AP Microeconomics REVIEW Hints for passing the Ms. Meachum.
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Transcript of AP Microeconomics REVIEW Hints for passing the Ms. Meachum.
AP Microeconomics
REVIEW
Hints for passing the
Ms. Meachum
Topics:MC=MR
Perfect competition
MR PARD
Indeterminant
Sample (capital, capital stock, capital flow)
Economic profit
Elasticity
Short-term/Long-term
Economies of Scale
Scarcity
Derived Demand
Change in Demand vs. Change in Quantity Demanded
Labor Markets
Prices vs. Costs
Consumer Surplus/Producer
Surplus/Deadweight
Government Controls
Externalities
Comparative Advantage
Sample AP Question: Externalities
SHOW ME!
GRAPH ME!
ANALYZE ME!
EXPLAIN ME!
MC = MRMC = MR**Tattoo this on your forehead
This equation comes in many forms: MC=MR, MC=MU,
MSC=MSB...etc
Single Farmer Industry
S
D
D=MR=AR
MMCC
p P
ATCATC
AVC
PERFECT COMPETITION
Perfect Competition--MUST Perfect Competition--MUST use SIDE-BY-SIDE GRAPHS or use SIDE-BY-SIDE GRAPHS or
no credit.no credit.
Price Price
Quantity
Quantity
Single Farmer Industry
S
D
MR=P=AR=D
MMCC
p
ATCATC
AVC
PERFECT COMPETITION
In perfect competitionIn perfect competition, , individual individual firms are price takers and will take firms are price takers and will take
the market price.the market price.Hint: memorize this line for the AP test.
Price Price
Quantity
Quantity
Single Farmer Industry
Price Price
Quantity
Quantity
S
D
MR=P=AR=D
MMCC
p
ATCATC
AVC
PERFECT COMPETITION
MUST show Economic Profit or MUST show Economic Profit or LossLoss
Economic Profit
MAKE SURE THEY SEE A GAP MAKE SURE THEY SEE A GAP between profit line and ATCbetween profit line and ATC
When I grew up on the farm, we lived next door to
MR. PARDPeople 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
Single Firm Industry
Price Price
Quantity
Quantity
S
D
D=MR=AR=P
MMCC
p1
q Q
ATCATC
In the LONG RUN, when individuals see the firms are earning an economic profit (above normal rates of return), more firms will enter the market causing the industry market supply curve to shift to the right.
Because the firm is a price taker and must take the market
price, Industry P and Firm p goes down to p1
0
Industry Q goes up to Q1
Firms’ q go down (q to q1)
MR1=P1=AR1=D1
S1
Q1
p
ATC = MR PARD ATC = MR PARD at its lowest at its lowest
pointpoint
q1
Single Firm Industry
Price
Price
Quantity
Quantity
S
D
D=MR=AR
MMCC
p1 P
How is this chart different from the previous chart reflecting an economic
profit?
q Q
ATCATC
Economic Loss
In this situation, P is below ATC at profit-maximizing quantity (q). This chart reflects
a loss.
Single Firm Industry
P P
Q Q
S
D
P=D=MR=AR
MMCC
p
q Q
ATCATC
Economic Loss
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.
S1
Industry Q goes down to Q1Firms’ q go up (q to q1)
MR1=P1=AR1=D1
ATC = MR PARD ATC = MR PARD at its lowest at its lowest
pointpoint
p1
Q1q1
Because the firm is a price taker and must take the market
price, Industry P and Firm p goes up to p1
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 GET TO THE POINT!!!POINT!!!JUST THINK JUST THINK
ECONOMICALLYECONOMICALLY
Good decisions using cost-benefit analysis and marginal thinking.
Chart V: (D ; S )Chart V: (D ; S )
QUANTITYQUANTITY
PRICEPRICES S
DD0 0
E0 P0
Q0
DD1 1
SS11
E1
Q1
Price will be indeterminate.
Quantity will
increase
Be sure to use the word indeterminindeterminateatewhen describing price in this graph!!
