exam material

Note: This document is a much summarized version of the items your next examination is based on. It is only intended to be used as one of the several sources students should use to study for the exam.

TOPIC 1

Scarcity, choices, trade-offs, and opportunity costs

Scarcity exists because resources are limited. People have unlimited wants and have limited resources, so people have to always make choices.

This leads to trade-offs. Trade-offs are choices between multiple alternatives. For example, instead of studying for two hours for an economics test, I can watch a movie, work-out, sleep, play games, or go out for a dinner. I have multiple alternatives for two hours of studying.

If I choose studying instead of any of the other alternatives, then I made a trade-off between study hours and other alternatives.

Opportunity costs are the cost associated with the next best alternative. Opportunity cost has only one alternative.

For example, my next best alternative to studying is sleeping. My opportunity cost is the lost satisfaction associated with sleeping.

Individuals, businesses, firms, and governments constantly make choices, and they have to do trade-offs because of scarcity.

Because of this they have to consider opportunity cost in business decision making purposes.

Demand:

Quantity demanded: The amount of a good buyers are willing to purchase, at any given price. Quantity demanded and price are negatively related. As the price increases, Qd decreases, and as the price decreases Qd increases. Demand curve slopes downward and has a negative slope.

The slope of the demand curve is given by slope = ∆Y/∆X = -∆Qd/∆P. Since price and the Qd are negatively related, slope is negative.

Market Demand: Sum of individual demand in the market gives the market demand.

Change along the demand curve: Holding other factors constant, when the price increases, quantity demanded decreases and vice-versa.

Change in price, moves (changes) the demand along the demand curve.

Shifts in demand curve: Shifts in demand curve is caused by non-price determinants. A demand curve shifts to the right when there is a decrease in one of the non-price determinants and shifts left when there is an increase in one of the non-price determinants, while holding the price constant.

The non-price determinants are:

Changes in tastes/preferences

Number of buyers

Prices of related goods: Substitutes (as price of good X increases, Qd of good Y increases) and compliments (as price of good X increases, Qd of good Y decreases).

Expectations: expectations about future price and future income

Income

(Read in detail about how the demand curve shifts for each of the above variables)

Supply:

Quantity supplied: The amount of a good sellers/firms are willing to sell/produce, at any given price. Quantity supplied and price are positively related. As the price increases, Qs increases, and as the price decreases Qs decreases. Supply curve slopes upward and has a positive slope.

The slope of the supply curve is given by, slope = ∆Y/∆X = ∆Qs/∆P. Since price and the Qs are positively related, slope is positive.

Market Supply: Sum of individual supply curves in the market gives the market supply.

Change along the supply curve: Holding other factors constant, when the price increases, quantity supplied increases and vice-versa.

Change in price, moves (changes) the supply along the supply curve.

Shifts in supply curve: Shifts in supply curve is caused by non-price determinants. As a general rule, a change in a non-price determinant that would increase costs of production, will shift the supply curve to the left; any change in a non-price determinant that would lower costs of production, will shift the curve to the right.

The non-price determinants are:

Input prices

Number of sellers Technology

Expectation about future prices

(Read in detail about how the supply curve shifts for each of the above variables)

Market equilibrium: Point at which quantity supplied is equal to quantity demanded. Qs = Qd at the same price. This price is the equilibrium price and the quantity at this price is the equilibrium quantity.

Surplus: When quantity supplied is greater than quantity demanded, there is surplus in the market. There will be a downward pressure on price until it reaches the equilibrium price.

Shortage: When quantity supplied is less than quantity demanded, there is a shortage in the market. There will be an upward pressure on price until it reaches the equilibrium price.

Price ceiling and price floor are government imposed price control programs.

Price Ceiling is the maximum legal price a seller is allowed to charge for a good or a service. Example, rent control programs.

Price floor is the minimum legal price at which a commodity or a good can be sold. Example minimum wage laws.

Three steps to analyze changes in equilibrium

1. Determine whether the effect shifts supply or the demand curve or both.

2. Determine which direction the curve is shifted (right or left for demand and for supply).

3. Use the supply and demand curves to see how their shifts changes the new equilibrium price and quantity.

Elasticity

Price elasticity of demand

Elasticity is responsiveness. This measures the changes in Qd with respect to changes in price.

