Econ Exam 2 Study Guide 10 22 14 Price Elasticity of Demand E change in Qd change in P change in Qd change in Q Q change in P change in P P Categories of Elasticity o E 0 perfectly inelastic o 0 E 1 inelastic o E 1 unitary elastic o 1 E elastic o E perfectly elastic Total Revenue TR P x Q o If P increases then Q decreases so its not clear what happens to the product of those two numbers o If demand is inelastic P increases TR increases o If demand is elastic P increases TR decreases o P decreases TR increases o Total Revenue will be maximized where E 1 Determinants of E 1 Availability of Substitutes a Ceteris paribus the more substitutes that are available the more 2 Proportion of a consumer s budget that is spent on the good a Ceteris paribus the larger the proportion of a consumer s budget the elastic the demand more elastic 3 The length of time that consumers have to adjust to a price change a Ceteris paribus the longer consumers have to adjust to a price change the more elastic the demand Income Elasticity of Demand o change in Q 0 normal good o change income 0 inferior good Cross Price Elasticity of Demand o change in Qa o change in Pb 0 substitutes 0 compliments Price Elasticity of Supply o change in Qs 1 x P o change in P slope Q Production Production Function shows the maximum amount of outputs that a firm can produce from a given amount of inputs o Q f l k assuming just 2 inputs L K o L labor o K capital Short run a period of time in which at least one input is fixed o Capital is typically the fixed input labor is variable Marginal Product of Labor MPl when the firm hires an additional unit of labor the additional output that is produced o MPl change in Q change in L Specialization Effect o As you hire more workers they can specialize in certain tasks taking advantage of comparative advantage MPl increases Congestion Effect o As you hire more workers each worker has less capital with which to work MPl decreases Law of Diminishing Marginal Product returns as you add more and more of a variable input to a fixed input at some point the marginal product of the variable input decreases Short Run Costs of Production Fixed Costs FC costs that do NOT vary with output Variable Costs VC costs that DO vary with output Total Costs TC FC VC TC Avg Fixed Costs AFC FC Q AFC Avg Variable Costs AVC VC Q AVC Avg Total Costs ATC TC Q ATC Marginal Costs MC the change in TC that occurs when the firm produces an extra unit of output o Assume there are two inputs capital K and labor L and that change in TC w x change in L w wage rate price of labor o MC W MPl o Diminishing marginal returns increasing marginal costs TC FC VC MC change in VC When marginal average average increases When marginal average average decreases The marginal cost curve will intersect both the AVC and ATC at their minimums if VC 0 when Q 0 then AVC MC at the 1st unit of output Long Run Production o in the LR all inputs are variable Q f L K o Returns to Scale o Production function Q f L K for t 1 o What happens to Q if the firm doubles both of its inputs o If output inc by more than double inc returns to scale o If output inc by exactly double constant returns to scale o If output inc by less than double dec returns to scale o Long Run ATC o LRATC TC Q If input prices w r are constant W wage rate price of labor R price of capital o Increasing returns to scale decreasing LRATC o Constant returns to scale constant LRATC o Decreasing returns to scale increasing LRATC Perfect Competition Assumptions 1 Many buyers and sellers 2 Firms produce homogenous identical products 3 Buyers and sellers have complete information 4 Easy entry and exit 5 No externalities 6 No transaction costs 7 No government interference taxes regulations o Individual firms face a perfectly elastic demand curve o We assume that firms try to maximize profit o Profit pi symbol TR TC o In order to maximize profit a firm should produce the quantity where the marginal revenue MC MR MC o This is a necessary condition for profit maximization 1 Suppose MR MC the firm can increase profit by increasing output 2 Suppose MR MC the firm can increase profit by decreasing output o Only if MR MC can the firm be maximizing profit o Perfectly Competitive Firms are price takers They take the market price as given and then determine how much output to produce to maximize profit o P MR perfectly competitive firm E infinity for any Q o MR MC Profit maximization necessary condition o A perfectly competitive firm that maximizes profit will produce the quantity o The supply curve of a perfectly competitive firm in the short run is its MC where P MC curve w 2 exceptions o 1 PRACTICE QUESTIONS If the income elasticity of demand for cereal is 25 and the income elasticity of demand for peaches is 1 5 then a Cereal is an inferior good and peaches are a normal good 2 Suppose you produce tie dyed tshirts You notice that when you charge 10 per shirt you sell 200 shirts Also when you raise the price to 12 you sell 150 shirts As the price goes up from 10 to 12 your total revenue therefore the demand for tie dyed shirts must be 3 Suppose a firm doubles all of its inputs and this results in the firm tripling its a Decreases elastic output The firm is experiencing a Economies of scale 4 If the price elasticity of demand for a good is 1 5 and then a 5 decrease in the price of the good will cause a a 7 5 increase in the quantity demanded 5 If demand for a good is perfectly inelastic then the demand curve will be 6 Ceteris paribus the fewer the substitutes there are for a good the more the demand for the good and the longer period of time people have to adjust to a price change the more the good 7 If the slop of a demand curve is constant then the price elasticity of demand for the good will a A vertical line a Inelastic elastic a Become more
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