ECO 201 Module 8 Project - Economic Simulations

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Feb 20, 2024

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ECO 201 Project Memo To: My Business Partner From: Date: 20 February, 2023 Re: Microeconomics Simulations Introduction This memorandum report identifies and explains key microeconomic principles using a set of simulation games. The outcome of these games illustrate how microeconomic principles can be applied within real-life situations to help us make better business decisions. This report is a summary of the simulations I played and their results, which include the key takeaways and their significance, for your review and reference. It is divided into the following sections: 1. Comparative Advantage 2. Competitive Markets and Externalities 3. Production, Entry, and Exit 4. Market Structures (including the Price Discrimination and Cournot simulations) 5. Conclusions 6. References Comparative Advantage Figure 1.1

Figure 1.2 Opportunity cost is the cost of choosing one situation over another. Comparative advantage is the advantage a firm has when specializing in producting one item over another. When we open up our own business, we will use opportunity cost and comparative advantage as tools to maximize our efficiency, production level and profit margin. Applying these theories means you can analyze our business model so that we reap the most benefit with the least amount of effort and resources. Additionally, these two concepts should be analyzed/applied to our business regularly, so that when our business changes, whether in supply/demand or supplies, we could make the necessary adjustments and position our business for the most success. The Production Possibility Frontier Graph (PPF) is a great tool. This graph gives you a visual representation of your opportunity cost, comparative advantage and where the ideal spot of each lands in regards to your business. In addition, it shows all possible outcomes of the output of our business. The PPF illustrates our rate of production and the opportunity cost of each unit we produce. The PPF also allows us to examine if we are being efficient in deploying our resources and capturing the maximum amount of profit and production. After completing this simulation, I could literally see the advantages of trade. Everyone seems to benefit when people use trade. I was very conservative when I was completing the simulation with trade, and even being ultra conservative I still managed to produce one more combo with trade versus without trade. Given that, a business’s decision to trade or not would cause a change to its PPF. In my case, it increased my production by one unit. As it applies to the business we are beginning, we will need to pinpoint with whom we can trade with in order to maximize our production.

Competitive Markets and Externalities Figure 2.1

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Figure 2.2 Policy interventions can have a large impact on the supply and demand equilibrium for a product. In the first simulation regarding the oranges, there were no policy interventions, however, I did not reach equilibrium because in two instances I sold my oranges above my cost, and in one simulation I was left with a producer surplus of two oranges because I set a price that exceeded consumer demand. If we address the simulation with the Robo Dogs, there was policy intervention in one of the two instances of that simulation and the impact was evident when we compare the two. However, to effectively analyze the impact on the supply and demand equilibrium, one has to look at the market with both a short- and long-term view. A real-world example of this is the gas crisis in the 1970’s and oil prices in the decades following, the concept of a changing market when a long-term view is taken is clearly illustrated. The government had regulations in place over oil companies, and how much they could charge for gasoline. With the decrease in supply by OPEC, this regulation in the short term, caused a gas shortage, and long lines at the gas pumps for consumers. Once OPEC started producing more crude oil, and the government repealed their regulation, the market balanced itself in the long run (Mankiw, 2021). Three examples of the price elasticity of demand are availability of substitutes, if the good is a luxury or necessity, and time horizon. Price elasticity definitely impacted pricing decisions in my business demonstrated in my Orange Market Simulation with the instance of having two left over oranges. During the simulation, I did not consider the fourth determinant of price elasticity of demand: time horizon. The market continually changed and rather than selling two oranges when I could, I waited and the market never reached the point I thought it would. As far as any other determinates, I don’t believe the availability of substitutes played a factor, since this was a single item market, however the second determinant, if the good is a luxury or a necessity could be considered here. I think most people consider food as a necessity, so therefore, this should be considered when analyzing the price elasticity of demand for the oranges market. A firm’s pricing decisions and total revenue are impacted by price elasticity of demand and if the market is elastic or inelastic. If a market is inelastic, it means that demand changes very little when the price changes. If a market is elastic, it means the demand changes in greater amounts if the price changes. Given this definition, firms pricing decisions will affect demand and revenue based on whether demand changes when the price changes and by how much. A firm cannot simply change a price without analyzing how this would affect demand, based on whether or not the market is elastic as this has a direct effect on production, costs and revenue. There are a few government interventions that can cause a consumer or producer surplus and They’re listed below. 1. Command and Control refers to the government’s ability to pass legislation in order to minimize the social cost of markets on bystanders and typically are used when there are negative externalities in the market. An example of this is pollution in the steel market. The government can pass legislation that commands the steel manufacturers to reduce pollution by an amount deemed acceptable in a certain time period (Mankiw, 2021). 2. A subsidy (either corrective or incentive) can be used with either a negative or a positive externality in the market. An example of a positive subsidy would be the benefits of a well-educated population. The government can, and does choose to subsidize education so that its citizens have the most opportunities to educate themselves in order to lead more informed and productive lives. This increases the social value of the population (Mankiw, 2021). 3. A Corrective tax is also known as a Pigovian Tax and is implemented in order to discourage negative behavior that impacts external bystanders. This type of tax can be seen if the government taxes steel manufacturers for producing XX amount of pollution (Mankiw, 2021). All of these affect the Consumer and Producer Surplus as it influences the way the market organically operates. In the Robo Dog simulation’s second instance, there was government intervention in the form of a nuisance tax. As a result, I could not sell all of the robo dogs I produced and as such, there was a producer surplus as it had me, the producer of the robo dogs, incur extra costs in order to pay the nuisance tax. In the first instance of the Robo Dog Simulation, there was no policy market intervention and as a result, I sold all of the robo dogs I produced-resulting in no producer surplus. Given this example, we can determine that yes, policy market interventions can cause surplus. However, this was a short-term

