AP Microeconomics REVIEW

1
Hints for passing the
AP Microeconomics REVIEW
Ms. Meachum
2
Topics MCMR Perfect competition MR
PARD Indeterminant Sample (capital, capital
stock, capital flow) Economic profit Elasticity Sh
ort-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
3
SHOW ME! GRAPH ME! ANALYZE ME! EXPLAIN ME!
4
MC MR
Tattoo this on your forehead
This equation comes in many forms MCMR,
MCMU, MSCMSB...etc
5
PERFECT COMPETITION
MC
Price
Price
S
ATC
p
P
DMRAR
AVC
D
Q
q
Quantity
Quantity
Single Farmer
Industry
Perfect Competition--MUST use SIDE-BY-SIDE GRAPHS
or no credit.
6
PERFECT COMPETITION
MC
Price
Price
S
ATC
p
MRPARD
AVC
D
Q
q
Quantity
Quantity
Single Farmer
Industry
In perfect competition, individual firms are
price takers and will take the market price.
Hint memorize this line for the AP test.
7
PERFECT COMPETITION
MC
Price
Price
S
ATC
p
MRPARD
Economic Profit
AVC
D
Quantity
Quantity
Q
q
Single Farmer
Industry
MUST show Economic Profit or Loss
MAKE SURE THEY SEE A GAP between profit line and
ATC
8
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
9
MC
Price
Price
S
S1
ATC
p
DMRARP
p1
MR1P1AR1D1
D
0
q
Q
Q1
q1
Quantity
Quantity
Single Firm
Industry
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
Industry Q goes up to Q1
Firms q go down (q to q1)
ATC MR PARD at its lowest point
10
MC
Price
Price
S
ATC
p1
P
Economic Loss
DMRAR
D
Quantity
Quantity
q
Q
Single Firm
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.
11
S1
MC
P
P
S
ATC
MR1P1AR1D1
p1
Economic Loss
p
PDMRAR
D
Q
Q
q
Q
Q1
q1
Single Firm
Industry
Because the firm is a price taker and must take
the market price, Industry P and Firm p goes up
to p1
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.
Industry Q goes down to Q1
Firms q go up (q to q1)
ATC MR PARD at its lowest point
12
A graph is worth a thousand words UNLESS you
forget to label it..
GRAPH FIRST, then let the graph tell the
storyLABEL, LABEL, LABEL
13
GET TO THE POINT!!!
JUST THINK ECONOMICALLY Good decisions using
cost-benefit analysis and marginal thinking.
14
Chart V (D S )
S
S1
PRICE
Price will be indeterminate.
E1
E0
P0
D1
Be sure to use the word indeterminatewhen
describing price in this graph!!
Quantity will increase
D0
Q0
Q1
QUANTITY
If you see the words long-run, need to double
shift.
15
Make it easy for the reader to grade!! Number
your responses. ANSWER THE QUESTION clearly and
concisely.
16
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.
17
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).
18
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)
19
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 students
response is as follows
20
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.
21
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.
NOT MONEY
The answer assumed (incorrectly) that output
changed.
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.
22
Economic Profit total revenue minus all the
opportunity costs (implicit explicit) of
production.
Accounting Profit total revenue minus explicit
costs
Economic Profit
Accounting Profit
Implicit Costs
Total Opportunity Costs
Revenue
Revenue
Explicit Cost
Explicit Cost
23
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.
24
Elastic Demand and Total Revenue
At point A, total revenue is 400 (10 x 40), or
area a b.
P
At point B, the total revenue is 500 (5 x 100),
or area b c.
Total revenue has increased by 100.
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 gt a.
10 5
a
B
c
b
Delastic
Q
0 20 40 60 80 100
25
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.
P
Total revenue has decreased by 100.
A
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 gt c.
10 5
a
B
c
b
Dinelastic
Q
0 10 20 30 40
26
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.
P1
PRICE
P0
D1
Relatively elastic
D0
Relatively inelastic
0
Q0
Q1
Q2
QUANTITY
27
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.
28
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
29
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.
30
ATC in short run w/medium factory
ATC in short run w/small factory
ATC in short run w/large factory
ATC in long run
Average Total Cost
12,000 10,000
Economies of Scale
Diseconomies of Scale
Constant Returns to Scale
Mankiw
0
1,000 1,200
Quantity of Cars per day

• CAUSES of economies or diseconomies of scale
• Specialization of workers will be found in higher
  production levels of economies of scale.

