COMMON MISTAKES ON THE AP MICRO EXAM

A change in Demand versus a change in the Quantity Demanded √ Moves the curve Income Future Expectations # of Buyers Consumer Information Taste and Preference Substitues and Complements Change in Quantity Demanded √ Moves Along the SAME curve • Caused only by Price change.

S D Consumer and Producer Surplus √ The value in excess of the purchase price √ The income the firm gets in excess of its marginal costs P S CS P1 Qe PS D Q

Price Floor and Price Ceiling S Surplus Pf P1 Qe Pc Shortage D Q

E i = %  Quantity % Income Elasticity Ed = % change in Qd % change in P PRICE E c = %  Quantity of X % Price of Y CROSS E i = %  Quantity % Income INCOME

Dead Weight Loss When the Price is Below P* Q/t P Demand Supply A P* C 0 Q’ Q* E F P’ B Value to the Consumer: 0AEQ’ Consumers Pay Producers: OP’FQ’ The Variable Cost to Producers: OBFQ’ Consumer Surplus: P’AEF Producer Surplus: BP’F DWL FEC

TAX INCIDENCE AND EFFICIENCY LOSS Tax Revenues Efficiency Loss of a Tax Role of Elasticities Qualifications Redistributive Goals Reducing Negative Externalities

Perfectly Inelastic Demand Q/t P S2 Q1=Q2 P2 S1 P1

Perfectly Elastic Demand Q/t P D S2 P1=P2 Q2 S1 Q1

Inelastic Demand (at moderate prices) Q/t D S1 P1 Q1 Q2 S2 P2

Elastic Demand (at moderate prices) Q/t P Q1 D S1 P1 S2 P2 Q2

DIMINISHING RETURNS Explanation: As additional units of a variable input (labor) are added to a fixed input (capital), at some point the additional output resulting from the addition of one more unit of variable input declines. This decline is referred to as diminishing marginal return. At this point, total product increases at a decreasing rate.

Rationale: As the variable input increases and the fixed input, by definition, remains the same, there is less fixed input with which the variable input can be combined. Example: As more workers are added but capital remains the same, there is less capital per worker.

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns Total Product Total Product, TP Increasing Marginal Returns Quantity of Labor Average Product, AP, and marginal product, MP Average Product Marginal Product Quantity of Labor

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns Total Product Total Product, TP Diminishing Marginal Returns Quantity of Labor Average Product, AP, and marginal product, MP Average Product Marginal Product Quantity of Labor

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns Total Product Total Product, TP Negative Marginal Returns Quantity of Labor Average Product, AP, and marginal product, MP Average Product Marginal Product Quantity of Labor

Two Approaches to Find the PROFIT MAXIMIZING QUANTITY ( PRICE)

Total Revenue Total Cost TOTAL REVENUE-TOTAL COST APPROACH Break-Even Point (Normal Profit) $1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 600 500 400 300 200 100 Total Revenue Maximum Economic Profits $299 Total revenue and total cost Total Cost Break-Even Point (Normal Profit) 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Profit Maximization Position MARGINAL REVENUE-MARGINAL COST APPROACH Profit Maximization Position $200 150 100 50 Economic Profit MC $131.00 MR ATC Cost and Revenue AVC $97.78 1 2 3 4 5 6 7 8 9 10

Key Micro Formulas

ECONOMIC INTERPRETATION   RELATIONSHIP ECONOMIC INTERPRETATION MR = MC When MR = MC, we know that the firm has chosen the output that maximizes profits.   P > ATC Firm is earning ECONOMIC PROFITS P = ATC Firm is earning NORMAL PROFIT (Break-Even Point) (economic profit = 0) P < ATC P > AVC Loss Minimization P = AVC SHUTDOWN POINT (firm will loseTFC if they produce or Shutdown and produce 0. P < AVC Firm does not produce

Finding the Perfectly Competitive Firm’s Supply Curve

Marginal Cost & Short-Run Supply MARGINAL REVENUE-MARGINAL COST APPROACH Marginal Cost & Short-Run Supply MC P5 MR5 ATC MR4 P4 Cost and Revenue, (dollars) AVC P3 MR3 P2 MR2 MR1 P1 Do not Produce – Below AVC Q2 Q3 Q4 Q5 Quantity Supplied

