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Investment Tools: Economics: Microeconomic Analysis
1.A: Preliminary Reading: Supply, Demand, and the Market Process
a: Explain the laws of supply and demand.
All else held constant, a higher price will increase the supply of goods produced and offered for sale. Existing producers will produce more, and new suppliers will enter the market. The law of supply states that there is a direct relationship between the price of a good and the amount of that good that will be supplied in the market place.
People’s desire for goods exceeds the purchasing power of their incomes. This forces them to make choices. People will choose those alternatives that enhance their welfare most relative to their cost. An increase in the cost of an item relative to alternative consumption choices reduces the likelihood of purchasing that item. Higher prices reduce the demand for an item and lower prices raise the demand for an item. This is called the law of demand. The availability of substitutes is the main reason that consumers buy less of a product as its price increases. Substitutes are goods that perform similar functions. The law of demand states that there is an inverse relationship between the price of a good and the amount buyers are willing to purchase.
Market demand schedule:The demand curve will slope downward to the right, indicating that the number of units demanded will increase as the price declines. Some goods are much more responsive to changes in price than others. The greater the number of viable substitutes for a good the more responsive demand is to price. When interpreting the demand curve, remember that we have assumed that factors other than price, such as consumer income, have not changed significantly
b: Discuss how market prices respond to changes in supply and demand.
A market is the environment that encompasses the trading arrangements of buyers and sellers that underlie the forces of supply and demand. Equilibrium occurs when the conflicting forces creating supply and demand are in balance. In the absence of shifts in supply and demand curves, if the price is so high that supply exceeds demand, some businesses will decrease their prices to sell their excess inventory while others elect to reduce production. The result is a reduction in both price and supply until the market is in equilibrium. Conversely, if demand exceeds supply, the price of the product will rise, resulting in reduced demand as consumers find substitutes and increased supply as producers add capacity. This will occur until the market is in equilibrium.
c: Explain the difference between shifts in and movements along supply and demand curves.
The demand curve isolates the impact that price has on the amount of a product purchased. A movement along a specific demand curve shows a change in quantity demanded resulting from a change in price.
d: Discuss the factors that cause a demand curve to shift.
Changes in consumer income: Consumers have more money so they can buy more of everything.
Changes in the prices of related goods (substitutes and compliments): The price of butter goes up, so consumers buy less butter and more margarine.
Changes in consumer expectations:Consumers expect the price of cars to rise next month, so they buy a new car now before the price increases later.
Changes in the number of consumers in the market:As cities grow and shrink, and as international markets open to domestic markets, the change in the number of customers changes the demand curves of many products.
Demographic changes: In recent years, the number of people in the U.S. aged 15 to 24 declined by more than 5 million. This change will shift the demand curve to the left for such things as jeans and pizza.
Changes in Market Demographics:Changes in the population can have a large influence in markets. Population increases cause the curve to shift to the right.
Changes in consumer tastes and preferences: As consumer tastes and preferences change, shifts in the demand curves for various products will shift.
e: Define short-run and long-run market equilibrium.
The short run is a time period of insufficient length to permit sellers to adjust fully to changes in market conditions. Producers are only able to increase the supply of a good offered for sale by using more labor and raw materials. New plant and equipment cannot be brought on line in the short run. In the short run, the market price of goods will change in the direction that brings the price which consumers are willing to pay into balance with the price at which producers are willing to sell.
The long run refers to a time period of sufficient length to enable producers to adjust fully to market changes. In the long run, producers have the time to alter their productive factors and increase or decrease the physical size of their plants.
In the short run, the balance between the amount supplied and the amount demanded that brings about market equilibrium is done by price alone. In the long run, production will increase supply as long as the return exceeds the opportunity cost of producing the item. When returns exceed opportunity costs, capital will flow into the industry and output will expand. This increased production will cause prices to fall eliminating the excess profits. If opportunity costs exceed returns from production, firms will remove capital from the production process, thus reducing supply and causing prices to rise.
f: Explain how shortages and surpluses affect the analysis of supply and demand.
Price ceilings are legally set maximum prices that sellers may charge. Ceilings are usually initiated during inflationary periods. Ceilings prevent the producer from increasing the selling
price to cover rising costs. This will lead to a reduction in supply that will cause a shortage.
A shortage exists when the amount of a good offered by sellers is less than the amount demanded by buyers at the existing price. An increase in price would eliminate the shortage, but since prices are capped, producers will direct resources away from these goods, reducing supply and increasing the shortage.
