1. Frank & bernanke Chapters 1-4: The highlights
MBA 525 Microeconomics
Frank & bernanke
Chapters 1-4:
The highlights

2. Lecture 1 Basic concepts in economics
Micro Economics vs. macro economics
Opportunity cost, scarcity, “no free lunch”
Opportunity cost examples
“Reservation prices” (WTP
The Cost-Benefit Principle and “rational behavior”
Marginal analysis and quantity decisions
Economic surplus (consumer surplus and producer surplus)
Decision Pitfalls

3. Lecture 2 The principle of comparative advantage
Generalizing vs. specializing at the individual level
“Low hanging fruit”
Examples illustrating gains from trade
If trade is good, why do we see opposition to trade?

4. Lecture 3 Supply and Demand (price determination)
Definition of a “market”
“Demand” (MB, WTP), Demand schedule, Demand curve
“Supply” (MC, WTA), Supply schedule, supply curve
Market equilibrium (equilibrium principle and efficiency principle)
Shortages and surpluses
Changes (shifts) in supply and demand
Price controls

5. Lecture 4 Elasticity measures The price elasticity of demand
Elastic vs. Inelastic demand
Determinants of demand elasticity
Changes in price elasticity of demand along the length of a demand curve
Changes in revenue from price changes depend on the price elasticity of demand
The income elasticity of demand
The cross-price elasticity of demand
The price elasticity of supply

6. Overall themes “Economic Naturalism”
Using insights from economics to make sense of observations from everyday life
E.G. Look for differences in costs and benefits
Recognizing and appreciating resource scarcity and opportunity costs
Understanding the way markets work

7. Lecture 1 key concepts

8. Opportunity Cost
Opportunity Cost: The value of the next-best alternative that must be forgone in order to undertake an activity
Decisions depend upon opportunity costs
It is not the combined value of all other forgone activities, just the next best one

9. Cost-Benefit Principle
Take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs
Measuring the costs and benefits is often difficult
One may have to use assumptions and/or approximations
Helps us answer “yes/no” questions
Economists assume that people make decisions this way. i.e. we assume that people are “rational”.
“Rational” here means only pursuing actions where the benefits are at least as great as the costs.

10. Reservation Prices
For a consumer, reservation price is the highest price one would be willing (and able) to pay for a good.
This “maximum willingness-to-pay (WTP)” should be the same as the benefit (value) received from the good.
For a producer, reservation price is the lowest price one would be willing (and able) to accept for a good or service.
This “minimum willingness-to-accept (WTA)” should be the same as the cost (expense) incurred in producing the good.

11. Economic Surplus The benefit of taking an action minus its cost
Rational decision makers take all actions that yield a positive economic surplus
Should you buy or sell an item if surplus = 0?
Consumer surplus = reservation price – actual price
Producer surplus = actual price – reservation price

12. Marginal Analysis
Comparing incremental or additional costs and benefits to help make quantity decisions.
Marginal Benefit
The increase in total benefit that results from carrying out one additional unit of the activity
Marginal Cost
The increase in total cost that results from carrying out one additional unit of the activity
Can be considered more powerful than traditional CBA, because marginal analysis leads us to the “best” answer (maximum surplus), while CBA only allows for “good” answers (non-negative surplus).

13. Marginal Analysis Example: How many slices of pizza to eat?
Assume: P = $1.50 per slice
Note: P = cost of an additional unit = marginal cost Q MC MB 1
$1.50
$4.00 2
$3.00 3
$2.00 4
$1.00

14. Finding the optimal quantity
If the marginal benefit is greater than marginal cost
Increase output (consume or produce more)
If the marginal benefit is less than the marginal cost
Decrease output (consumer or produce less)
Optimal output is where marginal benefit equals marginal cost
MB = MC

15. The principle of diminishing marginal benefit
The additional satisfaction received from units of a good tends to diminish as more units are consumed.
Marginal benefit curves will be downward-sloping
Assumes all units are of the same quality
Addictive goods may be an exception

16. Decision Pitfalls
It is a mistake to use proportions to make decisions (use dollars instead).
It is a mistake to ignore opportunity costs (opp costs are real economic costs that should influence our decisions).
It is a mistake to use average costs and benefits to make quantity decisions (use marginal costs and benefits).
It is a mistake to consider sunk costs (sunk costs are unrecoverable and they do not affect opportunity costs or marginal costs).