31
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).
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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 isnt 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)
33
CHANGE IN DEMAND vs CHANGE IN QUANTITY DEMANDED
34
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
35
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
E0
P0
P1
E1
D2
D0
D1
QUANTITY
Q0
Q1
Q2
36
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 70 60 50 40 30 20 10 0
P RI CE
D (demand)
100 200 300 400 500 600
QUANTITY
37
Changes in Quantity Demanded
Price of Ice-Cream Cones
A tax that raises the price of ice-cream cones
results in a movement along the demand curve.
A
1.00
D
0
8
Quantity of Ice-Cream Cones
38
CHANGE IN SUPPLY vs CHANGE IN QUANTITY SUPPLIED
39
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.
40
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
S0
S1
E2
P RI CE
P2
P0
E0
P1
E1
D
Q2
Q0
Q1
QUANTITY
41
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 70 60 50 40 30 20 10 0
P RI CE
100 200 300 400 500 600
QUANTITY
42
Change in Quantity Supplied
Price of Ice-Cream Cone
S
C
A rise in the price of ice cream cones results in
a movement along the supply curve.
A
1.00
Quantity of Ice-Cream Cones
1
5
0
43
DEMAND vs. DERIVED DEMAND (and other factor
market problems)
44
LABELING IMPORTANT IN LABOR MARKET!!
MUST indicate demand for labor not just D and
supply of labor not just S.
Price
WAGES
S
SL
P2 P1
W2 W1
DL2
D2
DL
D1
Quantity
Q1 Q2
Quantity of Labor
L1 L2
Product Market
Resource Market
45
There is an increase in demand for a good or
service in the product market, which results in
an increase in P and Q.
Price
Price
S
SL
P2 P1
P2 P1
D2
DL
D1
Quantity
Q1 Q2
Quantity
Q1 Q2
Resource Market
Product Market
46
There is a DERIVED DEMAND in the resource market
for labor that produces the good or service.
Price
S
Wages
SL
P2 P1
W2 W1
DL2
D2
DL
D1
Quantity
Q1 Q2
Quantity of Labor
QL1 QL2
Resource Market
Product Market
47
Because Q increased in the product market, the
DERIVED DEMAND in the resource market for labor
also increases.
Price
WAGES
S
SL
P2 P1
W2 W1
DL2
D2
DL1
D1
Quantity
Q1 Q2
Quantity of Labor
L1 L2
Product Market
Resource Market
48
This causes the WAGE RATE to increase (W1 to W2)
and quantity of labor to increase (L1 to L2)
Price
WAGES
S
S
P2 P1
W2 W1
DL2
D2
DL
D1
Quantity
Q1 Q2
Quantity of Labor
L1 L2
Product Market
Resource Market
49
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.
50
IMPORTANT In the resource market S MFC
(marginal factor cost) and D MRP (marginal
revenue product).
Price
Wage
S
S
MFC
W1 W
MRP1
D1
D1
D
MRP
D
Quantity
L L1
Quantity
Resource Market
Product Market
51
MARGINAL 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 COST is the change in total
cost resulting from the use of one additional
unit of a resource, or MRC --------------------
-
TC (resource)
Q (resource)
52
The profit maximizing rule for employing
resources is MRP MRC
53
A firm can maximize TP by hiring the workers at
MRP of labor MFC of labor.
Hire labor MRP gt MFC, stopping with the unit for
which MRP MFC. Do not hire any MRP lt MFC.
Wages
S
MFC
W
MRP
D
Quantity of Labor
L
Resource Market
54
In this perfectly competitive market, how many
workers would be employed if wages were
Workers Output MPP Price TR
MRP
13.95
0 0 2 1 7 2 2 13
2 3 18 2 4 22 2 5 25
2 6 27 2 7 28 2
0 14 26 36 44 50 54 56
- 14 - 12 - 10 - 8 - 6 - 4 - 2
- 7 - 6 - 5 - 4 - 3 - 2 - 1
1
11.95
2
9.95