Marginal Cost & Short-Run Supply MARGINAL REVENUE-MARGINAL COST APPROACH Marginal Cost & Short-Run Supply Yields the Short-Run Supply Curve Supply MC P5 MR5 MR4 P4 Cost and Revenue, (dollars) P3 MR3 P2 MR2 MR1 P1 No Production Below AVC Q2 Q3 Q4 Q5 Quantity Supplied

Long Run Equilibrium (Perfectly Competitive Firm) Productive Efficiency Allocative Efficiency

LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM MC ATC Price P MR Price = MC = Minimum ATC (normal profit) Q Quantity

How an Increase in Demand Changes Long-Run Equilibrium for the Firm and Industry

Firm Industry Temporary Profits and the Reestablishment PROFIT MAXIMIZATION IN THE LONG-RUN Temporary Profits and the Reestablishment Of Long-Run Equilibrium S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D1

Firm Industry An increase in demand increases profits… Economic PROFIT MAXIMIZATION IN THE LONG-RUN An increase in demand increases profits… Economic Profits S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D2 D1

Firm Industry New Competitors increase supply and lower PROFIT MAXIMIZATION IN THE LONG-RUN New Competitors increase supply and lower Prices decrease economic profits Zero Economic Profits S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 S2 MC ATC MR D2 D1

How an Decrease in Demand Changes Long-Run Equilibrium for the Firm and Industry

Firm Industry Decreases in demand, Losses and the PROFIT MAXIMIZATION IN THE LONG-RUN Decreases in demand, Losses and the Reestablishment of Long-Run Equilibrium S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D1

Firm Industry A decrease in demand creates losses… Economic Losses P Q PROFIT MAXIMIZATION IN THE LONG-RUN A decrease in demand creates losses… Economic Losses S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D1 D2

Firm Industry Competitors with losses decrease supply and PROFIT MAXIMIZATION IN THE LONG-RUN Competitors with losses decrease supply and prices return to zero economic profits S3 Return to Zero Economic Profits S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D1 D2

Price and Marginal Revenue for a Monopoly

MONOPOLY REVENUES & COSTS $200 150 200 50 Dollars Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 $750 500 250 Dollars Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

MONOPOLY REVENUES & COSTS Elastic $200 150 200 50 Dollars MR D Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 $750 500 250 Dollars TR Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

MONOPOLY REVENUES & COSTS Elastic Inelastic $200 150 200 50 Dollars MR D Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 $750 500 250 Dollars TR Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Failing to remember how to shade the area of ECONOMIC PROFIT THE PROFIT-MAXIMIZING POSITION OF A MONOPOLY

Remember the MR=MC Rule? OUTPUT AND PRICE DETERMINATION Profit Maximization Under Monopoly Remember the MR=MC Rule? Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue Profit Per Unit MC $122 Profit ATC $94 D MR = MC MR

And the Shading of Economic Losses LOSS MINIMIZATION OF THE IMPERFECT COMPETITOR

OUTPUT AND PRICE DETERMINATION Loss Minimization Under Monopoly Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue Since Pm exceeds AVC, the firm will produce Loss Per Unit MC ATC A Loss AVC Pm V D MR = MC MR Qm

Monopoly vs. Competition

PURE COMPETITION MONOPOLY --------------------------------------   PURE COMPETITION MONOPOLY   MR = MC The firms maximizes profit. The firm maximizes profit. P = ATC The firms just BREAK-EVEN (NORMAL PROFITS) in the Long Run. P > ATC  Long Run ECONOMIC PROFITS. P = min ATC Firm is forced to operate with maximum productive efficiency. -------------------------------------- PRODUCTIVE EFFICIENCY  (Least-Cost Method Production) P > min ATC Firm is not forced to operate with maximum productive efficiency. PRODUCTIVE INEFFICIENCY (Least-Cost Method Production not necessary) P = MC There is an optimal allocation of resources.   ALLOCATIVE EFFICIENCY  P > MC There is an UNDERALLOCATION of resources. ALLOCATIVE INEFFICIENCY  P = MR The firm’s DEMAND CURVE is infinitely ELASTIC. P > MR The firm’s DEMAND CURVE is less than infinitely ELASTIC.

