Global Econ Set 1

Front 1

What is an indifference curve?

Back 1

An indifference curve shows the various bundles of consumption that make the consumer equally happy. The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other. This rate is called the marginal rate of substitution

Front 2

What are the four properties of an indifference curve?

Back 2

Property 1: Higher indifference curves are preferred to lower ones. People usually prefer to consume more goods rather than less. This preference for greater quantities is reflected in the indifference curves. As Figure 2 shows higher indifference curves represent larger quantities of goods than lower indifference curves. Thus the consumer prefers being on higher indifference curves.Property 2: Indifference curves are downward sloping. The slope of an indifference curve reflects the rate at which the consumer is willing to substitute one good for the other. In most cases the consumer likes both goods. Therefore if the quantity of one good is reduced the quantity of the other good must increase for the consumer to be equally happy. For this reason most indifference curves slope downward.Property 3: Indifference curves do not cross. To see why this is true suppose that two indifference curves did cross as in Figure 3. Then because point A is on the same indifference curve as point B the two points would make the consumer equally happy. In addition because point B is on the same indifference curve as point C these two points would make the consumer equally happy. But these conclusions imply that points A and C would also make the consumer equally happy even though point C has more of both goods. This contradicts our assumption that the consumer always prefers more of both goods to less. Thus indifference curves cannot cross.Property 4: Indifference curves are bowed inward. The slope of an indifference curve is the marginal rate of substitution—the rate at which the consumer is willing to trade off one good for the other. The marginal rate of substitution usually depends on the amount of each good the consumer is currently consuming. In particular because people are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little the indifference curves are bowed inward. As an example consider Figure 4. At point A because the consumer has a lot of Pepsi and only a little pizza she is very hungry but not very thirsty. To induce the consumer to give up pizza she has to be given of Pepsi: The marginal rate of substitution is per pizza. By contrast at point B the consumer has little Pepsi and a lot of pizza so she is very thirsty but not very hungry. At this point she would be willing to give up pizza to get of Pepsi: The marginal rate of substitution is per pizza. Thus the bowed shape of the indifference curve reflects the consumer’s greater willingness to give up a good that she already has in large quantity.

Front 3

Explain marginal rate of substitution.

Back 3

The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other.

Front 4

What is a budget constraint?

Back 4

The graph in Figure 1 illustrates the consumption bundles that the consumer can choose. The vertical axis measures the number of liters of Pepsi and the horizontal axis measures the number of pizzas. Three points are marked on this figure. At point A the consumer buys no Pepsi and consumes pizzas. At point B the consumer buys no pizza and consumes of Pepsi. At point C the consumer buys pizzas and of Pepsi. Point C which is exactly at the middle of the line from A to B is the point at which the consumer spends an equal amount on pizza and Pepsi. These are only three of the many combinations of pizza and Pepsi that the consumer can choose. All the points on the line from A to B are possible. This line called the budget constraint shows the consumption bundles that the consumer can afford. In this case it shows the trade-off between pizza and Pepsi that the consumer faces.

Front 5

How might a budget constraint be impacted by an increase in income?

Back 5

Increase in amount of goods they can purchase; satisfaction goes up and the “optimum” goes up.

Front 6

What two graphical elements are needed in order to determine a consumer’s optimal point of consumption?

Back 6

The consumer chooses the point on her budget constraint that lies on the highest indifference curve. At this point called the optimum the marginal rate of substitution equals the relative price of the two goods.

Front 7

How is a consumer’s optimal point of consumption determined precisely? What is the condition that must be met?

Back 7

the consumer’s budget constraint and three of her many indifference curves. The highest indifference curve that the consumer can reach ( in the figure) is the one that just barely touches her budget constraint. The point at which this indifference curve and the budget constraint touch is called the optimum. The consumer would prefer point A but she cannot afford that point because it lies above her budget constraint. The consumer can afford point B but that point is on a lower indifference curve and therefore provides the consumer less satisfaction.

Front 8

How is marginal cost derived?

Back 8

Average total cost tells us the cost of the typical unit but it does not tell us how much total cost will change as the firm alters its level of production. The last column in Table 2 shows the amount that total cost rises when the firm increases production by of output. This number is called marginal cost. For example if Conrad increases production from 2 to 3 cups total cost rises from $3.80 to $4.50 so the marginal cost of the third cup of coffee is $4.50 minus $3.80 or $.70 . In the table the marginal cost appears halfway between any two rows because it represents the change in total cost as quantity of output increases from one level to another.

Front 9

How is marginal cost related to total cost?

Back 9

Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced. Marginal cost tells us the increase in total cost that arises from producing an additional unit of output.

Front 10

What is the specific formula to calculate marginal cost?