Price floors are legally established minimum prices that buyers must pay for a good. Price floors will stimulate production, since producers are receiving more than the equilibrium price. Buyers, however, will shift their consumption to lower price alternatives causing supply to exceed demand, causing a surplus.
g: Explain how the "invisible-hand" principle works.
The invisible hand principle refers to the tendency of market prices to direct individuals pursuing their own interests into productive activities that also promote the economic well being of society. The market does this by:
municating information to decision makers:Without the information provided by market
prices, it would be impossible for decision makers to determine how intensely a good is desired relative to its opportunity costs.
2.Coordinating actions of market participants: Prices direct producers to undertake those
projects that are demanded most intensely by consumers.
3.Motivating economic players: Market prices establish a reward-penalty structure that
induces the participants to work, cooperate with others, use efficient production methods, supply goods that are desired, and invest for the future.
4.Pricing products and providing order to the market: The market process works
automatically without the need for any government decision or central planners. The market system sets prices, determines production, and distribution channels without any outside control.
1.B: Preliminary Reading: The Economic Role of Government
a: Define economic efficiency and discuss the role of government in achieving economic efficiency.
Economic efficiency for the government means that for any given level of effort (cost), we obtain the largest possible benefit. Since everyone wants more rather than less, individuals are best served when the economic pie is as big as possible. Two conditions must exist for economic efficiency to exist:
1.Undertaking an economic action will be efficient if it produces more benefits than costs
for the individuals in the economy.
2.Undertaking an economic action will be inefficient if it produces more costs than benefits
to the individuals.
The role of government in creating/supporting economic efficiency is controversial. However, there is general agreement that the following two governments functions will help create the proper environment for economic efficiency.
1.Protective function of government: One of the two functions of government that are
generally recognized as legitimate is to maintain an infrastructure of rules so that citizens can interact peacefully with each other. This includes creating and enforcing laws against physical harm, theft, fraud, etc. It also includes national defense.
2.Productive function of government: A second function of government that is generally
recognized as legitimate is to produce (provide) goods and services that a market is unable or unwilling to provide efficiently on its own. While police and fire protection fall into this category, perhaps the most important service is a stable economic environment.
b: Explain how the market pricing system may fail to generate ideal economic efficiency because of lack of competition, externalities, the presence of public goods, or economic instability.
Recall that the invisible hand of market forces generally provides individuals with the incentive to work hard to create value. There are four important factors that can limit the ability of the invisible hand to do this, which creates a potential need for government productive action.
Lack of petition is vital to the proper operation of the pricing mechanism. When there are only a few firms in the industry, the competition from new entrants can be restrained. Sellers may, thus, be able to rig the market in their favor.
Externalities - failure to recognize all costs and benefits. Externalities are the side effects, or spillover effects, of an action between two parties that influences the well being of other individuals. The presence of externalities means that decision-makers do not have the proper cost and price information on which to make decisions.
Public goods – difficult for the market to provide:Public goods are goods consumed by the public as a whole. Police protection and sponsored medical research are examples of public goods.
Potential information problems: When individuals are unable to evaluate the quality of products properly, the makers of poor quality products thrive and the makers of high quality products have low or negative profits. For example, few individuals are capable of evaluating the safety features built into cars.
c: Discuss the differences and similarities between market action and collective action in seeking economic efficiency.
petitive behavior is present in both the market and public sector.
2.Public-sector organization can break the individual consumption-payment link. With
government, there is no direct link between the size of the payment and the amount of consumption. Some pay little in taxes and receive large benefits and vice versa.
3.Scarcity imposes the aggregate consumption payment link in both sectors. As in the private
sector, aggregate consumption equals aggregate payment (there is no free lunch). Someone must pay for everything provided by the government.
4.In the private sector, individuals make choices with mutual gain as the foundation. In
the public sector, the “majority” makes decisions, which generates some winners and some losers.
5.When collective decisions are made legislatively, voters must choose among candidates
who represent a bundle of positions on issues.
6.Income and power are distributed differently in the two sectors. Success in the market
place depends on one’s ability to provide products at a reasonable price.
d: Discuss the role of government in attempting to correct the shortcomings of the market.
Recall that the invisible hand of market forces generally provides individuals with the incentive to work hard to create value. There are four important factors that can limit the ability of the invisible hand to do this, which creates a potential need for government productive action.