INEFFICIENCY OF PURE MONOPOLY An industry in pure competition sells where supply and demand are equal P S = MC At MR=MC A monopolist will sell less units at a higher price than in competition Pm Pc D MR Q Qm Qc

INEFFICIENCY OF PURE MONOPOLY S = MC At MR=MC A monopolist will sell less units at a higher price than in competition Pm Pc Monopoly pricing effectively creates an income transfer from buyers to the seller! D MR Q Qm Qc

Not being able to GRAPH a Natural Monopoly and the Socially- Optimal Output and Fair-Return Output Levels

Socially Optimum Price P = MC Fair-Return Price P = ATC REGULATED MONOPOLY Natural Monopolies Rate Regulation Socially Optimum Price P = MC Fair-Return Price P = ATC Dilemma of Regulation Graphically…

REGULATED MONOPOLY Monopoly Price P MR = MC Price and Costs ATC MC D Q Qm

REGULATED MONOPOLY P Socially-Optimum Price and Costs Price P = MC ATC MR Q Qr

REGULATED MONOPOLY P Fair-Return Price Normal Profit Only Price and Costs ATC Pf MC D MR Q Qf

REGULATED MONOPOLY Dilemma of Regulation Which Price? P MR = MC Fair-Return Price Pm Socially-Optimum Price Price and Costs ATC Pf MC Pr D MR Q Qm Qf Qr

Single PRICE Monopoly vs. Price Discrimination

Monopoly Power Market Segregation No Resale More Profit PRICE DISCRIMINATION Conditions Monopoly Power Market Segregation No Resale Consequences More Profit More Production Graphically…

PRICE DISCRIMINATION Economic profits with a single MR=MC price MC P ATC Price and Costs D MR Q Q1

A perfectly discriminating producing more product PRICE DISCRIMINATION A perfectly discriminating monopolist has MR=D, producing more product and more profit! MC P ATC Price and Costs MR=D D Q Q1 Q2

PRICE DISCRIMINATION Economic profits with price discrimination MC P ATC Price and Costs MR=D D Q Q1 Q2

Monopolistic Competition What is it? Monopoly? Competition?

MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC Expect New Competitors ATC P1 A1 Price and Costs Economic Profits D MR Q1 Quantity

MONOPOLISTIC COMPETITION New competition drives down prices – leading to economic losses in the short run PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC Expect New Competitors ATC P1 A1 Price and Costs Economic Profits D MR Q1 Quantity

MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC ATC A2 P2 Economic Losses Price and Costs D MR Q2 Quantity

MONOPOLISTIC COMPETITION With economic losses, firms will exit the market – Stability occurs when economic profits are zero PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC ATC A2 P2 Economic Losses Price and Costs D MR Q2 Quantity

MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC Long-Run Equilibrium Normal Profit Only ATC P3 = A3 Price and Costs D MR Q3 Quantity

NOW, for the RESOURCE (Factor) MARKETS

Remember… Product Market: MR = MC Resource Market: MRP = MFC

MRP AS A DEMAND SCHEDULE Pure Competition Total Product (Output) Marginal product (MP) Marginal Revenue Product (MRP) Units of Resource Product Price Total Revenue 1 7 ] $2 2 $ 0 14 ] 7 $ 14 ] ] ] ] ] ] ] ] ] ] P 14 12 10 8 6 4 2 Resource price (wage rate) Q 0 1 2 3 4 5 6 7 8 Quantity of resource demanded

MRP AS A DEMAND SCHEDULE Pure Competition Total Product (Output) Marginal product (MP) Marginal Revenue Product (MRP) Units of Resource Product Price Total Revenue 1 2 7 13 ] $2 2 $ 0 14 26 ] 7 6 $ 14 12 ] ] ] ] ] ] ] ] ] ] P 14 12 10 8 6 4 2 Resource price (wage rate) Q 0 1 2 3 4 5 6 7 8 Quantity of resource demanded

MRP AS A DEMAND SCHEDULE Pure Competition Total Product (Output) Marginal product (MP) Marginal Revenue Product (MRP) Units of Resource Product Price Total Revenue 1 2 3 7 13 18 ] $2 2 $ 0 14 26 36 ] 7 6 5 $ 14 12 10 ] ] ] ] ] ] ] ] ] ] P 14 12 10 8 6 4 2 Resource price (wage rate) Q 0 1 2 3 4 5 6 7 8 Quantity of resource demanded

MRP AS A DEMAND SCHEDULE Pure Competition Total Product (Output) Marginal product (MP) Marginal Revenue Product (MRP) Units of Resource Product Price Total Revenue 1 2 3 4 5 6 7 7 13 18 22 25 27 28 ] $2 2 $ 0 14 26 36 44 50 54 56 ] 7 6 5 4 3 2 1 $ 14 12 10 8 6 4 2 ] ] ] ] ] ] ] ] ] ] P 14 12 10 8 6 4 2 The purely competitive seller’s demand for a resource Resource price (wage rate) Q 0 1 2 3 4 5 6 7 8 Quantity of resource demanded

