Microeconomics Principles by José J. Vázquez-Cognet

José J. Vázquez-Cognet teaches economics at the University of Illinois Urbana-Champaign (UIUC). These are lecture notes for his class "Microeconomic Princples" as taught on Coursera January 2013 through March 2013.

Week 2

• Demand Curve tells you how many consumers are willing to buy at different prices

Week 3

• WTP=willingness to pay
• Consumer Surplus = WTP - Price
• Demand Curve is a measure of WTP
• On Demand Curve, Consumer Surplus is area above the price (horizontal) and within the triangle
• WTS=willingness to sell
• WTS is similar to cost
• Producer Surplus = Price – WTS
• Graphically, Producer Surplus is area above supply curve and under price
• price ceiling causes supply shortage
• minimum wage creates a gap between buyers and sellers, which is by definition unemployment: more employees looking for work than jobs available
• examples of price ceilings
  • ban on selling organs
  • ban on ticket scalping
• examples of price floors
  • minumum wage
  • crop subsidy

Week 4

Key Phrases/Concepts

• Price elasticity of demand
• Price elasticity of supply
• Income elasticity of demand
• Cross-price elasticity of demand
• Tax incidence

Lecture Notes

• Price Elasticity of Demand for X (ex)=%change quantity change consumed X/% change quantity price X=
• Here elasticity: how price effects quantity consumed
• Usually negative
• abs(Elasticity) < 1
  • called not responsive or inelastic
  • raises revenue
• abs(Elasticity) > 1
  • called responsive or elastic
  • lost revenue
• abs(Elasticity) = 1 is called unitary
• Total Revenue = TR = Quantity x Price
• price elasticity determined by
  • substititutes (food: few; car: many)
  • how expensive (20% on $1 is low compared to 20% on $100)
  • time to adjust
• on the demand curve, up and to the left becomes more elastic
• (3.1) income elasticity of demand
  • in formula change price (P) for income (I)
  • can be positive or negative
  • (+) normal goods
  • (-) inferior goods such as second-hand clothes,cheap clothes, public transportation
• (3.2) cross-price elasticity of demand
  • notice the subscript has y to represent “the other good”:
  • say x=pizza, y=beer
  • If pizza and beer are complements, the cross-price elasticity will be negative. Price of pizza goes up, then less beer will be consumed.
  • (-) complements
  • (+) substititutes
• 4.1 definition price elasticity of supply
  • positive
  • [?formula looks like above Q/P]
• 4.2 determinants of price elasticity of supply
  • tobacco vs housing
    • depends on how quickly to change production
    • tobacco takes season to plant
    • housing is slower because building supply
  • manufactured good(toothpicks, laptops) are easier to change production
  • slower to change means inelastic
• 5.1 introduction to per-unit taxes
  • who shares must burden? Producer or consumer
  • what is effect of tax on size of market?
  • Example: person in couple is moving
    • pain is tax on relationship
    • who travels more? Person who is more in love
  • side of relationship that has trouble adjusting to pain/tax is that side that pays most of the burden
• 5.2 the distributional effects of taxes
  • if buyer pays tax, moves demand curve to left by amount of tax
  • if producer pays tax, moves supply curve left by amount of tax
  • in short term, buyer will have more trouble reacting to increase in tax than suppliers, so buyers more inelastic
• 5.3 taxes and surplus
  • tax is incentive to stop trading
  • eg: luxury cars market is elastic, so tax has more effect, and hurt society a lot
  • more inelastic, the less effect of tax on welfare
  • more elastic, more effect of tax on welfare
• 6.2 other applications of price elasticity
  • illegal drugs and crime
    • If government is successful fighting drugs, it reduces supply, which increases price.
    • Remaining suppliers have more incentive.
    • Remaining buyers may engage in drugs to buy. (Or they will stop buying.)
    • If price is very inelastic, a small reduction in quantity means a much higher price.
  • Farming
    • food is inelastic
    • increases in productivity through technology = shift supply to right
    • this decreased price a lot but not units sold
    • so some farmers decided not to farm

Week 5

Questions

• What are the most relevant costs of production?
• What is the level of output and workers that maximize profits?
• Should you hire an additional worker?
• Should the firm expand or exit?
• What price should the firm charge for a product?