Lack of petition is vital to the proper operation of the pricing mechanism. When there are only a few firms in the industry, the competition from new entrants can be restrained. Sellers may, thus, be able to rig the market in their favor.
Externalities - failure to recognize all costs and benefits. Externalities are the side effects, or spillover effects, of an action between two parties that influences the well being of other individuals. The presence of externalities means that decision-makers do not have the proper cost and price information on which to make decisions.
Public goods – difficult for the market to provide:Public goods are goods consumed by the public as a whole. Police protection and sponsored medical research are examples of public goods.
Potential information problems: When individuals are unable to evaluate the quality of products properly, the makers of poor quality products thrive and the makers of high quality products have low or negative profits. For example, few individuals are capable of evaluating the safety features built into cars.
2.A: Demand and Consumer Choice, including addendum Consumer Choice and Indifference Curves a: Explain consumer choice in an economic framework.
As consumption increases, the marginal utility (that is the benefit derived from consuming that next unit) decreases. For example, your twelfth consecutive beer does not taste nearly as good as your first beer. This is known as the Law of Diminishing Marginal Utility. The law of diminishing marginal utility helps determine the shape of an individual’s demand curve. The height of the demand curve at any point is the marginal benefit to the customer (the maximum price the consumer would pay for an additional unit).
Marginal utility and consumer choice: Given a fixed income and price schedule, consumers will maximize their satisfaction (total utility) by ensuring that the last dollar spent on each item yields an equal degree of marginal utility.
Price change and consumer choice:
1.The substitution effect: If a good becomes cheaper relative to other goods, you will
consume more of that good and
2.The income effect: As the price of a good drops, your real income rises, you will consume
more of that good (and other goods).
Time cost and consumer choice: Time, like money, is scarce to the consumer. Thus, a lower time cost, like a lower money price, makes a product more attractive.
b: Identify, describe, and calculate the determinants of price and income elasticity of demand.
Price elasticity of demand indicates the degree of consumer response to variation in price. It is determined by the % change in quantity demand divided by the % change in price.
Example:If the price of product A is increased from $1.00 per unit to $1.10 per unit, the demand will decrease from 5.0 million units to 4.8 million units. What is the price elasticity of demand for product A? Is product A an elastic good?
% change in quantity = [(4.8 - 5.0)] / [(5.0 + 4.8) / 2] = - 0.2 / 4.9 = -0.041 or -4.1%
% change in price = [(1.10 - 1.00)] / [(1.10 + 1.00) / 2] = 0.10 / 1.05 = .095 = 9.5%
Price elasticity of demand for product A = -4.1% / 9.5% = -.43. Because the price elasticity of demand is below 1.0, product A is inelastic.
Price elasticity of demand is determined by:
1.Availability of substitutes: Many substitutes indicate elastic demand. The most important
determinant of the price elasticity of demand is the availability of substitutes. When good substitutes for a product are available, a price rise induces many consumers to switch to other products and
2.Share of budget spent on product: Goods that occupy a relatively small portion of your
budget will tend to be price inelastic.
Income elasticity is the sensitivity of demand to change in consumer income. It is determined by the % change in quantity demanded divided by the % change in income.
An inferior good has negative income elasticity. As income increases (decreases), quantity demanded decreases (increases). Inferior goods include such things as bus travel and margarine. The opposite type of good, a normal good, has positive income elasticity meaning that, as income increases (decreases), demand for the good increases (decreases). Normal goods include things like bread and tobacco.
Generally, normal goods have low income elasticities (absolute values between 0 and 1) are considered necessities. Normal goods with high-income elasticities (absolute values greater than 1) are generally considered luxury goods.
Example: Suppose that your income has risen by $10,000 from a base rate of $50,000. During this period, your demand for bread has increased from 100 loaves per year to 110 loaves per year. Given this information, determine whether or not bread is a necessity or a luxury good.
The percentage change in income is (60,000 - 50,000) / 50,000 = 20%, while the percentage change in the quantity of bread demanded is (110 - 100) / 100 = 10%. Hence, the income elasticity of bread is 10 / 20 = .50. This good is a necessity.
c: Explain why the price elasticity of demand tends to increase in the long run.
The effect of time on elasticity: In general, when the price of a product increases, consumers will reduce their consumption by a larger amount in the long run than in the short run. Thus, the demand for most products will be more elastic in the long run than in the short run. This is sometimes called the second law of demand.