If you see the words long-run, 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 ProfitEconomic Profit = total revenue minus all the opportunity
costs (implicit & explicit) of production.
Accounting ProfitAccounting Profit = total revenue minus explicit
costs
Explicit Cost$
Explicit Cost$
Accounting Profit
Economic Profit
Implicit Costs Revenu
eRevenue
Total Opportunity Costs
“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
P
Q
$10
$5
0 20 40 60 80 100
B
A
cb
a
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.
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.Delasti
c
Inelastic Demand and Total Revenue
P
Q
$10
$5
0 10 20 30 40
B
A
cb
a
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.
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.Dinelastic
PRICE
QUANTITY
DD11
P0
P1
0 Q0Q1
DD00
Q2
RelativeRelatively ly inelastiinelasticc
RelativelRelatively elasticy elastic
When a demand curve is relatively steep, such as D0 in
this graph, its price elasticity is relatively inelastic.When a demand curve is
relatively flat, such as D1, its price elasticity is
relatively elastic.
Another area of confusion seems to be short-run vs. long-run:
SHORT-RUN refers to a SHORT-RUN refers to a period of time when at period of time when at least one factor of least one factor of production (input) is production (input) is fixed.fixed.
--It does not refer to a period of --It does not refer to a period of time.time.
--Increasing and diminishing --Increasing and diminishing marginal returns represent short-marginal returns represent short-run situations.run situations.
Another area of confusion seems to be short-run vs. long-run:
LONG-RUN refers to that LONG-RUN refers to that time period where all the time period where all the factors of production are factors of production are variable.variable.
Terms that deal with long-run Terms that deal with long-run include:include:
--economies of scale--economies of scale
--diseconomies of scale--diseconomies of scale
--constant returns to 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.
*Mankiw
Average Total Cost
Quantity of Cars per day
0 1,000 1,200
$12,000
10,000
ATC in short run w/small factory
ATC in short run
w/medium factory
ATC in short run w/large
factory
ATC in long run
Economies of Scale Diseconomi
es of ScaleConstant
Returns to Scale
CAUSES of economies or diseconomies of scale:
1) 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 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)
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….
CHANGE IN DEMANDCHANGE IN DEMAND
vsvs
CHANGE IN CHANGE IN QUANTITY QUANTITY
DEMANDEDDEMANDED
The Basic Determinants of Determinants of DemandDemand 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
QUANTITYQUANTITY
PRICEPRICES S
E0 P0
Q0
P1
Q1
E1
DD0 0 DD1 1
P2
Q2
DD2 2
A change in the demand schedule or, graphically, a shift in the location of the
demand curve is called a CHANGE IN CHANGE IN DEMANDDEMAND. This is caused by a change in one
or more of the determinants of demand.
QUANTITYQUANTITY
PP
RRII
CCEE D (demand)D (demand)
$80
$70
$60
$50
$40
$30
$20
$10
0100 200 300 400 500 600
By contrast, a CHANGE IN QUANTITY CHANGE IN QUANTITY DEMANDEDDEMANDED 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.PRICE.
0
D
Price of Ice-Cream Cones
Quantity of Ice-Cream Cones
A tax that raises the price of ice-cream cones results in a movement along
the demand curve.
A
B
8
1.00
$2.00
4
Changes in Quantity Demanded
CHANGE IN SUPPLYCHANGE IN SUPPLY
vsvs
CHANGE IN CHANGE IN QUANTITY SUPPLIEDQUANTITY SUPPLIED
The Determinants of SupplyDeterminants 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.
QUANTITYQUANTITY
PP
RRII
CCEE
SS0 0
D D
E0 P0
Q0
P1
Q1
E1
SS11
P2
Q2
E2
SS22
A CHANGE IN SUPPLYCHANGE 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.
QUANTITYQUANTITY
PP
RRII
CCEE
S (supply)S (supply)$80
$70
$60
$50
$40
$30
$20
$10
0 100 200 300 400 500 600
In contrast, a CHANGE IN QUANTITY SUPPLIEDCHANGE IN QUANTITY SUPPLIED is a movement from one point to another on a fixed
supply curve. The cause of which is a change in
PRICEPRICE of a specific product.