Back 10

marginal cost = change in total cost/change in quantity

Front 11

If Dave’s company has a total cost of $100 when quantity output is 5 and a total cost of $115 when quantity output is 6 what is the marginal cost of producing the 6th unit?

Back 11

marginal cost = change in total cost/change in quantity $15 = $15/1

Front 12

Total cost is made of two types of costs what are they?

Back 12

Because these opportunity costs require the firm to pay out some money they are called explicit costs. By contrast some of a firm’s opportunity costs called implicit costs do not require a cash outlay. Imagine that Caroline is skilled with computers and could earn per $100 hour working as a programmer. For every hour that Caroline works at her cookie factory she gives up in income and this forgone income is also part of her costs. The total cost of Caroline’s business is the sum of her explicit and implicit costs.

Front 13

How does a firm determine to shut down in the short-run? What rule characterizes this?

Back 13

A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to a long-run decision to leave the market. The short-run and long-run decisions differ because most firms cannot avoid their fixed costs in the short run but can do so in the long run. That is a firm that shuts down temporarily still has to pay its fixed costs whereas a firm that exits the market does not have to pay any costs at all fixed or variable. Now let’s consider what determines a firm’s shutdown decision. If the firm shuts down it loses all revenue from the sale of its product. At the same time it saves the variable costs of making its product (but must still pay the fixed costs). Thus the firm shuts down if the revenue that it would earn from producing is less than its variable costs of production. A bit of mathematics can make this shutdown rule more useful. If TR stands for total revenue and VC stands for variable cost then the firm’s decision can be written as shut down if TR < VC The firm shuts down if total revenue is less than variable cost. By dividing both sides of this inequality by the quantity Q we can write it as shut down if TR/Q < VC/Q The left side of the inequality TR/Q is total revenue P * Q divided by quantity Q which is average revenue most simply expressed as the good’s price P. The right side of the inequality VC/Q is average variable cost AVC . Therefore the firm’s shutdown rule can be restated as shut down if P < AVC That is a firm chooses to shut down if the price of the good is less than the average variable cost of production. This criterion is intuitive: When choosing to produce the firm compares the price it receives for the typical unit to the average variable cost that it must incur to produce the typical unit. If the price doesn’t cover the average variable cost the firm is better off stopping production altogether. The firm still loses money (because it has to pay fixed costs) but it would lose even more money by staying open. The firm can reopen in the future if conditions change so that price exceeds average variable cost.

Front 14

What is a price taker? Which of the market structures are characterized as being “price takers”?

Back 14

A competitive market sometimes called a perfectly competitive market has two characteristics:There are many buyers and many sellers in the market.The goods offered by the various sellers are largely the same.As a result of these conditions the actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given.

Front 15

When a market is characterized as being a price taker what fundamental shape does the demand curve for this market take?

Back 15

Because competitive firms are price takers they in effect face horizontal demand curves as in panel (a). Because a monopoly firm is the sole producer in its market it faces the downward-sloping market demand curve as in panel (b). As a result the monopoly has to accept a lower price if it wants to sell more output.

Front 16

How is the demand curve for a perfectly competitive firm distinct from the demand curve for a monopolistic market?

Back 16

Because competitive firms are price takers they in effect face horizontal demand curves as in panel (a). Because a monopoly firm is the sole producer in its market it faces the downward-sloping market demand curve as in panel (b). As a result the monopoly has to accept a lower price if it wants to sell more output.

Front 17

What does “downward sloping” with regards to a demand curve mean?

Back 17

because a monopoly is the sole producer in its market its demand curve is the market demand curve. Thus the monopolist’s demand curve slopes downward for all the usual reasons as in panel (b) of Figure 2. If the monopolist raises the price of its good consumers buy less of it. Looked at another way if the monopolist reduces the quantity of output it produces and sells the price of its output increases. The market demand curve provides a constraint on a monopoly’s ability to profit from its market power. A monopolist would prefer if it were possible to charge a high price and sell a large quantity at that high price. The market demand curve makes that outcome impossible. In particular the market demand curve describes the combinations of price and quantity that are available to a monopoly firm. By adjusting the quantity produced (or equivalently the price charged) the monopolist can choose any point on the demand curve but it cannot choose a point off the demand curve.

Front 18

Where do firms with market power determine the quantity of product/service they will produce?

Back 18

because a monopoly is the sole producer in its market its demand curve is the market demand curve. Thus the monopolist’s demand curve slopes downward for all the usual reasons as in panel (b) of Figure 2. If the monopolist raises the price of its good consumers buy less of it. Looked at another way if the monopolist reduces the quantity of output it produces and sells the price of its output increases.