Competitive Markets and Consumer Behavior: Lecture Notes - Prof. A. Marten, Study notes of Microeconomics

Download Competitive Markets and Consumer Behavior: Lecture Notes - Prof. A. Marten and more Study notes Microeconomics in PDF only on Docsity! Chapter 02 - Lecture Notes June 18, 2007 I. The competitive model A. Basic competitive model setup 1. Rational consumers 2. Profit-maximizing firms 3. Competitive markets 4. We ignore government for now, it will be introduced later B. Rational consumers 1. Scarcity of resources forces consumers to make choices 2. Economists assume that economic agents (consumers and firms) make choices rationally a. Make choices that benefit what they see as their own self-interest b. They weigh the cost and benefits associated with a choice and take the action if benefits > costs c. It is assumed that different people may have different interests 3. Economists do not judge people's preferences, but instead simply take them as given C. Profit-maximizing firms 1. A rational firm will act to maximize its profits 2. Profit = revenue - costs a. Revenue = pQ, where p = price and Q = quantity b. Therefore profit may be written as Profit = pQ - costs D. Information costs and a cause for mistaken irrationality 1. It is not uncommon for consumers and firms to make choices with incomplete (little or no) information a. This lack of information has the possibility to cause some decisions to appear irrational Ex. Is the car a lemon? Will the worker be productive? Will the investment be profitable? 2. Since information may be viewed like a good or service rationality requirements apply to it as well a. If the benefit of the additional information > cost of acquiring it the agent will obtain the information Ex. If one was looking to buy a used car for $2,000 and a Carfax vehicle history report cost $1,000 would the information be worth paying for? How about if the report cost $10. E. Competitive Markets 1. Defining assumptions of a competitive market a. Many firms sell identical products to many consumers b. Firms and consumers are price takers, that is they may not affect the market price with their individual actions c. Firms produce as much output as the consumers will purchase d. Each firm may sell as much as it wants, this implies that the firm is small compared to the size of the market e. If a firm charges a price higher than the market price they will lose all of their customers i. Therefore, all firms in an industry charge the same market price F. How do we know the model works and why do we want to model markets 1. The competitive market combines self-interested (rational) consumers, profit-maximizing (rational) firms, and competition 2. One may test the model by comparing its predictions with what happens in actual markets 3. Economists believe that the model can answer the following four key questions a. What is produced and in what quantities? b. How are goods produced? c. For whom are goods produced? d. Who decides the answers to the first three questions and how? 4. Notice that the government is not needed to answer these key economic questions G. Efficiency and the basic competitive model 1. The model is setup to be efficient, meaning that it satisfies the following three conditions a. Scarce resources are not wasted b. More of one good can not be produced without producing less of another good c. The model is Pareto efficient i. Pareto efficient means that it is not possible to make any one person better off without making at least one other person worse off no CDs or some combination between a. Let the price of pizza fall to $10, Alice's budget constraint rotates outward along the pizza axis (x axis) i. The new budget constraint is flatter than the previous one because pizza is now relatively cheaper ii. It is also farther from the origin that her previous budget constraint. The lower price for pizza has increased her purchasing power, and her opportunity set has expanded C. Time Constraint 1. We can do the same type of analysis with a time constraint Ex. Consider a college student, that after sleeping, eating, studying, and attending classes has 8 hours a day of free time. With this time the student chooses to either listen to music or watch movies. Assume that it takes 1 hour to listen to a CD and 2 hours to watch a movie. a. The student can listen to 8 CDs and watch no movies or watch 4 movies and listen to no CDs or some combination between D. Budget and time constraints are examples of trade-offs in that by choosing more of one good or activity, one must give up something else E. Production possibilities curve (PPC) 1. The PPC is a method of viewing the constraints faced by producers a. With a given quantity of inputs, a firm can only produce certain quantities of goods b. The boundary of what can be produced is the PPC Ex. Consider a firm that produces wheat and corn. The farm has two fields one of which is only able to produce wheat and the other which can only produce corn. Given that the firm only has a limited amount of workers it must choose how many are allocated to each field. Those combinations of wheat and corn production that are possible are described by the production possibilities curve 2. The PPC is typically convex a. This is due to the diminishing returns of workers on the farm. The first worker on a field will be able to improve the production much more than the tenth worker on the field 3. Efficiency and the PPC a. At any point withing the curve a firm can increase its production of both goods by moving out to the curve i. Therefore, points in the interior of the opportunity set are inefficient, resources are unemployed ii. A rational society will produce on the curve iii. The optimal production mix is always on the curve V. Costs A. Opportunity cost 1. The opportunity cost is the value of the next best alternative when one makes a choice 2. In the case of the budget and time constraints the opportunity cost of one item is described in terms of the other item Ex. The cost of college is not only the tuition, room and board, and books, but also the forgone earnings from working for four years which is the opportunity cost B. Sunk cost 1. Sunk costs are expenditures that the agent are unable to recover 2. Since sunk costs are already lost they play no role in deciding whether to continue an activity 3. Setup costs are sunk costs (Ex. An activation fee for a cellphone plan) C. Marginal cost 1. Marginal costs are those associated with consuming or producing one additional unit Ex. The marginal cost for one additional month of cellphone coverage would be the monthly price of the plan