AP Microeconomics REVIEW Hints for passing the Ms. Meachum.

AP Microeconomics

REVIEW

Hints for passing the

Ms. Meachum

Topics:MC=MR

Perfect competition

MR PARD

Indeterminant

Sample (capital, capital stock, capital flow)

Economic profit

Elasticity

Short-term/Long-term

Economies of Scale

Scarcity

Derived Demand

Change in Demand vs. Change in Quantity Demanded

Labor Markets

Prices vs. Costs

Consumer Surplus/Producer

Surplus/Deadweight

Government Controls

Externalities

Comparative Advantage

Sample AP Question: Externalities

SHOW ME!

GRAPH ME!

ANALYZE ME!

EXPLAIN ME!

MC = MRMC = MR**Tattoo this on your forehead

This equation comes in many forms: MC=MR, MC=MU,

MSC=MSB...etc

Single Farmer Industry

S

D

D=MR=AR

MMCC

p P

ATCATC

AVC

PERFECT COMPETITION

Qq

Perfect Competition--MUST Perfect Competition--MUST use SIDE-BY-SIDE GRAPHS or use SIDE-BY-SIDE GRAPHS or

no credit.no credit.

Price Price

Quantity

Quantity


S

D

MR=P=AR=D

MMCC

p

ATCATC

AVC

PERFECT COMPETITION

Qq

In perfect competitionIn perfect competition, , individual individual firms are price takers and will take firms are price takers and will take

the market price.the market price.Hint: memorize this line for the AP test.

Price Price

Quantity

Quantity


Price Price

Quantity

Quantity

S

D

MR=P=AR=D

MMCC

p

ATCATC

AVC

PERFECT COMPETITION

Qq

MUST show Economic Profit or MUST show Economic Profit or LossLoss

Economic Profit

MAKE SURE THEY SEE A GAP MAKE SURE THEY SEE A GAP between profit line and ATCbetween profit line and ATC

When I grew up on the farm, we lived next door to

MR. PARDPeople called him that because he knew so

much about perfect competition.

When labeling the demand curve for perfect competition, MAKE SURE it is

labeled

MR = P = AR = D

Single Firm Industry

Price Price

Quantity

Quantity

S

D

D=MR=AR=P

MMCC

p1

q Q

ATCATC

In the LONG RUN, when individuals see the firms are earning an economic profit (above normal rates of return), more firms will enter the market causing the industry market supply curve to shift to the right.

Because the firm is a price taker and must take the market

price, Industry P and Firm p goes down to p1

0

Industry Q goes up to Q1

Firms’ q go down (q to q1)

MR1=P1=AR1=D1

S1

Q1

p

ATC = MR PARD ATC = MR PARD at its lowest at its lowest

pointpoint

q1


Price

Price

Quantity

Quantity

S

D

D=MR=AR

MMCC

p1 P

How is this chart different from the previous chart reflecting an economic

profit?

q Q

ATCATC

Economic Loss

In this situation, P is below ATC at profit-maximizing quantity (q). This chart reflects

a loss.


P P

Q Q

S

D

P=D=MR=AR

MMCC

p

q Q

ATCATC

Economic Loss

In the LONG RUN, when individuals see the firms are making an economic loss, firms will leave the market causing the industry market supply curve to shift down.

S1

Industry Q goes down to Q1Firms’ q go up (q to q1)

MR1=P1=AR1=D1

ATC = MR PARD ATC = MR PARD at its lowest at its lowest

pointpoint

p1

Q1q1

Because the firm is a price taker and must take the market

price, Industry P and Firm p goes up to p1

A graph is worth a thousand words

UNLESS you forget to label it…..

GRAPH FIRST, then let the graph tell the story……LABEL,

LABEL, LABEL

GET TO THE GET TO THE POINT!!!POINT!!!JUST THINK JUST THINK

ECONOMICALLYECONOMICALLY

Good decisions using cost-benefit analysis and marginal thinking.

Chart V: (D ; S )Chart V: (D ; S )

QUANTITYQUANTITY

PRICEPRICES S

DD0 0

E0 P0

Q0

DD1 1

SS11

E1

Q1

Price will be indeterminate.

Quantity will

increase

Be sure to use the word indeterminindeterminateatewhen describing price in this graph!!

If you see the words long-run, need to

double shift.

Make it easy for the reader to grade!!

Number your responses.

ANSWER THE QUESTION clearly and concisely.

MAKE SURE YOU USE PROPER ECONOMIC

TERMINOLOGY WHEN ANSWERING FREE

RESPONSE QUESTIONS.***When answering free response

questions, many students’ explanations do not indicate an understanding of

economic principles. Instead they use common words and terms that may

make common sense but not economic sense.

For example, on the 2004 Micro Exam, Ques 3, part b, students were to indicate:

For the monopolistically competitive firm, what happens to output and profit if there is an elimination of a business license fee (a fixed cost).