Lecture notes

• 2.1 the production process
  • three step process
    • inputs
    • production
    • output
• 2.2 the production process at a glance
  • input: fixed (capital) vs variable (labor)
  • long run: some inputs are fixed
  • short run: all inputs are fixed
  • example: restaurant kitchen space is fixed. Restaurantt could open another location, but that would take time, so it is still fixed.
• 2.3 the production process
  • adding workers increases output at decreasing rate
  • “marginal product of labor” is slope of “total product curve”
  • MPL is invert U shaped
  • MPL =change in output/change in labor =
• 3.1 introducing costs: fixed, variable, and total costs
  • Total Costs = TC = Fixed + Variable
  • Cost of no production (e.g., zero sandwiches) = Fixed Costs
  • Total Cost Curve: Graph of Q (output; on X ) vs TC ($; on Y): as Q increases,costs “shoot up dramatically” because each new workers adds less output
  • Compare to TPC (total product curve): Workers (X) vs Output (Y)
  • TPC and TCC are mirror image
• 3.2 marginal costs
  • MC=change in total cost/change in output=
  • change in output = marginal product of labor
• 3.3 cost curves
  • FC=fixed cost
  • Q=quantity
  • AFC=average fixed cost=FC/Q
  • AVC=average variable costs=VC/Q
  • ATC=average total cost=AVC+AFC=TC/Q
  • Minimum of ATC curve crosses MC (marginal cost) curve
  • most efficient point of production is when MC = ATC
• conclusion
  • 1970 air line regulation
    • used to fly when 65% full based on average total cost
    • Contiental fly when 50% full based on marginal cost
  • telephone monopoly
    • AT&T broken and eventually “child” at&t became almost as big
    • FC/Q
    • by merging two companies, Q increases and automatically cuts costs
    • some companies that have fixed cost: phone, water, etc
    • called natural monopolies
  • increased productivity
    • eg: when kitchen is full, last worker is not productive. Increasing capital, getting bigger kitchen, makes last worker more productive
    • technology makes workers more productive
    • workers now have more technology and capital, so workers earn more

Week 6

Questions

• How does a competitive firm choose the quantity of output that maximizes profits?
• How does a firm decide whether to shut down operation in the short run?
• How does a firm decide whether to enter or exit in the long run?

Key phrases

• Economic profits
• Perfect competition
• Price taking firm
• Break-even price
• Profit maximizing output
• Long run supply curve

Lecture notes

• 2.1 profit maximization assumption
  • quote from movie Wall Street (1987): “Greed is good”
  • use this assumption for this discuss: goal is to maximize profits. (Some people have other goals.)
  • Profits=Revenue-Cost
  • R=Revenue
  • TC=costs
  • =Profits
• 2.2 profit equation
  • good when economics profits are zero
  • economic profits vs accounting profits
  • example: giving up bartending for own business
    • bartending salary:$100/day
    • business revenue:$200/day
    • oeprating cost:$100/day
    • accounting profit = $200-100=$100
    • economic profit includes opportunity cost=$200-100-100=0
• 2.3 profit maximization rule
  • how much output to maximize profit?
  • Need to know how much last worker or last product costs (i.e., marginal)
  • when MC>MR, then reduce output to maximize profits
  • when MR>MC, then increase output
• 3.1 perfect competion
  • if price is inelastic, it isn't always best to increase price
  • One consideration is competition: if competitors don't raise prices and products are the same, consumers will shift to competitors
  • price makers vs price takers
  • In perfect competition, firms “take the price” from the market.
  • Farmers have little control over price.
    • If one farmer increases price, consumers buy from elsewhere.
    • If they all decrease price, there are no are no new customers.
  • Examples of price takers: agricultural, stock market
  • Example of price makers: food, retail
• 4.1 short-run decision
  • Remember: in short run, there are fixed costs.
  • If a business fixed cost increases and causes a loss at all levels of output, exit isn't necessarily the best option.
  • Fixed cost is still owed if doors cloest.
  • The decision is called “shut down”: shut doors or produce output, both at a loss.
  • This doesn't change ATC, MC. It does change profits/
  • Producte optimal output to produce a minimal loss.
  • If P (price) < AVC, then shut down. Otherwise, continue to operate at a loss.
• 4.2 long run competitive output
  • if firm is successful (seeing lines/profits), competitors will try to emulate creating downward pressure, benefiting consumers.
  • Assumes no barriers to entry
  • Process stops when profits are eliminated.
  • Large Q is market quantity
  • small q is firm quantity
  • Q=sum(q's) for all firms
  • Firm is going to take price from market
  • Firm maximizes profit when MR (marginal revenue)=MC (marginal cost)
  • But in this situation MR=P (price)
  • TR=P x Q
  • Profits=(P-ATQ) x q
  • Equilibrium
    • P=ATC=MC
    • means zero economic profit
    • does not mean zero accounting profits
    • example: Mike at Black Dog can pay himself as much as he would elsewhere
  • Whatever company is left is operating at the minimum of ATC curve meaning most efficient scale of production.
  • Firmcompete mostly on costs
• 4.3 using the long-run equilibrium model
  • If firm is producing P=ATC (no profit) and demand increases, then profits increase with higher Q
  • “long run equilibrium” means companies are making zero profit
• 4.4 the long-run supply curve
  • LRSC=long run supply curve, a straight line, profits are eliminated as ATC=MC
  • “constant cost industry”
    • cost does not change
  • “increasing cost industry”
    • limited resource or expensive to do
    • oil industry
    • cost increases with output
  • decreasing cost industries
    • example: TV, computers, car, music players, flying
    • as demands increases and companies enter market, technology improvements make sense
    • investments in technology drives down cost
    • LRSC is downward sloping
• 5.1 conclusion

