Economics 160Microeconomic Principles

ReviewDepartment of Economics

College of Business and EconomicsCalifornia State University-Northridge

Professor Kenny Ng

Administrative Notes Articles for exam.

Online class articles available now. Live class articles will become available by the end of this week.

Online Class: Online students should also pay attention to the quizzes that have been given after the

midterm especially Quiz 5 Parts A and B. Live class.

Pay attention to the CSUN enrollment example from the notes. The Online Class Final will be made available on the MoodleCourse Outline after their exam

is finished.

Production Possibilities Frontier Individuals, groups, countries, and societies can enrich themselves collectively and

individually by specializing in the production of goods in which they have a comparative advantage and exchanging in the market for goods in which they have a comparative disadvantage (specialization and exchange).

No coercion is necessary to make individuals, groups, countries, and societies specialize and exchange because it is in their self interest to do so. The policy or system which increases wealth is therefore to do nothing. This is policy is

also referred to as a free markets policy, capitalism, letting the market operate, etc. In fact, any interference in voluntary exchange will reduce collective and individual

wealth by limiting the extent to which comparative advantage is exploited. If comparative advantage exists enrichment is possible through specialization and

exchange. The amount of enrichment, both individual and collective, is proportional to the degree of comparative advantage. The more different two parties to a voluntary exchange, the greater the benefits from

exchange.

A Second Example of the Benefits of Specialization According to Comparative Advantage and Exchange.

Consider a second example. Compute opportunity cost in the second example.

Can you characterize the change in Opportunity costs?

The difference in opportunity costs has widened, i.e. the farmer and rancher are more different.

Suppose the farmer and rancher productive resources, i.e. labor as in the original example. What will happen to collective welfare?

What has happened to the individual and collective gains from specialization and exchange?

See next slide.

Original Example

Hours Needed to Make 1 pound of

Amount Produced in 40 hrs

Meat Potatoes Meat Potatoes

Farmer 20 hrs./lb 10 hrs./lb 2 lbs. 4 lbs.

Rancher 1 hr./lb. 8 hrs./lb 40 lbs. 5lbs.

Second Example

Hours Needed to Make 1 pound of

Amount Produced in 40 hrs

Meat Potatoes Meat Potatoes

Farmer 40 hrs./lb 5 hrs./lb 1 lbs. 8 lbs.

Rancher 1 hr./lb. 8 hrs./lb 40 lbs. 5lbs.

Opportunity Costs

Original Example Second Example

Meat Potatoes Meat Potatoes

Farmer 2 1/2 8 1/8

Rancher 1/8 8 1/8 8

The difference in OC is greater in the second example compared to the first example.

For Meat: 2 to 1/8th vs. 8 to 1/8th.For Potatoes: 1 to 8 vs. 1/8th to 8.

In the second example to Rancher and the Farmer are “More Different”.

The Outcome Without Trade The Outcome With Trade The Gains From Trade

What they Produce and Consume

What They Produce

What They Trade What They Consume The Increase in

Consumption

Farmer

1 lb. meat½ lb. meat

Point A

O lbs. meat O lbs. meat

Get 3 lbs. of Meat for 1 lb. of Potatoes

Get 3 lbs. of Meat for 3 lb. of Potatoes

3 lbs. of Meat3 lbs. of Meat

Point A*

2 lbs. Meat2 ½ lbs. Meat

A to A*

2 lbs. potatoes

4 lbs. potatoes

4 lbs. Potatoes8 lbs. Potatoes

3 lbs. of Potatoes 5 lbs. of Potatoes

1 lbs. Potatoes1 lbs. Potatoes

Rancher20 lbs. meat20 lbs. meat

Point B

24 lbs. Meat 24 lbs. Meat

Give 3 lbs. of Meat for 1 lb. of Potatoes

Give 3 lbs. of Meat for 3 lb. of Potatoes

21 lbs. of Meat21 lbs. of Meat

Point B*

1 lb. Meat1 lb. Meat

B to B*

2 ½ lbs. potatoes2 ½ lbs. potatoes

2 lbs. Potatoes2 lbs. Potatoes

3 lbs. of Potatoes5 lbs. of Potatoes

½ lb. of Potatoes2 1/2 lb. of Potatoes

The Effect of Specialization According to Comparative Advantage and Exchange: Second Example

Farmer sells 3 lbs. of potatoes for 3 lbs. of meat.

Second Example in Blue.

Review of Supply and Demand Concepts Movement to equilibrium occurs as a result of suppliers and demanders

pursuing their own self interest, e.g. will occur without outside interference. Movement to equilibrium causes suppliers and demanders to enrich

themselves individually and collectively, i.e. the operation of the market enriches.