1 5
Price of Ice-Cream Cone
Quantity of Ice-Cream Cones
0
S
1.00A
C$3.00 A rise in the
price of ice cream cones results in a movement along the
supply curve.
Change in Quantity Supplied
DEMAND
vs.
DERIVED DEMAND
(and other factor market problems)
S
D1
D2
SL
LABELING IMPORTANT IN LABOR MARKET!!
Product Market Resource Market
Price
Quantity
Q1 Q2
P2
P1
WAGES
Quantity of Labor
L1 L2
W2
W1
DL
DL2
MUST indicate demand for labor not just “D” and supply of labor not just
“S”.
S
D1
Price
Quantity
D2
SL
Price
There is an increase in demand for a good or service in the product market, which results in an increase in P and Q.
Product Market
Resource Market
QuantityQ1 Q2
P2
P1
Q1 Q2
P2
P1
DL
S
D1
Price
Quantity
D2
SL
There is a DERIVED DEMAND in the resource market for labor that produces the good or service.
Product Market Resource MarketQ1 Q2
P2
P1
Wages
Quantity of
Labor
QL1 QL2
W2
W1
DL
DL2
S
D1
D2
Because Q increased in the product market, the DERIVED DEMAND in the resource market for labor also increases.
Product Market Resource Market
Price
Quantity
Q1 Q2
P2
P1
WAGES
Quantity of Labor
L1 L2
W2
W1
DL1
DL2
SL
S S
DL
DL2
This causes the WAGE RATE to increase (W1 to W2) and quantity of labor to increase (L1 to L2)
Product Market Resource Market
Price
Quantity
Q1 Q2
P2
P1
WAGES
Quantity of Labor
L1 L2
W2
W1
D1
D2
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 If demand increases in the product market, derived demand for labor market, derived demand for labor in the resource market will also in the resource market will also
increase.increase.
S
D
Price
Quantity
D1
S
D
Wage
Quantity
D1
IMPORTANT: In the resource market S = MFC (marginal factor cost) and D = MRP (marginal revenue product).
Product Market
Resource Market
W1
W
L L1
MFC
MRP
MRP1
MARGINAL REVENUE PRODUCTMARGINAL REVENUE PRODUCT is the change in total revenue resulting from the use of one additional unit of a resource, or
MRP = ---------------------TR
Q of resource
MARGINAL RESOURCE COSTMARGINAL RESOURCE COST is the change in total cost resulting from the use of one
additional unit of a resource, or
MRC = ---------------------TC (resource)Q (resource)
The profit maximizing rule for employing resources is:
MRP = MRP = MRCMRC
S
D
Wages
Quantity of Labor
A firm can maximize TP by hiring the #workers at MRP of labor = MFC of labor.
Resource Market
W
L
MFC
MRP
Hire labor MRP > MFC, stopping with the unit for which MRP = MFC. Do not hire any MRP < MFC.
0 0 $2
1 7 $2
2 13 $2
3 18 $2
4 22 $2
5 25 $2
6 27 $2
7 28 $2
Workers Output *MPP Price TR MRP
]- 7
]- 6
]- 5
]- 4
]- 3
]- 2
]- 1
0
14
26
36
44
50
54
56
]- 14
]- 12
]- 10
]- 8
]- 6
]- 4
]- 2
In this perfectly competitive market, how many workers would be employed if
wages were:
$13.95 $13.95
$11.95 $11.95
$ 9.95 $ 9.95
$ 7.95 $ 7.95
11
22
33
44
Workers Output *MPP Price TR MRP
0 0 2.80
1 7 2.60
2 13 2.40
3 18 2.20
4 22 2.00
5 25 1.85
6 27 1.75
7 28 1.65
]- 7
]- 6
]- 5
]- 4
]- 3
]- 2
]- 1
0
18.20
31.20
39.60
44.00
46.25
47.25
46.20
]- 18.20
]- 13.00
]- 8.40
]- 4.40
]- 2.25
]- 1.00
]- -1.05
In this imperfectly competitive market, how many workers would be employed if
wages were:$13.95 $13.95
$11.95 $11.95
$ 9.95 $ 9.95
$ 7.95 $ 7.95
11
22
22
33
Single Farmer
P
Q
MMCC
p
P**
ATCATC
AVC
q
SHUTDOWN = if P < AVCSHUTDOWN = if P < AVC
= if TR < VC= if TR < VC
= if TR/Q < VC/Q= if TR/Q < VC/Q
REMINDER: in any
firm……
Things haveThings haveprices...prices...