Total revenue, total expenditures, and price elasticity of demand: An important application of price elasticity is to estimate how total consumer expenditures on a product change when the price changes. There are three ways to do this: (a) Consider an individual’s elasticity of demand, (b) Consider the combined elasticity of demand for all consumers of the product, and (c) Consider the elasticity of demand for an individual business that produces the product.
d: Discuss the characteristics of consumer indifference curves.
∙More is preferred to less. Higher indifference curves represent greater absolute utility than lower curves.
∙Goods are substitutable. Therefore, indifference curves slope downward to the right.
∙The utility of a good declines the more of it you consume. Therefore, indifference curves are convex when viewed from below.
∙There are an infinite number of indifference curves.
∙Indifference curves cannot intersect.
e: Discuss the role of the consumption-opportunity constraint and the budget constraint in indifference curve analysis.
Consumers have budget constraints. These constraints separate the consumption opportunities that can be obtained from those that cannot be obtained. The optimal level of consumer satisfaction will be the tangency point between the budget constraint line and the highest obtainable indifference curve.
This analysis applies both in the cases of barter and an economy with money. In the money economy, the budget-constraint line applies. In a barter economy, the consumption –opportunity constraint line applies. This line indicates different bundles of goods that can be acquired (3 fish and 4 loaves of bread or 6 fish and 2 loaves of bread, etc.). In either case, it is the relative price of each good, which determines the slope of the line, and thus the optimal level of consumption of each good or bundle of goods.
f: Describe, and distinguish between, the income effect and the substitution effect.
The income effect: As the price of a good drops, your real income rises and you will consume more of that good (and other goods). The income effect occurs when the budget line shifts in or out.
The substitution effect: If a good becomes cheaper relative to other goods, you will consume more of that good. The substitution effect occurs when the price of one good relative to another increases.
Key point: Under the substitution effect, you will consume along the same indifference curve, whereas under the income effect, you will consume along a different indifference curve.
2.B: Costs and the Supply of Goods
a: Describe the principal-agent problem of the firm.
Principal-agent problem - the agent (management) may be working for different objectives than those of the principal (owner). The essence of the problem is that it is difficult or costly for the principal to monitor the actions of the agent. There is an incentive for the agent to "shirk".
b: Distinguish between (1) explicit costs and implicit costs, (2) economic profit and accounting profit, and (3) the short run and the long run in production.
Explicit costs are measurable cash flows for operating expenses. Implicit costs measure the opportunity cost of using a firm's assets. The opportunity cost of a machine or labor is the highest
return available from an alternative use. Business owners must ask themselves, “what was the highest return available from the funds that we used to buy our latest machine?”
Economic profit includes both the explicit and implicit cost components of the firm, while accounting profit ignores implicit costs such as the opportunity cost of equity capital. Accounting profits are generally higher than economic profits. When the firm’s revenues are just equal to its costs (explicit and implicit, including the normal rate of return) economic profits will be zero.
In the short-run, it is difficult to alter production methods. The short-run is defined as that time period in which the size of plant and equipment cannot be changed. The length of the "Short-run" varies from industry to industry. The long-run allows the firm to change all of its production methods and resource uses. In the long-run, all resources are variable.
c: Define various types of costs, including opportunity costs, sunk costs, fixed costs, variable costs, marginal costs, and average costs.
∙Fixed costs, sometimes called sunk costs, remain unchanged in the short-run.
∙Average fixed costs are fixed costs divided by output. Average fixed costs decline as output increases.
∙Variable costs are costs (like wages and raw materials) that vary with output.
∙Average variable cost = variable cost divided by output.
∙Average total cost = total cost (fixed and variable) divided by the number of units produced.
∙Marginal cost is the cost of producing an additional unit of output. The marginal cost is the opportunity cost of the last unit produced.
d: State the law of diminishing returns and explain its impact on a company's costs.
The law of diminishing returns states that as more and more resources (such as labor) are devoted to a production process, they increase output but at an ever decreasing rate. For example, if an acre of corn needs to be picked, the addition of a second worker is highly productive. But if you already have 300 workers in the field, the productive capacity of the 301st worker is not near that of the second worker. At some point the workers begin bumping into one another.
e: Define economies and diseconomies of scale, explain how each is possible, and relate each to a company's long-run average total cost curve.
