Transcript Micro in a nutshell

Hints
for
passing
the
AP Microeconomics
Topics:
MC=MR
Perfect competition
Change in Demand vs. Change
in
Quantity Demanded
MR PARD
Labor Markets
Indeterminant
Prices vs. Costs
Sample (capital, capital
stock, capital flow)
Consumer Surplus/Producer
Surplus/Deadweight
Economic profit
Government Controls
Elasticity
Externalities
Short-term/Long-term
Comparative Advantage
Economies of Scale
Sample AP Question:
Externalities
Scarcity
Derived Demand
SHOW ME!
GRAPH ME!
ANALYZE ME!
EXPLAIN ME!
MC = MR
**Tattoo this on your forehead
This equation comes in many
forms: MC=MR, MC=MU,
MSC=MSB...etc
PERFECT COMPETITION
MC
Price
Price
S
ATC
p
P
D=MR=AR
AVC
D
q
Single Farmer
Quantity
Q
Quantity
Industry
Perfect Competition--MUST use
SIDE-BY-SIDE GRAPHS or no credit.
PERFECT COMPETITION
MC
Price
Price
S
ATC
p
MR=P=AR=D
AVC
D
q
Quantity
Single Farmer
Q
Quantity
Industry
In perfect competition, individual firms are
price takers and will take the market price.
Hint: memorize this line for the AP test.
PERFECT COMPETITION
MC
Price
Price
S
ATC
p
Economic Profit
AVC
MR=P=AR=D
D
q
Single Farmer
Quantity
Q
Quantity
Industry
MUST show Economic Profit or Loss
MAKE SURE THEY SEE A GAP
between profit line and ATC
When I grew up on the farm, we lived next door to
MR. PARD
People called him that because he knew so much
about perfect competition.
When labeling the demand curve for perfect
competition, MAKE SURE it is labeled
MR = P = AR = D
MC
Price
Price
S
S1
ATC
p
p1
D=MR=AR=P
MR1=P1=AR1=D1
D
0
q1 q
Single Firm
Quantity
Q Q1
Quantity
Industry
In the LONG RUN, when
Because the firm is a price taker and
individuals see the firms are must take the market price, Industry
P and Firm p goes down to p1
earning an economic profit
Industry Q goes up to Q1
(above normal rates of return),
Firms’ q go down (q to q1)
more firms will enter the market
causing the industry market
ATC = MR PARD at
supply curve to shift to the right.
its lowest point
MC
Price
Price
S
ATC
p1
P
D=MR=AR
Economic Loss
D
q
Single Firm
Quantity
Q
Quantity
Industry
How is this chart different from the previous
chart reflecting an economic profit?
In this situation, P is below ATC at profit-maximizing
quantity (q). This chart reflects a loss.
MC
P
p1
p
S1
P
S
ATC
MR1=P1=AR1=D1
Economic Loss
P=D=MR=AR
D
q q1
Q
Single Firm
In the LONG RUN, when
individuals see the firms are
making an economic loss,
firms will leave the market
causing the industry market
supply curve to shift down.
Q1 Q
Q
Industry
Because the firm is a price taker and
must take the market price, Industry
P and Firm p goes up to p1
Industry Q goes down to Q1
Firms’ q go up (q to q1)
ATC = MR PARD at
its lowest point
A graph is worth a
thousand words
UNLESS you forget to
label it…..
GRAPH FIRST, then let the graph tell
the story……LABEL, LABEL, LABEL
GET TO THE POINT!!!
JUST THINK
ECONOMICALLY
Good decisions using cost-benefit
analysis and marginal thinking.
Chart V: (D ; S )
S
PRICE
P0
Be sure to
use the word
indeterminate
when
describing
price in this
graph!!
S1
E1
E0
D1
D0
Q0
Quantity
will
increase
Q1
QUANTITY
If you see the words longrun, need to double shift.
Make it easy for the reader
to grade!!
Number your responses.
ANSWER THE QUESTION clearly and
concisely.
MAKE SURE YOU USE PROPER
ECONOMIC TERMINOLOGY
WHEN ANSWERING FREE
RESPONSE QUESTIONS.
***When answering free response questions,
many students’ explanations do not indicate an
understanding of economic principles.
Instead they use common words and terms
that may make common sense but not
economic sense.
For example, on the 2004 Micro
Exam, Ques 3, part b, students
were to indicate:
For the monopolistically
competitive firm, what
happens to output and profit if
there is an elimination of a
business license fee (a fixed
cost).
For the monopolistically competitive firm, what
happens to output and profit if there is an
elimination of a business license fee (a fixed
cost).
