General advice for studying for mid-term: concentrate on the material emphasized in lecture and homework. Pay special attention to graphical analysis and elasticity. Don't just read over your notes. Engage with the material. Work problems. Ask yourself questions. Get together with others to study.

Plan for review:

I. go over three types of graphs: production possibilities, supply and demand in industry and supply and demand for individual firm

II. go over elasticity and comparative advantage problems

III. review basic terms/concepts

IV. practice some multiple choice

THREE TYPES OF GRAPHS

1.Production possibilities curves

What's on the axes? Two different types of good. Call them good A and good B.

What does the negative slope of the curve convey? A TRADEOFF between producing one or the other. What does the SLOPE of the curve convey? The tradeoff, in terms of the opportunity cost of producing one good rather than another. Points inside the curve are inefficient; outside the curve unattainable. We started out with PPC's for individuals that were straight lines with a constant slope; we ended up with PPCs for entire economies that were concave to the origin, with a slope that starts out initially almost horizontal and becomes almost vertical. This shape reflects the principle of increasing opportunity cost or the "low hanging fruit" principle. The further you are from the origin, on either axis, the greater the opportunity cost of expanding production.

good B
	good A

2. Supply and Demand in an industry

On the vertical axis--price. On the horizontal axis--quantity. Supply curve--generally a POSITIVE relationship between the two; Demand curve--generally a NEGATIVE relationship between the two. Extreme cases: vertical line (quantity fixed) is perfectly inelastic. Horizontal line (price fixed) perfectly elastic. Lines close to vertical relatively inelastic. Lines close to horizontal relatively elastic. Where supply and demand intersect: equilibrium price and equilibrium quantity. If you are not in equilibrium, market forces will tend to take you there. Market equilibrium is efficient. Both consumer's surplus and producer's surplus are maximized. Consumer's surplus is the triangle between the price and the demand curve. Producer's surplus is the triangle between the price and the supply curve. Suppose there is interference with the forces of the market. Price could be set above equilibrium or below equilibrium. In this case supply is not equal to demand and cannot move toward equilibrium. The result is determined by which ever curve constrains the outcome. If supply is greater than demand, demand alone determines the quantity sold.. If demand is greater than supply, demand alone determines the quantity sold.

Surplus is reduced.

Any change in a factor other than the price of a good--such as technological change, a change in the price of another good, a new piece of information, etc., can lead to shifts in either supply or demand and a new equilibrium price. Be prepared to demonstrate the effects of such shifts.

3. Supply and Demand For Individual Firms

Under conditions of perfect competition, there are so many firms that no individual firm can affect price. The demand curve facing the individual firm is horizontal, indicating that the firm can sell as much as it wants at that price. The supply curve facing the individual firm is its marginal cost curve, which tends to slope up after a certain point, reflecting increasing marginal costs. The reason we assume that marginal costs go up is that some of the factors that determine costs are fixed and cannot be changed in the short run--such as the size of the factory, or the amount of land of the farm. You can keep adding more variable factors, such as raw materials or labor to increase the level of production, but in most cases the returns to these variable factors will eventually decline. The law of diminishing returns implies a law of increasing costs.

Unless and until it can change its costs, the firm's only decision is what LEVEL OF Q to produce at. The profit maximizing firm chooses the level at which the marginal revenue (in this case, the price) equals the marginal cost. This is NOT the level at which marginal profit is highest--in fact, it is the point where marginal profit equals zero.

II. Elasticity

Elasticity--percentage change in quantity divided by percentage change in price. How sensitive are changes in quantity demanded (in the numerator) to changes in price (the denominator). If the numerator is greater, very sensitive. The ratio is greater than 1. Demand is elastic. If the denominator is greater, not very sensitive, ratio is less than 1. Demand is inelastic. If the numerator equals the denominator, ratio is equal to 1: unitary elasticity.

Be able to predict the effects of a price change on total revenue. In general:

Price increase decreases revenue if demand is elastic.

Price decrease increases revenue if demand is elastic.

Price increase increases revenue if demand is inelastic.

Price decrease decreases revenue if demand is inelastic.

This rule is approximate, because it applies to small changes in price. In a simple example that involves a big percentage change, the results may not always conform to the calculated elasticity.

I'm not going to try to trick you on this, I just want you to be aware of it.

Multiply this equation by QP/QP, remembering that ΔP/ΔQ equals the slope of the demand curve.

e=P/Q (1/slope)

Examples:

a.

Price=3
Quantity=4
Slope of demand curve= -2
Calculate elasticity.
3/4 (1/2) =3/8
inelastic

b.

Initial price =3, initial quantity=4
New price=4, new quantity=1
change in price=1; percentage change in price =33%
change in quantity=3; percentage change in quantity=75%
demand is elastic because .75/.33 > 1
initial revenue=12
new revenue=4
you raised price and you lost revenue
why? because consumers bought so much less

Comparative Advantage

Comparative advantage is always about ratios of two goods compared between people (or nations). If your ratio of producing good A to good B is greater than someone else's, then you have a comparative advantage producing good A. Another way of saying this: if the opportunity cost of producing good A is smaller for you than for someone else, you have a comparative advantage producing good A.

Let's take three examples, all of which are based on how many units of Good A or Good B Nancy and Bob can produce in an hour.

a.

 

Does Nancy have a comparative advantage?
Her ratio of A/B is 6/2=3
Bob's ratio is 2/1=2
Nancy has a comparative advantage with good A.

Alternatively, convert Nancy's ratio of A/B so that it, like Bob's, has a 1 in the denominator. 6 is to 2 as 3 is to 1. So the opportunity cost of Nancy producing one unit of Good B is 3, while the opportunity cost of producing one unit of Good B for Bob is 2. Bob has a comparative advantage producing Good B.

Practice on the following:

Basic Terms/Concepts/Definitions:

opportunity cost

reservation price

reservation wage

sunk cost

distinction between average and marginal

rational decision rule

absolute advantage

comparative advantage

inferior good

normal good

substitute

complement

consumers' surplus

producers' surplus

perfect competition

profit

explicit costs vs. implicit costs

Sample Multiple Choice

There are MANY of these on the text website. I am picking three that show how different angles on the material covered above.

When the price of a good is above its equilibrium value,

A) consumers will bid the price up
B) excess demand will occur
C) it will tend to stay above the equilibrium value
D) supplies will notice their inventories are shrinking
E) suppliers will lower the price

(correct answer is E)

If consumers completely cease purchasing a product when its price increases by any amount, demand is classified as

A) inelastic
B) perfectly inelastic
C) unit elastic
D) perfectly elastic
E) elastic

(correct answer is D)

Suppose that Penn's opportunity cost of producing an extra Pepsi is 3 cheeseburgers while Teller's opportunity cost is .14 cheeseburgers. One could predict that

A) Penn must have an absolute advantage in producing cheeseburgers
B) Teller must have an absolute advantage in producing Pepsis.
C) they have little to gain from specializing and coordinating production
D) Teller has a comparative advantage in cheeseburger production
E) they have a potentially large gain to specialization and coordinating production

(correct answer is E)