Principles of Microeconomics Module 1...Seamstress 1more bread = ½ sweater 1 more sweater = 2 bread...

PrinciplesofMicroeconomicsModule1.1

Scarcity,LimitedResourcesandOpportunityCosts

WhatisEconomics?

• Economicsisthestudyofhowpeopleandsocietyallocatescarceresources

• Scarceresources:• Forpeople:Time,Moneyect.• Forfirms:FactorsofProductionà Land,LaborandCapital

• Sincewedon’thaveaninfiniteamountofresources– whatdowedowithwhatwehave?

TradeoffsinDecisions

• Peoplefacetradeoffsindecisionsbecauseofscarceresources• Cannotdoeverything,buyeverything,makeeverything• Needtochoosehowtoallocateourtime,ourmoney,ourresources

• Whenyoumakeonechoice– yougiveuptheotheroption

OpportunityCosts

• OpportunityCost:Whatyougiveuptogetsomething• Example:Howmanytimescanyouhitthesnoozebutton?

Benefit Opportunity Cost

Hititonce MoreSleep Feelrushed inthemorning

Hitittwice MoreSleep Feel rushedSkipbreakfast

Hititthreetimes MoreSleep Feel rushedSkipbreakfastSkipthegym

Hititfourtimes MoreSleep Feel rushedSkipbreakfastSkipthegymLateforwork

OpportunityCost

• OpportunityCostsaresubjectivetotheindividualandchangedependingoncircumstances

• WhatifitwasSaturdaymorningandyouhitthesnoozebutton?• Benefitsofmoresleepmayoutweighanycostsifyoudon’thavetowakeup!

• Whatifyouworkintheafternoon?• Youdonothavethesameconstraintsassomeonewhoneedstogotoworkinthemorning!

OpportunityCosts

• OpportunityCostsdrivethedecisionswemakeeveryday• Wefacethemallthetime• Weweighthecostsandbenefitsofeachdecisionsconsciouslyorsubconsciouslyandmakeachoice

• Testyourself:Whatwasarecentdecisionyoumade?Whatdidyougiveupwhenyoumadethatchoice?Whatwastheopportunitycostforyou?

OpportunityCostsandProductionPossibilitiesFrontier

ProductionPossibilitiesFrontierProductionpossibilitiesfrontier(PPF)representstheopportunitycostsaneconomyfacesintheproductionoftwogoods.

Alleconomieshavescarceresources-- needtodecidehowtoallocatethoseresourcestoproducegoods.

Ifyouproducemoreofonegood– needtoproducelessoftheother(withnochangeinavailableresources)

PPFExerciseConsideraneconomythatproducestwogoods:Leatherjacketsandleatherboots.

• DrawthePPFcurveforthiseconomy• Aswemovefromonepointtothenext– calculatethechangeinthenumberofbootsproducedandthenumberofjacketsproduced.

• Whatdoesthistellyouabouthowopportunitycostschange?

A B C D E

Boots 0 20 40 60 80

Jackets 100 90 70 40 0

PPFExerciseA B C D E

Boots 0 20 40 60 80Jackets 100 90 70 40 0ΔBoots +20 +20 +20 +20ΔJackets - 10 - 20 - 30 - 40

AswemovealongthePPFcurve:OpportunityCostchanges

• O.C.RISES asgiveupmoreofthegoodthatisSCARCE

• O.C.isLOWERwhenthegoodisinrelativeABUNDANCE

PPFExercise

Supposenowthatthereisashortageinrubber.- Whathappensinthebootindustry?- Whathappensinthejacketindustry?

PPFExerciseWithashortageinrubber,thisaffectstheproductionofbootsrelativelymorethantheproductionofjackets

BiasshiftofPPF

Ifthereisachangeinresources– needtoconsidertheimpactthishasonbothindustries– equalorbias?

KeyTakeaway

• Alleconomicagentsfacetradeoffswhenmakingdecisions

• Whatevertheychoosecomeswithanopportunitycost– whattheycouldotherwisedowiththeirtime,money,resources

• ApplythisconcepttounderstandhowaneconomymakeschoicesbetweentheproductionofgoodsinthePPF

Comparativeadvantage,specialization,andtrade

Howcanwesatisfyourneeds/wants?

1.EconomicSelf-sufficiency:Produceallofthegoodsweneed/wanttoconsumeourselves

2.SpecializationandTrade: ProduceonegoodthatwehaveaComparativeAdvantageinandtradewithothersforwhatweneed

GAINSFROMTRADE:WecanCONSUMEMOREwhileworkingthesameamount.