17. Lecture 2 key concepts

18. The Principle of Comparative Advantage
If nations (or individuals) specialize in producing goods for which they have low opportunity cost and trade for goods for which they have high opportunity cost, then they can consume more via trade.
Trade leads to higher standards of living.
“Comparative advantage” means being able to do something at lower opportunity cost than someone else.
Sources of Comparative Advantage?

19. Principle of Increasing Opportunity Cost
AKA “The Low Hanging-Fruit Principle”
In expanding the production of any good, first employ those resources with the lowest opportunity cost, and only afterward turn to resources with higher opportunity costs

20. Why trade barriers & opposition to trade?
International trade does increase the total value of all goods and services, but certain industries may be harmed.
Putting all your eggs in one basket may be unwise if trading partners have unstable economies or politics
Putting all your eggs in one basket may be unwise if the future market for that commodity or product is uncertain

21. Example of Comparative Advantage and Mutual Gains from Trade
Assume that Lara and Leah can spend the day either washing cars or mowing lawns. The table below shows how much of each task they could accomplish in one day if they spent the whole day doing just that task. For example, Lara could wash 20 cars or mow 5 lawns in one day.
______________________________________________
Lara Leah
Cars washed
Lawns mowed
Question: Use the principle of comparative advantage to illustrate how specialization can make them more productive than they can be alone.

22. Lecture 3 key concepts

23. An Introduction to Supply and Demand
What is a market?
Where do prices come from?
What happens if prices are set “too high”?
What happens if prices are set “too low”?
Do markets really achieve equilibrium?

24. Demand
Shows the total quantity of a good or service that buyers wish to buy at each price
On a graph = demand curve
In a schedule = demand schedule
Inverse relationship between P and QD
As price rises, consumers want fewer items
People switch to substitutes
People cannot afford as much
At higher quantities, consumers are willing to pay less (application of the principle of diminishing marginal utility/benefit)

25. Daily Demand Curve for Hamburgers

26. Supply
Shows the quantity of a good or service that sellers wish to sell at each price
On a graph = supply curve
In a schedule = supply schedule
Positive relationship between P and QS
As price rises, a higher quantity can be sold because more opportunity costs can be covered
Application of the “low-hanging fruit principle”
Reflects the rising marginal costs of producing additional units

27. Daily Supply Curve of Hamburgers

28. Market Equilibrium
When all buyers and sellers are satisfied with their respective quantities at the market price
There is a stable, balanced, unchanging situation
The supply and demand curves intersect
This results in the equilibrium price
The price the good sells for
This results in the equilibrium quantity
The quantity that will be sold
Do markets really exist in equilibrium?

29. The Equilibrium Price and Quantity of Hamburgers

30. Disequilibrium Excess supply Excess demand
“Market Surplus”
Price is higher than equilibrium price
Sellers are dissatisfied
Excess demand
“Market Shortage”
Price is lower than equilibrium price
Buyers are dissatisfied
Free markets have an automatic tendency to eliminate excess supply and excess demand
A market surplus serves as a signal to sellers that price is too high and therefore leads producers to decrease the price
A market shortage serves as a signal to sellers that price is too low and therefore leads producers to increase the price

31. Markets and Efficiency
Efficiency Principle
Efficiency is an important social goal
Everyone can have a larger slice of a larger pie
Equilibrium Principle
A market in equilibrium leaves no unexploited opportunities for individuals
No “cash on the table” remains
All opportunities for profit have been exploited
Efficiency occurs when
the market-demand curve captures all the marginal benefits of the good
the market-supply curve captures all the marginal costs of the good

32. Shifting supply and demand
Several factors cause changes in demand or supply
If there is a “change in demand”, we shift of the entire demand curve
If there is a change in supply”, we shift of the entire supply curve
Change in supply or demand cause equilibrium price to change.
Price changes are the RESULT of shifts, not the CAUSE of shifts

33. Shifts in Demand Change in price of complement goods
Change in price of substitute goods
Change in consumer Income
normal v. inferior goods
Change in consumer preferences
Change in consumer expectations about price
Change in consumer expectations about income
Demand curve shifts rightward
higher equilibrium price and higher equilibrium quantity
Demand curve shifts leftward
lower equilibrium price and lower equilibrium quantity

34. Shifts in Supply Change in input or factor prices
Change in current production technology
Change in prices of other goods that can be produced with the same inputs
Change in the number of sellers in the market
Favorable changes to the producer shift supply curve rightward
lower equilibrium price and higher equilibrium quantity
Unfavorable changes to the producer shift supply leftward
higher equilibrium price and lower equilibrium quantity