For the monopolistically competitive firm, what happens to output and profit if there is an elimination of a business license fee (a fixed cost).

The correct answer is:

--output does not change because the license fee is a fixed cost and does not affect marginal cost.

--profit will increase since total revenue (p x q) does not change and total cost has decreased. (Note: students could have used average instead of total--be consistent)

For the monopolistically competitive firm, what happens to output and profit if there is an elimination of a business license fee (a fixed cost).The correct answer is:


--profit will increase since total revenue (p x q) does not change and total cost has decreased. (student could have used average instead of total)

The term “profit” seems to have given students the most difficulty. A typical student’s response is as

follows:

For the monopolistically competitive firm, what happens to output and profit if there is an elimination of a business license fee (a fixed cost).The correct answer is:


--profit will increase since total revenue (p x q) does not change and total cost has decreased. (student could have used average instead of total)

“Economic profits will also increase because if the license fee is eliminated, there will be more money for the firm which means increased production.

More people will buy the product and there will be more of a profit for the

firm.”



firm.”**The answer assumed (incorrectly) that output changed.

NOT MONEY

***In order to receive the profit point, the student would have to discuss the effect on total revenue (or AR), the effect on total cost (or ATC) and the resulting effect on profit.

Economic ProfitEconomic Profit = total revenue minus all the opportunity

costs (implicit & explicit) of production.

Accounting ProfitAccounting Profit = total revenue minus explicit

costs

Explicit Cost$

Explicit Cost$

Accounting Profit

Economic Profit

Implicit Costs Revenu

eRevenue

Total Opportunity Costs



firm.”**Since the question involved a monopolistically competitive firm with a downward sloping demand curve, increasing output would bring about a decrease in price. This would not necessarily increase total revenue, depending on the price elasticity of demand.

Elastic Demand and Total Revenue

P

Q

$10

$5

0 20 40 60 80 100

B

A

cb

a

At point A, total revenue is $400 ($10 x 40), or area a + b.

At point B, the total revenue is $500 ($5 x 100), or area b + c.

Total revenue has increased by $100.

We can also see in the graph that total

revenue has increased because the area b + c is greater than area

a + b, or c > a.Delasti

c

Inelastic Demand and Total Revenue

P

Q

$10

$5

0 10 20 30 40

B

A

cb

a

At point A, total revenue is $300 ($10 x 30), or area a + b.

At point B, the total revenue is $200 ($5 x 40), or area b + c.

Total revenue has decreased by $100.

We can also see in the graph that total

revenue has decreased because

the area a + b is greater than area b +

c, or a > c.Dinelastic

PRICE

QUANTITY

DD11

P0

P1

0 Q0Q1

DD00

Q2

RelativeRelatively ly inelastiinelasticc

RelativelRelatively elasticy elastic

When a demand curve is relatively steep, such as D0 in

this graph, its price elasticity is relatively inelastic.When a demand curve is

relatively flat, such as D1, its price elasticity is

relatively elastic.

Another area of confusion seems to be short-run vs. long-run:

SHORT-RUN refers to a SHORT-RUN refers to a period of time when at period of time when at least one factor of least one factor of production (input) is production (input) is fixed.fixed.

--It does not refer to a period of --It does not refer to a period of time.time.

--Increasing and diminishing --Increasing and diminishing marginal returns represent short-marginal returns represent short-run situations.run situations.

Another area of confusion seems to be short-run vs. long-run:

LONG-RUN refers to that LONG-RUN refers to that time period where all the time period where all the factors of production are factors of production are variable.variable.

Terms that deal with long-run Terms that deal with long-run include:include:

--economies of scale--economies of scale

--diseconomies of scale--diseconomies of scale

--constant returns to scale--constant returns to scale

ECONOMIES OF SCALE

ECONOMIES OF SCALE: When long-run average total cost declines as output increases.

DISECONOMIES OF SCALE: When long-run average total cost rises as output increases.

CONSTANT RETURNS TO SCALE: When long-run average total cost does not vary with the level of output.

*Mankiw

Average Total Cost

Quantity of Cars per day

0 1,000 1,200

$12,000

10,000

ATC in short run w/small factory

ATC in short run

w/medium factory

ATC in short run w/large

factory

ATC in long run

Economies of Scale Diseconomi

es of ScaleConstant

Returns to Scale

CAUSES of economies or diseconomies of scale:

1) Specialization of workers will be found in higher production levels of economies of scale.

STUMBLING BLOCKS -- Micro

--Scarcity

--Demand vs. Quantity Demanded

--Demand vs. Derived Demand

--Price vs. Cost

--Direction of a shift: UP instead of increase (right) and DOWN instead of decrease (left).

