. In contrast to part b, the rental fee is now not a sunk cost; here Mike can reduce the rental fee by driving less. So, a sunk cost, is a cost that you incur regardless of the choice that you make. It is a cost that will not change depending on what choice you make. Question 1(d) Now assume that Mike owns his own car. It turns out that there is a local florist looking for someone to deliver flowers. There is also a local bakery looking for someone to deliver bread. Mike estimates that if he takes the job delivering flowers, he’ll earn £40 per day in profit. If he takes the job delivering bread, he’ll earn £45 in profit. Assume Mike can only have one job. i) What is the opportunity cost to Mike of continuing to work as a taxi driver? The opportunity cost is the value of the next best alternative available. In this case, it’s the £45 per day Mike gives up from delivering bread. ii) Should Mike continue to work as a taxi driver or take one of these other two jobs? Compare his profit in part (a) to his opportunity cost to make this decision. From part a, we know that Mike will operate his cab for 5 hours. He’ll earn total revenue of £75 and his total cost is 5*5 = £25. Thus, mike earns £50 in profit per day operating the taxi. Since the benefit of operating the cab, £50, is greater than the opportunity cost, £45, Mike should continue to operate as a taxi driver. Questions 2-5 deal with shifts in supply and demand, which are covered in Chapter 3 of your book. Let’s quickly review: - The difference between an increase in supply and quantity supplied (demand and quantity demanded) - The four rules governing the effects of supply and demand shifts - What are the factors that shift supply and demand. Supply vs. Quantity Supplied What is a change in quantity supplied? How can we graph it? What is a change in supply? How can we graph it? The same is true for demand vs. quantity demanded. Supply vs. Quantity Supplied What is a change in quantity supplied? How can we graph it? It is a movement along a supply curve, in response to a change in price of a good or s service. What is a change in supply? How can we graph it? It is a shift of the entire supply curve. The same is true for demand vs. quantity demanded. Let’s Graph Supply & Demand Shifts Increase in Demand Decrease in Demand Increase in Supply Decrease in Supply Four Rules for Supply & Demand Shifts Increase in Demand Demand increases, causing an increase in equilibrium price and in equilibrium quantity. Increase in Supply An increase in supply will cause the equilibrium price to decline and the equilibrium quantity to rise. Decrease in Demand A decrease in demand will cause the equilibrium price and the equilibrium quantity to decline. Decrease in Supply Supply decreases, causing an increase in equilibrium price and a decrease in equilibrium quantity. Factors that shift Supply & Demand Factors that cause an increase in demand: A decrease in the price of compliments An increase in the price of substitutes An increase in income (for a normal good) An increased preference by demanders for the good/service. An increase I the population of potential buyers An expectation of higher prices in the future All of these cause demand to shift to the right. The opposite of these factors will cause demand to shift left. Factors that shift Supply & Demand Factors that cause an increase in supply: A decrease in the cost of materials, labour, or other inputs used in production of the good/service An improvement in technology that reduces the cost of production of the good/service A improvement in the weather (for agricultural products) An increase in the number of suppliers An expectation of lower prices in the future All of these cause supply to shift to the right. The opposite of these factors will cause supply to shift left. Question 2 Dimethylpolysiloxane is a chemical used in the U.S. to produce various items sold by fast food restaurants, like McDonald’s. Graphically illustrate and explain what would happen in the market for fast food in the U.S. if the price of Dimethylpolysiloxane decreased dramatically. This chemical is an input to production in the U.S. fast food industry. Thus, a decrease in its price leads to an increase in the supply of fast food in the U.S. The supply curve shifts right, price of fast food falls, and the quantity of fast food consumed increases. Question 3 Graphically illustrate and explain what would happen in the market for tea if instability in Columbia limited the supply of coffee beans. A decrease in supply of coffee beans leads to an increase in the price of coffee. Since coffee and tea are substitutes, this leads to an increase in demand for tea. Price of tea rises, and quantity of tea increases. Question 4 You own a cookie production plant. Recently the spread of mad cow disease has left the cattle industry devastated. Your economic advisor does not believe this will impact your sales. I think your advisor is mistaken. Who do you think is correct, and why? Provide a graphical milk illustration. Milk and cookies are complements. If the supply of cattle falls => the supply of milk decreases => price of milk increases. If the price of milk increases => demand for cookies decreases => price and quantity of cookies decreases. cookies Question 5 Graphically illustrate and explain the following newspaper headline: “Price of ACE inhibitors increase dramatically as baby boomers reach retirement age”. (Note: ACE inhibitors are a type of medication used to treat heart disease.) As the baby boomers reach retirement age, there is essentially an increase in the population of elderly people. Since elderly people would be more likely to have need for heart disease medication, the demand for ACE inhibitors increases, which leads to the rise in the price. Maths Questions S im plify (i) 1 5 ( ii ) 1 2 3 y-x 15 (x y) x y ( iii ) S olve for x x 2 3 1 x 4 0 8 ( iv ) S olve for x 1 3 4x 1 8x 2 0 ( v ) solve for x and y w here 4y = x - 2 2y = 2x - 4 Maths Questions S im plify (i) 1 5 ( ii ) 1 3 y-x (i) 0 2 15 (x y) x y ( iii ) S olve for x x 2 3 1 x 4 0 (ii) 2 − 2 1 2 1 4 (iii) = , = 8 ( iv ) S olve for x 1 3 4x 1 8x 2 0 ( v ) solve for x and y w here (iv) = 1 2 , = 1 4 4y = x - 2 2y = 2x - 4 (v) = 2, = 0 Extra Practice/Extra Help Note: Most students find that reviewing David Peel’s lecture notes and extra problems are enough to help them with the maths problems. They should be revised first. Some students find these videos useful, so I have provided them here, as a secondary resource. S im plify (i) 1 5 ( ii ) 1 3 y-x 2 15 3 (ii) Algebra (the fraction rules above are applied to algebra. If you have having trouble with algebra and want a refresher, select from the range of topics provided. Again, you will need to figure out on your own what you already know and what you are having trouble with and start there.) y ( iii ) S olve for x 2 Fractions (note, there are many videos and practice problems (with solutions) on fractions, you will need to figure out on your own what you already know and what you are having trouble with and start there. ) (x y) x x (i) x 4 1 0 8 (iii) and (iv) Factoring polynomials. ( iv ) S olve for x 1 3 1 0 (v) Solving simultaneous equations (or systems of equations) by graphing ( v ) solve for x and y w here by substitution (note there are multiple videos for different methods of solving 4y = x - 2 simultaneous equations – I’d recommend doing all of the ones in the “super fast systems of equations” section (graphing is the first one). They 2y = 2x - 4 also provide practice problems with solutions). 4x 8x 2 Next Week The following tutorial groups will have a different tutor, Yohannes Ayele: T01/03 - Mondays, 6-7PM – weeks 2 & 3 T01/34 – Tuesdays, 9-10AM – week 2 only No change for other tutorial sections. Please check Moodle for next week’s worksheet from Prof. Rietzke (on Wednesdays), and for maths questions from Prof. Peel (on Thursdays).