Week 7

Goals and Objectives

• Identify different market structures.
• Distinguish between marginal revenue for a perfectly competitive firm and marginal revenue for a firm with market power.
• Explain the welfare effects of a firm with market power (e.g. monopoly).
• Identify different types of price discrimination.
• Explain whether price discrimination is good or bad for society.

Key Phrases/Concepts

• Monopoly
• Market structure
• Price making firm
• Market power
• Price discrimination
• Pricing

Guiding Questions

• What is a monopoly?
• What is the relation between market demand and marginal revenue for a firm with market power?
• What are the welfare effects of having a monopoly?
• What is the difference between monopoly, monopolistic competition, and perfect competition in terms of long-run equilibrium?
• What is price discrimination?
• What are the different types of price discrimination and how are they different?
• Why is price discrimination better for sellers and buyers?

Lecture notes

• 1.1 introduction to pricing with market power
  • 1978 government de-regulated airlines: fares, routes, etc
  • people on same flight do not pay same fare
  • closer flight may be more expensive
• 2.1 market structures with pricing power
  • e.g. price is inelastic and BBQ sandwich cannot be emulated, should you increase price? Yes
  • monopoly, oligopoly, and monopolistic competition are degrees of the same thing: can set prices

• 2.2 sources of market power
  • barriers to entry
  • other firms cannot sell the same thing
  • company controls resource. De Beers owned 85% of diamond mines.
  • Technological advancement
    • phones, computers, tablets, etc.
    • way in produced: Walmart
  • from government
    • patents
    • e..g: Pfizer has Viagra patent until 2019
    • exclusive rights in exchange for description of product
    • gives incentive to innovate
  • product differentiatation
    • three basic ways: style, location, quality
    • Starbucks used all three
    • advertising creates image that product is different
  • Above sources of market power are short lived.
  • Natural monopolies
    • e.g. phone companies
    • Unlike other sources of market power, natural monopolies get worse over time
    • AT&T broken and then started combining into at&t
    • AFC reduced with higher Q (quantity produced)
    • Phone companies have high fixed cost
    • Economics classify this as a market failure: free markets are the problem
• 3.1 marginal revenue is less than price
  • firm with market power cannot set any price: constrained by consumer income/assets
  • as price increases, demand decreases
  • TR=total revenue
  • “price effect”
  • on every unit, your change in revenue is going to be less than the unit before
  • change in price takes effect for all units and customers at once
• 3.2 marginal revenue and the price elasticity of demand
  • why cheaper to fly from champagne to new york (far) than chicago (near)?
  • Because more competitors to NY
  • markup: difference in customer and firm's cost
  • Starbucks marked up price because product seemed unique
• 4.1 perfect price discrimination
  • several pricing strategies
  • “price discrimination”: charging different prices to different customers for same good
  • can sell more units
  • creaes more revenue
  • requires market power
  • requires preventing people who bought at lower to resell at higher price
  • “perfect price discrimination” find out how much willing to pay
  • examples
    • car dealership, negotiate sticker price
    • college financial aid
• 4.2 imperfect price discrimination
  • price discrimination is difficult
  • examples
    • happy hour: bar charges less for certain drinks during times of day when price is elastic
    • discounts at movie theater: senior citizen, student pricing, matinees
    • coupons
    • airlines
      • business traveler because he has to go
      • leisure traveler has flexible schedule and location
      • buying within two weeks=probably business traveler
      • business traveler wants to come home instead of seeing sights, so he will not stay over Saturday
      • airline clubs
    • new book came out
  • not price discrimination
    • insurance charging red car more is not price discrimination because risk is higher
    • first class
• 4.3 other pricing strategies
  • bundling
    • software industry, cable TV
    • bundling can increase revenue
    • isometric combination of willingness to pay
    • forcing people to buy what they would not have gotten
  • two part tarrif
    • amusement park: entrance plus ride
    • health club: membership fee plus monthly
    • in model (graphical): extract the surplus from consumers
    • cell phone company: one price for 500 minutes, more money for more minutes
• 5.1 social cost of market power
  • monopoly vs perfectly competitive
  • monopoly produces less and charges more
  • price discrimination helps by producing more output to more consumers
  • monopoly is one of three kinds of market failures
  • theoretical argument for government intervention
• 6.1 pricing with market power: conclusion
  • more people are able to fly because of price discrimination and deregulation

Week 8

Goals and Objectives

After you actively engage in the learning experiences in this module, you should be able to:

• Identify the free rider problem.
• Classify a good according to its excludability and rivalry.
• Explain the reasons it is difficult to provide a public good
• Identify different types of externalities.
• Explain why the market has a hard time solving the problem of externalities.