Price Elasticity of demand is a relative measure (of ∆P to ∆Qd).

Price elasticity of demand has no units and it is an absolute value. The negative sign in the price elasticity only shows the inverse relationship between price and the quantity demanded.

Price Elasticity of demand is given by the formula Ep = %∆Qd/%∆P.

(Remember the price elasticity is not the slope, it is the inverse of the slope as slope is given by ∆P/∆Qd)

Elasticity of Demand	Definition	Formula	Price Elasticity Value	Shape of the Demand Curve
Perfectly Elastic	Quantity demanded changes infinitely to any small change in price. That is consumers have infinite substitutes	Ep = =	Ep =	Perfectly Horizontal
Elastic	Quantity demanded responds strongly to change in price	Ep = = = 4	E > 1	Flatter demand curve
Unit Elastic	Quantity demanded changes by the same percentage as the price	Ep = = = 1	E = 1	Slope will be always one
Inelastic	Quantity demanded does not respond strongly to change in price	Ep = = = 0.25	E < 1	Steeper demand curve
Perfectly Inelastic	Quantity demanded does not respond to change in price at all	Ep = = = 0	E = 0	Perfectly inelastic (steep)

The mid-point or arc price elasticity of demand is given by

Cross-price elasticity : E =

· When an increase in the price of Product B results in an increase in the quantity demanded for Product A, the two products are substitute goods. In the face of increasing prices for Product B, consumers tend to shift to Product A instead. Example, bagels and doughnuts.

· On the other hand, when an increase in the price of Product B results in a decrease in the demand for Product A, the two products are complementary goods. The two products are typically consumed together, so when rising prices force consumers to reduce their consumption of Product B, they also reduce their consumption of Product A. Example, bagels and cream cheese.

Read about the of determinants of elasticity

1. Necessity Vs. Luxury goods

2. Availability of substitutes

3. Relative price (percentage of income spent on the good).

4. Time

5. Width of market definition

Relationship between total revenue (TR = P*Q) and price elasticity

For elastic demand, changes in price and changes in total revenue move in opposite direction.

For inelastic demand, changes in price and changes in total revenue move in the same direction.

Elasticity	Price	Total Revenue (P*Q)
Elastic (EP >1)	Increases	Decreases
	Decreases	Increases
Unit Elastic (EP =1)	Increases	Stays the same
	Decreases	Stays the same
Inelastic (EP <1)	Increases	Increases
	Decreases	Decreases

TOPIC 2

Economic Vs. Accounting Profit

Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.

Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.

When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.

Economic profit is smaller than accounting profit as the accounting profit does not include the implicit costs

Total, Average, and Marginal Productivity

The production function shows the relationship between quantities of inputs used to make a good and the quantity of output of that good.

Total Productivity – total output produced with the total labor input

Average product of labor (APL) is the per unit of labor output

Marginal product of labor (MPL) is the change in total productivity divided by the change in the quantity of labor.

Marginal product of labor (MPL) is given by the slope of the production function

MPL = ∆ Output/ ∆ Labor

Input = ∆Q/ ∆L

Costs

Term	Definition	Mathematical Expression
Explicit costs	Costs that require an outlay of money
Implicit costs	Costs that do not require an outlay of money
Sunk Costs	Costs that once incurred cannot be recovered and does not include the opportunity costs
Opportunity Costs	Forgone costs or the cost of getting something by giving up something else
Fixed Costs or Total Fixed Costs	Costs that do not vary with the quantity of output produced	FC or TFC
Variable Costs or Total Variable Costs	Costs that varies with the quantity of output produced	VC or TVC
Total Costs	The market value of all the inputs that a firm uses in the production process	TC = TFC + TVC
Average Total Costs	Total costs divided by the quantity of output	ATC = TC/Q
Average Fixed Costs	Total fixed costs divided by the quantity of output produced	AFC = TFC/Q
Average Variable Costs	Total variable costs divided by the quantity of output produced	AVC = TVC/Q
Marginal Costs	The change in total costs due to an additional unit of output produced	MC = ∆TC/∆Q

Economies of scale -If average costs fall with output, you have increasing returns to scale or economies of scale

Constant returns to scale - -If long-run average costs are constant with respect to output, then you have constant returns to scale

Diseconomies of scale - If long run average costs rise with output, you have decreasing returns to scale or diseconomies of scale

Profit maximization

Profit maximization occurs at the quantity where marginal revenue equals marginal cost.