The correct answer is:
--output does not change because the
license fee is a fixed cost and does not affect
marginal cost.
--profit will increase since total revenue (p x
q) does not change and total cost has
decreased. (Note: students could have used
average instead of total--be consistent)
For the monopolistically competitive firm, what
happens to output and profit if there is an elimination of
a business license fee (a fixed cost).
The correct answer is:
--output does not change because the license fee is a fixed cost
and does not affect marginal cost.
--profit will increase since total revenue (p x q) does not change
and total cost has decreased. (student could have used average
instead of total)
The term “profit” seems to have given
students the most difficulty. A typical
student’s response is as follows:
For the monopolistically competitive firm, what
happens to output and profit if there is an elimination of
a business license fee (a fixed cost).
The correct answer is:
--output does not change because the license fee is a fixed cost and
does not affect marginal cost.
--profit will increase since total revenue (p x q) does not change and
total cost has decreased. (student could have used average instead
of total)
“Economic profits will also increase because if
the license fee is eliminated, there will be more
money for the firm which means increased
production. More people will buy the product
and there will be more of a profit for the firm.”
“Economic profits will also increase because if
the license fee is eliminated, there will be more
money for the firm which means increased
production. More people will buy the product
and there will be more of a profit for the firm.”
**The answer assumed (incorrectly)
that output changed.
NOT
MONEY
***In order to receive the profit point, the student
would have to discuss the effect on total
revenue (or AR), the effect on total cost (or ATC)
and the resulting effect on profit.
Economic Profit = total
revenue minus all the
opportunity costs
(implicit & explicit) of
production.
Accounting Profit =
total revenue minus
explicit costs
Economic
Profit
Total
Opportunity
Costs
Implicit
Costs
Explicit
Cost$
Accounting
Profit
Revenue
Revenue
Explicit
Cost$
“Economic profits will also increase because if
the license fee is eliminated, there will be more
money for the firm which means increased
production. More people will buy the product
and there will be more of a profit for the firm.”
**Since the question involved a monopolistically
competitive firm with a downward sloping
demand curve, increasing output would bring
about a decrease in price. This would not
necessarily increase total revenue, depending
on the price elasticity of demand.
Elastic Demand and Total Revenue
At point A, total revenue is $400 ($10 x 40), or
area a + b.
At point B, the total revenue is $500 ($5 x
100), or area b + c.
Total revenue has increased by $100.
P
A
We can also see in the
graph that total revenue
has increased because the
area b + c is greater than
area a + b, or c > a.
$10
a
B
$5
b
0
20
c
40
60
Delastic
80 100
Q
Inelastic Demand and Total Revenue
At point A, total revenue is $300 ($10 x 30), or
area a + b.
At point B, the total revenue is $200 ($5 x
40), or area b + c.
Total revenue has decreased by $100.
P
A
$10
We can also see in the
graph that total revenue
has decreased because
the area a + b is greater
than area b + c, or a > c.
a
B
$5
b
c
Dinelastic
0
10
20
30
40
Q
When a demand curve is relatively
steep, such as D0 in this graph, its price
elasticity is relatively inelastic.
P
R
I
C
E
When a demand curve is
relatively flat, such as D1, its
price elasticity is relatively
elastic.
P1
P0
D1
D0
0
Q
2
Q1
Q0
QUANTITY
Relatively
elastic
Relatively
inelastic
Another area of confusion seems to be
short-run vs. long-run:
SHORT-RUN refers to a period
of time when at least one
factor of production (input) is
fixed.
--It does not refer to a period of time.
--Increasing and diminishing marginal
returns represent short-run situations.
Another area of confusion seems to be
short-run vs. long-run:
LONG-RUN refers to that time
period where all the factors of
production are variable.
Terms that deal with long-run include:
--economies of scale
--diseconomies of scale
--constant returns to scale
ECONOMIES OF SCALE
ECONOMIES OF SCALE: When long-run
average total cost declines as output increases.
DISECONOMIES OF SCALE: When long-run
average total cost rises as output increases.
CONSTANT RETURNS TO SCALE: When
long-run average total cost does not vary with
the level of output.
Average Total
Cost
ATC in short
run w/small
factory
ATC in short
run w/medium ATC in short runATC in long
w/large factory
run
factory
$12,000
Economies
10,000
of Scale
Constant Returns
to Scale
*Mankiw
0
1,000
1,200
CAUSES of economies or diseconomies of scale:
1)
Diseconomies
of Scale
Quantity of
Cars per
day
Specialization of workers will be found in higher production levels of
economies of scale.
