Top 10+ Misunderstood Concepts in Econ 101
And the important clarification!
In my experience teaching principles level microeconomics these are the top 10 misunderstandings. I’ll present them in the order encountered in a typical semester long course.
Opportunity costs: The opportunity cost of an activity is the value of the next highest alternative forgone. Opportunity costs represent sacrifice. It’s not what you get to do, it’s what you get to lose or give up when you do one thing instead of another. The common misunderstanding comes from the term ‘opportunity’. For example, if you get a free ticket to a concert, the opportunity cost of attending the concert is the forgone alternative uses of your time and resources expended to go to the concert and NOT the value of the ticket.
Supply & Demand: The term economists use for the amount of a good that consumers are willing to buy at a certain price is ‘quantity demanded’. Then by ‘demand’ we mean the entire relationship between prices and quantities demanded at that price. The amount sellers are willing to bring to the market at a given price is the ‘quantity supplied’. The entire relationship between all such pairs of prices and quantities supplied is ‘supply’. The first misunderstanding comes from way people use the terms ‘supply’ and ‘demand’ in common everyday language. To an economist it is an error to say ‘when prices rise, demand falls’. An economist instead says, ‘when prices rise, quantity demanded falls’. The distinction is between a movement along a demand curve versus a shift. If prices change, only quantity will change and that change moves up or down a single stationary demand curve. If something other than price changes, then the entire demand curve shifts left or right. Similarly for supply. If prices rise, quantity supplied rises but supply is unchanged. In order for supply to change we need something other than price to change.
Supply & Demand: Interpreting the effects of changes in demand or supply. When one of our determinants of demand or supply changes, we get an increase or decrease in either demand or supply accordingly. When this happens we assume that the other relationship remains unchanged. Suppose there’s a positive news report that comes out about some product. That’s going to create a change in consumer tastes and preferences and as a result we’re going to get a shift of the demand curve. Let’s just say it’s good news, so there’s an increase in demand, and we model that with a rightward shift. What happens to supply? Absolutely nothing! We assume the supply curve is stationary so as the demand curve shifts against it, we get a new higher equilibrium price and quantity. A common error is to say something like due to the positive effect on tastes and preferences and the increase in demand, we get an increase in supply to meet demand. Actually what happens is the increase in demand causes an increase in price which gives us a movement up the supply curve to a higher quantity supplied. But it’s better not even to mention this. When we have a change in demand or supply we seek only the impact on the market price and quantity. Never seek an impact on the other curve.
Elasticity: We cannot judge price elasticity of demand on the basis of the sign of the elasticity nor on the fact that the quantity demanded may or may not change. It’s an error to observe that price elasticity of demand is negative (or positive in absolute value) and try to make any sort of inference regarding whether the good is elastic or inelastic. Similarly if we observe that the price changes and the quantity demanded changes, we cannot simply declare that demand must be elastic. Price elasticity of demand measures the responsiveness or sensitivity of the quantity demanded to changes in price. If we’re talking about the price elasticity of demand we’re talking about a movement along a single demand curve. We already know that by the law of demand if prices rise, the quantity demanded falls. What elasticity conveys above and beyond the law of demand is how much the change in quantity demanded was relative to the price change. We measure this in percentages. If quantity changes by a greater percentage than price changes, we’d say demand is pretty responsive and therefore elastic. If quantity changes by a smaller percentage than the price changes, we’d say demand is pretty unresponsive and therefor inelastic.
Taxes: A per-unit tax does not generally raise the equilibrium price by an amount equal to the tax. The exception is when demand or supply is perfectly inelastic. The reason why not is because if there’s slopes to our demand and supply curves, when the tax is assessed this alters the price and there’s also a quantity response. When the per-unit tax is applied to a good the consumer is going to purchase a smaller amount. That smaller amount is going to correspond to a higher point on the demand curve and a lower point on the supply curve. The quantity purchased after the tax is applied will correspond to where the demand curve is above the supply curve by an amount equal to the tax. The interpretation is that the vertical height of the supply curve corresponds to the marginal cost of producing that unit. If the good is sold at cost, that would be the proceeds necessary to go to the seller (price seller receives), but the government gets their share too, and this brings us up to the demand curve.
Price control don’t set the price, only constrain it. A price floor is a legal minimum. A price ceiling is a legal maximum. When a price control is imposed the market, you might think that the government has set the price. That’s only true if the price control is binding. A binding price control is one that prevents the price from reaching the equilibrium. For a price floor it’s that the government sets a legal minimum above the true equilibrium price. The price is prevented from going lower. For a price ceiling the government sets a legal maximum that’s below the true equilibrium price. The price is prevented from going higher.
Externalities are not just about unintended consequences. Externalities are bystander effects. They’re external benefits or harms that the original decision-makers ignore when setting their optimal level of the activity that generates them. But the key is that they’re external to the decision-maker. Second-hand smoke imposes an external cost. Lung cancer is a private cost.
A tariff means everyone pays the tariff price but not that everyone pays the tariff. Tariffs are taxes on imports. They raise the price at which foreign goods are allowed to compete with domestic producers. A tariff increases the price of the good in the economy. But if you buy from a domestic producer you’re not going to pay the tariff. Tariffs are taxes on imports. You’ll pay the tariff if you buy an imported good.
A competitive firm will shut down when price is lower than average variable cost, not just when price is less than average total cost. If price is below average variable cost the firm is taking inputs and transforming them into something that’s worth less and therefore should quit it. If the price is above average variable cost we know at least the firm is transforming inputs into something worth more than when they started. But that doesn’t mean they’re overall profitable. They might have really high fixed costs that they’re unable to recoup. In that case the price is less than average total cost and while the firm will produce in the short run, it will exit in the long run. Shut down is a short run concept and exit is the long run counterpart.
A Nash equilibrium is not about maximizing profit or winning or anything like that. It simply is an outcome where all players are currently best responding. An outcome is a Nash equilibrium if no one has a profitable unilateral deviation meaning that no one can improve their payoffs when they’re the only one to switch their strategy. A dominant strategy dominants a player’s own other options, not their rival.
Here is the video version:
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