Price at which exchange occurs divides the potential gain from trade between buyers and seller so that both parties are left better off after moving to equilibrium than before.

Changes in price act as signals to the market. For the market to operate, prices must be allowed to fluctuate freely in response to market forces.

The Effects of Crop Failure in Africa (1)The world food market starts in equilibrium with a world price of P1.

The crop failure causes the African food supply to fall.

The decrease in the African food supply creates a situation of excess demand at the price P1. As the market moves to a new short term equilibrium the price will rise to P2.

There is now a difference in the food prices in Africa vs. the Rest of the World and an opportunity for profit exists by reallocation food from the Rest of the World to Africa.

Demand

Quantity

Price

0

Supply

Demand

Quantity

Price

0

Supply

P1

Rest of World Africa

P2

The Effects of Crop Failure in Africa (2)

Demand

Quantity

Price

0

Supply

Demand

Quantity

Price

0

Supply

P1

Owners of food in the Rest of the World will ship food to Africa because it is their own self-interest to do so.

As the food is reallocated to Africa, Rest of the World’s food supply falls and Africa’s food supply increases.

Food will continue to be reallocated until it is no longer in the food owners interest to do so, i.e. the price of food in Africa and the Rest the World has equalized at P3.

If the food supply in the Rest of the World is large relative to the Africa, there will be a small increase in food prices in the Rest of the World and a large drop in Africa.

Rest of World Africa

P2 P3

The Effects of Crop Failure in Africa (3)

Demand

Quantity

Price

0

Supply

Demand

Quantity

Price

0

Supply

P1

If governments and international aid organizations “do nothing” market forces will prevent mass starvation by reallocating the existing supply of food from low valued use in the Rest of the World to high valued use in Africa.

This reallocation of food which alleviates the famine will only occur if the price of food is allowed to move in response to market forces.

Rest of World Africa

P2 P3

Effects of Violating the Do-Nothing Policy (1) Any regulation or interference in the normal operation of the market can be thought as an action that

prevents the market from moving to equilibrium. In previous slides, we discussed the real world forces that move the market to equilibrium (excess supply

and demand, desire to engage in trade which makes one better off, etc.). Any interference in the movement to equilibrium can be thought of as an attempt to prevent people

from engaging in a behavior that they want to engage in or in engaging in behavior that will make the person, in his own mind, better off or richer.

When government tries to prevent people from engaging in behavior that they believe will make them better off, people will resist.

The regulation will set off a process of resistance, increasing regulation/enforcement, more resistance, more regulation, etc.

It may be impossible or extremely costly for the government to effectively impose regulation and the result of regulation or interference in the normal operation may not be what was originally intended.

Regulation will also force people to rely on non-price measures to allocate scarce supplies of the good.

The type of non-price rationing that will be used depends on the particulars of the good and the details of the regulation scheme.

CSUN Enrollment Policy

DemandQuantity 0

Price

Supply

Controlled Price

Shortage

Why is the supply curve vertical?

If the price were not regulated how would the market allocated the scarce supply of course?

CSUN Enrollment Policy

DemandQ

P Supply

Controlled Price

Shortage

1 20K

CSUN Course Enrollment. The goal of CSUN enrollment policy

is to allocate the scarce supply of classes according to non-price criteria.

Number of classes fixed by the physical plant and number of professors.

Is the allocation of classes “better” or just different under a non-price allocation system?

Instead of allocating courses according to their value to the student, the courses are allocated according to other criteria.

Number of units completed.

Is the allocation of classes the one intended by CSUN administrators?

Gaming the system. First time freshman. Graduating seniors. Orientation Aides. Course overloads and

selling classes. Bitch and moan scam.

ReviewChange in the World:

1. Price.

2. Price of Related Goods

3.Income

4. Other

Elasticities tell us how much and in which direction will demand change?

1. Price Elasticity-Elastic or Inelastic

2. Cross Price Elasticity-Complements or Substitutes

3. Income Elasticity-Normal or Inferior

4. Other

2 Good of Pricein ChangePercent

1 Good ofQuantity in ChangePercent Elasticity Price Cross

Incomein ChangePercent

Quantityin ChangePercent Elasticity Income

P

Qd

%

%=Demand of Elasticity Price

Change in the world: Newspaper article or other source.1. Change in Demand (normal/inferior, complements/substitutes).

• Change in income, change in the price of a related good, change in preferences. 2. Change in the price of inputs.