STUMBLING BLOCKS -- Micro
--Scarcity
--Demand vs. Quantity Demanded
--Demand vs. Derived Demand
--Price vs. Cost
--Direction of a shift: UP instead of
increase (right) and DOWN instead
of decrease (left).
Scarcity:
Insufficient supply of something where “insufficient”
is interpreted relative to the desires of a group of
people. (I.e.) For instance, antiques are valued for
their scarcity….
Scarcity is NOT:
the same as poverty.
(eg. Goods can be
scarce in United States AND Somalia. However, scarcity isn’t
going away; poverty might.)
the same as shortage.
(eg. Whether you
have a shortage or not depends upon how you handle the rationing
problem made necessary by scarcity)
CHANGE IN DEMAND
vs
CHANGE IN QUANTITY
DEMANDED
The Basic Determinants of Demand
are:
1) consumer tastes and preferences
2) number of consumers in the market
3) consumers’ money incomes
4) prices of related goods
5) consumer expectations about future
prices and incomes
A change in the demand schedule or, graphically, a
shift in the location of the demand curve is called a
CHANGE IN DEMAND. This is caused by a change
in one or more of the determinants of demand.
S
PRICE
P2
P0
P1
E0
E1
D2
D1
Q1 Q0
Q2
D0
QUANTITY
By contrast, a CHANGE IN QUANTITY DEMANDED
designates the movement of one point to another--from one
price quantity to another--on a fixed demand curve, resulting
from (i.e.) a change in PRICE.
$80
P
$70
$60
R
I
C
E
$50
$40
$30
$20
D (demand)
$10
0
100 200 300 400 500 600
QUANTITY
Changes in Quantity Demanded
Price of IceCream
Cones
B
$2.00
A tax that raises the
price of ice-cream
cones results in a
movement along the
demand curve.
A
1.00
D
0
4
8
Quantity of Ice-Cream Cones
CHANGE IN SUPPLY
vs
CHANGE IN QUANTITY
SUPPLIED
The Determinants of Supply are:
1) resource prices
2) technique of production
3) taxes and subsidies
4) prices of other goods
5) price expectations
6) number of sellers in the market.
A CHANGE IN SUPPLY means a change in the
entire schedule and a shift of the entire curve,
which is caused by a change in one or more of the
determinants of supply.
S2
P
P2
RP
0
I
P1
C
E
S0
E2
E0
E1
D
Q2 Q0 Q1
QUANTITY
S1
In contrast, a CHANGE IN QUANTITY SUPPLIED is a
movement from one point to another on a fixed supply curve.
The cause of which is a change in PRICE of a specific
product.
S (supply)
$80
P
$70
$60
R
I
C
E
$50
$40
$30
$20
$10
0
100 200 300 400 500 600
QUANTITY
Change in Quantity Supplied
Price of IceCream
Cone
S
C
$3.00
A rise in the price
of ice cream
cones results in a
movement along
the supply curve.
A
1.00
0
1
5
Quantity of
Ice-Cream
Cones
DEMAND
vs.
DERIVED DEMAND
(and other factor market
problems)
LABELING IMPORTANT IN LABOR MARKET!!
MUST indicate demand for labor not just “D”
and supply of labor not just “S”.
Pric
e
S
WAGES
P2
SL
W2
P1
W1
DL2
D2
Q1
D
1
Q2 Quantity
Product Market
DL
L1
L2 Quantity
of Labor
Resource Market
There is an increase in demand for a
good or service in the product market,
which results in an increase in P and Q.
Pric
e
Pric
e
S
P2
P2
P1
P1
SL
D2
Q1
Q2
Product Market
D
1Quantity
DL
Q1
Q2
Quantity
Resource Market
There is a DERIVED DEMAND in the
resource market for labor that produces
the good or service.
Pric
e
S
Wages
P2
SL
W2
P1
W1
D2
Q1
D
1
Q2 Quantity
Product Market
DL2
DL
QL1
Quantity
ResourceQL2
Marketof Labor
Because Q increased in the product
market, the DERIVED DEMAND in the
resource market for labor also increases.
Pric
e
S
WAGES
P2
SL
W2
P1
W1
DL2
D2
Q1
D
1
Q2 Quantity
Product Market
DL1
L1
L2 Quantity
of Labor
Resource Market
This causes the WAGE RATE to increase
(W1 to W2) and quantity of labor to
increase (L1 to L2)
Pric
e
S
WAGES
P2
S
W2
P1
W1
DL2
D2
DL
D1
Q1
Q2 Quantity
Product Market
L1
L2 Quantity
of Labor
Resource Market
IMPORTANT:
There is a direct relationship
between what happens in the
product market and what happens
to DERIVED DEMAND in the
resource market.