Decisions Decisions have have
costs…..costs…..
INVESTMENTSome 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 Consumer Surplus Producer Surplus Producer Surplus Deadweight LossDeadweight 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.
$4
$3
$2
$1
Beers per week
0 1 2 3 4 5 6 7
S
D
E
Ge
In this example, the average beers consumed per week is 6at an average price of $2.50.
$4
$3
$2
$1
Beers per week
0 1 2 3 4 5 6 7
S
D
E
This chart illustrates the effects upon people if they were forced
to go from Ge to zero.
Ge
You might be You might be willing to pay willing to pay $4 for your $4 for your first beer, first beer, but price is but price is $2.50 …..now $2.50 …..now you are you are $1.50 better $1.50 better off. This is off. This is called called CONSUMER CONSUMER SURPLUS.SURPLUS.
The 9th beer is worth to people what it is worth
to people.
It is different for everybody.
$4
$3
$2
$1
Beers per week
0 1 2 3 4 5 6 7
S
D
E
Ge
From the From the suppliers’ suppliers’ standpoint, standpoint, they they could could supply at a supply at a lower price lower price but they but they CAN CAN get more. get more. This is called This is called PRODUCER SURPLUS.
$4
$3
$2
$1
Beers per week
0 1 2 3 4 5 6 7
S
D
E
Ge
The The colored colored area is area is the the total total valuevalue to to society society of the of the cost of 6 cost of 6 beers.beers.
Consumer Surplus
Producer Surplus
$4
$3
$2
$1
Beers per week
0 1 2 3 4 5 6 7
S
D
E
Ge
What if government mandate What if government mandate limited the maximum price of a limited the maximum price of a
beer to $1.00?beer to $1.00?
Consumers would want to buy more beer.
10
However, suppliers would not want to
produce as much beer.
NOTE: Another example of this is the price ceiling on gasoline during the Nixon administration.
$4
$3
$2
$1
Beers per week
0 1 2 3 4 5 6 7
S
D
E
Ge
If If governmengovernmen
t limited t limited the the
maximum maximum price of a price of a beer to beer to $1.00, it $1.00, it would would
create a create a shortage.shortage.
shortage
REMEMBER: Producers will not want to produce for low
prices.
The legal maximum price that can be charged is
called a PRICE CEILINGPRICE CEILING. A legal minimum price that can be charged is
called a PRICE FLOORPRICE FLOOR. Price ceilings and floors
keep markets from reaching equilibriumequilibrium..
Politically popular ideas include:
--$ minimums on inputs (wages).
--$ maximums on outputs (prices/rent control).When POLITICS vs. POLITICS vs.
ECONOMICS => ECONOMICS => Politics Politics always winsalways wins
$4
$3
$2
$1
Beers per week
0 1 2 3 4 5 6 7
S
D
E
Ge
The The governmegovernme
nt nt mandatinmandatin
g the g the maximum maximum price of a price of a
beer is beer is called a called a PRICE PRICE
CEILINGCEILING..
shortage
A price ceiling keeps the market from reaching equilibrium.
$4
$3
$2
$1
Beers per week
0 1 2 3 4 5 6 7
S
D
E
Ge
shortage
The shortage created from the price ceiling will result in
increased demand.
X
NOTE: Another example of a price ceiling is rent control.