Scarcity is NOT: the same as poverty. (eg. Goods can be scarce in United States AND Somalia. However, scarcity isn’t going away; poverty might.)

the same as shortage. (eg. Whether you have a shortage or not depends upon how you handle the rationing problem made necessary by scarcity)

Scarcity:Insufficient supply of something where

“insufficient” is interpreted relative to the desires of a group of people. (I.e.) For instance, antiques are valued for their scarcity….

CHANGE IN DEMANDCHANGE IN DEMAND

vsvs

CHANGE IN CHANGE IN QUANTITY QUANTITY

DEMANDEDDEMANDED

The Basic Determinants of Determinants of DemandDemand are:

1) consumer tastes and preferences

2) number of consumers in the market

3) consumers’ money incomes

4) prices of related goods

5) consumer expectations about future prices and incomes

QUANTITYQUANTITY

PRICEPRICES S

E0 P0

Q0

P1

Q1

E1

DD0 0 DD1 1

P2

Q2

DD2 2

A change in the demand schedule or, graphically, a shift in the location of the

demand curve is called a CHANGE IN CHANGE IN DEMANDDEMAND. This is caused by a change in one

or more of the determinants of demand.

QUANTITYQUANTITY

PP

RRII

CCEE D (demand)D (demand)

$80

$70

$60

$50

$40

$30

$20

$10

0100 200 300 400 500 600

By contrast, a CHANGE IN QUANTITY CHANGE IN QUANTITY DEMANDEDDEMANDED designates the movement of one

point to another--from one price quantity to another--on a fixed demand curve, resulting from

(i.e.) a change in PRICE.PRICE.

0

D

Price of Ice-Cream Cones

Quantity of Ice-Cream Cones

A tax that raises the price of ice-cream cones results in a movement along

the demand curve.

A

B

8

1.00

$2.00

4

Changes in Quantity Demanded

CHANGE IN SUPPLYCHANGE IN SUPPLY

vsvs

CHANGE IN CHANGE IN QUANTITY SUPPLIEDQUANTITY SUPPLIED

The Determinants of SupplyDeterminants of Supply are:

1) resource prices

2) technique of production

3) taxes and subsidies

4) prices of other goods

5) price expectations

6) number of sellers in the market.

QUANTITYQUANTITY

PP

RRII

CCEE

SS0 0

D D

E0 P0

Q0

P1

Q1

E1

SS11

P2

Q2

E2

SS22

A CHANGE IN SUPPLYCHANGE IN SUPPLY means a change in the entire schedule and a shift of the

entire curve, which is caused by a change in one or more of the determinants of

supply.

QUANTITYQUANTITY

PP

RRII

CCEE

S (supply)S (supply)$80

$70

$60

$50

$40

$30

$20

$10

0 100 200 300 400 500 600

In contrast, a CHANGE IN QUANTITY SUPPLIEDCHANGE IN QUANTITY SUPPLIED is a movement from one point to another on a fixed

supply curve. The cause of which is a change in

PRICEPRICE of a specific product.

1 5

Price of Ice-Cream Cone

Quantity of Ice-Cream Cones

0

S

1.00A

C$3.00 A rise in the

price of ice cream cones results in a movement along the

supply curve.

Change in Quantity Supplied

DEMAND

vs.

DERIVED DEMAND

(and other factor market problems)

S

D1

D2

SL

LABELING IMPORTANT IN LABOR MARKET!!

Product Market Resource Market

Price

Quantity

Q1 Q2

P2

P1

WAGES

Quantity of Labor

L1 L2

W2

W1

DL

DL2

MUST indicate demand for labor not just “D” and supply of labor not just

“S”.

S

D1

Price

Quantity

D2

SL

Price

There is an increase in demand for a good or service in the product market, which results in an increase in P and Q.

Product Market

Resource Market

QuantityQ1 Q2

P2

P1

Q1 Q2

P2

P1

DL

S

D1

Price

Quantity

D2

SL

There is a DERIVED DEMAND in the resource market for labor that produces the good or service.

Product Market Resource MarketQ1 Q2

P2

P1

Wages

Quantity of

Labor

QL1 QL2

W2

W1

DL

DL2

S

D1

D2

Because Q increased in the product market, the DERIVED DEMAND in the resource market for labor also increases.


Price

Quantity

Q1 Q2

P2

P1

WAGES

Quantity of Labor

L1 L2

W2

W1

DL1

DL2

SL

S S

DL

DL2

This causes the WAGE RATE to increase (W1 to W2) and quantity of labor to increase (L1 to L2)


Price

Quantity

Q1 Q2

P2

P1

WAGES

Quantity of Labor

L1 L2

W2

W1

D1

D2

IMPORTANT:There is a direct relationship between what happens in the

product market and what happens to DERIVED

DEMAND in the resource market.