• Increased wages, higher interest rates, higher fuel costs, higher insurance, etc. 3. Change in technology.4. Other

Short Run Supply: Shift to the right or leftWhere is the new short run equilibrium?At the new price will existing firms be losing money, making money breaking even.

Demand: Shift to the right or left.1. Where is the new short run Equilibrium? 2. What is the new price?

Short Run Changes: at the new price how will existing firms adjust output?Apply 3-Part Output Rule, i.e. shutdown decision and short run output decision

Long Run Changes: What effect will entry and exit of firms cause to the short run supply curve, output, and price. Is this an Increasing or Constant Cost Industry

Long Run Changes: What effect will entry and exit of firms cause to the short run supply curve, output, and price. Is this an Increasing or Constant Cost Industry?

Start off in Long Run EquilibriumConstant or Increasing Cost Industry?

Unit cost curves: Will a firm’s unit cost curves shift up or down?At the current price, will existing firms produce more or less

Demand Side Changes.

Initial Condition: Long Run Equilibrium

Market

Representative Firm

Quantity(firm)

0

$/unit

MC ATC

P1

Quantity(market)

Price

0

D1

P1

Q1

A

S 100 firms

Long-runsupply

The left hand graph shows the unit cost curves for a single firm producing the good. An industry is composed of many firms with identical cost curves all producing the same good.

The Short Run Market Supply curve shows the amount produced by the existing firms as price varies. The Long Run supply curve shows how the amount produces as price varies when the effects of entry and exit to the industry are included.

Quantity(firm)

0

$/unit

MC ATC

P1

Market

Quantity(market)

Price

0

D1

P1

Q1

A

S 100 firms

Long-runsupply

Quantity(firm)

0

$/unit

MC ATC

P1

Quantity(firm)

0

$/unit

MC ATC

P1

Firm 1

Firm 2

Firm 3

3-Firm Industry (alternative setup)

Short-Run Response to an increase in Demand

MarketFirm

Quantity(firm)

0

$/unit

P1

Quantity(market)

Price

0

D 1

D 2

P1

Q1

A

S 100 firms

Long-runsupply

MC ATC

P1

B

The increase in demand (D1 to D2) causes the price in to increase.

q1

At current output levels (Q1-industry, q1-firm) the existing firms are producing where P >MC.

Therefore, they can increase profits by increasing output.

The increase in output by existing firms causes a movement along the short run supply curve (S1) from A to B.

Short-Run Response to an increase in Demand

MarketFirm

Quantity(firm)

0

$/unit

MC ATC

P1

P2

Quantity(market)

Price

0

D 1

D 2

P1

Q1 Q2

P2 A

B S 100 firms

Long-runsupplyExisting firms choose their output

level by setting price equal to MC.Since the price has risen, the quantity at which P=MC is now higher. Therefore, existing firms increase output.

Since all existing firms are increasing output, industry output increases from Q1 to Q2.

Short-Run Response to an increase in Demand

MarketFirm

Quantity(firm)

0

$/unit

MC ATCProfit

P1

P2

Quantity(market)

Price

0

D 1

D 2

P1

Q1 Q2

P2 A

B S 100 firms

Long-runsupply

In the short run, the existing firms will earn a profit.

Increase in Demand in the Long RunOver time, the short-run supply curve shifts as

profits encourage new firms to enter the market.Price falls as new firms enter the marketIn the new long-run equilibrium profits return to

zero and price returns to minimum average total cost.

The market has more firms to satisfy the greater demand.

Long-Run Response

MarketFirm

Quantity(firm)

0

Price

MC ATCProfit

P1

P2

Quantity(market)

Price

0

D 1

D 2

P1

Q1 Q2

P2 A

B S100 firms

Long-runsupply

At price P2, existing firms are earning a profit. Entrepreneurs see the profit earned by existing firms and open new firms (enter the industry).

Long-Run Response

MarketFirm

Quantity(firm)

0

Price

MC ATCProfit

P1

P2

Quantity(market)

Price

0

P1

Q1 Q2

P2 A

B

Long-runsupply

S150 firms

D1

D2

S100firms

As new firms enter, the amount of the good produced at each price by the existing firms (new and old) has increased. This is depicted as a shift in the short run supply curve from S1 to S2.

Long-Run Response

MarketFirm

Quantity(firm)

0

$/unit

MC ATC

P1

Quantity(market)

Price

0

D1

D2

P1

Q1 Q2

P2 A

B

Long-runsupply

As the new firms begin producing, the price falls from P2 to P1.

