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ECO 2013 - Principles of Microeconomics

Frequently Asked Questions

  1. Isn't Economics a business subject like Marketing, Management, or Accounting?
  2. Isn't an item scarce simply because there is a limited amount of it?
  3. Isn't an item scarce only if people can't buy as much of it as they want?
  4. Does a country have a comparative advantage in producing a product if it can produce more of that product than another country can?
  5. Why does Economics teach that free (or, unrestricted) trade with other nations is generally a good idea?
  6. Doesn't a shortage or a product simply indicate that there is too little of it while a surplus indicates that there is too much?
  7. What is the difference between a change in demand (or supply) and a change in quantity demanded (or quantity supplied)?
  8. Doesn't a price increase always lead to a rise in a company's total revenue?
  9. Why is price elasticity of demand important?
  10. Doesn't an inelastic demand imply that people don't respond to a change in price?
  11. If you sell a product you company produces to a friend for "cost" (i.e., your out-of-pocket expense), didn't you simply break even on the deal?
  12. Why is considering implicit costs as well as explicit costs important?
  13. What is the difference between accounting profit and economic profit?
  14. If “profit” and “loss” opposites, how can it be profitable for a company to sell a product at a loss?
  15. Why must marginal revenue equal marginal cost (MR = MC) in order for a firm to maximize its profit?
  16. Isn't a market competitive so long as there are at least two firms that compete with one another?
  17. If a company accounts for a very large share of its market, isn't it a monopoly?
  18. Can't a monopolist charge as high a price as it wants since it has no rivals?
  19. If a company has market power and experiences an increase in its cost, can't it maintain its profits simply by passing all of the cost increase on to its customers by raising the price by the same amount as its cost rose?
  20. Why can't monopolistically competitive firms, which have market power due to their selling differentiated products, earn an economic profit in the long run?
  21. Many cartels have existed for a long time and yet Economics teaches that cartels are generally unstable.How can this seeming contradiction be reconciled?
  22. What do economists do?
  23. What do economists do for a living?
  1. Isn't Economics a business subject like Marketing, Management, or Accounting?
    No, Economics is a social science, as are Political Science and Sociology for example, because it focuses on a facet of how we relate to one another, especially in terms of how we use our resources.
  2. Isn't an item scarce simply because there is a limited amount of it?
    No, scarcity reflects the relationship between an item's availability and its desirability.For example, there are likely very few one-legged chickens in the world, but they aren't scarce because doubtless no one wants any.
  3. Isn't an item scarce only if people can't buy as much of it as they want?
    No, if people can't buy as much of an item as they want, this means there is a shortage of the item, and a shortage exists only if the item's price is below its equilibrium (or market-cleaning) price.By contrast, an item is scarce if people want more of it for free (without cost or sacrifice) than is available.
  4. Does a country have a comparative advantage in producing a product if it can produce more of that product than another country can?
    No, "comparative advantage" means relative advantage.A country only has a comparative advantage if it is relatively (or more) better (not simply better) at producing a product than is another country; in other words, it must be better to a greater extent at producing one product vs. another.[Please don't tell your English professor about the use of the double comparative ("more better").]
  5. Why does Economics teach that free (or, unrestricted) trade with other nations is generally a good idea?
    This is basically because we can only gain from specialization, which enables us to produce more output, if we also trade with one another.The reverse of specialization coupled with trade is self-reliance – would you want to live in a world in which you and everyone else had to rely solely on himself or herself for food, clothing, shelter, health care, transportation, entertainment, etc.?!
  6. Doesn't a shortage or a product simply indicate that there is too little of it while a surplus indicates that there is too much?
    No.In fact shortages and surpluses aren't physical phenomena, they are pricing phenomena.They reflect the fact that the actual price of a product is different from the equilibrium price (a shortage exists if a product's actual price is below equilibrium and surplus exists if the going price is above equilibrium).Shortages and surpluses can be eliminated by allowing the price to move to equilibrium.
  7. What is the difference between a change in demand (or supply) and a change in quantity demanded (or quantity supplied)?
    This is a very important distinction with which many students struggle, in part at least because we are accustomed in everyday conversation to using the words “demand” or “supply” to refer to a specific amount of a product, and this is not how the words are used in Economics.In Economics, these words refer to buyers' or seller's intentions about how much they are willing to buy or sell at various prices (all else equal).When we refer to a specific amount of a product buyers want to buy or sellers want to sell at a specific price, we use the terms quantity demand or quantity supplied (after all, “quantity” refers to an amount).The distinction is important because failing to understand it leads to making inaccurate predictions.For example, one might think that an increase in the supply of gasoline, which would reduce the price of gas, would cause an increase in the demand for gas that would then raise it price.In fact, the increase in supply, which would lower the price, would raise the quantity demanded (not demand) of gas, and there would be no subsequent increase in its price (otherwise, we'd be suggesting that a fall in the price causes a rise in the price, which is nonsense).
