Review for Final Part 2

1. Review for FinalPart 2 Exam is Saturday, December 9, 2 pm. In our regular room (Comer Auditorium).

2. Final is comprehensive • Material is covered fairly evenly from all four units. • Many multiple choice questions are similar to, but not identical to, the ones you've seen. • Problems will look like ones you've seen before on paper homework or exams, but with different numbers.

3. Format of Final? 40 multiple choice questions, worth 2 points each. (80 points) 20 points of short problems. You don't need a Scantron. You do need a calculator.

4. Studying • Online practice problems still available. • Exam 1-4 multiple choice questions are available in Comer 308. You have to look at them there. You can’t photocopy them. • I have announced some extra office hours via email.

5. Average and Marginal Cost MC intersects AC and AVC at each minimum. AC gets closer to AVC as output increases MC AC AVC Output (y)

6. Perfect Competition Market Efficiency: The market is “efficient” under perfect competition in the absence of externalities. It is efficient because price = MC. Reservation prices of the marginal buyer = reservation price of the marginal seller and all relevant costs and benefits are captured by the market.

7. Externalities If there are externalities, the market equilibrium is not efficient because it does not capture all relevant costs (or all relevant benefits in the case of positive externalities). If there are externalities, people outside the market are affected by the transactions in the market but their welfare is not represented in CS or PS.

8. Suppose that a firm is located along a river. The firm uses water from the river to cool its machinery and returns the water to the river several degrees warmer, which has led to a decline in the fish population downstream of the firm. The externality (the dead fish) is a relevant cost of production that is not captured by the market equilibrium. If a relevant cost is ignored, that means the market price is too low and market quantity too high. If the firm had to pay the cost for the dead fish, supply would decrease. In this case, if the government fines the firm to account for society’s cost of the dead fish, efficiency in this market would increase.

9. Suppose that an increase in the college-educated population increases job opportunities and community well-being for everyone. In this case, the externality (increased job growth for all) is a relevant benefit of consumption that is not captured by the market equilibrium. If a relevant benefit is ignored, that means the market price is too high and market quantity too low. In this case, to reach the socially optimal level of output, the government will employ strategies to decrease the price of education to those who consume it and to increase the quantity. They can do this via reduced-cost loans or grants to students to defray tuition costs, or by building state-subsidized universities.

10. Chapter 6 Concepts • Supplier’s Reservation Price and Opportunity Costs • Diminishing Returns • Cost Concepts • Perfect Competition • Profit Maximization

11. Chapter 7 Concepts • Market equilibrium and efficiency • Welfare loss from price ceilings and price floors • Sales taxes and efficiency • Subsidies and efficiency

12. Chapter 8 Concepts • Accounting Profit versus Economic Profit • Responses to profit and loss and the allocative function of price • Long-run equilibrium under perfect competition

13. Opportunity Costs • In determining their reservation price, suppliers consider their opportunity costs. • If Jamie can earn $10 an hour as a student worker, she will normally not be willing to give up work for another job paying less than that.

14. Jamie can earn extra money washing cars for $5 per car Calculate her Marginal Benefit from washing cars. She will be willing to wash cars so long as the extra benefit is at least as large as her opportunity cost ($10). How many hours (at most) would she work washing cars?

15. The Production Function The production function relates inputs to output in physical terms. The production function, along with input prices, will determine the costs of producing output.

16. Average Product To find average product, divide total product (or output) by the input level.

17. Marginal Product Marginal product tells you how much extra output you get from each extra unit of input. To calculate marginal product, take the change in total product (or output) and divide by the change in input.

18. Example

19. Costs • Total Cost (TC) = Variable Costs (VC) + Fixed Costs (FC) • AC (ATC) = TC divided by output or AC= AVC + AFC • AVC = VC divided by output • AFC = FC divided by output

20. Variable Costs Total variable costs = the amount spent on variable inputs. Price of input 1 X Amount of variable input 1 + Price of input 2 X Amount of variable input 2 + Price of input 3 X Amount of variable input 3 etc. In our homework, there was only one variable input.

21. Variable Cost Variable cost is what is spent on variable inputs. If there is only one variable input, VC = Px*X Where Px is the input price and X is the amount used. Some books use “TVC” for “VC” where T stands for “total.”

22. More on Variable Cost If there are two or more variable inputs: VC = Px1*X1 + Px2*X2 + Px3*X3 . .. Where Px1 is the input price for one of the variable inputs and X1 is the amount of that input used, Px2 is the input price for the next variable input and X2 is the amount of the second input used, and so on.