If demand increases in the product
market, derived demand for labor in the
resource market will also increase.
IMPORTANT:
In the resource market S =
MFC (marginal factor cost) and D = MRP
(marginal revenue product).
Pric
e
Wage
S
MFC
S
W1
D1
D
Quantity
Product Market
W
MRP1
D1
MRP
D
L L1 Quantity
Resource Market
MARGINAL REVENUE PRODUCT is the
change in total revenue resulting from the use of
one additional unit of a resource, or
TR
MRP = --------------------Q of resource
MARGINAL RESOURCE COST is the change in
total cost resulting from the use of one additional
unit of a resource, or
TC (resource)
MRC = --------------------Q (resource)
The profit maximizing rule for
employing resources is:
MRP = MRC
A firm can maximize TP by hiring the
#workers at MRP of labor = MFC of labor.
Hire labor MRP >
MFC, stopping
with the unit for
which MRP =
MFC. Do not
hire any MRP <
MFC.
Wages
MFC
S
W
MRP
D
L
Resource Market
Quantity
of Labor
In this perfectly competitive market, how many
workers would be employed if wages were:
Workers
0
1
2
3
4
5
6
7
Output
*MPP
0
7
13
18
22
25
27
28
]- 7
]- 6
]- 5
]- 4
]- 3
]- 2
]- 1
Price
TR
$2
0
$2
14
$2
26
$2
36
$2
44
$2
50
$2
54
$2
56
MRP
$13.95
]- 14
]- 12
]- 10
]- 8
]- 6
]- 4
]- 2
1
$11.95
2
$ 9.95
3
$ 7.95
4
In this imperfectly competitive market, how many
workers would be employed if wages were:
Workers
MRP
0
1
2
3
4
5
6
7
Output
*MPP
0
7
13
18
22
25
27
28
]- 7
]- 6
]- 5
]- 4
]- 3
]- 2
]- 1
Price
$13.95
TR
2.80
0
2.60
18.20
2.40
31.20
]- 8.40
2.20
39.60
]- 4.40
2.00
44.00
]- 2.25
1.85
46.25
1.75
47.25
1.65
46.20
]- 18.20
]- 13.00
1
$11.95
2
$ 9.95
2
]- 1.00
$ 7.95
]- -1.05
3
MC
P
ATC
p
REMINDER:
in any
firm……
AVC
P**
q
Q
Single Farmer
SHUTDOWN = if P < AVC
= if TR < VC
= if TR/Q < VC/Q
Things have
prices...
Decisions
have
costs…..
INVESTMENT
Some students use the term
“investment” incorrectly. They do
not relate investment to machinery,
tools, and equipment. Instead, they
use the term as it relates to stocks
and bonds.
CAPITAL is another term that
confuses students:
CAPITAL: refers to the machinery,
tools, and equipment used to produce
other goods and services. It is NOT
money.
CAPITAL STOCK: refers to the
current market value of machinery,
tools, equipment and inventories
available to the firm. It does NOT
refer to stock of a corporation.
CAPITAL FLOW is another term
students should know. For example on
the 2002 Macro Exam, question 3,
students were asked, “ how and why
will capital flows be affected by this
change in the real interest rates?” The
question referred to a change in real
interest rates in the U.S. and abroad.
***In this case, capital flow refers to the
purchase of foreign assets.
Preparing for 2006: Efficiency
& welfare economy.
Consumer Surplus
Producer Surplus
Deadweight Loss
What happens when
prices are “fixed” by
the government?
Let’s look at a graph which
shows the average
consumption of beer in the
United States.
In this example,
the average
beers consumed
per week is 6
S
$4
$3
at an average
price of
$2.50.
E
$2
$1
D
0 1 2 3 4 5 6 7 Beers per week
Ge
This chart illustrates the effects upon
people if they were forced to go from Ge
to zero.
You might be
willing to pay $4
for your first
beer, but price is
$2.50 …..now
you are $1.50
better off. This
is called
CONSUMER
SURPLUS.
S
$4
$3
E
$2
$1
D
0 1 2 3 4 5 6 7 Beers per week
Ge
The 9th beer is
worth to people
what it is worth to
people.
It is different for
everybody.
S
From the
suppliers’
standpoint, they
could supply at a
lower price but
they CAN get
more. This is
called
PRODUCER
SURPLUS.