If demand increases in the product If demand increases in the product market, derived demand for labor market, derived demand for labor in the resource market will also in the resource market will also

increase.increase.

S

D

Price

Quantity

D1

S

D

Wage

Quantity

D1

IMPORTANT: In the resource market S = MFC (marginal factor cost) and D = MRP (marginal revenue product).

Product Market

Resource Market

W1

W

L L1

MFC

MRP

MRP1

MARGINAL REVENUE PRODUCTMARGINAL REVENUE PRODUCT is the change in total revenue resulting from the use of one additional unit of a resource, or

MRP = ---------------------TR

Q of resource

MARGINAL RESOURCE COSTMARGINAL RESOURCE COST is the change in total cost resulting from the use of one

additional unit of a resource, or

MRC = ---------------------TC (resource)Q (resource)

The profit maximizing rule for employing resources is:

MRP = MRP = MRCMRC

S

D

Wages

Quantity of Labor

A firm can maximize TP by hiring the #workers at MRP of labor = MFC of labor.

Resource Market

W

L

MFC

MRP

Hire labor MRP > MFC, stopping with the unit for which MRP = MFC. Do not hire any MRP < MFC.

0 0 $2

1 7 $2

2 13 $2

3 18 $2

4 22 $2

5 25 $2

6 27 $2

7 28 $2

Workers Output *MPP Price TR MRP

]- 7

]- 6

]- 5

]- 4

]- 3

]- 2

]- 1

0

14

26

36

44

50

54

56

]- 14

]- 12

]- 10

]- 8

]- 6

]- 4

]- 2

In this perfectly competitive market, how many workers would be employed if

wages were:

$13.95 $13.95

$11.95 $11.95

$ 9.95 $ 9.95

$ 7.95 $ 7.95

11

22

33

44

Workers Output *MPP Price TR MRP

0 0 2.80

1 7 2.60

2 13 2.40

3 18 2.20

4 22 2.00

5 25 1.85

6 27 1.75

7 28 1.65

]- 7

]- 6

]- 5

]- 4

]- 3

]- 2

]- 1

0

18.20

31.20

39.60

44.00

46.25

47.25

46.20

]- 18.20

]- 13.00

]- 8.40

]- 4.40

]- 2.25

]- 1.00

]- -1.05

In this imperfectly competitive market, how many workers would be employed if

wages were:$13.95 $13.95

$11.95 $11.95

$ 9.95 $ 9.95

$ 7.95 $ 7.95

11

22

22

33

Single Farmer

P

Q

MMCC

p

P**

ATCATC

AVC

q

SHUTDOWN = if P < AVCSHUTDOWN = if P < AVC

= if TR < VC= if TR < VC

= if TR/Q < VC/Q= if TR/Q < VC/Q

REMINDER: in any

firm……

Things haveThings haveprices...prices...

Decisions Decisions have have

costs…..costs…..

INVESTMENTSome students use the term “investment” incorrectly.

They do not relate investment to machinery, tools, and

equipment. Instead, they use the term as it relates to

stocks and bonds.

CAPITAL is another term that confuses students:

CAPITAL: refers to the machinery, tools, and equipment used to produce other goods and services. It is NOT money.

CAPITAL STOCK: refers to the current market value of machinery, tools, equipment and inventories available to the firm. It does NOT refer to stock of a corporation.

CAPITAL FLOW is another term students should know. For example on the 2002 Macro Exam, question 3, students were asked, “ how and why will capital flows be affected by this change in the real interest rates?” The question referred to a change in real interest rates in the U.S. and abroad.

***In this case, capital flow refers to the purchase of foreign assets.

Preparing for 2006: Efficiency & welfare

economy.

Consumer Surplus Consumer Surplus Producer Surplus Producer Surplus Deadweight LossDeadweight Loss

What happens when prices are “fixed” by the government?

Let’s look at a graph which shows the

average consumption of beer in the United

States.

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

In this example, the average beers consumed per week is 6at an average price of $2.50.

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

This chart illustrates the effects upon people if they were forced

to go from Ge to zero.

Ge

You might be You might be willing to pay willing to pay $4 for your $4 for your first beer, first beer, but price is but price is $2.50 …..now $2.50 …..now you are you are $1.50 better $1.50 better off. This is off. This is called called CONSUMER CONSUMER SURPLUS.SURPLUS.

The 9th beer is worth to people what it is worth

to people.

It is different for everybody.

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

From the From the suppliers’ suppliers’ standpoint, standpoint, they they could could supply at a supply at a lower price lower price but they but they CAN CAN get more. get more. This is called This is called PRODUCER SURPLUS.

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

The The colored colored area is area is the the total total valuevalue to to society society of the of the cost of 6 cost of 6 beers.beers.

Consumer Surplus

Producer Surplus

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

What if government mandate What if government mandate limited the maximum price of a limited the maximum price of a

beer to $1.00?beer to $1.00?