$4
$3
$2
$1
Beers per week
0 1 2 3 4 5 6 7
S
D
E
Ge
Four beers is Four beers is not enough not enough (too little, (too little, inefficient) inefficient) ….This is ….This is
called called DEADWEIGHT DEADWEIGHT
loss.loss.
What if government mandate limited What if government mandate limited the maximum number of beers one the maximum number of beers one could drink to 4 per week?could drink to 4 per week?
Government Mandated Supply
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.
$5
$4
$3
$2
$1
Labor0 1 2 3 4 5 6 7
S
D
E
Ge
When the government mandates a When the government mandates a the minimum price of something, the minimum price of something, it is called a it is called a PRICE FLOORPRICE FLOOR..
NOTE: The minimum wage is an example of a price floor.
$5
$4
$3
$2
$1
Labor0 1 2 3 4 5 6 7
S
D
E
Ge
The minimum wage increases the number of people who want to work (supply of labor). . . . . . And decreases the number of businesses who want to hire (demand for labor)Creating a SURPLUS of labor.
SURPLUS
•Those who continue to work are Those who continue to work are better off. (90%)better off. (90%)
•Some people are worse off (10%)Some people are worse off (10%)
•Prices rise for some goods using Prices rise for some goods using low skilled labor.low skilled labor.
•Discrimination is created in the Discrimination is created in the labor market.labor market.
•Some people leave home to make Some people leave home to make more money creating larger more money creating larger unemployment and disemployment.unemployment and disemployment.
RESULTS:
Easy to show overall:
•Costs > return of benefitsCosts > return of benefits
•Total welfare higher => Total welfare higher => those working incur higher those working incur higher costscosts
•Output will fall => fewer Output will fall => fewer people workingpeople working
Extreme case:Extreme case:
What would happen if What would happen if the government raised the government raised the minimum wage to the minimum wage to $100 an hour?$100 an hour?
Even though water Even though water is essential for is essential for life and diamonds life and diamonds are not, water is are not, water is cheap and diamonds cheap and diamonds are expensive?are expensive?
Why?Why?
It has to do with the elasticity of the It has to do with the elasticity of the supply curve and the amount of supply curve and the amount of
consumer/producer surplusconsumer/producer surplus
Pri
ce
Quantity
Consumer Consumer SurplusSurplus
Q
S
Pri
ce
Quantity
Producer Producer SurplusSurplus
S
Q
P
P
DD
With DIAMONDS, With DIAMONDS, supply is very supply is very inelastic.inelastic.
With WATER, With WATER, supply is very supply is very
elastic.elastic.
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 also called
GAME THEORY. John Nash
1994 Nobel Prize, Economics
***Kinked ***Kinked demand curve demand curve
is out!!is out!!
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.”
Bonnie’s Decisionconfess
confess
Remain silent
Remain
silent
Clyde’s Decision
8 years each
Bonnie - 20 yrs
Clyde goes freeBonnie goes
free
Clyde - 20 yrs.
1 year each
Each prisoner has two strategies, confess or remain silent. However, the sentence
that each gets depends upon the actions of the other.
OR you can use the PAYOFF MATRIX
Bonnie’s Decison
Clyde’s Decison
Clyde’s Decison
confe
ss
confe
ss
confe
ss
Remain
silent
Remain
silent
Remain
silent
B: 8 years
C: 8 yearsB: free
C: 20 years
B: 20 years
C: free
B: 1 year
C: 1 year
Iraq’s DecisionHigh prod.
High prod.
Low prod.
Low prod.
Iran’s Decision
$40 billion each
Iraq - $30 billion
Iran - $60 billionIraq - $60
billion
Iran - $30 billion
$50 billion each
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.
U.S.’s DecisionArm.
Arm
Disarm
Disarm
USSR’s Decision
Both at risk
US at risk
USSR safe
US safe
USSR at risk
Both safe
It can be used in the arms race…...