3
7.95
4
55
In this imperfectly competitive market, how many
workers would be employed if wages were
13.95
Workers Output MPP Price
TR MRP
1
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
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
- 7 - 6 - 5 - 4 - 3 - 2 - 1
11.95
2
9.95
2
7.95
3
56
REMINDER in any firm
MC
P
ATC
p
AVC
P
Q
q
Single Farmer
SHUTDOWN if P lt AVC if TR lt VC if
TR/Q lt VC/Q
57
Things have prices...
Decisions have costs..
58
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.
59
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.
60
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.
61
Preparing for 2006 Efficiency welfare economy.
Consumer Surplus Producer Surplus Deadweight Loss
62
What happens when prices are fixed by the
government?
Lets look at a graph which shows the average
consumption of beer in the United States.
63
S
In this example, the average beers consumed per
week is 6
4 3 2 1
E
at an average price of 2.50.
D
0 1 2 3 4 5 6 7
Beers per week
Ge
64
This chart illustrates the effects upon people if
they were forced to go from Ge to zero.
S
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.
4 3 2 1
E
D
0 1 2 3 4 5 6 7
Beers per week
Ge
65
The 9th beer is worth to people what it is worth
to people. It is different for everybody.
66
S
From the suppliers standpoint, they could supply
at a lower price but they CAN get more. This is
called PRODUCER SURPLUS.
4 3 2 1
E
D
0 1 2 3 4 5 6 7
Beers per week
Ge
67
The colored area is the total value to society of
the cost of 6 beers.
S
4 3 2 1
Consumer Surplus
E
Producer Surplus
D
0 1 2 3 4 5 6 7
Beers per week
Ge
68
What if government mandate limited the maximum
price of a beer to 1.00?
However, suppliers would not want to produce as
much beer.
S
4 3 2 1
NOTE Another example of this is the price
ceiling on gasoline during the Nixon
administration.
E
Consumers would want to buy more beer.
D
0 1 2 3 4 5 6 7
10
Beers per week
Ge
69
REMEMBER Producers will not want to produce for
low prices.
S
If government limited the maximum price of a
beer to 1.00, it would create a shortage.
4 3 2 1
E
shortage
D
0 1 2 3 4 5 6 7
Beers per week
Ge
70
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.
71
Politically popular ideas include -- minimums
on inputs (wages). -- maximums on outputs
(prices/rent control).
When POLITICS vs. ECONOMICS gt Politics always
wins
72
A price ceiling keeps the market from reaching
equilibrium.
The government mandating the maximum price of a
beer is called a PRICE CEILING.
S
4 3 2 1
E
shortage
D
0 1 2 3 4 5 6 7
Beers per week
Ge
73
The shortage created from the price ceiling will
result in increased demand.
S
4 3 2 1
NOTE Another example of a price ceiling is rent
control.
E
shortage
D
0 1 2 3 4 5 6 7
X
Beers per week
Ge
74
What if government mandate limited the maximum
number of beers one could drink to 4 per week?
Government Mandated Supply
S
4 3 2 1
Four beers is not enough (too little,
inefficient) .This is called DEADWEIGHT loss.
E
D
0 1 2 3 4 5 6 7
Beers per week
Ge
75
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.
76
When the government mandates a the minimum price
of something, it is called a PRICE FLOOR.
S
5 4 3 2 1
NOTE The minimum wage is an example of a price
floor.
E
D
Labor
0 1 2 3 4 5 6 7
Ge
77
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)
S
5 4 3 2 1
SURPLUS
E
Creating a SURPLUS of labor.
D
Labor
0 1 2 3 4 5 6 7
Ge
78
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.