$4
$3
E
$2
$1
D
0 1 2 3 4 5 6 7 Beers per week
Ge
The
colored
area is the $4
total value
$3
to society
of the cost $2
of 6 beers.
S
Consumer
Surplus
E
Producer
Surplus
D
$1
0 1 2 3 4 5 6 7 Beers per week
Ge
What if government mandate limited the
maximum price of a beer to $1.00?
$4
NOTE: Another
example of this
is the price
ceiling on
gasoline during
the Nixon
administration.
$3
However,
suppliers would
not want to
produce as
much beer.
E
$2
$1
S
Consumers
would want to
buy more beer.
D
0 1 2 3 4 5 6 7 Beers10per week
Ge
REMEMBER: Producers will not
want to produce for low prices.
If government
limited the
maximum
price of a beer
to $1.00, it
would create a
shortage.
S
$4
$3
E
$2
$1
shortage
D
0 1 2 3 4 5 6 7 Beers per week
Ge
The legal maximum price that can
be charged is called a PRICE
CEILING. A legal minimum
price that can be charged is called
a PRICE FLOOR. Price
ceilings and floors keep markets
from reaching equilibrium.
Politically popular ideas include:
--$ minimums on inputs (wages).
--$ maximums on outputs (prices/rent
control).
When POLITICS vs.
ECONOMICS => Politics always
wins
A price ceiling keeps the market from
reaching equilibrium.
The
S
government
mandating $4
the
maximum $3
E
price of a
beer is called $2
shortage
a PRICE
CEILING. $1
D
0 1 2 3 4 5 6 7
Ge Beers per week
The shortage created from the price ceiling
will result in increased demand.
S
$4
NOTE:
Another
example of a
price ceiling is
rent control.
$3
E
$2
shortage
$1
0 1 2 3 4 5 6 7
X
D
Ge Beers per week
What if government mandate limited the maximum
number of beers one could drink to 4 per week?
Government
Mandated Supply
S
$4
Four beers is not
enough (too little,
inefficient)
….This is called
DEADWEIGHT
loss.
$3
E
$2
$1
D
0 1 2 3 4 5 6 7 Beers per week
Ge
The increased demand and a
willingness to pay higher
prices will result in a BLACK
MARKET for beer.
NOTE: This is what happened during prohibition
when (legal) supply was limited to zero.
When the government mandates a the
minimum price of something, it is called a
PRICE FLOOR.
S
$5
NOTE: The
minimum
wage is an
example of
a price floor.
$4
E
$3
$2
$1
D
0 1 2 3 4 5 6 7
Ge
Labor
The minimum wage increases the number of people
who want to work (supply of labor). . .
. . . And
decreases the
number of
businesses who $5
want to hire
$4
(demand for
$3
labor)
$2
Creating a
SURPLUS
of labor.
S
SURPLUS
E
$1
D
0 1 2 3 4 5 6 7
Ge
Labor
RESULTS:
•Those who continue to work are
better off. (90%)
•Some people are worse off (10%)
•Prices rise for some goods using
low skilled labor.
•Discrimination is created in the
labor market.
•Some people leave home to make
more money creating larger
unemployment and disemployment.
Easy to show overall:
•Costs > return of benefits
•Total welfare higher =>
those working incur higher
costs
•Output will fall => fewer
people working
Extreme case:
What would happen if the
government raised the
minimum wage to $100 an
hour?
Even though water is
essential for life and
diamonds are not,
water is cheap and
diamonds are
expensive?
Why?
It has to do with the elasticity of the supply curve and
the amount of consumer/producer surplus
With DIAMONDS,
supply is very
inelastic.
S
P
With WATER, supply
is very elastic.
Consumer
Surplus
Producer
Surplus
S
P
D
Q
Quantity
D
Q
Quantity
NASH
EQUILIBRIUM is a
situation where
economic actors
interacting with each
other each choose their
best strategy given the
strategies that others
have chosen. This is
GAME
THEORY.
also called
***Kinked
demand curve is
out!!
John Nash
1994 Nobel Prize,
Economics
Game Theory can be illustrated by what is called
THE PRISONER’S DILEMMA.
The police have enough evidence to convict Bonnie
and Clyde of possession of an illegal firearm so that
each would spend 1 year in jail. But they suspect
that the two have pulled off some bank robberies
but they have no evidence. They put Bonnie and
Clyde in separate rooms and offer a deal.
“Right now, we can lock you up for one year.
But if you testify against your partner, we will
set you free and your partner will get 20
years in prison. If you both confess to the
crime, we can avoid the cost of a trial and
you both get 8 years.”