TradeExerciseTimetoProduceOneUnit Amount ProducedinOneDay

(8hrsofwork)

Bread Sweaters Bread Sweaters

Seamstress 60minutes =1loaf

120minutes =1sweater

Baker 20minutes=1loaf

60minutes=1sweater

Howmuchbreadandsweaterscaneachagentproduceinonedayofwork?

TradeExercise

• Whoisbetteratproducingbread?• Whoisbetteratproducingsweaters?• Iftheysplittheirtimeevenlybetweenproducingbothgoods,howmuchcantheyconsume(notrade)?

TimetoProduceOneUnit Amount ProducedinOneDay(8hrsofwork)

Bread Sweaters Bread Sweaters

Seamstress 60minutes –1loaf

120minutes –1sweater

(60/60)*8hrs =8loaves

(60/120)* 8hrs=4sweaters

Baker 20minutes–1loaf

60minutes– 1sweater

(60/30)*8hrs=24loaves

(60/60)*8hrs=8sweaters

EconomicSelf-Sufficiency

TradeExerciseBasedonopportunitycost:• Seamstress hasaloweropportunitycostinmakingsweaters• Fortheseamstress,ifsheproducesonemoresweater,shegivesupbaking2loavesofbreadinthattime

• Baker hasaloweropportunitycostinbakingbread

• Forthebakerifheproducesonemoreloafofbread,hegivesupmaking3sweatersinthattime

OpportunityCostdeterminesspecialization

Amount ProducedinOneDay OpportunityCostBread Sweaters Bread Sweaters

Seamstress 8loaves 4sweaters ½ Sweater 2Breads

Baker 24loaves 8sweaters 1/3Sweater 3Breads

TradeExerciseWhathappens ifthebakerandseamstresswanttotrade?

Supposetheagentsagreethat:• Bakerwillspend5hoursonbread,3hoursonsweaters• Seamstresswillspend8hoursonsweaters

Howmuchdotheyproduce?Howmuchwilltheyconsume?Willtheygainfromthetrade?

TradeExercise

Whatiftheyagreetotrade2sweatersfor5loavesofbread?

Howmuchwilltheyconsume?

AMOUNTPRODUCEDBread Sweaters

Seamstress 0 (60/120)*8hrs=4sweaters

Baker (60/20)*5hrs =15loaves

(60/60)*3hrs=3sweaters

TradeExercise

Hastheseamstressgainedfromthistrade?Hasthebakergainedfromthistrade?

AMOUNTCONSUMEDBread Sweaters

Seamstress 0 bread+5bread=5bread

4sweaters– 2sweaters=2sweaters

Baker 15bread- 5bread=10bread

3sweaters+2sweaters=5sweaters

WithTrade

ComparativeAdvantageAgentwiththeloweropportunitycostinproducingthegoodwill

haveacomparativeadvantageinitsproduction

OpportunityCostsBread Sweaters

Seamstress 1 morebread=½sweater 1moresweater =2breadCOMPARATIVEADVANTAGE

Baker 1morebread=1/3sweaterCOMPARATIVEADVANTAGE

1moresweater =3bread

• Nosingleagentcanhaveacomparativeadvantageinbothgoods.• Aslongastheopportunitycostsbetweentwoagentsdiffer– both

cangainfromtrade.

KeyTakeaway• Tradeandspecializationmakeeveryonebetteroffbecause– consumemorewithoutworkingmore

• Tradecanbebeneficialevenwhenoneeconomicagentismuchbetteratproducingbothgoods

• Todeterminewhichgoodsaneconomicagentwillproduce– needtounderstandcomparativeadvantage(or)opportunitycostinproducingeachgood

PrinciplesofMicroeconomicsModule1.4(A)

EconomicSystems

• Economicsystemsaresystemsof• Production• ResourceAllocation• Exchange• Distributionofgoodsandservices

1. Whattoproduce?2. Howmuchtoproduce?3. Whoreceivestheoutput?

PropertyRightsandEconomicSystems

• Propertyrightsareanimportantcomponentofeconomicsystems• Becauseaneconomyistryingtoanswerthepreviousthreequestions-à whoownswhatinfluencesthetypeofsystemwehave

• PropertyRights– determinewhoownsaresourceandwhodecideshowitisused.

• Individuals• Associations• Government

• PropertyRights– determinewhoownsaresourceandwhodecideshowitisused.

• PropertyRights determinewhoownsaresourceandwhodecideshowitisused.

