A level Economics

A-LEVELMicroeconomicsbasic21WhatisEconomicsabout?Theproblemofscarcity Economicsisthestudyofhowsocietychoosestoallocateitsscarceresourcestotheproductionofgoodsandservicesinordertosatisfyunlimitedwants.Humanwantsareunlimited,butResourcesarelimited(scarce)Acentralproblemthereforeexists…wecallthistheproblemofSCARCITY43Definitionofeconomics Economicsisthestudyofsociety’sdecisionsaboutproductionconsumptionallocationofscarceresources inordertosatisfyasmanyunlimitedwantsaspossible.54TwobranchesofeconomicsMicroeconomicsisthebranchofeconomicsthatstudiesdecision-makingbyasingleindividual,household,firm,industryorlevelofgovernment.Macroeconomicsisthebranchofeconomicsthatstudiesdecision-makingfortheeconomyasawhole.65MacroeconomicIssuesaggregatedemand,aggregatesupplyeconomicgrowthunemploymentinflationbalanceoftradeexchangerates76MicroeconomicIssuesdemandandsupplydecisionsofwhattoproduce,howtoproduce,forwhomtoproducetheconceptofopportunitycostbasedoncomparingwhatyouhavedecidedvswhatisthenextbestalternativeyouhavegivenuprationaldecisionmakingbasedoncostvsbenefit;bestvalueformoneyweighingupmarginalcostsandmarginalbenefitsbasedoncomparingtheextrabenefitwiththeextracostthesocialimplicationsofchoicesocietyi.e.takingintoconsiderationhowacertainchoicemayhaveanindirectcostonResourcesResourcesarethebasiccategoriesofinputsusedtoproducegoodsandservices.Resourcescanalsobecalledthefactorsofproduction.JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaThreecategoriesofresourcesLandLabourCapitalJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaResources:landAnynaturalresourceprovidedbynatureusedintheprocessofproductionForexample:forests,minerals,wildlife,oil,rivers,lakes,oceansMayberenewableornon-renewableJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaResources:labourThementalandphysicalcapacityofworkerstoproducegoodsandservicesForexample:farmers,nurses,lawyersEntrepreneurshipisaspecialtypeoflabourthecreativeabilityofindividualstomanagethecombinationofresourcestoproduceproducts.JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaEntrepreneurshipOrganisesandmanagestheresourcesneededtoproducegoodsandservicesJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaResources:capitalCapitalisthephysicalplant,machineryandequipmentusedtoproduceothergoods.Thatis,human-madegoodsthatdonotdirectlysatisfyhumanwants,forexample:Earlier:axe,bowandarrowNow:buildings,productionequipment,software,factories.JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaAnoteaboutfinancialcapitalEconomistsdonotincludemoneyintheirdefinitionofcapitalmoneysimplygivesameasuretothevalueofassets.JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaOpportunitycostThebestalternativesacrificedforachosenalternativeOpportunitycostappliestopersonal,groupandnationaldecision-making,forexampleWhatcouldyoubedoingifyouwerenotcurrentlystudying?Howmanynewroadshavetobeforgoneifthegovernmentspendstaxrevenuesonhomelandsecurity?JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaMarginalanalysisMarginalanalysisexamineshowthecostsandbenefitschangeinresponsetoincrementalchangesinactions.Anyadditionalactionbyanindividualorafirm,suchasbuyinganadditionalpairofshoesorincreasingproductionofaproductbyanadditionalunit,bringsadditionalcost.ThecentralquestioninmarginalanalysisiswhethertheexpectedbenefitsofthatactionexceedtheaddedcostJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaMarginalanalysisMarginalanalysishelpsbusinessesandindividualsbalancethecostsandbenefitsofadditionalactions---whethertoproducemore,consumemore,orotherdecisions---anddeterminewhetherthebenefitswillexceedcosts,thusincreasingutility.JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaMarginalanalysisMarginalanalysisbenefitsgovernmentpolicymakers,aswell.WeighingthecostsandbenefitscanhelpgovernmentofficialsdetermineifallocatingadditionalresourcestoaparticularpublicprogramwillgenerateadditionalbenefitsforthegeneralpublicJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaShort-RunvLongRunShort-Run: Atimeperiodinwhichatleastonefactorofproductionisfixed(i.e.cannotincreaseitsamount) itisnotdefinedintermsofnumberofdays/weeks)LongRun: Atimeperiodlongenoughforallinputstobevaried