common mistakes on the ap micro exam · consumer and producer surplus √ the value in excess of...

COMMON MISTAKES ON THE AP MICRO EXAM

A change in Demand versus a change in the Quantity Demanded

Change in Demand

√ Moves the curve

•Income

•Future Expectations

•# of Buyers

•Consumer Information

•Taste and Preference

•Substitues and Complements

Change in Quantity Demanded

√ Moves Along the SAMEcurve

• Caused only by Price change.

Consumer and Producer Surplus√ The value in excess of the purchase price

√ The income the firm gets in excess of its marginal costs

Price Floor and Price Ceiling

Pc Shortage

PfSurplus

Ed = % change in Qd% change in P

Elasticity

E c = % Δ Quantity of X%Δ Price of Y

INCOME E i = % Δ Quantity%Δ Income

Dead Weight Loss When the Price is Below P*

Demand

SupplyA

0 Q’ Q*

• 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 RevenuesEfficiency Loss of a TaxRole of ElasticitiesQualifications

•Redistributive Goals•Reducing Negative Externalities

TAX INCIDENCE ANDEFFICIENCY LOSS

Perfectly Inelastic Demand

Perfectly Elastic Demand

Inelastic Demand

(at moderate prices)

Elastic Demand(at moderate prices)

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 PRODUCTIONRELATIONSHIPS

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

IncreasingMarginalReturns

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

DiminishingMarginalReturns

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

NegativeMarginalReturns

Two Approaches to Find the PROFIT MAXIMIZING

QUANTITY ( PRICE)

$1,8001,7001,6001,5001,4001,3001,2001,1001,000

900800700600500400300200100

tTotal

Revenue

TotalCost

MaximumEconomic

Profits$299

Break-Even Point(Normal Profit)

1 2 3 4 5 6 7 8 9 10 11 12 13 14

TOTAL REVENUE-TOTAL COST APPROACH

1 2 3 4 5 6 7 8 9 10

AVCATC

Economic Profit

$131.00

$97.78

MARGINAL REVENUE-MARGINAL COST APPROACH

Profit Maximization Position

Key Micro Formulas

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 < ATCP > 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

Quantity Supplied

Q2 Q3 Q4 Q5

Marginal Cost & Short-Run Supply

Do notProduce –Below AVC

Quantity Supplied

Q2 Q3 Q4 Q5

Marginal Cost & Short-Run SupplyYields theShort-Run

Supply Curve

Supply

NoProductionBelow AVC

Long Run Equilibrium (Perfectly Competitive

• Productive Efficiency• Allocative Efficiency

Quantity

Price = MC = Minimum ATC(normal profit)

LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM

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

Firm and Industry

Temporary Profits and the ReestablishmentOf Long-Run Equilibrium

Q100,000

IndustryFirm(price taker)

$605040

PROFIT MAXIMIZATION IN THE LONG-RUN

An increase in demand increases profits…

Q100,000

$605040

EconomicProfits

New Competitors increase supply and lowerPrices decrease economic profits

Q100,000

$605040

Zero EconomicProfits

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

Firm and Industry

Decreases in demand, Losses and the Reestablishment of Long-Run Equilibrium

Q100,000

$605040

A decrease in demand creates losses…

Q100,000

$605040

EconomicLosses

Q100,000

$605040

Return to ZeroEconomic Profits

Competitors with losses decrease supply andprices return to zero economic profits

Price and Marginal Revenue for a

Monopoly

MONOPOLY REVENUES & COSTS

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Q0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Elastic

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

InelasticElastic

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18Q

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

Profit Maximization Under Monopoly

$122Profit

MR = MC

ProfitPer Unit

OUTPUT AND PRICE DETERMINATION

0 1 2 3 4 5 6 7 8 9 10

Remember the MR=MC Rule?

And the Shading of Economic Losses

LOSS MINIMIZATION OF THE IMPERFECT

COMPETITOR

Loss Minimization Under Monopoly

MR = MC

LossPer Unit

OUTPUT AND PRICE DETERMINATION

0 1 2 3 4 5 6 7 8 9 10

Since Pm exceeds AVC,the firm will produce

Monopoly

Competition

PURE COMPETITION

MONOPOLY

MR = MC

The firms maximizes profit.