Consumers would want to buy more beer.

10

However, suppliers would not want to

produce as much beer.

NOTE: Another example of this is the price ceiling on gasoline during the Nixon administration.

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

If If governmengovernmen

t limited t limited the the

maximum maximum price of a price of a beer to beer to $1.00, it $1.00, it would would

create a create a shortage.shortage.

shortage

REMEMBER: Producers will not want to produce for low

prices.

The legal maximum price that can be charged is

called a PRICE CEILINGPRICE CEILING. A legal minimum price that can be charged is

called a PRICE FLOORPRICE FLOOR. Price ceilings and floors

keep markets from reaching equilibriumequilibrium..

Politically popular ideas include:

--$ minimums on inputs (wages).

--$ maximums on outputs (prices/rent control).When POLITICS vs. POLITICS vs.

ECONOMICS => ECONOMICS => Politics Politics always winsalways wins

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

The The governmegovernme

nt nt mandatinmandatin

g the g the maximum maximum price of a price of a

beer is beer is called a called a PRICE PRICE

CEILINGCEILING..

shortage

A price ceiling keeps the market from reaching equilibrium.

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

shortage

The shortage created from the price ceiling will result in

increased demand.

X

NOTE: Another example of a price ceiling is rent control.

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

Four beers is Four beers is not enough not enough (too little, (too little, inefficient) inefficient) ….This is ….This is

called called DEADWEIGHT DEADWEIGHT

loss.loss.

What if government mandate limited What if government mandate limited the maximum number of beers one the maximum number of beers one could drink to 4 per week?could drink to 4 per week?

Government Mandated Supply

The increased demand and a willingness to

pay higher prices will result in a BLACK MARKET for beer.

NOTE: This is what happened during prohibition when (legal) supply was limited to zero.

$5

$4

$3

$2

$1

Labor0 1 2 3 4 5 6 7

S

D

E

Ge

When the government mandates a When the government mandates a the minimum price of something, the minimum price of something, it is called a it is called a PRICE FLOORPRICE FLOOR..

NOTE: The minimum wage is an example of a price floor.

$5

$4

$3

$2

$1

Labor0 1 2 3 4 5 6 7

S

D

E

Ge

The minimum wage increases the number of people who want to work (supply of labor). . . . . . And decreases the number of businesses who want to hire (demand for labor)Creating a SURPLUS of labor.

SURPLUS

•Those who continue to work are Those who continue to work are better off. (90%)better off. (90%)

•Some people are worse off (10%)Some people are worse off (10%)

•Prices rise for some goods using Prices rise for some goods using low skilled labor.low skilled labor.

•Discrimination is created in the Discrimination is created in the labor market.labor market.

•Some people leave home to make Some people leave home to make more money creating larger more money creating larger unemployment and disemployment.unemployment and disemployment.

RESULTS:

Easy to show overall:

•Costs > return of benefitsCosts > return of benefits

•Total welfare higher => Total welfare higher => those working incur higher those working incur higher costscosts

•Output will fall => fewer Output will fall => fewer people workingpeople working

Extreme case:Extreme case:

What would happen if What would happen if the government raised the government raised the minimum wage to the minimum wage to $100 an hour?$100 an hour?

Even though water Even though water is essential for is essential for life and diamonds life and diamonds are not, water is are not, water is cheap and diamonds cheap and diamonds are expensive?are expensive?

Why?Why?

It has to do with the elasticity of the It has to do with the elasticity of the supply curve and the amount of supply curve and the amount of

consumer/producer surplusconsumer/producer surplus

Pri

ce

Quantity

Consumer Consumer SurplusSurplus

Q

S

Pri

ce

Quantity

Producer Producer SurplusSurplus

S

Q

P

P

DD

With DIAMONDS, With DIAMONDS, supply is very supply is very inelastic.inelastic.

With WATER, With WATER, supply is very supply is very

elastic.elastic.

NASH EQUILIBRIUM is a situation where economic actors interacting with each other each

choose their best strategy given the

strategies that others have chosen. This is also called

GAME THEORY. John Nash

1994 Nobel Prize, Economics

***Kinked ***Kinked demand curve demand curve

is out!!is out!!

Game Theory can be illustrated by what is called THE PRISONER’S DILEMMA.

The police have enough evidence to convict Bonnie and Clyde of possession of an illegal firearm so that each would spend 1 year in

jail. But they suspect that the two have pulled off some bank robberies but they have no evidence. They put Bonnie and

Clyde in separate rooms and offer a deal. “Right now, we can lock you up for one year. But if you testify against

your partner, we will set you free and your partner will get 20 years in

prison. If you both confess to the crime, we can avoid the cost of a trial

and you both get 8 years.”