  8. Doesn't a price increase always lead to a rise in a company's total revenue?
    No, while this could be the effect, it isn't necessarily the effect.This is because a price increase is accompanied by a decrease in quantity demanded (from the Law of Demand).Recalling that total revenue is computed by multiplying price times quantity, while the increase in price would tend to increase revenue, the decrease in quantity would tend to decrease revenue.Therefore, the net impact on total revenue depends on which change (the one in price or the one in quantity) is relatively larger.This is why the concept of price elasticity of demand is useful, because it enables us to know which change is relatively greater.
  9. Why is price elasticity of demand important?
    It is important because it enables us to predict the impact of a price change on a company's total revenue.This is so because of two facts.One, total revenue is computed by multiplying the product's price times the quantity of it that is sold (TR = P x Q).And two, the Law of Demand holds that price and quantity vary negatively (or inversely).The upshot of these considerations is that a change in price causes an opposite change in quantity, which in turns puts two opposing influences on the resulting change in total revenue (this is akin to a tug-of-war in which two groups of people are pulling in opposite directions on a rope, and the direction in which the rope moves depends on which group is pulling harder).Thus, the direction in which TR changes depends both on the directions in which price and quantity are each changing and on which of these two opposite changes is relatively larger.This is the point at which price elasticity of demand (Ed) comes in.First, recall that Ed=%DQ / %DP.Now recall that basically demand can be price elastic (in which case |Ed| > 1, meaning that %DQ > %DP) or price inelastic (in which case |Ed| < 1, meaning that %DQ < %DP).The result of this is that a change in price will cause total revenue to change in the same direction as quantity if demand is elastic (because the change in quantity is relatively larger than the change in price, so that Q “wins” the tug-of-war) and in the same direction as price if demand is inelastic (because the change in price is relatively larger than the change in quantity, so that P “wins” the tug-of-war).
  10. Doesn't an inelastic demand imply that people don't respond to a change in price?
    No, it only means that the accompanying change in quantity demanded is relatively smaller than the change in price (rather than implying that quantity demand does not change at all, as the Law of Demand indicates that it will).
  11. If you sell a product you company produces to a friend for "cost" (i.e., your out-of-pocket expense), didn't you simply break even on the deal?
    No, because you presumably could have sold the product to a customer for more than your out-of-pocket expenses (you are in business to make a profit, aren’t you?). Thus, you lost the difference between what you could have sold the product for and what you charged your friend (of course, the friendship might be worth it to you, which is fine provided understand that you lost money).
  12. Why is considering implicit costs as well as explicit costs important?
    Basically, this is because failing to take implicit costs into account can lead to making irrational decisions.Suppose you gave up a $40,000 per year job to go into business for yourself and found that you had $30,000 left at the end of the year after you had paid your bills (i.e., covered your explicit costs).Apart from any nonfinancial satisfaction you might receive from working for yourself, you in effect traded $40,000 for $30,000, which is financially a bad trade.While you made $30K from a bookkeeping perspective, you lost $10K from an economic perspective, after your opportunity cost (the $40K per year job you gave up) was taken into account.
  13. What is the difference between accounting profit and economic profit?
    First, “accounting” profit in this context might be better termed “bookkeeping” profit because it refers to what money (if any) a company has left it has paid its bills, i.e., subtracted its explicit costs from its revenue (which is not what accountants have in mind by the term profit).Economic profit, by contrast, refers to how much (if any) a company made after subtracting all of its costs (implicit as well as explicit) from it revenue, which provides a better indicator of its actual profitability.As the example in the above question shows, a business might earn a positive accounting profit but a negative economic profit.Taking economic profit into account provides the basis for better decision-making.
  14. If “profit” and “loss” opposites, how can it be profitable for a company to sell a product at a loss?
    First, companies are in business to maximize their profit (i.e., do the best they can in terms of profitability).Second, a corollary of profit maximization is loss minimization, which entails realizing as small a loss as possible if sustaining a loss is the best the firm can do.If sustaining a loss is the only possibility, a company has two options: it can produce or it can shut down (the latter refers to a temporary halt to production, not going out of business).Here it is important to remember, first, that firms always produce in the short run and, second, that in the short run there are both fixed costs and variable costs.Fixed costs are costs that do not vary with the output rate, so they are costs that must be paid even if the company produces no output.Consequently, to minimize its loss, a firm must compare what it would lose if it did not produce (its fixed costs, which have to be paid regardless) with what it would lose if it did produce (its total revenue minus its total costs).If the loss is smaller by producing, then the firm should produce even though it will realize a loss.Another way of stating this is that a company should produce provided its revenue is sufficient to pay its variable costs, which would be avoided if it did not produce (i.e., P > AVC or TR > TVC).