simulation. If we believe that a long-term market will correct itself and eventually find equilibrium, in the long term such as the gas crises of the 1970’s example I outlined above, the answer is no: policy market interventions won’t have an impact on consumer or producer surplus because there will be equilibrium in the market in the long-term (Mankiw, 2021). Production, Entry, and Exit Figure 3.1 As a result of the simulation, it became clear very quickly that my decision to enter or exit a market was based on price, hours worked, and the number of other drivers I thought might enter the market. When one applies the marginal cost concept, you realize the supply curve reflects the marginal cost curve, therefore that tells you at each point of production how much it’s going to cost. As a business owner, the production decision is balanced by maximizing profits. Therefore, producing the amount of goods where marginal costs are low enough that I can have the greatest amount of profit by producing one increment more is the equilibrium or sweet spot as a firm. This is the ideal spot for our business as well, and anticipate running this analysis on our business model for our business. In the example of the simulation, it became clear very quickly that the less drivers in the market, the better. A driver could work fewer hours at a higher rate and make more of a profit. When the drivers numbered any more than six, trying to make a profit meant working at least 8 hours. In fact, in all five iterations of the simulation, I declined to drive twice, and of the three I did drive, I worked a full 8 hours each time, and only made a profit once. In the two

instances that I exited the market, I didn’t make any profit, however, the other drivers did because their revenue per hour was high due to a lower number of drivers. In the short run, fixed costs are fixed costs and they aren’t going anywhere, however, in the long run, they turn into variable costs. I think in the short run our business will have to use the short run curve it has since that’s based on decisions we’ve made previously. In the long run, fixed costs turn into variable costs, therefore, this offers our business more flexibility in the long run as we can use the short run curve that’s most desirable. Additionally, the Average Total Cost (ATC) rises in the short run because of decreased marginal product, but in the long run once we make adjustments that take more time, the ATC returns to the level it was previously in the short run. Market Structures Market Structure Number of Firms Type of Product Sold Price Taker? Price Formula Freedom of Entry? Short-run Profit? Long-run Profit? Industry Examples Perfect Competition Furniture Stores, Grocery Stores, farmer’s markets Monopolistic Competition Automotive Industry, Home Improvement Stores (Home Depot, Lowes, Ace Hardware), fast food industry Monopolies Tobacco Companies, Steel Industry, Residential Water Service, Diamond Mining, Coal Mining Oligopolies Wireless Phone Service, TV Streaming Services, Movie Production Studios, Music Production Studios Table 4.1 When a monopoly exists within a market, inefficiencies are derived. This area of inefficiency is known as the deadweight loss triangle. The deadweight loss triangle occurs because the monopoly’s prices are above marginal cost. Because of this, not everyone who wants the goods will want to pay the price to purchase it. As a result, while total surplus does not change, Consumer surplus is lower and producer surplus is greater in a monopoly market. Monopoly Markets favor the firms that hold the monopoly versus the consumer (Mankiw, 2021). Monopolistic Competition Market exists between a monopoly and perfect competition. Firms entry and exit in both the short-term and long-term determine the inefficiencies of this market. In the short term, if a firm is making a profit (when price is greater than average total cost), then there is an incentive for more firms to enter the market. If the firm is realizing a loss (because the price is less than average total cost), then there is incentive for firms to exit a market. Therefore, there are more inefficiencies in a short-term scenario for a monopolistic competition. In the long term, due to the entry and exit of firms based off of either profits or losses recognized, equilibrium is achieved.