Each prisoner has two strategies, confess or remain
silent. However, the sentence that each gets
depends upon the actions of the other.
Bonnie’s Decision
confess
confess
Clyde’s
Decision
8 years each
Remain Bonnie goes free
silent Clyde - 20 yrs.
Remain silent
Bonnie - 20 yrs
Clyde goes free
1 year each
OR you can use the PAYOFF MATRIX
B: 8 years
C: 8 years
Clyde’s
Decison
B: free
Bonnie’s
Decison
C: 20 years
B: 20 years
Clyde’s
Decison
C: free
B: 1 year
C: 1 year
In the real world, this dilemma is played out by
real players. Once a negotiation is reached, each
country must decide whether they should keep
their agreement.
Iraq’s Decision
High prod.
Iran’s
Decision
High
prod.
$40 billion
each
Low Iraq - $60 billion
prod. Iran - $30 billion
Low prod.
Iraq - $30 billion
Iran - $60 billion
$50 billion
each
It can be used in the arms race…...
U.S.’s Decision
Arm.
Arm
USSR’s
Decision
Disarm
Both at risk
Disarm
US at risk
USSR safe
US safe
USSR at risk
Both safe
It can be used in the everyday economic
decisions……Consider 2 firms which must
decide whether to make a new product or not….
Firm 1
Yes
Yes
Firm 2
No
No
Firm 1: $1.5m
Firm 1: 0
Firm 2: $1.5m
Firm 2: $2m
Firm 1: $2m
Firm 1: 0
Firm 2: 0
Firm 2: 0
GAME THEORY
•
•
•
•
Prisoners' Dilemma
Battle of the Sexes
Dominant Strategies
Nash Equilibria
By David Anderson, PhD
Centre College, Danville, KY
The Payoff Matrix
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
The Payoff Matrix
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
The Payoff Matrix
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
The Payoff Matrix
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
The Payoff Matrix
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
The Circle Trick
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
The Circle Trick
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
The Circle Trick
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
The Circle Trick
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
Chris has a Dominant Strategy:
The “Confess” strategy is best
regardless of Pat’s move.
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
Checking Pat’s Options
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
Checking Pat’s Options
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
Checking Pat’s Options
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
Checking Pat’s Options
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
Pat has a dominant strategy:
Confess
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
Nash Equilibrium:
Neither side has a desire to switch strategies
given what the other is doing.
Pat
Confess
Confess
Chris
Deny
Deny
5, 5
1,10
10, 1
2, 2
David Anderson, PhD
Battle of the Sexes
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
John Analyses the Possibilities
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
John Analyses the Possibilities
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
John Analyses the Possibilities
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
John Analyses the Possibilities
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
Sarah Analyses the Possibilities
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
Sarah Analyses the Possibilities
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
Sarah Analyses the Possibilities
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
Sarah Analyses the Possibilities
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
Two Nash Equilibria, No
Dominant Strategies
Sarah
Rally
John
Town Hall
Rally
20, 30
9, 4
Town
Hall
10, 16
40, 27
David Anderson, PhD
Chicken
Sarah
Straight
Straight
John
Swerve
Swerve
-10,-10 +5, -5
-5, +5
0, 0
David Anderson, PhD
COMPARATIVE
ADVANTAGE
Comparative Advantage: an individual (or
country) has comparative advantage in
producing a good or service if the opportunity
cost of producing the good is lower for that
individual than for other people.
Absolute Advantage: an individual (or
country) is said to have absolute advantage if
they (he/she) can do it better than anyone
else. Having an absolute advantage is not
the same thing as comparative advantage.
Let’s say we have 2 individuals named Adam and Eve, who are
the only people in the world. Can they benefit from trading
with each other?
Let’s take a look at the Production Possibilities curve for each
person.
Quantity of
apples
Adam’s PPC
Eve’s PPC
Quantity of
apples
30
20
Adam’s
consumption
without trade
9
Eve’s
consumption
without trade
8
0
28
40
Quantity of Fish
0
6
10
Quantity of Fish
The slope of Adam’s line is 3/4. That is for every 4
additional fish that Adam
chooses to catch, he
gathers 3 fewer apples.
Quantity of
apples
The slope of Eve’s line is -2.
Eve is less productive: the
most she can produce is 10
fish or 20 apples. She is
particularly bad at fishing.