23. Average Variable Cost AVC = Variable Cost divided by output.

24. Fixed Cost Fixed cost doesn’t change as output changes, in the short run. .

25. Average Fixed Cost AFC = FC/output. Some books used “TFC” for FC AFC falls as output increases.

26. Marginal Cost Marginal cost is the change in VC divided by the change in output. It can also be calculated using the change in TC divided by the change in output.

27. Profit-Maximizing Decision Rule In perfect competition, the rule is: MC = output price If there are two points where MC=Py then pick the one with higher output. Also, check that Py>AVC (else firm should shut down)

28. Perfect Competition: Illustration of firm-level demand P P S d D q Q Entire Market One firm

29. Marginal Revenue Marginal revenue is the extra amount a firm will earn from selling one more unit of its output. Under perfect competition, the marginal revenue will therefore by equal to ___________. product price Formal definition: Marginal revenue is the change in total revenue resulting from a one unit increase in output.

30. Goal of Profit Maximizing The firm’s goal is assumed to be maximizing profit. Remember that profit is: Firm Profit = Py*Y - TC Where Y is firm output.

31. On the graph We find the point where Marginal Revenue or price (as shown by the flat demand curve, d), hits MC. The profit-maximizing output is found at this point. Profit, or loss, per unit is the vertical distance between MR and AC at that point. On the following graph, the unit profit is shown by the solid orange line.

32. Graphically Profit >0 Profit > 0 MC AC d p q

33. Graphically Profit = 0 MC Profit = 0 AC p d q

34. Zero-profit point The zero-profit point occurs at the minimum point of the AC curve. This point is also called the “break-even” point.

35. Graphically Profit < 0i Profit < 0 MC AC p d q

36. Recall • In economics, total costs include “opportunity costs.” • Thus, a firm earning “0 profit” is in fact covering its opportunity costs. • Accounting Profit – Opportunity Costs = Economic Profit

37. Producing at a Loss Would a rational, profit-maximizing producer ever produce at a loss? Remember that TC is the sum of VC and fixed costs, which do not change in the short run even if nothing is produced.

38. Producing at a loss, continued In the short run, firms will produce at a loss so long as that loss is less than total fixed costs. In other words, they compare the loss they would get from not producing (the total fixed costs) with the loss they would get if they produce.

39. At the point where price = MC for • a perfectly competitive firm, Total • Revenue = $2000, VC = $2100 and • FC = $100. What should this firm do? • Shut down • Produce and make a profit • Produce because the loss is less than • Fixed costs • d) Change its output level

40. Covering Variable Costs In the short run, producers will produce so long as the TR is greater than the total variable costs. The shutdown point comes where revenues just equal variable costs, or losses from production are equal to the fixed costs.

41. AVC and Price If TR = VC (total variable costs), then Price = AVC. Why? TR= Py*Y, so divide both sides by Y to get this equivalency.

42. Shutdown Rule When the price falls below the minimum AVC, the firm will shut down. On a table, find the shutdown point by looking at the AVC entries and finding the smallest one. The shutdown price is equal to the lowest AVC. The output level is found by reading across the table to find the output level.

43. Graphically AC MC AVC ps shutdown point

44. The Firm’s Supply Curve AC MC AVC ps shutdown point

45. The firm’s supply curve, cont. The firm’s supply curve is the portion of its marginal cost curve beyond the shutdown point. (Shown in green on the preceding graph.)

46. From Firm to Industry The market supply curve for a good is the horizontal sum of all the individual firms’ supply curves.

47. short run and long run In the short run, demand shifts produce greater price adjustments and smaller quantity adjustments than in the long run.

48. Factor Adjustments In the short run, supply can only be adjusted using variable factors. The fixed factors (such as equipment and factory buildings) cannot change. In the longer run, the fixed factors can also be adjusted, and firms can enter or exit the industry. Hence, supply tends to be more elastic in the long run than in the short run.

49. What happens when demand increases? In the short run: There will be an increase in price and output per firm will rise. The increased price will bring higher profits for each firm in the industry.

50. When firms earn economic profits New firms will enter the industry in the longer run. The long run supply curve is more elastic than the short run. The increased number of firms will bring more output to the industry. In most cases, the new entrants will also bid up the price of inputs, so that the AC curves will rise.