79
Easy to show overall

• Costs gt return of benefits
• Total welfare higher gt those working incur
  higher costs
• Output will fall gt fewer people working

80
Extreme case What would happen if the government
raised the minimum wage to 100 an hour?
81
Even though water is essential for life and
diamonds are not, water is cheap and diamonds are
expensive? Why?
82
It has to do with the elasticity of the supply
curve and the amount of consumer/producer surplus
With DIAMONDS, supply is very inelastic.
With WATER, supply is very elastic.
S
Consumer Surplus
P
Price
Price
Producer Surplus
S
P
D
D
Q
Q
Quantity
Quantity
83
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 demand curve is out!!
84
Game Theory can be illustrated by what is called
THE PRISONERS 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.
85
Each prisoner has two strategies, confess or
remain silent. However, the sentence that each
gets depends upon the actions of the other.
Bonnies Decision
confess
Remain silent
Bonnie - 20 yrs Clyde goes free
confess
8 years each
Clydes Decision
Bonnie goes free Clyde - 20 yrs.
Remain silent
1 year each
86
OR you can use the PAYOFF MATRIX
B 8 years C 8 years
confess
Clydes Decison
Remain silent
confess
B free C 20 years
Bonnies Decison
Remain silent
B 20 years C free
confess
Clydes Decison
Remain silent
B 1 year C 1 year
87
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.
Iraqs Decision
High prod.
Low prod.
Iraq - 30 billion Iran - 60 billion
40 billion each
High prod.
Irans Decision
Iraq - 60 billion Iran - 30 billion
Low prod.
50 billion each
88
It can be used in the arms race...
U.S.s Decision
Arm.
Disarm
US at risk USSR safe
Both at risk
Arm
USSRs Decision
US safe USSR at risk
Disarm
Both safe
89
It can be used in the everyday economic
decisionsConsider 2 firms which must decide
whether to make a new product or not.
Firm 1
Yes
No
Firm 1 1.5m Firm 2 1.5m
Firm 1 0 Firm 2 2m
Yes
Firm 2
Firm 1 2m Firm 2 0
No
Firm 1 0 Firm 2 0
90
GAME THEORY

• Prisoners' Dilemma
• Battle of the Sexes
• Dominant Strategies
• Nash Equilibria

By David Anderson, PhD Centre College, Danville,
KY
91
The Payoff Matrix
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
92
The Payoff Matrix
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
93
The Payoff Matrix
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
94
The Payoff Matrix
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
95
The Payoff Matrix
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
96
The Circle Trick
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
97
The Circle Trick
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
98
The Circle Trick
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
99
The Circle Trick
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
100
Chris has a Dominant StrategyThe Confess
strategy is best regardless of Pats move.
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
101
Checking Pats Options
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
102
Checking Pats Options
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
103
Checking Pats Options
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
104
Checking Pats Options
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
105
Pat has a dominant strategy Confess
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
106
Nash Equilibrium Neither side has a desire to
switch strategies given what the other is doing.
Pat
Confess Deny
Confess 5, 5 1,10
Deny 10, 1 2, 2
Chris
David Anderson, PhD
107
Battle of the Sexes
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
108
John Analyses the Possibilities
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
109
John Analyses the Possibilities
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
110
John Analyses the Possibilities
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
111
John Analyses the Possibilities
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
112
Sarah Analyses the Possibilities
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
113
Sarah Analyses the Possibilities
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
114
Sarah Analyses the Possibilities
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
115
Sarah Analyses the Possibilities
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
116
Two Nash Equilibria, No Dominant Strategies
Sarah
Rally Town Hall
Rally 20, 30 9, 4
Town Hall 10, 16 40, 27
John
David Anderson, PhD
117
Chicken
Sarah
Straight Swerve
Straight -10,-10 5, -5
Swerve -5, 5 0, 0
John
David Anderson, PhD
118
COMPARATIVE ADVANTAGE
119
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.
120
Lets 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?
Lets take a look at the Production Possibilities
curve for each person.
Adams PPC
Eves PPC
Quantity of apples 30
9 0
Quantity of apples
20 8
Adams consumption without trade
Eves consumption without trade
28 40 Quantity of Fish
Quantity of Fish
0 6 10
121
The slope of Adams line is -3/4. That is for
every 4 additional fish that Adam chooses to
catch, he gathers 3 fewer apples.
The slope of Eves line is -2. Eve is less
productive the most she can produce is 10 fish
or 20 apples. She is particularly bad at fishing.
Eves PPC
Adams PPC
Quantity of apples 30
9 0
Quantity of apples
20 8
Adams consumption without trade
Eves consumption without trade
28 40 Quantity of Fish
Quantity of Fish
0 6 10
122
Adam Eves Opportunity Cost Adams Opp
Cost Eves Opp Cost One fish 3/4 apple
2 apples One apple 4/3 fish 1/2
fish
Eves PPC
Adams PPC
Quantity of apples 30
9 0
Quantity of apples
20 8
Adams consumption without trade
Eves consumption without trade
28 40 Quantity of Fish
Quantity of Fish
0 6 10
123
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 heres 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.
124
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 4 6