35. Example: An Increase in Demand
Sequence of events:
Conditions change such that consumers want more units at any price. Egs: lower price of complement good, higher price of a substitute, higher income, …
Higher Qd at all prices means rightward shift in the demand curve
Demand shifts right (along supply) resulting in higher P* and Q*

36. The Effect on the Market for Tennis Balls of a Decline in Court Rental Fees

37. Example: An Increase in Supply
Sequence of events:
Conditions become more favorable to firms. Eg: lower cost of inputs
Firms now can earn higher per-unit profits at any price, so they wish to sell more units at all prices.
Firms increase Qs for all Prices = shift right in the supply curve (along demand).
Shift results in lower P* and higher Q*

38. The Effect on the Market for New Houses of a Decline in Carpenters’ Wage Rates

39. Simultaneous Shifts
In reality, several factors may be changing at the same time.
Example: suppose that consumer income is falling while technology used in production is advancing.
Demand decreases (shifts left) and supply increases (shifts right)
Demand shift implies a lower price & lower quantity
Supply shift implies a lower price, higher quantity
We can predict that price will fall
But, what happens to quantity?
We must know the magnitude of the shifts

40. Legislation and Markets
Legislators protect producers and consumers by using price controls
Price ceilings
Price floors

41. Price controls price ceilings – intended to help consumers
A maximum allowable price specified by law because the true equilibrium price was deemed “too high”
Price ceiling price < P* so now consumers want too much
e.g. rent controls, limits on the price of gasoline
Result in permanent shortages
price floors – intended to help producers
A minimum allowable price specified by law
For example, agricultural price supports, minimum wages
Price floor price is > P* so now sellers want to sell more
Result in surpluses

42. Lecture 4 key concepts

43. Price Elasticity of Demand
In order to predict what will happen to sales and expenditures (revenue) firms must know how much quantity will change when the price changes.
The price elasticity of demand is
the percentage change in the quantity demanded that results from a one-percent change in its price

44. Price Elasticity
Demand is said to be “elastic” if quantity demanded changes by a lot when price changes even a little
price elasticity is greater than one
Demand is said to be “inelastic” if quantity changes by a little even if price changes a lot
price elasticity is less than one
Demand is said to be “unit elastic” if quantity changes by the same amount as the price change
price elasticity equals one

45. Price Elasticity and Expenditures
If demand is elastic:
Quantity demanded is highly responsive to price changes
Percentage change in quantity dominates
An increase in price will reduce total expenditure
A decrease in price will increase total expenditure
If demand is inelastic:
Quantity demanded is not very responsive to price changes
Percentage change in price dominates
An increase in price will increase total expenditure
A decrease in price will decrease total expenditure

46. Determinants of Elasticity
Substitution possibilities
Price elasticity of demand will be relatively high if it is easy to substitute between products – Why?
Budget share
The larger the share of the budget the good uses tends to have higher price elasticities of demand – Why?
Time
Because substitution takes time, price elasticity will be higher in the long run than in the short run

47. Examples? What are some goods that will have very elastic demand?
Can demand be perfectly elastic?
What does an elastic demand curve look like?
What are some goods that will have very inelastic demand?
Can demand be perfectly inelastic?
What does an inelastic demand curve look like?

48. Other Elasticities of Demand
Income Elasticity of Demand
The amount by which the quantity demanded changes in response to a one-percent change in income
Positive for normal goods
Negative for inferior goods
Cross Price Elasticity of Demand
The amount by which the quantity demanded of one good changes in response to a one-percent change in the price of another good
Positive for substitutes
Negative for complements

49. Price Elasticity of Supply
The percentage change in the quantity supplied that will occur in response to a one-percent change in its price

50. Elasticity of Supply
What determines whether the supply of a particular good will be elastic or inelastic?
Availability of resources used to produce the good – how quickly and easily can producers respond to a price change?
Eg of good with inelastic supply?
Eg of good with elastic supply?

51. Perfect Elasticity Perfectly Inelastic Perfectly Elastic
Elasticity of supply is zero
Whether the price is high or low, the same amount is available
Perfectly Elastic
Elasticity of supply is infinite
When additional units can be produced using the same combination of inputs purchased at the same prices

52. Naturalist Questions
Why do you pay $6 for a beer in the airport when you can buy the same beer for less than $1 outside the airport?
Why do you get a discounted airfare when you stay over a Saturday night?
Why are there so many personalized license plates in Virginia vs. NC?