Bonnie’s Decisionconfess

confess

Remain silent

Remain

silent

Clyde’s Decision

8 years each

Bonnie - 20 yrs

Clyde goes freeBonnie goes

free

Clyde - 20 yrs.

1 year each

Each prisoner has two strategies, confess or remain silent. However, the sentence

that each gets depends upon the actions of the other.

OR you can use the PAYOFF MATRIX

Bonnie’s Decison

Clyde’s Decison

Clyde’s Decison

confe

ss

confe

ss

confe

ss

Remain

silent

Remain

silent

Remain

silent

B: 8 years

C: 8 yearsB: free

C: 20 years

B: 20 years

C: free

B: 1 year

C: 1 year

Iraq’s DecisionHigh prod.

High prod.

Low prod.

Low prod.

Iran’s Decision

$40 billion each

Iraq - $30 billion

Iran - $60 billionIraq - $60

billion

Iran - $30 billion

$50 billion each

In the real world, this dilemma is played out by real players. Once a negotiation is reached, each country must decide

whether they should keep their agreement.

U.S.’s DecisionArm.

Arm

Disarm

Disarm

USSR’s Decision

Both at risk

US at risk

USSR safe

US safe

USSR at risk

Both safe

It can be used in the arms race…...

Firm 1Yes

Yes

No

No

Firm 2

Firm 1: $1.5m

Firm 2: $1.5m

Firm 1: 0

Firm 2: $2m

It can be used in the everyday economic decisions……Consider 2 firms which must decide whether to make a new product or

not….

Firm 1: $2m

Firm 2: 0

Firm 1: 0

Firm 2: 0

GAME THEORY

• Prisoners' Dilemma

• Battle of the Sexes

• Dominant Strategies

• Nash Equilibria

By David Anderson, PhD Centre College, Danville, KY

The Payoff Matrix

Confess Deny

Confess 5, 5 1,10Deny 10, 1 2, 2

Pat

Chris

David Anderson, PhD

The Circle Trick

Confess Deny

Confess 5, 5 1,10Deny 10, 1 2, 2

Pat

Chris

David Anderson, PhD

Chris has a Dominant Strategy:The “Confess” strategy is best

regardless of Pat’s move.

Confess Deny

Confess 5, 5 1,10Deny 10, 1 2, 2

Pat

Chris

David Anderson, PhD

Checking Pat’s Options

Confess Deny

Confess 5, 5 1,10Deny 10, 1 2, 2

Pat

Chris

David Anderson, PhD

Pat has a dominant strategy: Confess

Confess Deny

Confess 5, 5 1,10Deny 10, 1 2, 2

Pat

Chris

David Anderson, PhD

Nash Equilibrium: Neither side has a desire to switch strategies

given what the other is doing.

Confess Deny

Confess 5, 5 1,10Deny 10, 1 2, 2

Pat

Chris

David Anderson, PhD

Battle of the Sexes

Rally Town Hall

Rally 20, 30 9, 4

Town Hall

10, 16 40, 27

Sarah

John

David Anderson, PhD

John Analyses the Possibilities

Rally Town Hall

Rally 20, 30 9, 4

Town Hall

10, 16 40, 27

Sarah

John

David Anderson, PhD

Sarah Analyses the Possibilities

Rally Town Hall

Rally 20, 30 9, 4

Town Hall

10, 16 40, 27

Sarah

John

David Anderson, PhD

Two Nash Equilibria, No Dominant Strategies

Rally Town Hall

Rally 20, 30 9, 4

Town Hall

10, 16 40, 27

Sarah

John

David Anderson, PhD

Chicken

Straight Swerve

Straight -10,-10 +5, -5

Swerve -5, +5 0, 0

Sarah

John

David Anderson, PhD

COMPARATIVE ADVANTAGE

Comparative Advantage:Comparative Advantage: an individual (or country) has comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than for other people.

Absolute Advantage:Absolute Advantage: an individual (or country) is said to have absolute advantage if

they (he/she) can do it better than anyone else. Having an absolute advantage is not the same thing as comparative advantage.

Let’s say we have 2 individuals named Adam and Eve, who are the only people in the world. Can they benefit from trading

with each other?

Let’s take a look at the Production Possibilities curve for each person.

Quantity of apples

30

9

028 40

Quantity of Fish

Adam’s PPC Eve’s PPCQuantity of apples

20

8

Quantity of Fish0 6 10

Adam’s consumption without trade

Eve’s consumption without trade

Quantity of apples

30

9

028 40

Quantity of Fish


20

8




The slope of Adam’s line is -3/4. That is for every 4 additional fish that Adam chooses to catch, he gathers 3 fewer apples.

The slope of Eve’s line is -2. Eve is less productive: the most she can produce is 10 fish or 20 apples. She is particularly bad at fishing.