Eve’s PPC
Adam’s PPC
Quantity of
apples
30
20
Adam’s
consumption
without trade
9
Eve’s
consumption
without trade
8
0
28
40
Quantity of Fish
0
6
10
Quantity of Fish
Adam & Eve’s Opportunity Cost
Adam’s Opp Cost
Quantity of
apples
One fish
3/4 apple
One apple
4/3 fish
Eve’s Opp Cost
2 apples
1/2 fish
Eve’s PPC
Adam’s PPC
Quantity of
apples
30
20
Adam’s
consumption
without trade
9
Eve’s
consumption
without trade
8
0
28
40
Quantity of Fish
0
6
10
Quantity of Fish
GAINS FROM TRADE
Without Trade
Production
Adam
Eve
Fish
Consumption
With Trade
Production
Gains from Trade
Consumption
28
28
40
30
+2
Apples
9
9
0
10
+1
Fish
6
6
0
10
+4
Apples
8
8
20
10
+2
So here’s how it works:
Adam specializes in the catching of fish (40/week) and gives 10 to Eve.
Meanwhile, Eve specializes in the picking of apples (20/week) and gives
10 to Adam.
As you can see by the table above, both Adam and Eve have gains from
trade. They both increase their consumption of both commodities.
It is better for Adam to catch the fish because his opportunity cost of a
fish is only 3/4 of an apple not picked versus 2 apples for Eve.
Another way to say it is because Adam is so good at catching fish, his
opportunity costs of picking apples is high: 4/3 fish not caught for every
apple picked. Because Eve is a poor fisherman, her opportunity cost of
picking apples is less: only 1/2 a fish per apple.
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
1) What is Slovenia’s opportunity cost of
making microwaves?
4/12 = 1/3
For every microwave, it must give
up 1/3 of a Refrigerator.
2) What is Bohemia’s opportunity cost of
making microwaves?
6/10 =3/5
For every microwave, it must give
up 3/5 of a refrigerator
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
3) What is Slovenia’s opportunity cost of
making refrigerators? 12/4 = 3
For every refrigerator, it must give
up 3 of a microwaves.
4) What is Bohemia’s opportunity cost of
making refrigerators?
10/6 = 5/3
For every refrigerator, it must give
up 1 2/3 of a microwave.
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
5) Which country has absolute
advantage in microwaves?
Slovenia
Bohemia
12
10
4
6
Slovenia
12 Slovenia/10 Bohemia
6) Which country has absolute
advantage in refrigerators?
Bohemia
6 Bohemia/4 Slovenia
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
7) Which country has comparative
advantage in microwaves? Slovenia
1/3 Slovenia vs.
3/5 Bohemia
8) Which country has absolute
advantage in refrigerators?
Bohemia
5/3 Bohemia vs
3 Slovenia
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
9) Which country should produce what?
Slovenia should produce microwaves and
Bohemia should produce refrigerators because
microwaves and refrigerators will then be
produced by the lower-cost country. The TOTAL
OUTPUT of microwaves and refrigerators will be
higher.
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
10) Use the law of comparative
advantage to explain why selfsufficiency leads to a lower standard
of living.
If people and countries do not trade on the basis
of comparative advantage, there will be fewer
goods and services for people to enjoy. People
will be poorer.
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen
Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
1) What is Karen’s opportunity cost of cleaning the kitchen
in terms of mowing the lawn.
60/30 = 2
Mowing 2 lawns.
2) What is Charlie’s opportunity cost of cleaning the
kitchen in terms of mowing the lawn?
20/15 = 4/3
Mowing 4/3 lawns.
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen
Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
3) What is Karen’s opportunity cost of mowing the lawn in
terms of cleaning the kitchen?
30/60 = 1/2
Cleaning 1/2 kitchen
4) What is Charlie’s opportunity cost of mowing the lawn in
terms of cleaning the kitchen?
15/20 = 3/4
kitchen
Cleaning 3/4
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen
Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
5) Who has absolute advantage in cleaning the kitchen?
Charlie
20 minutes
6) Who has absolute advantage in mowing lawns?
Charlie
15 minutes
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen
Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
7) Who has comparative advantage in cleaning the kitchen?
Charlie
4/3 to 2
8) Who has comparative advantage in mowing lawns?
Karen
1/2 to 3/4
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen
Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
9) Who should do which chore and why?
Charlie should clean the kitchen and Karen
should mow the lawn and they will finish
sooner. The person with the lower
opportunity cost should perform the chore.
SAMPLE AP TEST
QUESTION
The production of Good X creates an
externality.
Is this a negative
or positive
externality?
Price
Marginal Social
Cost
13
12
Negative
Marginal Private
Cost
7
Why?
4
D-MSB
MR
0
Q1 Q2
Quantity of
Good X
Q3
MR
MSC > MPC
The production of Good X creates an
externality.