FourComponentsofPropertyRights

1. Therighttousethegood2. Therighttoearnincomefromthegood3. Therighttotransferthegoodtoothers4. Therighttoenforcepropertyrights

EconomicSystems

Allocation

OWNERSHIP

Planned Private

Planned SocialistPlannedEconomy

CommandCapitalism

Private MarketSocialism Capitalism

Market-basedEconomy

PrinciplesofMicroeconomicsModule1.4(B)

MarginalAnalysis

• Inthisvideowewilldiscussmarginalanalysisandhowchangesinincentiveswillchangedecisionsoffirmsandconsumers

MarginalAnalysis• Marginalanalysis:examinationoftheassociatedcostsandpotentialbenefits ofspecificbusinessactivitiesorfinancialdecisions.

• Goal:todetermineifthecostsassociatedwiththechangeinactivitywillresultinabenefitthatissufficientenoughtooffsetthem.

• Insteadoffocusingonbusinessoutputasawhole,theimpactonthecostofproducinganindividualunitismostoftenobservedasapointofcomparison.

MarginalAnalysis• Marginalanalysis:examinationoftheassociatedcostsandpotentialbenefitsofspecificbusinessactivitiesorfinancialdecisions.

• Goal:todetermineifthecosts associatedwiththechangeinactivitywillresultinabenefitthatissufficientenoughtooffsetthem.

• Insteadoffocusingonbusinessoutputasawhole,theimpactonthecostofproducinganindividualunitismostoftenobservedasapointofcomparison.

MarginalAnalysis• Marginalanalysis:examinationoftheassociatedcostsandpotentialbenefitsofspecificbusinessactivitiesorfinancialdecisions.

• Goal:todetermineifthecostsassociatedwiththechangeinactivitywillresultinabenefitthatissufficientenoughtooffsetthem.

• Insteadoffocusingonbusinessoutputasawhole,theimpactonthecostofproducinganindividualunitismostoftenobservedasthebestpointofcomparison.

ExampleofMarginalAnalysis• Amanufacturerwishestoexpanditsproduction• A marginalanalysisofthecostsandbenefitsisnecessary.

COSTS BENEFITS

Additionalmanufacturingequipment Estimatedincreaseinsalesattributedtotheadditionalproduction

Additional employeesforincreasedoutput

Larger orNewFacilities

Additionalmaterialsforproduction

ExampleofMarginalAnalysis• Iftheincreaseinincome>theincreaseincost,theexpansionmaybeawiseinvestment

COSTS BENEFITS

Additionalmanufacturingequipment Estimatedincreaseinsalesattributedtotheadditionalproduction

Additional employeesforincreasedoutput

Larger orNewFacilities

Additionalmaterialsforproduction

Incentives

• Peoplefacetrade-offsintheeverydecisionsthattheymake• Weighthecosts/benefitsassociatedwiththeirchoices• Choosewhatfitstheirneeds/wantsbest

• Incentiveschangecosts/benefitsofadecision• Becausetheyalterthecostsorbenefitsofdoingsomething– theymaychangethechoiceapersonmakes

ExamplesofIncentivesandDisincentives

INCENTIVES DISINCENTIVES

Retailstoresales:Buy-one get-onesales

Taxesoncigarettes,alcohol ect.

Attendance policiesinclass Calorie reportsatfast-food restaurants

Taxsubsidy fornewgreentechnology Pollution tax

ExamplesofIncentivesandDisincentives

INCENTIVES DISINCENTIVES

Retailstoresales:Buy-one get-onesales

Taxesoncigarettes,alcohol ect.

Attendance policiesinclass Calorie reportsatfast-food restaurants

Taxsubsidy fornewgreentechnology Pollution tax

KeyTakeaways

• Marginalanalysisisusedfrequentlybyfirmstoweighthebenefitsanddrawbacksofbusinessdecisions

• Peopledothistoo!Theyweighthecostsandbenefitsofvariousdecisionsandmakeachoice

• Incentives/disincentiveschangethecostsorbenefitsofachoice,thereforemayalterthedecisionsomeonemakes

SupplyandDemandintheMarketforGoodsandServices

Whatarecompetitivemarkets?CompetitiveMarkets:

• Bringtogetherthedecentralizeddecisionsofbuyersandsellers• DecentralizedDecisionsofBuyers:

• Drivethemtotrytogetthelowestpossiblepriceforthegoodstheywant

• DecentralizedDecisionsofSellers:• Drivethemtotrytogetthehighestpossiblepriceforthegoodstheyareselling