Itisnotadefinedperiodoftime; JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaCostconceptsTotalfixedcostsarecoststhatdonotvaryasoutputvariesandmustbepaidevenifoutputiszero.Totalvariablecostsarecoststhatarezerowhenoutputiszeroandvaryasoutputvaries.Totalcostisthesumoffixedcostandvariablecost. TC=TFC+TVCJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaTotalcostsNote:ThexandyaxisunitshereareunrelatedtothepreviousdiagramJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaAveragecostconceptsAveragefixedcost(AFC)–totalfixedcostdividedbythequantityofoutputproduced:Averagevariablecost(AVC)–totalvariablecostdividedbythequantityofoutputproduced:AFC=TFCAVC=TVCQQJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaAveragetotalcostTotalcostdividedbythequantityofoutputproducedATC=AFC+AVC=TCQJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaMarginalcostMeasureshowmuchtotalcostincreaseswhenanadditionalunitofoutputisproduced. MC:thechangeintotalcostwhenoneextraunitofoutputisproducedMC=TC=TVCQQJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaTotalcostsJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaInverserelationship:MP&MCNote:ThexandyaxisunitshereareunrelatedtothepreviousdiagramJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaAverageandmarginalcostsThisgraphusesinformationfromthepreviousslideJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaNotethemarginal-averageruleWhenMC<AC,ACisfalling.WhenMC>AC,ACisrising.WhenMC=AC,ACisatitsminimumpoint.JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaLong-runsituationAllfactorsofproductionarevariable.thereistimeforthefirmtobuildanewfactorytoinstallnewmachines,tousedifferentproductiontechniques,tocombineinputsinwhateverproportionandquantitiesitchooses;thefirmwillneedtodecideaboutthescaleofitsoperationandtheproductiontechniquesthatituses;thesedecisionswillaffectproductioncostssoitisimportanttogetthesedecisionsright.JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaRelationbetweenLRACandSRACCurvesAfirmwithjustonefactoryandfacesSRACcurve(followingdiagrams);Inthelong-runitcanbuildmorefactoriesandexperienceseconomiesofscaleduetoadministrativesavings,eachsuccessivefactorywillallowittoproducewithanewlowerSRACcurve;Thuswith2factoriesitwillhavecurveSRAC2andwiththreethenSRAC3,andsoon;EachSRACcurvecorrespondstoaparticularamountofthefactorthatisfixedintheshort-run(inthiscasethefactory);TherearemanySRACcurvesasmanydifferentfactoriesofdifferentsizesorextensionstoexistingonecouldbemade.TheLRACcurveisanENVELOPECURVEJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaCostsOutputOExamplesofshort-runaveragecostcurvesSRAC2SRAC3SRAC4SRAC5ConstructingaLong-runAverageCostCurvefromShort-runAverageCostCurvesJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaLRACCostsOutputOSRAC5SRAC4SRAC3SRAC2ConstructingaLong-runAverageCostCurvefromShort-runAverageCostCurvesJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaScalesofproductionThelong-runaveragecostcurveis U-shaped.Thisreflectsreturnstoscale–threetypesarerecognised:Economiesofscale(LRACfallsasoutputrises)ConstantreturnstoscaleDiseconomiesofscale(LRACrisesasoutputrises).JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaScalesofproductionJohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaEconomiesofscaleAsituationinwhichthelong-runaveragecostcurvedeclinesasthefirmincreasesoutputSourcesofeconomiesofscale:SpecialisationandDivisionofLabourGreaterefficiencyoflargermachines(egcombineharvester,‘super’photocopier’.EgmachineAcosts$1000&produces1000unitsdaily.MachineBcosts$4000butcanproduce8000unitsdaily.Unitcostis$1vs$0.50.)ByproductsOrganisationaleconomies(centraliseadminorI.T.supportfunctions;eliminateduplication)Financialeconomies(bulkdiscounts)EconomiesofScope(producingarangeofproductsmayincreasesalesandspreadoutoverheadsEg:CD,DVD,players,amplifiersetcvsonlyCD) (RefertoSlomanp87,88formoreinfo)JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaConstantreturnstoscaleAsituationinwhichthelong-runaveragecostcurvedoesnotchangeasthefirmincreasesoutput.JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaDiseconomiesofscaleAsituationinwhichthelong-runaveragecostcurverisesasthefirmincreasesoutputSourcesofdiseconomiesofscale:BureaucracyBarrierstocommunicationManagementdifficulties(e.g.lackofcoordination).Production-lineprocessesand‘interdependencies’JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaLong-runCosts“ToScale”meansthatallinputsincreasebythesameproportion’Decreasingreturnstoscalearequitedifferentfromdiminishingmarginalreturns(whereonlythevariablefactorincreases)DMR(short-run)andDRS(long-run)JohnSloman,KeithNorris:PrinciplesofEconomics2e©2007PearsonEducationAustraliaProfitMaximisationSlomanCh5BUECO1507RevenueDefiningtotal,averageandmarginalrevenuetotalrevenue:TR=P×Qaveragerevenue:AR=TR/Qmarginalrevenue:MR=TR/QRevenueRevenuecurveswhenpriceisnotaffectedbythefirm’soutput(horizontaldemandcurve)averagerevenue(AR)marginalrevenue(MR)Examiningrevenuecurvesin2situations1)Ifafirmisverysmallrelativetothewholemarket.2)IfafirmhasarelativelylargeshareofthemarketOOAR,MR($)PeSDD=AR=MRQ(millions)Q(hundreds)(a)ThemarketThefirmBeingsosmall,itsoutput,whateveritis,doesnotaffectmarketpriceatallAverageRevenueandMarginalRevenuecurves(1)ofafirmthatisverySMALLrelativetothewholemarket.(Price-takingfirm)Price($)TRQuantity(units)020040060080010001200Price=AR=MR($)5555555TR($)0100020003000400050006000TotalRevenuecurve(1)ofafirmthatisverySMALLrelativetothewholemarket.(Price-takingfirm)QTR($)Q(units)1234567P=AR($)8765432TR($)8141820201814MR($)6420-2-4MRAR,MR($)QuantityARAverageRevenueandMarginalRevenuecurves(2)ofafirmthathasarelativelyLARGEshareofthewholemarket.Ifsuchafirmwantstosellmore,itcan onlydosobyloweringprice.Ifitchoosestoraiseitsprice,itwillhaveto acceptlowersales.ThereforeAR(price)slopesdownward.HowabouttheMRcurve?Q(units)1234567P=AR($)8765432TR($)8141820201814MR($)6420-2-4MRAR,MR($)QuantityARAverageRevenueandMarginalRevenuecurves(2)ofafirmthathasarelativelyLARGEshareofthewholemarket.Supposingfirmisselling2unitsat$7 each.Itcansellthe3rdunitonlyby reducingthepriceofallunitsto$6.Sellingthe3rdunitgains$6butreducingthe priceofunits1&2loses$1x2=$2.MRtherefore=$6-$2=$4TRTR($)Quantity(units)1234567P=AR($)8765432TR($)8141820201814TotalRevenuecurve(2)ofafirmthathasarelativelyLARGEshareofthewholemarket.QuantityRevenuecurvesandpriceelasticityofdemandAR,MR($)QuantityMRARRevenuecurvesandpriceelasticityofdemandRecall:a)Whendemandiselasticandprice isreduced,totalrevenueincreases. TotalrevenueincreasingmeansMRispositiveb)Whendemandisinelasticandpriceisreduce,totalrevenuedecreases.TotalrevenuedecreasingmeansMRisnegativeTRElasticInelasticTR($)TRCurveforaFirmFacingaDownward-slopingDemandCurveQuantityRevenueRevenuecurveswhenpricevarieswithoutput(downward-slopingdemandcurve)averagerevenue(AR)marginalrevenue(MR)totalrevenue(TR)revenuecurvesandpriceelasticityofdemandShiftsinrevenuecurvesHiddenDetermininga) Outputwhereprofitismaximisedb) Profitatthatoutput1)UsingtotalcurvesmaximisingthedifferencebetweenTRandTC2)UsingmarginalandaveragecurvesTR,TC,TP($)TPTRTCQuantity1)Usingtotalcurvesa)Profitismaximizedwhenoutputis3b)Maximumprofitisd-eQuantityCostsandrevenue($)MRMC2a)Usingmarginalandaveragecurvestodetermineprofitmaximisingoutputa)Profitismaximizedatoutputof3Below3units,thefirmshouldincreaseoutputbecausetherewillbeabiggeradditiontorevenue(MR)thantocost(MC).Beyond3unitsadditionalcost(MC)isbiggerthanadditionalrevenue(MR)thereforeshouldn’tgobeyonditQuantityCostsandrevenue($)MCACARTotalprofit=$1⅓x3=$4.002b)UsingmarginalandaveragecurvestomeasuremaximumprofitTotalProfitMROCostsandrevenue($)QuantityMR2b)UsingmarginalandaveragecurvestodeterminelossminimisingoutputTheshutdownruleIfpricedropsbelowtheAVCcurve,therevenuefromeachunitproduceddoesnotevencoverthevariablecost/sofproduction.Thefirmshouldshutdown.Illustration: (A) (B) (C) (D)Sales $60 0 60 60VC (40) 0 (70) (60)Grossprofit 20 0 (10) 0FC (30) (30) (30) (30)Loss (10) (30) (40) (30)Theshutdownrule(cont.)(MR)NeedtochangeRevenue,CostsandProfitSomequalificationslong-runprofitmaximisationthemeaningof‘profit’lossminimising:stillproducewhereMR=MCshort-runshut-downpoint:P=AVClong-runshut-downpoint:P=LRACHiddenNormal,Supernormal,EconomicprofitNormalprofit:Theminimumprofitnecessarytokeepafirminoperation(i.e.$85,00intheexample)Afirmthatearnsnormalprofithasearnedenoughtocoveritsopportunitycost.IfyouearnmorethanopportunitycostyouareearningSupernormal(orEconomic)profit.ITEMACCOUNTINGPROFITECONOMICPROFITTotalRevenueWagesMaterialsInterestpaidOtherpaymentsLessforegoneprofitfromnextbestalternativeEqualsprofit$555,000400,00050,00010,00010,000Lessprofitforegonefromnextbestalternative$85,000$555,000400,00050,00010,00010,00085,0000Accountingprofit,Normalprofit,Supernormalprofit,Economicprofit