MRP AS A DEMAND SCHEDULE Pure Competition Total Product (Output) Marginal product (MP) Marginal Revenue Product (MRP) Units of Resource Product Price Total Revenue 1 2 3 4 5 6 7 7 13 18 22 25 27 28 ] $2 2 $ 0 14 26 36 44 50 54 56 ] 7 6 5 4 3 2 1 $ 14 12 10 8 6 4 2 Now, consider the case of resource demand under Imperfect Competition ] ] ] ] ] ] ] ] ] ] P 14 12 10 8 6 4 2 The purely competitive seller’s demand for a resource Resource price (wage rate) Q 0 1 2 3 4 5 6 7 8 Quantity of resource demanded

MRP AS A DEMAND SCHEDULE Imperfect Competition Total Product (Output) Marginal product (MP) Marginal Revenue Product (MRP) Units of Resource Product Price Total Revenue 1 2 3 4 5 6 7 7 13 18 22 25 27 28 ] $2.80 2.60 2.40 2.20 2.00 1.85 1.75 1.65 $ 0 18.20 31.20 39.60 44.00 46.25 47.25 46.20 ] 7 6 5 4 3 2 1 $ 18.20 13.00 8.40 4.40 2.25 1.00 -1.05 ] ] ] ] ] ] ] ] ] ] P 14 12 10 8 6 4 2 The imperfectly Competitive seller’s demand for a resource Resource price (wage rate) Q 0 1 2 3 4 5 6 7 8 Quantity of resource demanded

LABOR MARKETS: Wage Determination

PURELY COMPETITIVE LABOR MARKET Many Firms Numerous Qualified Workers “Wage Taker” Behavior Market Demand for Labor Market Supply of Labor

LABOR SUPPLY AND DEMAND PURELY COMPETITIVE MARKET Quantity of Labor Wage Rate (dollars) Includes Normal Profit Non- Labor Costs S = MRC Wc $10 $10 $10 $10 $10 $10 Wc ($10) Labor Costs D = MRP ( mrp’s) d = mrp (1000) (5) Labor Market Individual Firm

MONOPSONISTIC LABOR MARKET In monopsony MRC lies above the supply curve Wage Rate (dollars) Quantity of Labor

MONOPSONISTIC LABOR MARKET MRC S MRP = MRC Wage Rate (dollars) Wm MRP Qm units of labor hired Qm Quantity of Labor

MONOPSONISTIC LABOR MARKET MRC S The competitive solution would result in a higher wage and greater employment Wage Rate (dollars) Wc Wm MRP Qm Qc Quantity of Labor

EXTERNALITIES Negative Positive

Externalities COST-BENEFIT ANALYSIS Spillover Costs Spillover Benefits Marginal Cost = Marginal Benefit Rule Externalities Spillover Costs Overallocation Spillover Benefits Underallocation

SPILLOVER COSTS AND BENEFITS Illustrating a Negative Externality Overallocation Q Q0 Qe

SPILLOVER COSTS AND BENEFITS Illustrating a Positive Externality Dt D Underallocation Q Qe Q0

Taxation Concepts

APPORTIONING THE TAX BURDEN Benefits-Received Principle Ability-to-Pay Principle Progressive Tax Regressive Tax Proportional Tax

Identify whether progressive, regressive, or proportional TAX APPLICATIONS: Identify whether progressive, regressive, or proportional Personal Income Tax Progressive Sales Tax Regressive Corporate Income Tax Proportional - Regressive Payroll Taxes Property Taxes

Price Supports Surpluses Subsidies

EFFECT OF PRICE SUPPORTS Surplus Price Support Level Ps Surplus being created by the subsidies Pe D Q Qc Qs Qe

International Trade Comparative Advantage Case for Free Trade Export Supply Import Demand

Principle of Comparative Advantage PRODUCTION POSSIBILITIES Principle of Comparative Advantage Total output will be greatest when Each good is produced by the nation that has the lowest domestic opportunity cost for that good. U.S has comparative advantage in wheat Brazil has comparative advantage in coffee

Principle of Comparative Advantage PRODUCTION POSSIBILITIES Principle of Comparative Advantage Terms of Trade Gains From Trade Improved Options Trading Possibilities Line Graphically…

