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Microeconomics Test Review I: How Demand and Supply Affect Profit
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I. How Elasticity of Demand Affects Total Revenue from  19) Elasticity of Demand Affects Total Revenue
    A. Elasticity of demand measures the responsiveness of quantity demanded 
         to changes in price, income, and the price of related goods.
    B. Price elasticity of demand measures the effect of price changes on  quantity demanded. 
    C. Coefficient of elasticity of demand for product x measures its price elasticity.  

      D. Interpreting Elasticity of demand  





Relative Change 
in Quantity


E Parameters

None, will pay anything, numerator is  zero.

Perfectly Inelastic

E = 0

E . Summary Elasticity of Demand and Total Revenue



0 < ED < 1


When Price Increases

Total Revenue

Q demanded and P change same percentage

Unitary Elasticity

ED = 1

ED   >1


Quantity Changing a Lot so you could lose lots of money.





1 < E <

ED = 1


Quantity/Price Changing Same %

no change

Infinitely Large, price doesn't change, denominator is zero

Perfectly Elastic

E is undefined, can't divide by zero.

ED <1

Somewhat Inelastic

Quantity Doesn't Change Much, so you could make lots of money


II. Consumer Behavior and Demand Theory Source Chapter 20 
     A. Satisfaction received and limited budgets determine 
        consumer demand.
     B. Utility measures the want-satisfying power of a good
          or service.
     C. Marginal utility is the additional or incremental 
          satisfaction (utility) a consumer  receives from acquiring
          one additional
unit of a product.
     D. Law of diminishing marginal utility: Consuming more of
product within a given period will at some point result in  
          diminishing marginal utility. 
Utility maximizing rule: When spending a limited amount
         of money, consumers try to equate the marginal utility per
          dollar for the items being purchased.
     F. Consumer's surplus
          1. All goods are purchased at an equilibrium price. 
          2. Because consumers would have paid more for smaller
             quantities purchased, they are said to receive a surplus.  

      I. Understand cost  of production is necessary to understand



 G.  Normal Goods, consumers buy more as income
       rises, Inferior Goods, buy less.
H. Consumer's and Producer's Surplus: 
Allocation efficiency exists at the equilibrium
    quantity and at other quantities, there are 
    efficiency  losses or Deadweight Loss
III. How Cost of Production Affects Supply chapter 21, is our source.  
     A. Understanding costs
          1. Costs are the dollars paid for the factors of production.
          2. Opportunity cost is the value of the best alternate use, e.g., the cost of labor is the value that could have been  
              received from using capital.  
          3. Explicit costs versus implicit costs
              a. Explicit costs require an out-of-pocket expenditure, e.g., wages, materials, and overhead.
              b. Implicit costs do not require an outlay, e.g., forgone wages for uncompensated efforts by family members in
                  a family-operated business, included a normal return on investment, which is the minimum
amount required
                  to keep resources employed at their current use.
          4. Short run costs are both fixed and variable, in the long run, all costs are variable
              a. Fixed costs do not vary with production, e.g., plant and equipment, property taxes, most overhead, etc.
              b. Variable costs vary directly with production, e.g., labor and materials 
              c. Marginal cost is the change in total costs which results from making one more unit.
          5. Diminishing returns:  
              a. Adding a variable resource (labor) to a fixed resource (capital) will increase production for a while.
              b. At some point the rate of increase declines and eventually becomes negative. 
              c. Diminishing returns affect both the production of labor and cost of production.
              d. Example: Using three people to do the dishes didn't make sense because the third person just got in the way.
                  Mom did agree so she relaxed.
   B. Accounting profits versus economic profits
         1.  Accounting profit is revenue minus explicit costs and economic profit is revenue minus explicit plus implicit costs.
         3  Since implicit cost includes a payment for the risk factor part of  interest and payment for entrepreneurial skill.
         4. This means Normal Profit is a cost  to economists and paid for as an explicit cost, in the long run competition 
             causes economic profit to be zero.

In analyzing profit, average cost data is
 often used.

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Total product of labor (TPL) measures total production occurring as more workers are added to a production process containing fixed resources.
Marginal product of labor
measures the change in the TPL which occurs as more workers are added to a production process containing fixed resources.
Average product of labor
measures the average production of all workers as additional workers are added to a production process containing fixed resources.
Note: MPL should be plotted at the mid-point on the x-axis.

Stage 1 Increasing marginal returns to scale (getting bigger)
because of worker specialization.

Stage 2 Decrease marginal returns to scale because of fixed resources.
Stage 3 Negative marginal returns to scale because workers are in the way of each other.

Note that AV is the mirror image of AP and MC is the mirror image of MP.


At low quantities MP is above AP so AP is rising. As MP starts to fall AP flattens but continues to rise because MP is still higher. When MP drops below AP, AP immediately begins to decrease indicating the intersection must be AP's highest point.

At low quantities MC is below AVC so AVC is falling. As MC starts to rise AVC flattens but continues to decrease because MC is still lower. When MC rises above AVC, AVC immediately begins to rise indicating the intersection must be AVC's lowest point.

IV. Understanding Profit chapter 22, is our source.
     A. Profit equals total revenue minus total costs.
B. Understanding profit requires bringing revenue and costs together.
C. Demand determines marginal revenue.
          1. Marginal revenue (MR) is the change in total revenue which is 
              received from selling one more unit.
          2. Demand may be thought of as average revenue with what is happening 
             on the margin an indication of what is happening to the average.
         3. When product demand is downsloping, marginal revenue is below 
             demand indicating the average
         4. The special case of horizontal  perfectly elastic demand will be explored
             in chapter 23.


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Maximizing profit using marginal analysis

Maximizing profit using total analysis of revenue and cost



Economies and diseconomies of scale  
affect profit

Long-run costs Long-run average total costs are the horizontal summation of ever larger short-run average total costs.


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Economics Macro Review 2.htm

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