S100firms

S150 firms

Increase in Demand in the Short and Long Run

MarketFirm

Quantity(firm)

0

$/unit

MC ATC

P1

Quantity(market)

Price

0

D2

P1

Q1

D1

Q2

A

B

Long-runsupply

Q3

C

New firms will continue to enter the industry, increasing the quantity produced, shifting the short run supply curve outward, and driving down the price until potential entrants no longer anticipate earning a profit after entering the industry.

S100firms

S150 firms

Quantity(firm)

0

$/unit

MCrest of worldATCrest of world

P1=$10

Quantity(market)

P

0D1930

P1

Q1

SMiddle East

LRSAVCrest of world

q1

A

A

An Increasing Cost Industry-Oil Industry$/unit

Quantity(firm)

MCSaudia Arabia

ATCSaudia Arabia

P1=$10

In 1930, oil was only produced in the Middle East, the demand for oil was not that great, and the price of oil was low—P1. At P1 it was profitable to produce oil in Saudi Arabia and other parts of the Middle East but not in other parts of the world.

Profit

D1970

As the 20th century progressed, the demand for oil increased. There was a short term increase in Middle Eastern oil production and in the long run (point B), the high price of oil led to the discovery of higher cost deposits in other parts of the world.

P2=$30

B

P1=$30

Profit

SME + rest of world

Will the entry of new firms, i.e. the discovery of new oil deposits outside the Middle East, eliminate the oil profits of Saudi Arabia?

Price is above ATC so SA makes a profit at P-$10

Price is below min AVC so Rest of World does no produce at P-$10

At P-$30, the price is above min ATC so the Rest of the World produces oil.

Decrease in Demand

See solution to Quiz 5A.

Supply Side Changes.

Changes in input pricesChanges in Technology.Start off by shifting unit cost curves.Winners and losers.

Quantity(firm)

0

$/unit

MC

ATC

P1

Quantity(market)

Price

0

D1

P1

Q1

S100 firms

Long-runsupply

AVC

L

q1

AA

Analyzing the effect of a decrease in the price of labor

After the decrease in the price of labor, the unit costs of production are lower at each level of output. At every price each firm will produce more (at P1 the firm will increase output from q1 to q2).

q2

S100 firms

The increase in output at each price by existing firms causes the short run supply curve to shift right, lowering price to P2

P2

1. Will the likely new contract increase of decrease the cost of production?2. Will unit costs at any output level increase or decrease?3. At any given price will existing firms produce more or less?4. What effect will this have on the short run supply curve?

Quantity(firm)

0

$/unit

MC

ATC

P1

Quantity(market)

Price

0

D1

P1

Q1

S100 firms

Long-runsupply

AVC

q1

AA

Who benefits and loses from a reduction in the cost of labor.

q2

S100 firms

P2

Consumers are better off because the price of the good has fallen.

In the short run, firms are better off because their costs fall and they earn a profit.

In the long run, if the existing firms are earning a profit because of lower costs, new firms will enter shifting the short run supply curve to the right, increasing output, and further lowering price.

If this were a constant cost industry, the reduction in the cost of labor would cause the long run supply curve to shift down.

In the Long Run, consumers are the sole beneficiary of the drop in the price of labor.

S150 firms

The reduced unit costs of production mean that at any given price the existing firms will produce more, shifting the short run supply curve outward. Even at the new lower price, the existing firms will earn a profit in the short run.

In the long run, new firms will continue entering shifting the SR supply curve farther to the right, increasing supply, and reducing price until the existing firms are just breaking even with their lower costs.

P3

Quantity(firm)

0

$/unit

MC

ATC

P1

Quantity(market)

Price

0

D1

P1

Q1

S1

Long-runsupply

AVC

q1

AA

Who benefits from an improvement in technology?An improvement in technology is any change which allows a firm to produce more output with the same inputs.

A degredation in technology is any change which means a firm to produces less output with the same inputs.

The improvement in technology allows the firm to produce more output with the same inputs.Because the firm is producing more output with fewer inputs, and the price of inputs hasn’t changed, the unit costs of producing will fall.

S2

The reduced unit costs of production mean that at any given price the existing firms will produce more, shifting the short runs supply curve outward. Even at the new lower price, the existing firms will earn a profit in the short run.

In the long run, new firms will continue entering shifting the SR supply curve farther to the right, increasing supply, and reducing price until the existing firms are just breaking even with their lower costs.

In the SR, firms and consumers benefit from the improvement in technology. In the LR just consumers benefit.

S3

If this were a constant cost industry, the technological change would shift the long run supply curve down.