MR = MC

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 MONOPOLYP

S = MC

At MR=MCA monopolistwill sell less

units at ahigher price

than incompetition

An industry in pure competitionsells where supply and

demand are equal

INEFFICIENCY OF PURE MONOPOLYP

S = MC

At MR=MCA monopolistwill sell less

units at ahigher price

than incompetition

Monopoly pricing effectivelycreates an income transfer from

buyers to the seller!

Not being able to GRAPH a Natural Monopoly and the Socially- Optimal

Outputand

Fair-Return Output Levels

Natural MonopoliesRate RegulationSocially Optimum Price

P = MCFair-Return Price

P = ATCDilemma of Regulation

REGULATED MONOPOLY

Graphically…

REGULATED MONOPOLY

Monopoly PriceMR = MC

REGULATED MONOPOLY

Socially-OptimumPrice

P = MC

REGULATED MONOPOLY

Fair-Return PriceNormal Profit Only

REGULATED MONOPOLY

MR = MC

Fair-Return Price

Socially-OptimumPrice

Qm Qf Qr

Dilemma of RegulationWhich Price?

Single PRICE Monopoly

Price Discrimination

ConditionsMonopoly PowerMarket SegregationNo Resale

ConsequencesMore ProfitMore Production

PRICE DISCRIMINATION

Graphically…

Economic profits witha single MR=MC

A perfectly discriminatingmonopolist has MR=D,producing more product

and more profit!

Economic profits withprice discrimination

Monopolistic Competition

What is it?Monopoly?

Competition?

EconomicProfits

Expect New Competitors

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

EconomicProfits

Expect New Competitors

Quantity

New competition drives down theprice level – leading to economic

losses in the short run

EconomicLosses

Quantity

EconomicLosses

Quantity

A2With economic losses, firms willexit the market – Stability occurswhen economic profits are zero

P3= A3

Quantity

Long-Run EquilibriumNormalProfitOnly

for theRESOURCE (Factor)

MARKETS

Remember…

Product Market:MR = MC

Resource Market:MRP = MFC

Units ofResource

TotalProduct(Output)

Marginalproduct

(MP)Product

PriceTotal

Revenue

MarginalRevenue

Product (MRP)

]]]]]]

0 1 2 3 4 5 6 7 8 Q

P 141210

Quantity of resource demanded

Pure CompetitionMRP AS A DEMAND SCHEDULE

]]]]]]

07 7 $2

2$ 014

Units ofResource

Marginalproduct

(MP)Product

PriceTotal

Revenue

MarginalRevenue

Product (MRP)

]]]]]]

0 1 2 3 4 5 6 7 8 Q

P 141210

]]]]]]

$ 01426

$ 1412

Units ofResource

Marginalproduct

(MP)Product

PriceTotal

Revenue

MarginalRevenue

Product (MRP)

]]]]]]

0 1 2 3 4 5 6 7 8 Q

P 141210

]]]]]]

$ 0142636

$ 141210

Units ofResource

Marginalproduct

(MP)Product

PriceTotal

Revenue

MarginalRevenue

Product (MRP)

]]]]]]

0 1 2 3 4 5 6 7 8 Q

P 141210

]]]]]]

01234567

131822252728

7654321

$22222222

$ 014263644505456

$ 1412108642

The purely competitiveseller’s demand fora resource

Units ofResource

Marginalproduct

(MP)Product

PriceTotal

Revenue

MarginalRevenue

Product (MRP)

]]]]]]

0 1 2 3 4 5 6 7 8 Q

P 141210

]]]]]]

01234567

131822252728

7654321

$22222222

$ 014263644505456

$ 1412108642

The purely competitiveseller’s demand fora resource

Now, consider the caseof resource demand under

Imperfect Competition

Units ofResource

Marginalproduct

(MP)Product

PriceTotal

Revenue

MarginalRevenue

Product (MRP)

]]]]]]

0 1 2 3 4 5 6 7 8 Q

P 141210

Imperfect CompetitionMRP AS A DEMAND SCHEDULE

]]]]]]

01234567

131822252728

7654321

$2.802.602.402.202.001.851.751.65

$ 018.2031.2039.6044.0046.2547.2546.20

$ 18.2013.008.404.402.251.00-1.05

The imperfectlyCompetitive seller’sdemand for a resource

LABOR MARKETS:

Wage Determination

PURELY COMPETITIVELABOR MARKET

Purely competitive labor market:Many FirmsNumerous Qualified Workers“Wage Taker” BehaviorMarket Demand for LaborMarket Supply of Labor