Quantity of apples

30

9

028 40

Quantity of Fish


20

8




Adam & Eve’s Opportunity Cost

Adam’s Opp Cost Eve’s Opp Cost

One fish 3/4 apple 2 apples

One apple 4/3 fish 1/2 fish

GAINS FROM TRADE

Without Trade With Trade Gains from Trade

Production Consumption Production Consumption

Adam Fish 28 28 40 30 +2

Apples 9 9 0 10 +1

Eve Fish 6 6 0 10 +4

Apples 8 8 20 10 +2

So here’s how it works:

Adam specializes in the catching of fish (40/week) and gives 10 to Eve. Meanwhile, Eve specializes in the picking of apples (20/week) and gives 10 to Adam.

As you can see by the table above, both Adam and Eve have gains from trade. They both increase their consumption of both commodities.

It is better for Adam to catch the fish because his opportunity cost of a fish is only 3/4 of an apple not picked versus 2 apples for Eve.

Another way to say it is because Adam is so good at catching fish, his opportunity costs of picking apples is high: 4/3 fish not caught for every apple picked. Because Eve is a poor fisherman, her opportunity cost of

picking apples is less: only 1/2 a fish per apple.

Compare the following two countries and assume they only produce these two goods.

Slovenia Bohemia

Microwaves 12 10

Refrigerators 4 6

1) What is Slovenia’s opportunity cost of making microwaves?

2) What is Bohemia’s opportunity cost of making microwaves?

4/12 = 1/3

For every microwave, it must give up 1/3 of a Refrigerator.

6/10 =3/5

For every microwave, it must give up 3/5 of a refrigerator


Slovenia Bohemia

Microwaves 12 10

Refrigerators 4 6

3) What is Slovenia’s opportunity cost of making refrigerators?

4) What is Bohemia’s opportunity cost of making refrigerators?

12/4 = 3

For every refrigerator, it must give up 3 of a microwaves.

10/6 = 5/3

For every refrigerator, it must give up 1 2/3 of a microwave.


Slovenia Bohemia

Microwaves 12 10

Refrigerators 4 6

5) Which country has absolute advantage in microwaves?

6) Which country has absolute advantage in refrigerators?

Slovenia

12 Slovenia/10 Bohemia

Bohemia

6 Bohemia/4 Slovenia


Slovenia Bohemia

Microwaves 12 10

Refrigerators 4 6

7) Which country has comparative advantage in microwaves?

8) Which country has absolute advantage in refrigerators?

Slovenia

1/3 Slovenia vs. 3/5 Bohemia

Bohemia

5/3 Bohemia vs 3 Slovenia


Slovenia Bohemia

Microwaves 12 10

Refrigerators 4 6

9) Which country should produce what?

Slovenia should produce microwaves and Bohemia should produce refrigerators because microwaves and refrigerators will then be produced by the lower-cost country. The TOTAL OUTPUT of microwaves and refrigerators will be higher.


Slovenia Bohemia

Microwaves 12 10

Refrigerators 4 6

10) Use the law of comparative advantage to explain why self-sufficiency leads to a lower standard of living.

If people and countries do not trade on the basis of comparative advantage, there will be fewer goods and services for people to enjoy. People will be poorer.

Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores.

Karen Charlie

Clean the kitchen 60 minutes 20 minutes

Mow the lawn 30 minutes 15 minutes

1) What is Karen’s opportunity cost of cleaning the kitchen in terms of mowing the lawn.

2) What is Charlie’s opportunity cost of cleaning the kitchen in terms of mowing the lawn?

60/30 = 2 Mowing 2 lawns.

20/15 = 4/3 Mowing 4/3 lawns.


Karen Charlie



3) What is Karen’s opportunity cost of mowing the lawn in terms of cleaning the kitchen?

4) What is Charlie’s opportunity cost of mowing the lawn in terms of cleaning the kitchen?

30/60 = 1/2 Cleaning 1/2 kitchen

15/20 = 3/4 Cleaning 3/4 kitchen


Karen Charlie



5) Who has absolute advantage in cleaning the kitchen?

6) Who has absolute advantage in mowing lawns?

Charlie 20 minutes

Charlie 15 minutes


Karen Charlie



7) Who has comparative advantage in cleaning the kitchen?

8) Who has comparative advantage in mowing lawns?

Charlie 4/3 to 2

Karen 1/2 to 3/4


Karen Charlie



9) Who should do which chore and why?

Charlie should clean the kitchen and Karen should mow the lawn and they will finish sooner. The person with the lower opportunity cost should perform the chore.

SAMPLE AP TEST SAMPLE AP TEST QUESTIONQUESTION

PricePrice

Quantity of Good X

D-D-MSBMSBMR

Marginal Social Cost

Marginal Private Cost

Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

Is this a Is this a negative or negative or

positive positive externality?externality?

NegativeNegative

Why?Why?