  15. Why must marginal revenue equal marginal cost (MR = MC) in order for a firm to maximize its profit?
    First, recall that economic profit equals total revenue minus total cost.Second, note that marginal revenue indicates the change in total revenue accompanying a one unit change in output (MR = DTR / DQ) while marginal cost indicates the change in total cost accompanying a one unit change in output (MC = DTC / DQ).Now, if MR = MC, then a firm has no reason to change its production rate (Q) because no change in Q would increase its profit.To understand why this is so, it is necessary to realize why a company would want to change its output rate (Q) if MR ≠ MC.First, if MR > MC, the firm would want to increase Q because doing so would add more to revenue that it would add to cost (because MR > MC), which would increase its profit.Second, if MR < MC, the company would want to decrease Q because doing so would cause a loss in revenue that would be less that the saving in cost (because MR < MC), which would increase its profit.Thus, while you should know that MR = MC is necessary for profit maximization, it is perhaps even more useful to know that a company should expand its output rate if MR > MC and should reduce its output rate if MR < MC.
  16. Isn't a market competitive so long as there are at least two firms that compete with one another?
    No, not as the term “competitive” (as in purely competitive or monopolistically competitive) is used.In economics, competition implies more than simple rivalry; it describes a market setting in which there are many sellers, indeed potentially so many, given the ease of entry, that none of them can make an economic profit in the long run.
  17. If a company accounts for a very large share of its market, isn't it a monopoly?
    No, not strictly given the literal meaning of the term “monopoly” (which comes from the Greek for “one seller).Of course, such a firm likely has “market power” (which is the ability to raise its price without losing all of its sales).
  18. Can't a monopolist charge as high a price as it wants since it has no rivals?
    Perhaps strictly speaking it can do so, but this would not be consistent with maximizing its profits because even a monopolist faces a down-sloping demand curve so that if it raises its price, it will sell less of its product and beyond some point, raising its price would cause it to lose more in revenue than it would save in costs (by not having to produce as much output), which would lower its profit.
  19. If a company has market power and experiences an increase in its cost, can't it maintain its profits simply by passing all of the cost increase on to its customers by raising the price by the same amount as its cost rose?
    Surprisingly perhaps, the answer is no.While the firm will raise the price, it will raise it by an amount less than the cost increase and it will experience a decline in its profit.The key lies in recognizing that as a company raises its price, marginal revenue rises more than price does, so that once MR equals the new, higher marginal cost, the price will have risen less than MR and MC did.And not only does price rise less than cost did, the impact of this is that the firm's profit will be smaller than before.
  20. Why can't monopolistically competitive firms, which have market power due to their selling differentiated products, earn an economic profit in the long run?
    Their inability to earn long-run economic profits stems from the ease of entry into such a market.If these firms were realizing an economic profit in the short run, this would attract new firms to the market.And as new firms enter, they will attract some customers from the previously existing companies and those companies will then experience a decline in the demand for their products, so they will have to reduce their prices, which will eventually eliminate their profits.
  21. Many cartels have existed for a long time and yet Economics teaches that cartels are generally unstable.How can this seeming contradiction be reconciled?
    The reason cartels tend to be unstable is that once the firms agree to charge a specific price (even assuming its the price that is best for the cartel as a whole), each firm has an incentive to “cheat” by in effect lowering its price.Generally, when a price-fixing agreement breaks down, the cartel members meet again to reestablish a price, in part at least because while they realize that reducing the price is in their best interest in the short term (if the other firms sticks with the higher price), they also know that touching off a price war by cutting their prices is not in their best interest.Also, cartels are sometimes supporting by the firms' own governments, making it easier to agree on a price.
  22. What do economists do?
    People who work as economists engage in various activities from analyzing and interpreting raw data to helping develop government or business policies to researching problems or issues to teaching economics.Someone once defined economics as “what economists do.”
  23. What do economists do for a living?
    Broadly, there are three categories of employment opportunities: government, private business, and education.To work as an economist per se, a person typically must have at least a master's degree.Still, people with a bachelor's degree can use the skills they acquire in their economics courses in a wide variety of careers, mainly in the private sector.And many people major in economics in order to sharpen their reasoning skills and knowledge in preparation for careers in other areas such as law or public administration. According to the American Economic Association (which is the professional organization in economics), people with a bachelor's degree in economics earn starting salaries of over $48,000 per year (which is more than in traditional business fields such as accounting or management) and they earn an average annual salary of roughly $60,000. For more information about careers in economics go to http://www.vanderbilt.edu/AEA/ or http://www.aeaweb.org/

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