PRODUCTION POSSIBILITIES Curve For Each Country United States Brazil Coffee (tons) 45 40 35 30 25 20 15 10 5 5 10 15 20 25 30 5 10 15 20 Wheat (tons) A B

TRADING POSSIBILITIES LINES The Gains from Trade United States Brazil 45 40 35 30 25 20 15 10 5 Trading possibilities line 30 25 20 15 10 5 Coffee (tons) Coffee (tons) Trading possibilities line A B 5 10 15 20 25 30 5 10 15 20 Wheat (tons) Wheat (tons)

TRADING POSSIBILITIES LINES The Gains from Trade United States Brazil 45 40 35 30 25 20 15 10 5 Trading possibilities line 30 25 20 15 10 5 Coffee (tons) Coffee (tons) Trading possibilities line A’ A B’ B 5 10 15 20 25 30 5 10 15 20 Wheat (tons) Wheat (tons)

The Case For Free Trade TRADING POSSIBILITIES LINES The Gains from Trade United States Brazil 45 40 35 30 25 20 15 10 5 Trading possibilities line The Case For Free Trade 30 25 20 15 10 5 Coffee (tons) Coffee (tons) Trading possibilities line A’ A B’ B 5 10 15 20 25 30 5 10 15 20 Wheat (tons) Wheat (tons)

U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand Sd $1.50 1.25 1.00 .75 .50 .25 Price (per pound; U.S. dollars) 100 50 75 125 150 Quantity of Aluminum 100 50 Price (per pound; U.S. dollars) $1.50 1.25 1.00 .75 .50 .25 Quantity of Aluminum If the world price exceeds the U.S. price by 25 cents... Dd

U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand Sd $1.50 1.25 1.00 .75 .50 .25 $1.50 1.25 1.00 .75 .50 .25 EXPORTS = 50 SURPLUS = 50 Price (per pound; U.S. dollars) Price (per pound; U.S. dollars) If the world price goes further up... Dd 50 75 100 125 150 50 100 Quantity of Aluminum Quantity of Aluminum

U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand Sd SURPLUS = 100 EXPORTS = 100 $1.50 1.25 1.00 .75 .50 .25 $1.50 1.25 1.00 .75 .50 .25 EXPORTS = 50 U.S. export supply SURPLUS = 50 Price (per pound; U.S. dollars) Price (per pound; U.S. dollars) If world prices fall below $1.00... Dd 50 75 100 125 150 50 100 Quantity of Aluminum Quantity of Aluminum

U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand Sd SURPLUS = 100 EXPORTS = 100 $1.50 1.25 1.00 .75 .50 .25 $1.50 1.25 1.00 .75 .50 .25 EXPORTS = 50 U.S. export supply SURPLUS = 50 Price (per pound; U.S. dollars) Price (per pound; U.S. dollars) SHORTAGE = 50 IMPORTS = 50 Dd 50 75 100 125 150 50 100 Quantity of Aluminum Quantity of Aluminum

U.S. EXPORT SUPPLY AND IMPORT DEMAND U.S. Domestic Aluminum Market U.S. Export Supply And Import Demand Sd SURPLUS = 100 EXPORTS = 100 $1.50 1.25 1.00 .75 .50 .25 $1.50 1.25 1.00 .75 .50 .25 EXPORTS = 50 U.S. export supply SURPLUS = 50 Price (per pound; U.S. dollars) Price (per pound; U.S. dollars) U.S. import demand SHORTAGE = 50 IMPORTS = 50 SHORTAGE = 100 IMPORTS = 100 Dd 50 75 100 125 150 50 100 Quantity of Aluminum Quantity of Aluminum

CANADIAN EXPORT SUPPLY Canada’s Export Supply AND IMPORT DEMAND Canada’s Domestic Aluminum Market Canada’s Export Supply And Import Demand Dd SHORTAGE = 50 $1.50 1.25 1.00 .75 .50 .25 100 50 Price (per pound; U.S. dollars) 75 125 150 SURPLUS = 100 Canadian export supply import demand Sd SURPLUS = 50 Quantity of Aluminum

EQUILIBRIUM WORLD PRICE AND QUANTITY OF EXPORTS & IMPORTS Price (per pound; U.S. dollars) U.S. export supply U.S. import demand Quantity of Aluminum Canadian export Canadian import 100 50 $1.50 1.25 1.00 .75 .50 .25 25 .88 Equilibrium