· When MR > MC, increase Q

· When MR < MC, decrease Q

· When MR = MC, profit is maximized

A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions.

The firm shuts down (in the short run) if the revenue it gets from producing is less than the variable cost of production.

· Shut down if TR < VC

· Shut down if TR/Q < VC/Q = P*Q/Q < AVC

· Shut down if P < AVC

Remember in the short-run, firms do not include fixed costs in the production decision to shut down or stay open, so it makes sense that we consider price and AVC and not ATC.

In the long run, the firm exits if the revenue it would get from producing is less than its total cost.

· Exit if TR < TC

· Exit if TR/Q < TC/Q

· Exit if P < ATC

A firm will enter an industry if it is profitable,

Enter, if TR > TC

Enter, if TR/Q > TC/Q

Enter, if P > ATC

Profit = TR-TC

= (TR/Q – TC/Q)*Q

= (P-ATC)*Q

In the long-run, a firm will shut down (or exit) if it average revenue (AR) cannot cover average total costs (ATC).

TOPIC 3

Perfectly competitive market: a market in which there are so many buyers and so many sellers that decisions of each firm have a negligible impact on the market price.

Assumptions of a perfectly competitive Market

1. There are large number of buyers and sellers, so that no single buyer or seller has any influence on the market price.

2. Buyers and sellers are “price takers” in this market.

3. All goods are exactly the same (homogeneous goods).

4. Free entry and exit into the market.

5. Perfect information is available to both buyers and sellers.

Monopoly

They are single firms in a market. They have strong influence over price.

In a monopoly, Q does not solely depend on P. Q and P are jointly determined by MC, MR and the demand curve.

Monopolies maximize profit at MR=MC (as any firm in other market structure does), but the price is set at the point where the Q meets the demand curve. In this way monopolies capture the consumer’s willingness to pay.

Profit in monopoly is given by: Profit = TR – TC or Profit = (P-ATC)*Q

Barriers to entry in a monopoly market structure

· Monopoly resources

· Government regulation

· The production process   Price discrimination in a monopoly – a monopoly can price discriminate the same good based on consumers’ price elasticity of demand. For consumers with high price elasticity charge a lower price, for consumers with low price elasticity charge a higher price.   Monopolistic Competition Large number of small firms that have some market power from producing differentiated products.

· Product differentiation exists among firms.

· There are a large number of firms in the product group.

· No interdependence among firms (decisions of one firm mostly don't affect decisions of other firms).

· Entry and exit by firms is relatively easy.   Since there is some degree of product differentiation (and, thus, they can charge a different price than competitors given their somewhat "uniqueness"), the demand curve is no longer perfectly elastic (i.e.: not horizontal) like that of a perfectly competitive firm, but downward sloping. On the other hand, since they do not provide a completely unique product (they do have competitors), their demand curve will not tend to be as inelastic as that of a monopoly. Thus, it will tend to be is less elastic as that of a perfectly competitive firm, and less inelastic than that of a monopolist.   Given lack of barriers to entry, new firms can enter the industry and abnormal profits can disappear in the long run (just as with a perfectly competitive market).  

Oligopoly Market structure characterized by competition among a small number of large firms that have market power, but that must take their rivals' actions into account when developing their own competitive strategies. The main feature in an oligopoly, thus, is that firms are interdependent.   Given their kinked demand curve, oligopolies will tend to avoid competing in terms of prices (prices tend to fluctuate far less compared to other types of market structures).

Questions for review

1. What is the present value of receiving $25 one year from now, given that the interest rate is 7%?

Present Value =

= -C0 + + +……+

Since we have one year and no cash outflow in year 0 (that is we did not invest any cash to get the returns), n = 1 and C0 = 0.

= -0 + = = 23.36

You can either be asked to find the interest rate, PV or the FV (which is the cash flow during the time periods).

2. If the marginal net benefits (MB) > Marginal Cost (MC), is is profitable to increase Q?

Yes it is, because the profit maximization occurs at the point where the MB = MC. Marginal benefit curve is the slope of the total benefit curve and it is negative.

If you are given an equation of MB and MC and asked to solve for the unknown equate MB = MC.