MSC > MSC > MPCMPC

The production of Good X creates an The production of Good X creates an externality.externality.

MR

PricePrice

Quantity of Good X

D-D-MSBMSBMR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

Identify the Identify the socially socially

optimum optimum output.output.

Q2Q2

Why?Why?

MSC=MSBMSC=MSB

The production of Good X creates an The production of Good X creates an externality.externality.

MR

PricePrice

Quantity of Good X

D-D-MSBMSBMR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

Identify the Identify the unregulated unregulated

firm’s output.firm’s output.

Q1Q1

Why?Why?

At Q1, MPC At Q1, MPC = MR= MR

Suppose that good X is produced by a Suppose that good X is produced by a profit-maximizing monopoly.profit-maximizing monopoly.

MR

PricePrice

Quantity of Good X

D-D-MSBMSB

MR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

How much will How much will it be?it be?

$3$3Why?Why?

Optimum Optimum Quantity at QQuantity at Q22

= MR= MR

To produce socially optimum To produce socially optimum output, should the government tax output, should the government tax

or subsidize the firm?or subsidize the firm?

subsidizesubsidize

Suppose that good X is produced by a Suppose that good X is produced by a profit-maximizing monopoly.profit-maximizing monopoly.

MR

PricePrice

Quantity of Good X

D-D-MSBMSBMR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

Why?Why?

D=MPC or D=MPC or MSB=MPCMSB=MPC

Identify equilibrium output in the Identify equilibrium output in the absence of regulation.absence of regulation.

Q3Q3

Suppose that good X is produced in a Suppose that good X is produced in a perfectly competitive industry.perfectly competitive industry.

PricePrice

Quantity of Good X

D-D-MSBMSBMR



Q1 Q2 Q3Q1 Q2 Q3

13

12

7

4

0

How much?How much?

$5$5

To produce at socially optimum To produce at socially optimum output, should the government tax output, should the government tax

or subsidize?or subsidize?

TaxTax

Suppose that good X is produced in a Suppose that good X is produced in a perfectly competitive industry.perfectly competitive industry.

STUDENTS SHOULD:

--recognize the importance of understanding terminology.

--be expected to use economic terms in discussion, essays, and analysis

--identify the economic terms in the exam questions

--ANSWER THE QUESTION. Simply restating a question will not earn points.

HINTS for taking THE AP

MICROECONOMICS EXAM

Pay attention to the instruction words.

Identify, state, list, define = Don’t explain the logical sequence.

Explain and discuss = Explain the logical sequence, the linkages. Graphs can be the explanation at times.

Draw and show = Draw a graph or diagram, label with care.

Use abbreviations!

MR=MC, P and Q, Δ, ATC, AVC, P=MR=d, MCS or MSC, , , etc., etc., etc. Words frequently explain better, but symbols can be inserted when appropriate or short on time. For example, “If the purely competitive firm has eco profits in the SR, then other firms will enter the market S↑ P↓, Q↑ for the industry.”

When writing . . .Use correct terminology, such as “income” or “profit”, not “money”, unless the topic is really money.

Use outline numbers like “a” or “i” to reference an answer.

Emphasize the logical sequence, the line of reasoning.

Use the 10-minute planning time to script out answers on the green question pages of the FRQ exam.

When writing . . .

May answer questions in any order.

Do not restate question. It is a waste of time.

Draw graphs well-labeled.


Price

Price

Quantity

Quantity

S

D

P=D=MR=AR

MMCC

p

q Q

ATCATC

Economic Loss

S1

MR1=P1=AR1=D1

p1

Q1q1

MISTAKES MADE ON THE AP

MICROECONOMICS EXAM

GENERAL MISTAKES

•Label both axes on all graphs and all curves. No labels, no points awarded.

•Not knowing the difference between a change in quantity demanded and a change in demand and the resultant movement along a demand curve versus shifting a demand curve -- and the same for supply or any other curve.

•Confusing comparative advantage calculations

•Double shifts resulting in a change in one variable, but the other “indeterminant”

•Differences in “normal” and “economic” profits

MICROECONOMIC MISTAKES

•Failing to remember how to shade the area of economic profit, especially in the case of a monopoly model

•Not understanding how a per unit subsidy leads to an increase in output through either lower MC or an increase in demand.

•Not being able to calculate average fixed cost

•Getting confused between product and factor markets

•Not knowing the elasticity of demand and TR relationship (total revenues)

MICROECONOMIC MISTAKES

•Confusing the different types of efficiency: economic efficiency = P=MC=ATC, allocative efficiency = P=MC, productive efficiency = P=ATC

•Failing to use side by side graphs of the market and the industry

•Not knowing that “market” and “industry” are the same thing.

•Not knowing that “imperfect markets” can be anything except perfect competition

•Game theory

AP Microeconomics REVIEW Hints for passing the Ms. Meachum.

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