Government Policies7Production/Cost13Dynamic Demand25Market DefinitionGovernment Policies:Unregulated, Competitive MarketGovernment Policies: Price ControlB – some consumers can no longer buy the good.C – some producers can no longer sell the good?CS = A – BGovernment Policies: Taxes?CS = -(A + B)Govt = A + DGovernment Policies: Tariffs/QuotasWithout a tariff or quota, a company will import a good when Pworld < Pmarket if there were no importsUnregulated Market:Tariff OR QuotaQuota: Gain to Foreign Producers = DAverage Total CostMarginal CostNetwork ExternalitiesFigure 4.15 Positive Network Externality: Bandwagon EffectLearning CurvesTRUE / FALSE / UNCERTAINYour firm produces a new, patented Super Gelato home ice cream maker. You are about to begin production, and you must decide what price to use. Your marginal cost in the short run is constant, however, you expect it to drop in a few years, when the cosTime and Uncertainty – Present ValueTime and Uncertainty – Uncertainty and Risk AversTime and Uncertainty – Option ValueMonopoly: Market with only one seller (P&R fig. 10.3)The objective is to maximize profits: ?=TR-TCThis requires MR = MCDemand is the average revenue curve. If demand is linear, MR is linear. Therefore, it has the intercept and twice the slope as the inverse demand curve, P(Q).Monopoly powerMulti-plant production15.010/15.011: ECONOMIC ANALYSIS FOR BUSINESS DECISIONS MIDTERM EXAM REVIEW SESSION OCTOBER 9, 2004 PAGE MARKET DEFINITION, SUPPLY/DEMAND, ELASTICITIES 2 GOVERNMENT POLICIES 7 PRODUCTION/COST 13 NETWORK EXTERNALITIES 17 LEARNING CURVE 20 DYNAMIC DEMAND 25 TIME AND UNCERTAINTY 31 MONOPOLIES, MARKET POWER 36 MIDTERM SECRET KEY 42 Midterm Review 1 10/06/04Market Definition A market is a collection of buyers and sellers, resulting in the possibility for exchange. Market boundaries are defined in both geographic terms and in terms of a range of products. • Demand Substitutability: − Would consumers adjust purchases of good A when the price of good B changes? • Supply Substitutability: − Would producers modify production of good A as a result of a change in the price of good B? Midterm Review 2 10/06/04Market Definition Example: True / False: Fast food chains like McDonald’s, Burger King, and Wendy’s operate all over the United States. Therefore, from the consumer’s perspective, the market for fast food is a national market. Answer: False. San Francisco consumers won’t travel to New York to buy a BigMac there even if the price is lower (or has decreased) in New York. Midterm Review 3 10/06/04Supply and Demand Where do the curves come from and what do they represent? • Demand − Aggregate reservation prices of the market. What consumers are willing to pay. − How much consumers will buy at a particular price − Linear Demand: Qd = a - b P − Isoelastic Demand: ln(Qd) = a - b ln(P) • Supply − Aggregate marginal cost curves of an industry − How much will producers provide at a particular price − Linear Supply: Qs = c + d P − Isoelastic Supply: ln(Qs) = c + d ln(P) Midterm Review 4 10/06/04Elasticities An elasticity is a measure of the sensitivity of one variable to another. For our purposes, it is the percentage change in quantity (demanded / supplied) in response to a 1 percent increase in price, income, etc. • Price elasticity of demand − Linear Demand: Ed = - b PQ − Isoelastic Demand: Ed = - b • Price elasticity of supply – Linear Supply: Ed = d PQ – Isoelastic Supply: Ed = d • Cross-price elasticity of demand − Substitutes: positive cross price elasticity (butter and margarine) − Complements: negative cross price elasticity (cars and gasoline) Midterm Review 5 10/06/04• Short run and long run elasticities may be different. – Consumable Goods: ESR < ELR (example: orange juice) – Durable Goods: ESR > ELR (example: cars) Example: True / False: The potential gain to the OPEC cartel from agreeing to production cutbacks and adhering to the agreement is greater if the elasticity of supply is low rather than if it is high. Answer: True. If supply is inelastic (e.g., low), a small production cutback will result in a large price increase. Example: What happens to elasticity along a linear demand curve as Q increases? Ed = -b*P/Q Thus, as Q increases, demand becomes less elastic. Midterm Review 6 10/06/04Government Policies: Unregulated, Competitive Market P0 PS CS • Consumers and producers buy and sell at market clearing price • Consumer surplus: for some consumers, the value of the good exceeds the market price • Producer surplus: some producers produce units at a cost lower than the market price Q0 Measuring Impact of Government Policies: • Start with unregulated competitive market • Determine new price, quantity given government policy • DWL is resultant loss of welfare after all transfer of surplus between producers, consumers, government and foreign entities. Midterm Review 7 10/06/04Government Policies: Price Control Unregulated Market: Price Control: Maximum Price P1 D S D S P1 P0 CBAQ0 P0 PS CS A – Transfer from producers to consumers. Consumers who can purchase good do so at a lower P B – some consumers can no longer buy the good. C – some producers can no longer sell the good ∆CS = A – B Q1Q0 ∆PS = -(A + C) DWL = -(B + C) Midterm Review 8 10/06/04Example: If supply is very inelastic, do consumers gain or lose on net from imposition of Pmax? Why? – If Pmax > PFree, then the price ceiling is irrelevant. Consumers will gain when Pmax < PFree when ∆CS is positive. Obviously, ∆CS will be positive when A > B as shown above. Given the demand curve depicted above, for very inelastic supply curves, A > B, therefore consumers will be better off. Midterm Review 9 10/06/04Government Policies: Taxes Unregulated Market: Taxes: t Pd = Ps + t S D SDDAtPs PdP0C B Q0 P0 PS CS QD = QD(Pd) QS = QS(Ps) QD = QS = Q1 ∆CS = -(A + B) ∆PS = -(C + D) Govt = A + D DWL = -(B + C) Q1Q0 To solve taxes exercises, follow these steps: 1) Express QD = QD(Pd) and QS = QS(Ps) [Demand and Supply in terms of Pd and Pd] 2) Use [Pd = Ps + t] to replace Pd in the demand curve (or alternatively replace Ps in supply curve) 3) Equate QD = QS and solve for price Pd (or alternative Ps). Find Q1 using one of the equations and the