For example, If ‘C’ is the number of cokes (1 liter) sold and the MB = 5000 – 3C and MC = 7C, how many liters of coke need to be sold for profit maximization?

Profit maximization occurs when MB = MC

5000 – 3C = 7C

5000 = 10C

C = 500

500 liters of coke need to be sold for profit maximization.

3.  ​A company invested $400,000 in a technology that reduced the overall costs of production by reducing their cost per unit from $2 to $1.85. Later, a manager has an opportunity to outsource production to another company at a cost per unit of $1.75. If you are the manager, you

  a.  ​should consider the $400,000 as a sunk cost, not relevant to the decision.

  b.  ​should reduce his effort by ignoring any new developments and letting the production run as it is.

  c.  ​should ignore the $400,000 fixed cost.

  d.  ​Both a & c

Answer is d. Both a & c, as $400,000 should be considered as a sunk cost and cannot recovered and it is irrelevant to the decision making. In the SR production decision $400,000 fixed costs should be ignored as this will still be treated as a sunk cost and is irrelevant to the firm’s decision.

4. ​If a firm produces 8 units of output with average fixed cost=$40 and average variable cost=$25, what is its total cost?

  a.  ​$200

  b.  ​$1,000

  c.  ​$520

  d.  ​$320

Answer is C. $520

TC = TFC + TVC

TFC = AFC*Q = 40*8 = $320

TVC = AVC*Q = 25*8 = $200

5. The number of workers and the total cost of productivity is given below

0:$50; 1:$110; 2:$160; 3:$200; 4:$240; 5:$250; 6:$260; 7:$280; 8:$310; 9:$350; 10:$400

i) The marginal cost of hiring the 9th worker is

MC9th worker = (TC9thworker – TC8thworker)/(L9- L8)

= (350-310)/(9-8) = $40

ii) If the firm hires 7 workers, what is the total fixed cost?

The total fixed cost equals $50, as the fixed cost is the same in the SR for all the units of labor hired.

iii) If hiring the 7th worker increases total product by 5 units and the price of each unit is $2,

  a. ​the firm should not hire the 7th worker as MR<TC

  b. the firm should not hire the 7th worker as MR<MC

  c. marginal revenue equals $2

  d. the firm should hire the 7th worker as MR>MC

Answer is b, as the MR<MC. MR = ∆Q*P = 5*$2 = $10.

MC(7th worker) = = ($280-$260)/(7-6) = $20

Since MR ($10) < MC ($20), the firm should not hire the 7th worker

6. Firm X is producing 1000 units, selling them at $15 each. Variable costs are $3 per unit and the firm is making an accounting profit of $3000. What is the firm’s total costs?

  a. $10,000

  b. ​$11,000

  c. ​$12,000

  d. ​$13,000

Answer is d) $12,000.

Profit = TR – TC

= TR – (TFC+TVC)

3000 = 15000 – TFC – 3000

TFC = 15000 – 6000 = $9000

 ​

7. A catering company is producing at a point where its marginal costs are $25 and its fixed costs are $5000. At the current price of $10 it is producing 50 meals. If the demand goes up, such that they can now charge $20 per meal, how much should the firm now produce?

	a.	​60 meals
	b.	​70 meals
	c.	​80 meals
	d.	​None, they should shut down

Answer is: d) None, they should shut down

Their cost of producing extra units is $25. However, the revenues per unit are now $10 and $20 if sales increase. Either way, the firm isn't covering their marginal costs (let alone their fixed costs; which would only be considered for a long-run decision).

If in the short-run a firm cannot cover their marginal costs (or average variable costs), the firm should shut down.

8. A pottery craftsman is debating attending the crafters fair. It costs $50 to set up the booth and $20 in transportation to get his pottery to the fair. He nets $5 for each of his pieces, number of pots he must sell to make going to the fair worth the cost?

	a.	​10
	b.	​12
	c.	​14
	d.	​16

Answer is: c) 14 pots.

Break-even point is given by the formula

Break-even point (units) = Fixed Cost/ (Selling Price per unit – Variable cost per unit)

B.E. point = ($50+$20) / $5

B.E. point = 14

References:

Mankiw, G.N. 2016. Principles of Macroeconomics, Eighth Edition. @ Cengage Learning

Froeb, McCann, Shor, and ward, 2014. Managerial Economics: A Problem Solving Approach. @ Cengage Learning