Firm 1Yes
Yes
No
No
Firm 2
Firm 1: $1.5m
Firm 2: $1.5m
Firm 1: 0
Firm 2: $2m
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: $2m
Firm 2: 0
Firm 1: 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
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
The Payoff Matrix
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
The Payoff Matrix
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
The Payoff Matrix
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
The Payoff Matrix
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
The Circle Trick
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
The Circle Trick
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
The Circle Trick
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
The Circle Trick
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
Chris has a Dominant Strategy:The “Confess” strategy is best
regardless of Pat’s move.
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
Checking Pat’s Options
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
Checking Pat’s Options
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
Checking Pat’s Options
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
Checking Pat’s Options
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
Pat has a dominant strategy: Confess
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
Nash Equilibrium: Neither side has a desire to switch strategies
given what the other is doing.
Confess Deny
Confess 5, 5 1,10Deny 10, 1 2, 2
Pat
Chris
David Anderson, PhD
Battle of the Sexes
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
John Analyses the Possibilities
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
John Analyses the Possibilities
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
John Analyses the Possibilities
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
John Analyses the Possibilities
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
Sarah Analyses the Possibilities
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
Sarah Analyses the Possibilities
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
Sarah Analyses the Possibilities
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
Sarah Analyses the Possibilities
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
Two Nash Equilibria, No Dominant Strategies
Rally Town Hall
Rally 20, 30 9, 4
Town Hall
10, 16 40, 27
Sarah
John
David Anderson, PhD
Chicken
Straight Swerve
Straight -10,-10 +5, -5
Swerve -5, +5 0, 0
Sarah
John
David Anderson, PhD
COMPARATIVE ADVANTAGE
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: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
30
9
028 40
Quantity of Fish
Adam’s PPC Eve’s PPCQuantity of apples
20
8
Quantity of Fish0 6 10
Adam’s consumption without trade
Eve’s consumption without trade
Quantity of apples
30
9
028 40
Quantity of Fish
Adam’s PPC Eve’s PPCQuantity of apples
20
8
Quantity of Fish0 6 10
Adam’s consumption without trade
Eve’s consumption without trade
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.
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.
Quantity of apples
30
9
028 40
Quantity of Fish
Adam’s PPC Eve’s PPCQuantity of apples
20
8
Quantity of Fish0 6 10
Adam’s consumption without trade
Eve’s consumption without trade
Adam & Eve’s Opportunity Cost
Adam’s Opp Cost Eve’s Opp Cost
One fish 3/4 apple 2 apples
One apple 4/3 fish 1/2 fish
GAINS FROM TRADE
Without Trade With Trade Gains from Trade
Production Consumption Production Consumption
Adam Fish 28 28 40 30 +2
Apples 9 9 0 10 +1
Eve 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.
Slovenia Bohemia
Microwaves 12 10
Refrigerators 4 6
1) What is Slovenia’s opportunity cost of making microwaves?
2) What is Bohemia’s opportunity cost of making microwaves?
4/12 = 1/3
For every microwave, it must give up 1/3 of a Refrigerator.
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.
Slovenia Bohemia
Microwaves 12 10
Refrigerators 4 6
3) What is Slovenia’s opportunity cost of making refrigerators?
4) What is Bohemia’s opportunity cost of making refrigerators?
12/4 = 3
For every refrigerator, it must give up 3 of a microwaves.
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.
Slovenia Bohemia
Microwaves 12 10
Refrigerators 4 6
5) Which country has absolute advantage in microwaves?
6) Which country has absolute advantage in refrigerators?
Slovenia
12 Slovenia/10 Bohemia
Bohemia
6 Bohemia/4 Slovenia
Compare the following two countries and assume they only produce these two goods.
Slovenia Bohemia
Microwaves 12 10
Refrigerators 4 6
7) Which country has comparative advantage in microwaves?
8) Which country has absolute advantage in refrigerators?
Slovenia
1/3 Slovenia vs. 3/5 Bohemia
Bohemia
5/3 Bohemia vs 3 Slovenia
Compare the following two countries and assume they only produce these two goods.
