IO Ch. 2

Review of Microeconomics

Demand

Willingness to pay (marginal benefit) creates the downward sloping demand curve. How much will you be willing to pay for each subsequent item of a good? q will be determined where p=MB

The area between the Demand curve and the price represents Consumer surplus (CS). The slope of the demand curve determines demand elasticity

Supply

Costs determine the supply curve. In particular, marginal costs, although you may recall that economists distinguish between fixed, variable and total, as well as average and marginal costs. In addition, they differentiate between long and short run costs. Under perfect competition q will be determined where p=MC. As such MB=MC will also be the case. (More generally firms will have to cover their average costs, and those costs determine whether the firm stays in business.)

Remember also the concepts of opportunity and sunk costs.

So does the cost structure vary for different industries? How do the costs of an airline company compare with those of an accountant?

Economy of scale means that average cost declines with output. Diseconomies means that average costs increase with output. Both may be the case. Can you think of a product that enjoys economies of scale, versus one which might experience diseconomies? electricity (any natural monopoly) and restaurant food.

Minimum efficient scale refers to a minimum production size. What do you think the minimum production size for Boeing is as opposed to frozen peas or dress shirts?

Economies of scope refers to items which might be complimentary in production. In other words it may cheaper to produce frozen peas and carrots in the same plant than to set up two plants.

Economists generally assume that firm's objective is maximizing profit. Under perfect competition, firms cannot set price, so they simply take p and set it to their MC and that determines q. If firms have market power, then they set MR=MC (this is also the case for PC, but p=MR). In this case the elasticity of demand becomes important.