Principles of Microeconomics Test 2 Study Guide

Chapter 6 · What is the budget constraint? How do you find the intercepts of a budget constraint? Be able to show the change in the budget constraint when income changes or the prices of either good X or Y changes. What does the slope of the budget constraint represent? Budget Constraint: the limits imposed on household choices by income, wealth, and product prices Intercepts: On line: compromise Inside line: used inefficiently Outside line: unavailable Slope of budget constraint: represents opportunity cost When the price of a good , budget constraint swivels to right When income , budget line shifts outward parallel · What is utility? What is Marginal Utility? What is the Law of Diminishing Marginal Utility? Utility: satisfaction a product yields (made up measure) Marginal Utility: additional satisfaction gained by the consumption or use of one more unit of a good or service Law of Diminishing Marginal Utility: the more of any one good consumed in a given period, the less satisfaction (utility) generated buy consuming each additional (marginal) unit of the same good · What is the household’s objective function or main goal? Households Goal = Maximize Total Utility · What is the Utility Maximization Rule? (Marginal Utility Approach in text.) How does it work? Be able to follow the logic behind the Utility Maximization Rule. So if the marginal utility from the last dollar spent on X is greater than the marginal utility from the last dollar spent on Y, then what should the consumer do? Utility Maximization Rule: the ratio of Marginal Utility/Price If MUx > MUy, consumer could increase utility by spending a dollar less on Y and dollar more on X · How does the income effect work with normal or inferior goods? How does the substitution effect work? Be able to find the substitution effect and the income effects when a price changes. Income Effect: the change in consumption of good X, when price of good X , and more income is spent on good X Normal Goods: purchase more when income  Inferior Goods: purchase less when income  Substitution Effect: shift when price of product falls, causing a household to shift its purchasing pattern away from substitutes of X · Why do demand curves slope downward? Price increases when supply decreases · Be able to use the Work-Leisure model. Describe the optimum bundle of leisure and consumption in the work-leisure model. How do you find the quantity of labor supplied with the model? What happens when the wage changes? What are the substitution effect and income effect when there is a change in wage. Optimum Bundle of Leisure: Optimum Bundle of Consumption: Quantity of labor supplied: Wage changes: Substitution effect: Income effect: Chapter 7 · What is the difference between accounting costs and economic costs? What does a positive economic profit mean? Zero economic profit? An economic loss? What is every firm’s objective function? Accounting Cost: Economic Cost: Positive Economic Profit: firm earning above normal rate of return Zero Economic Profit: firm earning exactly normal rate of return Economic Loss: firm earning less that normal rate of return Firms Objective Function: · In terms of production (and cost in Ch 8), what is the difference between the long-run and the short-run? Production: Long-Run: nothing fixed. Firms can change capital or labor to produce +/- output Short-Run: firms capital stock is fixed. Firms hire +/- labor to change output · What is total product? What is the marginal product of labor? Explain the typical shape of marginal product of labor curve in the text and from the lectures. What does it mean if the MPL is rising, or falling? Know the Law of Diminishing Returns. Be able to find Marginal Product from a production function. Total Product: TP = Q Marginal Product of Labor (MPL): additional output from last labor Shape of MPL Curve: increases, then decreases with a point. Falls at point of diminishing returns MPL : when MC  MPL : when MC  Law of Diminishing Returns: with fixed, more inputs yield a smaller and smaller increase in output Chapter 8 · What are Total Variable Cost and Total Fixed Cost? What is Marginal Cost? Know formulas for AVC, AFC, and ATC. What is the relationship between MPL and MC? What does the Law of Diminishing Returns mean to MC? What is the relationship between MC and AVC? Where is the minimum AVC? What is the shape of AFC? TFC? What is the distance between ATC and AVC? What is the relationship between MC and ATC? Where is the minimum ATC? What is the efficient scale? TVC: Total Variable Cost; costs that very with output (ex. Labor and materials); TVC = AVC x Q TFC: Total Fixed Cost; costs that do not vary with output. (ex. Legal fees, accounting fees, property taxes); TFC + AFC x Q Shape: horizontal line MC: Marginal cost; additional cost of the last unit of output produced; MC = change TC / change Q OR MC = change TVC / Change Q AVC: Average variable cost; AVC = TVC / Q Minimum AVC: Intersection of MC and AVC AFC: Average Fixed Cost; AFC = TFC / Q OR AFC = ATC - AVC Shape: falling ATC: Average Total Cost; ATC = TC / Q OR ATC = AFC + AVC Minimum ATC: intersection of MC and ATC MPL vs MC: MPL , MC . MPL , MC  Law of Diminishing Returns (MC): MPL must eventually fall, then ShortRun MC curves must eventually rise MC vs AVC: When MC is below AVC, AVC is falling. When MC is above AVC, AVC is rising Distance between ATC & AVC: as Q increases, the distance between AVC and ATC should get closer MC vs ATC: When MC is below ATC, ATC is falling Efficient Scale: minimum ATC is at intersection of MC · What is the objective (or goal) for firms? Firms Goal = Maximize profit · What are the 3 characteristics of Perfect Competition? Perfect Competition: 1. Many buyers & sellers, not 1 can influence market 2. Each firm produces standardized products, each buyer values each firms output the same 3. Free entry & exit in the Long-Run · For perfectly competitive firms, be able to explain why the market price is their individual demand curve and MR curve. The Market Price serves as the firms individual demand curve (horizontal line on firm graph where supply & demand intersect on market graph) · Where do all firms produce to maximize profit? Explain why that is the profit maximizing level of output. The additional revenue from selling the x amount of a good is greater than the additional cost of making it, therefore the firm can increase profit by making more (MR > MC). The additional revenue from selling the x amount of a good is less than the additional cost of making it, therefore the firm can increase profits by making less of that good (MR < MC) · Be able to find profit on a graph with the market price, MC, and ATC. When does a firm earn a profit? When do they earn a loss? Profit on graph: profit = ( P - ATC ) Q Firm earns profit: maximum profit at market price is above a normal rate of return (positive profit) Firm earns loss: maximum profit firm can earn is below normal rate of return (negative profit) Chapter 9 · When is it better for a firm to shut-down than operate in the short-run? Be able to find the shutdown point on a graph of MC and AVC. Firm Shut-down (short-run): shutdown when TR < TFC, or P < AVC. · What is the individual supply curve for perfectly competitive firms and why? (hint: P=MR=MC) How do you find the market supply curve? Individual Supply curve for perfectly competitive firms: Market Supply: horizontal sum of each firms MC curve above AVC · What is the LRAC curve? How does a firm move from one short-run ATC curve to another on the LRAC curve? What does Economies of Scale mean? Diseconomies of Scale? Identify returns to scale from a graph of LRAC. How are returns to scale different than diminishing returns? What are the main sources of Economies of Scale and Diseconomies of Scale? What is the Minimum Efficient Scale (MES)? LRAC Curve: envelope that includes the lowest point on each possible short-run ATC curve Economies of Scale: firm increases in size & average cost falls (decline on LRAC) Main Sources: larger firms have more production techniques available Diseconomies of Scale: firm increases in size & average cost rises (incline on LRAC) Main Sources: more difficult for managers to control cost for large firms Returns to scale on graph: flat section on graph where average cost stays the same Minimum Efficient Scale (MES): lowest point on LRAC curve · What determines long-run decision making? Explain what happens in markets in the long-run when existing firms are earning above a normal rate of return profits, exactly a normal rate of return profits, and less than normal rate of return profits. Long-run decision making: economic profit Profit > 0, firms are earning above a normal rate of return (market price above minimum ATC). Attracts investments into the market, new firms enter Profit < 0, firms earning below a normal rate of return (market price below minimum ATC). Existing firms exit market Profit = 0, firms earning exactly a normal rate of return. No net change in number of firms in market · If firms are earning above a normal rate of return or below a normal rate of return, explain the long-run adjustments in the market to the long-run equilibrium. What happens to the number of firms, to the market supply curve, and to the market price when the market adjusts to the long-run equilibrium in either case? Above Normal Rate of Return: new firms enter bringing market price down until price falls to minimum ATC. Supply curve shifts to the right. (market price above minimum ATC to begin with). Below Normal Rate of Return: existing firms exit until market price rises to minimum ATC. Supply curve shifts left. (market price below minimum ATC to begin with) · Where do perfectly competitive firms have to operate on the LRAC in the longrun? Describe the long-run equilibrium in perfectly competitive markets. · What is the difference between constant, increasing, and decreasing cost industries? What is the Long Run Supply Curve? What determines the slope of the Long Run Supply curve, and how? (Ch 9 appendix.)