Slovenia Bohemia
Microwaves 12 10
Refrigerators 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.
Slovenia Bohemia
Microwaves 12 10
Refrigerators 4 6
10) Use the law of comparative advantage to explain why self-sufficiency 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.
2) What is Charlie’s opportunity cost of cleaning the kitchen in terms of mowing the lawn?
60/30 = 2 Mowing 2 lawns.
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?
4) What is Charlie’s opportunity cost of mowing the lawn in terms of cleaning the kitchen?
30/60 = 1/2 Cleaning 1/2 kitchen
15/20 = 3/4 Cleaning 3/4 kitchen
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?
6) Who has absolute advantage in mowing lawns?
Charlie 20 minutes
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?
8) Who has comparative advantage in mowing lawns?
Charlie 4/3 to 2
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 SAMPLE AP TEST QUESTIONQUESTION
PricePrice
Quantity of Good X
D-D-MSBMSBMR
Marginal Social Cost
Marginal Private Cost
Q1 Q2 Q3Q1 Q2 Q3
13
12
7
4
0
Is this a Is this a negative or negative or
positive positive externality?externality?
NegativeNegative
Why?Why?
MSC > MSC > MPCMPC
The production of Good X creates an The production of Good X creates an externality.externality.
MR
PricePrice
Quantity of Good X
D-D-MSBMSBMR
Marginal Social Cost
Marginal Private Cost
Q1 Q2 Q3Q1 Q2 Q3
13
12
7
4
0
Identify the Identify the socially socially
optimum optimum output.output.
Q2Q2
Why?Why?
MSC=MSBMSC=MSB
The production of Good X creates an The production of Good X creates an externality.externality.
MR
PricePrice
Quantity of Good X
D-D-MSBMSBMR
Marginal Social Cost
Marginal Private Cost
Q1 Q2 Q3Q1 Q2 Q3
13
12
7
4
0
Identify the Identify the unregulated unregulated
firm’s output.firm’s output.
Q1Q1
Why?Why?
At Q1, MPC At Q1, MPC = MR= MR
Suppose that good X is produced by a Suppose that good X is produced by a profit-maximizing monopoly.profit-maximizing monopoly.
MR
PricePrice
Quantity of Good X
D-D-MSBMSB
MR
Marginal Social Cost
Marginal Private Cost
Q1 Q2 Q3Q1 Q2 Q3
13
12
7
4
0
How much will How much will it be?it be?
$3$3Why?Why?
Optimum Optimum Quantity at QQuantity at Q22
= MR= MR
To produce socially optimum To produce socially optimum output, should the government tax output, should the government tax
or subsidize the firm?or subsidize the firm?
subsidizesubsidize
Suppose that good X is produced by a Suppose that good X is produced by a profit-maximizing monopoly.profit-maximizing monopoly.
MR
PricePrice
Quantity of Good X
D-D-MSBMSBMR
Marginal Social Cost
Marginal Private Cost
Q1 Q2 Q3Q1 Q2 Q3
13
12
7
4
0
Why?Why?
D=MPC or D=MPC or MSB=MPCMSB=MPC
Identify equilibrium output in the Identify equilibrium output in the absence of regulation.absence of regulation.
Q3Q3
Suppose that good X is produced in a Suppose that good X is produced in a perfectly competitive industry.perfectly competitive industry.
PricePrice
Quantity of Good X
D-D-MSBMSBMR
Marginal Social Cost
Marginal Private Cost
Q1 Q2 Q3Q1 Q2 Q3
13
12
7
4
0
How much?How much?
$5$5
To produce at socially optimum To produce at socially optimum output, should the government tax output, should the government tax
or subsidize?or subsidize?
TaxTax
Suppose that good X is produced in a Suppose that good X is produced in a perfectly competitive industry.perfectly competitive industry.
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.
Single Firm Industry
Price
Price
Quantity
Quantity
S
D
P=D=MR=AR
MMCC
p
q Q
ATCATC
Economic Loss
S1
MR1=P1=AR1=D1
p1
Q1q1
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