Costs Revenues Econ 1 Final Review Sunk Fixed Costs costs that do not vary with quantity costs already incurred and cannot be reduced by alternating production Variable Costs vary with quantity Marginal Revenue the change in total revenue from selling one additional unit for a firm in a competitive industry MR Price Marginal Cost the change in total cost from producing an additional unit Marginal cost will increase over time Total revenue price times the quantity sold Total cost the cost of producing a given quantity of output opportunity cost what is given up when taking an action or making a choice Explicit cost amount paid out in actual dollars Implicit cost the value of something sacrificed when no direct payment is made Firms will continue to maximize profits as long as marginal revenue is less than marginal cost For a firm in a competitive industry marginal revenue price of good being sold The profit maximizing quantity will be where MR MC P Allocate production resources based on which producer has a lower marginal cost for each additional unit A free market minimizes the total costs of production even without a central planner due to the fact that sellers will always try to minimize the costs of their production Adam Smith s Invisible Hand Theory Average Cost the average cost of producing one unit total cost divided by the quantity Profit P AC x Q and P Total Revenue Total Cost Just because a firm is maximizing profits doesn t mean it is making profits because it is maximizing profits at P MC but if the price is low enough price can be less than the average cost P AC a firm will make profits when P AC MC and AC meet at the average costs minimum point In the long run firms will enter profitable industries P AC exit unprofitable P AC and there is neither entry or exit at zero profits P AC What we mean by zero profits is the price of output is just enough to cover normal payments to capital and labor in that industry When marginal cost exceeds average variable cost average variable cost is rising When it is less than average variable cost average variable cost is falling When marginal cost is equal to average variable cost it is neither rising nor falling Average variable cost is at a minimum Profit is maximized at the quantity at which price equals marginal cost Comparative Advantage C A allows people to benefit from trade because it allows people to specialize in what they do best Absolute Advantage is the ability to produce a good using fewer inputs than another producer To determine the comparative advantage find the opportunity cost of producing each good and compare each producers opportunity costs to each other look at page 292 293 in reader for clarification Comparative Advantage is the ability to produce a good at a lower opportunity cost than another producer It is possible for someone to have absolute advantage in all goods but impossible for someone to have a comparative advantage in both goods CA reflects the relative opportunity cost Competitive Equilibrium Equilibrium where quantity demanded equals quantity supplied Consumer s surplus the difference between the reservation price and price they actually have to pay it is the area below the demand curve and above the line representing market price Producer surplus the area above the supply curve below the price line Price ceiling floor price cannot be above below a given value Deadweight loss loss of efficiency loss in profits According to the invisible hand theorem a competitive equilibrium maximizes the total profit from trade It does not necessarily maximize the number of profits trades competitive equilibrium is efficient Goods normal inferior substitutes Normal Good A good where an increase in income leads to an increase in demand Inferior Good increase in income decreases demand substitutes increase in price of one increases demand for another complements increase in price of one good decreases demand for another Elasticity Elasticity a measure of how much buyers and sellers respond to changes in market conditions a measure of the responsiveness of quantity demanded or supplied to a change in one of its determinants Necessities tend to have inelastic demands while luxuries have elastic demands More narrowly defined markets have more elastic demands then broadly defined markets Example food vs vanilla ice cream Goods tend to have more elastic demand over longer periods of time Elasticity of demand Refers to the degree of responsiveness a demand curve has with respect to price If quantity drops a great deal when price goes up then the curve is elastic if quantity doesn t drop easily with increases in price the curve is inelastic Elasticity of supply Refers to the degree of responsiveness a supply curve has with respect to price If quantity increases a great deal when price goes up then the curve is elastic if quantity doesn t increase easily with increases in price the curve is inelastic Elasticity Change in Quantity Change in Price An elasticity of 1 is the established borderline between elastic and inelastic goods A curve with an elasticity of 1 is called unit elastic an elasticity of 1 indicates perfect responsiveness of quantity to price If the elasticity of demand is greater than or equal to 1 it is elastic If less than one it is inelastic Note One solution to studying elasticity over a curve rather than at a specific point is to calculate elasticity using the following formula Elasticity Change in quantity Average quantity Change in price Average price Elasticity Q1 Q2 Q1 Q2 2 P1 P2 P1 P2 2 Adam Smith s Theories Labor not nature was the main source of value He was concerned with promoting the wealth of the entire nation which consisted of the goods that all people of society consume including the poor just not in equal amounts The flow of goods services consumed by everyone constitutes the ultimate aim and end of economic life Sought to describe the invisible hand that causes the private interests of men to agree with the interests of the whole society Saw society as a changing organism one that has its own history Self interest is a driving power that will guide men to whatever work society is willing to pay for A community activated only by self interest would be a community of ruthless profiteers but this is prevented due to competition prices are kept down by other producers and other potential producers Producers of society heed society s demand for the quantities of goods Self interest and