Key Phrases/Concepts

Keep your eyes open for the following key terms or phrases as you complete the readings and interact with the lectures. These topics will help you better understand the content in this module.

• Rival good
• Excludable good
• Common resource
• Free-rider problem
• Externalities
• Public goods

Guiding Questions

Develop your answers to the following guiding questions while completing the readings and working through the week.

• How should goods be classified according to excludability and rivalry?
• Why doesn't the market do a good job at distributing public goods?
• What is the free-rider problem?
• How does the government decide how much of the public good to provide?
• What is a common resource?
• What is the tragedy of the commons?
• What is an externality?
• What is the difference between a positive and a negative externality?
• Why does an externality result in an inefficient distribution of the resource?
• What are the different ways to solve the problem of externalities?

Lecture notes

• 2.1 how to classify goods
  • public goods
    • not public good: public park, internet
    • example: national defense
  • to classify ask
    • Rivalry: does my consumption affect someone else's consumption?
    • Excludability: Can I prevent someone from using the good?

• Market is best at distributing private goods
• 2.2 what type of good is this?
  • Voting: public or common resource
  • flu vaccine
    • public good or common resource
    • one person's vaccine benefits another person
  • fighting poverty: public good
  • fireworks: public good
  • fish in water: common resource
  • some goods cannot be perfectly classified
  • think about how these goods can be distributed
• 3.1 the public goods game
  • best for everyone to cooperate
  • if one person free loads, he gets even more benefit
  • so no incentive to cooperate
  • “paradox”
• 3.2 public good
  • review of game
  • free rider: problem with public goods
• 3.3 solving the free rider
  • TV over airwaves used advertising
  • Google uses advertisements
  • education, fire protection, highway, national defense, fighting poverty, traffic light: force people to pay
  • how much should government provide?
  • What is the value for life?
    • There is a cost to traffic light, but even though life is priceless, it doesn't justify traffic light at every intersection
• 4.1 tradegy of the commons
  • fishing is classic common resource
  • scenario #1: you own the eight boat and not the first seven, you make 2000lb fish/8 boats x $1/lb=$250 revenue
  • scenario #2: you own all boats, the best choice is sending 6 boats to maximize profit
  • 8th boat is driving fish to extinction
• 4.2. How to Deal with the Tragedy of the Commons
  • solution: giving or transfer property rights, controlling access
  • quota: hunting, fishing license
  • highway tolls
• 5.1. Negative Externalities
  • rather than put polution to zero, find optimal level
  • criteria
    • one agent changes welfare of another agent
    • welfare is not compensated
  • examples
    • pollution
    • dark barking
    • one person having bulgar alarm increases likeliness of neighbhor's house being robbed
    • smoking in public place
  • without incorporating price, market cannot efficiently distribute the good
  • if price is incorported, then supply shift moves to the left and up, price goes up, quantity goes down
  • however, hard to measure the external cost
  • Negative externality creates too much quantity
• 5.2 positive externalities
  • improving appearance of one house improves the value of neighbhor's house
  • Posting on discussion forum (beyond what is counted for grade). Other people read it.
  • Flu shot decreases risk of other people
  • Basic research, scientific discovery
  • Positive externalityt creates too low quantity
• 5.3 private solutions
  • example: bringing dog to school
    • value $100
    • cost in allergy pills $200
    • say Jose has right to bring dog
      • solution: Peter pays Jose $110 to leave the dog at home
      • satisfying because both parties benefit
    • say Peter has right, then Jose just leaves the dog at home for $0
      • say Peter has right and pills cost $50, then solution is Jose pays $75 to Peter and brings dog to work
  • lesson: solved by assigning property rights and negotiation
  • called Coase Theorem
  • example: Home owners association
  • sometimes difficult to do in practice privately because of “transaction cost” of bringing together all parties, so requires government
• 5.4 government solutions
  • example: two companies create pollution of gunk
    • river can assimilate 200tons gunk/year
  • EPA=Environmental Pollution Agency
  • options
    • regulation: each company can produce 100tons per company. No incetive to produce less polution.
    • Tax pollution: $50,000/ton. Creates incentive.
    • Permits: create market to trade permits. One company may want to increase production or be more efficient at reducing pollution.
  • Trading mechanism can be difficult if pollution affects wide area (e.g., US pollutes other country).
  • Gas tax: cars create pollution and congestion
• 6.1 conclusion
  • public library
    • when busy people talking, less valuable
    • example of tradegy of the commons or externality
    • managed by peer/social pressure (dirty looks) and librarians