1. What is Slovenias opportunity cost of making
   microwaves?
2. What is Bohemias 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
125
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 4 6

• 3) What is Slovenias opportunity cost of making
  refrigerators?
• 4) What is Bohemias 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.
126
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 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
127
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 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
128
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 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.
129
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 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.
130
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 Karens opportunity cost of cleaning the
   kitchen in terms of mowing the lawn.
2. What is Charlies 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.
131
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 Karens opportunity cost of mowing the
  lawn in terms of cleaning the kitchen?
• 4) What is Charlies 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
132
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
133
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
134
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.
135
SAMPLE AP TEST QUESTION
136
The production of Good X creates an externality.
Is this a negative or positive externality?
Price
Marginal Social Cost
13 12 7 4 0
Negative
Marginal Private Cost
Why?
MSC gt MPC
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
MR
137
The production of Good X creates an externality.
Price
Identify the socially optimum output.
Marginal Social Cost
13 12 7 4 0
Q2
Marginal Private Cost
Why?
MSCMSB
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
MR
138
Suppose that good X is produced by a
profit-maximizing monopoly.
Identify the unregulated firms output.
Price
Q1
Marginal Social Cost
13 12 7 4 0
Why?
Marginal Private Cost
At Q1, MPC MR
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
MR
139
Suppose that good X is produced by a
profit-maximizing monopoly.
To produce socially optimum output, should the
government tax or subsidize the firm?
Price
subsidize
Marginal Social Cost
13 12 7 4 0
How much will it be?
Marginal Private Cost
3
Why?
D-MSB
Optimum Quantity at Q2 MR
MR
Quantity of Good X
Q1 Q2 Q3
MR
140
Suppose that good X is produced in a perfectly
competitive industry.
Identify equilibrium output in the absence of
regulation.
Price
Q3
Marginal Social Cost
13 12 7 4 0
Why?
DMPC or MSBMPC
Marginal Private Cost
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
141
Suppose that good X is produced in a perfectly
competitive industry.
To produce at socially optimum output, should the
government tax or subsidize?
Price
Tax
Marginal Social Cost
13 12 7 4 0
How much?
5
Marginal Private Cost
D-MSB
MR
Quantity of Good X
Q1 Q2 Q3
142
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.
143
HINTS for taking THE AP MICROECONOMICS EXAM
144

• Pay attention to the instruction words.
• Identify, state, list, define Dont explain
  the logical sequence.
• Explain and discuss Explain the logical
  sequence, the linkages. Graphs can be the
  explanation at times.
• v Draw and show Draw a graph or diagram, label
  with care.

145

• Use abbreviations!
• MRMC, P and Q, ?, ATC, AVC, PMRd, MCS or MSC,
  ?, ?, etc., etc., etc.
• v 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.

146

• 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.
• v Use the 10-minute planning time to script out
  answers on the green question pages of the FRQ
  exam.

147

• When writing . . .
• May answer questions in any order.
• v Do not restate question. It is a waste of
  time.

148
Draw graphs well-labeled.
S1
MC
Price
Price
S
ATC
MR1P1AR1D1
p1
Economic Loss
p
PDMRAR
D
Quantity
Quantity
q
Q
Q1
q1
Single Firm
Industry
149
MISTAKES MADE ON THE AP MICROECONOMICS EXAM
150
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

151
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)

152
MICROECONOMIC MISTAKES

• Confusing the different types of efficiency
  economic efficiency PMCATC, allocative
  efficiency PMC, productive efficiency PATC
• 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