Review of Topics for Midterm 2

Review of Topics for Midterm 2

ARSC 1432 Microeconomics Co-Seminar

SPRING 2009

1. Demand, Willingness to Pay and Marginal Benefits

A person's willingness to pay for something shows the dollar value she attaches to it. Her willingness to pay for one more unit of a good is thus a dollar measure of the benefits the extra unit of the good gives her. As a result, the terms "willingness to pay" and "marginal benefit" are often used interchangeably.

DF: Marginal benefit-- the benefit a person receives from consuming one more unit of a good.

The marginal benefit is measured as the maximum amount that a person is willing to pay for it. So, the marginal benefit of a hamburger is the maximum amount of other goods and services a person is willing to give up to get that last hamburger.

DF: The principle of decreasing marginal benefit-- the marginal benefit from consuming a good or service decreases as the quantity consumed of that good or service increases.

Previously we referred to the demand curve as the willingness-and-ability-to-pay curve. Therefore, the demand curve is the same as the marginal benefit curve. The demand/marginal benefit curve is downward sloping. So, the marginal willingness to pay (marginal benefit) is lower and lower as more and more is consumed

A demand curve is a marginal benefit curve.

The value of a good and the price of that good are not necessarily the same thing. Value is the benefit we receive from a good, price is what we pay for a good.

DF: Consumer surplus-- the value of a good minus the price paid for it.

If you are willing to pay more for a good than you actually have to pay, then the difference is your consumer surplus.

1. Supply, Willingness to Accept and Marginal Cost

A seller's "willingness to accept" (W2A) is the absolute minimum amount she would take when selling a good. In general, a seller's W2A will be equal to her opportunity cost of selling the object: the amount of benefit she gives up when she hands the object over to someone else.

Supply Curve and Marginal Cost

The supply curve for a good is a graphical representation of the prices that individuals or firms are willingness to accept when selling the good.

Sellers distinguish between cost and price.

• Cost is what a seller must give up to produce the good.
• Price is what a seller receives when the good is sold.

The cost of producing one more unit of a good or service is its marginal cost.

Production decision rule: The seller will produce one more unit of a good or service if the price for which it can be sold exceeds or equals its marginal cost.

A supply curve is a marginal cost curve.

Producer surplus: The price of a good minus the opportunity cost of producing it. In other words, producer surplus is the price received by a seller less the minimum amount the seller is willing to accept in exchange for the good.

For producers as a whole, producer surplus is the area between the price they receive and their willingness to accept, which is given by the height of the supply curve:

1. Consumer and Producer Surplus

Consumer Surplus = CS = the difference between what consumers are willing to pay and what they actually pay for a good or service.

Producer Surplus = PS = the difference between what producers are willing to accept for their produce and what they actually receive for a good or service.

Social Surplus = SS = CS + PS

To calculate CS or PS, use the formula for area of a triangle: (½)(base)(height)

1. International Trade

1) The Equilibrium with Trade: The World Price and Comparative Advantage

Definition of World Price: the price of a good that prevails in the world market for that good.

a)If the world price is greater than the domestic price, Isoland should export steel; if the world price is lower than the domestic price, Isoland should import steel.

i)The domestic price represents the opportunity cost of producing steel in Isoland, while the world price represents the opportunity cost of producing steel abroad.

ii)Thus, if the domestic price is low, this implies that the opportunity cost of producing steel in Isoland is low, suggesting that Isoland has a comparative advantage in the production of steel. If the domestic price is high, the opposite is true.

b)If the world price is higher than the domestic price, Isoland will export steel. Once free trade begins, the domestic price will rise to the world price.

c)As the price of steel rises, the domestic quantity of steel demanded will fall and the domestic quantity of steel supplied will rise. Thus, with trade, the domestic quantity demanded will not be equal to the domestic quantity supplied. The difference is the amount of steel Isoland will export at the world price.

Steel Market in Isoland

2)The Winners and Losers from Trade

Steel Market in Isoland

a)Welfare Before Trade

i)Consumer surplus is equal to: A + B.

ii)Producer surplus is equal to: C.

iii)Total surplus is equal to: A + B + C.

b)Welfare After Trade:

i)Consumer surplus is equal to: A.

ii)Producer Surplus is equal to: B + C + D.

iii)Total surplus is equal to: A + B + C + D.

1. Production Costs

Definition of total revenue: the amount a firm receives for the sale of its output.

Definition of total cost: the market value of the inputs a firm uses in production.

Definition of profit: total revenue minus total cost.

Total opportunity costs include both implicit and explicit costs.

a.Definition of explicit costs: input costs that require an outlay of money by the firm.

b.Definition of implicit costs: input costs that do not require an outlay of money by the firm (opportunity cost).

Definition of economic profit: total revenue minus total cost, including both explicit and implicit costs, (or economics profit = accounting profit – implicit costs).

Definition of accounting profit: total revenue minus total explicit cost.

Definition of production function: the relationship between quantity of inputs used to make a good and the quantity of output of that good.

Definition of marginal product (MP): the increase in output that arises from an additional unit of input.

a.The slope of the production function measures marginal product.

b.Definition of diminishing marginal product: the property whereby the marginal product of an input declines as the quantity of the input increases.

Total-Cost Curve

This increase in the slope of the total cost curve is also due to diminishing marginal product.

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