Price
Identify the
socially optimum
output.
Marginal Social
Cost
13
12
Marginal Private
Cost
7
Q2
Why?
4
D-MSB
MR
0
Q1 Q2
Quantity of
Good X
Q3
MR
MSC=MSB
Suppose that good X is produced by a profitmaximizing monopoly.
Identify the
unregulated firm’s
output.
Price
Marginal Social
Cost
13
Q1
12
Why?
Marginal Private
Cost
7
4
D-MSB
MR
0
Q1 Q2
Quantity of
Good X
Q3
MR
At Q1, MPC =
MR
Suppose that good X is produced by a profitmaximizing monopoly.
Price
To produce socially optimum output,
should the government tax or subsidize
the firm?
subsidize
Marginal Social
Cost
13
How much will it
be?
Marginal Private
Cost
$3
Why?
12
7
4
D-MSB
MR
0
Q1 Q2
Quantity of
Good X
Q3
MR
Optimum
Quantity at Q2 =
MR
Suppose that good X is produced in a perfectly
competitive industry.
Price
Identify equilibrium output in the absence
of regulation.
Q3
Marginal Social
Cost
13
12
Marginal Private
Cost
7
4
MR
0
Q1 Q2
Q3
D-MSB
Quantity of
Good X
Why?
D=MPC or
MSB=MPC
Suppose that good X is produced in a perfectly
competitive industry.
Price
To produce at socially optimum output,
should the government tax or subsidize?
Tax
Marginal Social
Cost
13
12
Marginal Private
Cost
7
4
MR
0
Q1 Q2
Q3
D-MSB
Quantity of
Good X
How much?
$5
STUDENTS SHOULD:
--recognize the importance of
understanding terminology.
--be expected to use economic terms in
discussion, essays, and analysis
--identify the economic terms in the
exam questions
--ANSWER THE QUESTION. Simply
restating a question will not earn points.
HINTS for taking THE AP
MICROECONOMICS
EXAM
Pay attention to the instruction words.
Identify, state, list, define = Don’t
explain the logical sequence.
Explain and discuss = Explain the
logical sequence, the linkages.
Graphs can be the explanation at
times.

Draw and show = Draw a graph
or diagram, label with care.
Use abbreviations!
MR=MC, P and Q, Δ, ATC, AVC,
P=MR=d, MCS or MSC, , , etc.,
etc., etc.

Words frequently explain
better, but symbols can be inserted
when appropriate or short on time.
For example, “If the purely
competitive firm has eco profits in
the SR, then other firms will enter
the market  S↑  P↓, Q↑ for the
industry.”
When writing . . .
Use correct terminology, such as
“income” or “profit”, not “money”,
unless the topic is really money.
Use outline numbers like “a” or “i” to
reference an answer.
Emphasize the logical sequence, the
line of reasoning.

Use the 10-minute planning time
to script out answers on the green
question pages of the FRQ exam.
When writing . . .
May answer questions in any order.

Do not restate question. It is a
waste of time.
Draw graphs well-labeled.
MC
Price
p1
p
S1
Pric
e
S
ATC
MR1=P1=AR1=D1
Economic Loss
P=D=MR=AR
D
q q1
Single Firm
Quantit
y
Q1 Q
Industry
Quanti
ty
MISTAKES MADE ON
THE AP
MICROECONOMICS
EXAM
GENERAL MISTAKES
•Label both axes on all graphs and all curves. No
labels, no points awarded.
•Not knowing the difference between a change in
quantity demanded and a change in demand and the
resultant movement along a demand curve versus
shifting a demand curve -- and the same for supply or
any other curve.
•Confusing comparative advantage calculations
•Double shifts resulting in a change in one variable,
but the other “indeterminant”
•Differences in “normal” and “economic” profits
MICROECONOMIC MISTAKES
•Failing to remember how to shade the area of
economic profit, especially in the case of a monopoly
model
•Not understanding how a per unit subsidy leads to an
increase in output through either lower MC or an
increase in demand.
•Not being able to calculate average fixed cost
•Getting confused between product and factor
markets
•Not knowing the elasticity of demand and TR
relationship (total revenues)
MICROECONOMIC MISTAKES
•Confusing the different types of efficiency: economic
efficiency = P=MC=ATC, allocative efficiency = P=MC,
productive efficiency = P=ATC
•Failing to use side by side graphs of the market and
the industry
•Not knowing that “market” and “industry” are the
same thing.
•Not knowing that “imperfect markets” can be
anything except perfect competition
•Game theory