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Oligopolies can set their prices in different ways. There is the Nash Equilibrium, game theory involving the prisoner’s dilemma and the dominant strategy, which all have to do with a firm either serving or not serving their own self-interest. Also, it’s the goal of the oligopoly to act like a Monopoly, but given this self-interest, it forces them towards competition. That’s another reason why reaching some sort of production and pricing agreement within an Oligopoly gets more and more difficult with the more firms that make up the Oligopoly (Mankiw, 2021). In playing the simulation related to Oligopolies, my strategy was to take the total number of barrels in the market, divide it by the firms in the market and come up with an ideal number of barrels. The second time I played the simulation, I used the same strategy, but once I had the number of barrels I should produce, I increased it by two. I wanted to be able to compare and contrast between one scenario that had equilibrium in mind among the firms and one scenario where I served my firm’s self-interest first. The result, as it illustrates in the textbook, is that my profits were larger the first scenario than in the second. By this example, you can see that firms in Oligopolies make more profit if they can shelve their own self interest for the greater good. Perfectly competitive markets determine profitability when they reach maximum profit. In this market, maximum profit is the quantity of goods sold where the difference between total revenue and total cost is largest. Unfortunately, in the long-term, profitability equals zero due to the easy entry and exit of firms in this market. Monopolistic Competitive Markets determine profitability at the point where marginal revenue exceeds the marginal cost of producing one more unit. In the long-term, firms make zero economic profit due to the freedom of entry and exit of firms in the market. Monopolistic Markets determine profitability by choosing a point of production where marginal revenue equals marginal cost, then uses the demand curve to figure out the price and quantity where those two intersect. Oligopolies would like to be able to determine profitability as if they were a monopoly, however, that seldom works since most firms’ self-interest interfere with this effort. Therefore, Oligopolies maximize profits when marginal revenue equals marginal costs. Conclusions Overall, microeconomics is an area a business owner must embrace as it has a significant impact on a business. If there’s any desire to be competitive and successful with your business, one has to not only be familiar, but understand and utilize these concepts. This is the most efficient and best way to decide on production levels, pricing, marginal costs, total costs and total profit. If a business owner ignores microeconomics, how would that owner decide on a price? How much to produce? If their business is making a profit? The answer is, a business owner would be flying blind in the market without using microeconomics to run their business. Furthermore, microeconomics is used in both the short and long-term. Given markets change and fluctuate as firms enter or exit the market, a business owner must adjust accordingly to insure they are operating efficiently. Without microeconomics, businesses wouldn’t be able to discern what type of market they operate within. Firms operate differently depending on the competition, if you do not use the concepts of microeconomics, not only do you not understand what your competition is like, your business is more than likely doomed to fail. In closing, it’s my belief that since the business we are starting will compete in a perfectly competitive market, we can easily make important and relevant business decisions that will best position our business for success. By using the PPF outlined in section 1, and plotting all the various factors out, we’ll be easily able to see all of the factors that influence our business; price, marginal cost, average total cost, marginal revenue, demand and supply. Furthermore, in analyzing these data points, we can determine market elasticity and the tolerance for increased pricing and how demand would be affected by it. Since we do exist in a perfectly competitive market, we are a business that is a price taker and the market will set the price for us, however, we’ll be able to maximize profits at the point where the difference between total revenue and total cost is largest. I look forward to discussing this report in detail when next we meet.

References Mankiw, N. G. (2021). Principles of microeconomics (#9 edition). Cengage.

ECO 201 Module 8 Project - Economic Simulations

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