Are large firms more efficient than small firms? It depends on the industry.
Three reasons why unit cost declines as output or plant size increases:
1.Mass production,
2.Specialization of labor and machinery, and
3.Experience.
Economies of scale are present when unit costs fall as output increases. Diseconomies of scale are present when costs rise as output increases.
f: Describe the factors that cause cost curves to shift.
∙Changes in resource prices
∙Changes in taxes paid
∙Changes in regulations that increase costs
∙Improvements in technology that lower production costs
Each of these factors changes the marginal cost of a unit of output. Lower input prices, lower taxes, and better technology all lower the marginal cost for the firm. This will, in turn, lower the AVC and ATC.
2.C: Price Takers and the Competitive Process
a: Distinguish between price takers and price searchers.
Price takers have small output relative to the market. They can sell all of their output at the prevailing market price. However, if they set their output price higher than the market price, they would sell nothing. The term "price-taker market" means the same thing as "purely competitive market."
Price searchers have downward sloping demand curves. They can set their own prices, and the higher the price, the less they will sell.
b: Discuss the conditions that characterize a purely competitive market.
Pure competition assumes the following characteristics:
∙All the firms in the market produce a homogeneous product.
∙There are a large number of independent firms.
∙Each buyer and seller is small relative to the total market.
∙There are no barriers to entry or exit.
Producers must sell their product at the going market price or be shut out of the market. The market's (not the individual firm’s) supply and demand determines the price. Under pure competition, individual firms have no control over price. Thus, the firm’s demand schedule is perfectly elastic, horizontal.
c: Explain how and why price takers maximize profits at the quantity for which marginal cost = price = marginal revenue.
In the short run, a firm will continue to expand production until marginal revenue (MR) = marginal cost (MC). Marginal revenue (change in total revenue divided by change in output) is the revenue obtained from selling one more unit of output. In the pure competition case, since the market price is constant, the firm's marginal revenue is constant. This means the firm's marginal revenue curve is flat and overlapping the demand curve, so d = p = MR.
In the short run, economic profit is maximized when MR = MC = P. This is because if marginal revenue was less than marginal cost, you are losing money on the last unit, so you should decrease production until MR = MC. The reverse is also true. Profits are also maximized when total revenue - total cost is at its maximum positive value.
In the long run, a purely competitive firm will earn zero economic profits, which means they will earn their normal rate of return. Why? When economic profits are positive, returns are greater than the opportunity cost. This attracts new entrants, increasing supply to the market and forcing the market price down to the point where zero economic profits are available. This result is driven by the no barriers to entry assumption. Equilibrium in the long run occurs when P = MC = ATC.
Remember: The term zero economic profit does not mean that the firm is not making money, rather it means the firm is making a normal return. Thus, accounting profits may be positive, but accounting profits adjusted for the opportunity cost of running the business will be zero.
d: Describe the short-run supply curve for a company and for a competitive market.
Recall that price takers should produce where P = MC. At a price below P1the firm will shut down. Between P1 and P2 the firm will continue to operate in the short run. At P2 the firm is earning a normal return. Above P2the firm is making economic profits and will expand its production along the MC line. Thus, the short-run supply curve for a firm is its MC line above the AVC curve. The short-run market supply curve is the horizontal sum of the MC curves for the firms in the industry. Because firms will supply more units at higher prices, the short-run market supply curve slopes upward to the right.
e: Contrast the role of constant-cost, increasing-cost, and decreasing-cost industries in determining the shape of a long-run market supply curve.
The long-run supply curve indicates the minimum price at which firms will supply various output levels. The shape of the supply curve depends on the shape of the industry’s production cost schedule.
∙Constant cost industries- production costs remain constant as output expands. The supply curve will be perfectly elastic (i.e. horizontal).
∙Increasing cost industries - production costs rise as output increases. Supply will be directly related to price (i.e. sweep upward to the right).
∙Decreasing cost industries- production costs decline as production increases. As price declines, demand increases, which reduces production costs, and supply rises. Thus, the supply slopes downward to the right (Atypical).
f: Explain the impact of time on the elasticity of supply.
Supply elasticity and the role of time: The market supply curve is more elastic in the long run than in the short run. This means the long-run supply curve is flatter than the short-run curve. This occurs because in the long run, firms in an industry can adjust the fixed nature of their costs. Basically, it costs less to adjust output slowly in response to a change in demand - hence,。