Non-LaborCosts

LaborCosts

LABOR SUPPLY AND DEMANDPURELY COMPETITIVE MARKET

Labor Market

D = MRP(Σ mrp’s)

(1000)

Individual Firm

S = MRC

d = mrp

Quantity of Labor

$10$10$10$10$10$10

IncludesNormalProfit

Quantity of Labor

MONOPSONISTICLABOR MARKET

In monopsonyMRC lies abovethe supply curve

Quantity of Labor

MRP = MRC

Qm units oflabor hired

Quantity of Labor

The competitivesolution would

result in a higherwage and greater

employment

EXTERNALITIES

Negative

Positive

COST-BENEFIT ANALYSISMarginal Cost = Marginal Benefit Rule

Spillover Costs

Overallocation

Spillover BenefitsUnderallocation

Externalities

SPILLOVER COSTS AND BENEFITSIllustrating a Negative Externality

Spillovercosts

Overallocation

SPILLOVER COSTS AND BENEFITSIllustrating a Positive Externality

0 Qe Q0

SpilloverBenefits

Underallocation

Taxation Concepts

APPORTIONING THETAX BURDEN

Benefits-Received Principle

Ability-to-Pay Principle

• Progressive Tax• Regressive Tax• Proportional Tax

TAX APPLICATIONS:

• Personal Income TaxProgressive

• Sales TaxRegressive

• Corporate Income TaxProportional - Regressive

• Payroll TaxesRegressive

• Property TaxesRegressive

Identify whether progressive, regressive, or proportional

Price Supports SurplusesSubsidies

EFFECT OF PRICE SUPPORTS

QeQc Qs

SurplusPs

Surplus beingcreated by the

subsidies

Price SupportLevel

International Trade• Comparative Advantage

• Case for Free Trade

• Export Supply

• Import Demand

Total output will be greatest whenEach good is produced by the nationthat has the lowest domesticopportunity cost for that good.

U.S has comparative advantage in wheat

Brazil has comparative advantage in coffee

Principle of Comparative AdvantagePRODUCTION POSSIBILITIES

Terms of Trade

Gains From TradeImproved Options

Principle of Comparative AdvantagePRODUCTION POSSIBILITIES

Trading Possibilities LineGraphically…

PRODUCTION POSSIBILITIES

05 10 15 20 25 30 5 10 15 20

Wheat (tons) Wheat (tons)

Curve For Each CountryUnited States Brazil

TRADING POSSIBILITIES LINES

05 10 15 20 25 30 5 10 15 20

Tradingpossibilities line

The Gains from TradeUnited States Brazil

05 10 15 20 25 30 5 10 15 20

The Case ForFree Trade

U.S. EXPORT SUPPLYAND IMPORT DEMAND

U.S. DomesticAluminum Market

U.S. Export SupplyAnd Import Demand

If the world priceexceeds the U.S.

price by 25 cents...

.25Pric

10050 75 125 150Quantity of Aluminum

10050Pr

Quantity of Aluminum

EXPORTS = 50

DdPric

10050 75 125 150

SURPLUS = 50

If the world pricegoes further up...

Quantity of Aluminum Quantity of Aluminum

EXPORTS = 50

EXPORTS = 100

DdPric

10050 75 125 150

SURPLUS = 50

SURPLUS = 100 $1.50

If world pricesfall below $1.00...

U.S.exportsupply

SHORTAGE = 50

DdPric

10050 75 125 150

SURPLUS = 50

SURPLUS = 100 $1.50

EXPORTS = 50

EXPORTS = 100

IMPORTS = 50

U.S.exportsupply

SHORTAGE = 50

SHORTAGE = 100

DdPric

10050 75 125 150

SURPLUS = 50

SURPLUS = 100

U.S.exportsupply

EXPORTS = 50

EXPORTS = 100

IMPORTS = 50

IMPORTS = 100

U.S.import

demand

CANADIAN EXPORT SUPPLYAND IMPORT DEMANDCanada’s DomesticAluminum Market

Canada’s Export SupplyAnd Import Demand

DdSHORTAGE = 50

10050 75 125 150

SURPLUS = 100

Canadianexportsupply

Canadianimport

demand

SURPLUS = 50

EQUILIBRIUM WORLD PRICE ANDQUANTITY OF EXPORTS & IMPORTS

U.S. exportsupply

U.S. importdemand

Quantity of Aluminum

Canadianexportsupply

Canadian importdemand

.88 Equilibrium

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