Whenthesedecisionscometogether– competitivemarketsyield:

• Bestpossiblepricefortheproduct• Producedatthelowestpossiblecost• Mostefficientallocationofresources

Whatarecompetitivemarkets?FundamentalAssumptionsofSupply+DemandModel:

1.OperatingunderPerfectCompetition• Lotsofbuyersandsellers• Goodssoldareidentical• Nocosttoenteringorleavingthemarket

2.Equalaccesstoinformation3.Externalitiesdonotexist

Nosingleeconomicagentcanunilaterallyexertanypricecontrol

WhatisDemand?• Demandcomesfromthebuyerofagood/service• Eachbuyeristryingtogetthelowestpricepossibleforthegood/servicethattheywant

• LawofDemand:Aspriceofagooddeclines,peoplewanttobuymoreofit

Qdemanded

FactorsthatShiftDemand

• ChangeinIncome• NormalGoods• InferiorGoods

• ChangeinTastesandPreferences• ChangeinPriceofRelatedGoods• ChangeinNumberofBuyers• ChangeinFutureExpectations

WhatisSupply?• Supplycomesfromthesellerofagood/service• Eachselleristryingtogetthehighestpricepossibleforthegood/servicethattheyproduce

• LawofSupply:Aspriceofagoodincreases,peoplewanttosellmoreofit

Qdemanded

FactorsthatShiftSupply

• ChangeinPriceofInputs• ChangeinProductionTechnology• ChangeinNumberofSellers• ChangeinFutureExpectations

KeyTakeaway• Demandisdeterminedbythebuyersofagood.Buyeralwayswanttogetthelowestpricetheycan!Hence,demandisdownwardsloping

• Supplyisdeterminedbythesellersofthegood.Sellersalwayswanttogetthehighestpricetheycan!Hence,supplyisupwardsloping

• Certainfactorsaffecteachofthecurvesandcausethemtoshift.Theshiftscomefromanunderlyingchangetothe“willingnesstobuy”or“willingnesstosell”.

SupplyandDemandintheMarketforGoodsandServices

MarketEquilibrium

Supply

Demand

Quantity

MarketEquilibrium

Supply

Demand

Quantity

SURPLUS

MarketEquilibrium

Supply

Demand

Quantity

SHORTAGE

TestyourUnderstandingConsiderthemarketfororanges.Drawoutthesupplyanddemandcurvesbasedonthefollowingsupplyanddemandschedule:

1. Drawoutthesupplyanddemandcurvesbasedonthisinformation.Whereistheequilibrium priceandquantity?

2. Suppose thereisanexceptionallycoldwinterinFloridawithfrostsruiningmanygroves.Whathappenstothismarket?Illustrate.

3. Whathappens ifthepriceofapplesfalls?Illustrate.

Price QD QS

$5 10 50

$4 20 40

$3 30 30

$2 40 20

$1 50 10

$0 60 0

• EquilibriumP=$3• EquilibriumQ=30

• Whenthereisafrost– increasesthecostofproduction(weather– inputinproduction)

• SUPPLYCURVESHIFTS(INorLEFT)• At$3:S1<D– shortageinthemarketfororanges

• PricesmustadjusttoP2– movementalongdemandcurve

• Ifthereisadecreaseinthepriceofapples–changeinthepriceofarelatedgood

• DEMANDCURVESHIFTS• Thisisasubstitutegood– soifthepriceofapplesfalls– morepeoplebuyapplesanddemandlessoranges

• SHIFTSINorLEFT• Equilibriumpricefalls• Equilibriumquantityfalls• Nochangeinwillingnessofsellers– movementalongthesupplycurve!

Ifhappenssimultaneouslywithfrost(shiftsinbothcurves)• Definitefallinequilibriumquantity• Ambiguousimpactonequilibriumprice

KeyTakeaway

• MarketEquilibriumbringstogetherthedecentralizeddecisionsofbuyersandsellers

• Becauseeachagentislookingoutfortheirownbestinterest– wegettheoptimalresultsinthemodel

• ShiftsintheSorDcurvemustcomefromachangeinoneofthefactorsthatchangeeither“willingnesstosell”or“willingnesstobuy”

• S-DGraphiscriticalinhelpingusfindequilibriumandanalyze/understandchangesinthemarket.

PrinciplesofMicroeconomicsModule2.1(C)

PriceControls

• Inthisvideo,wewilldiscusswhathappenswhenthegovernmentimposesapricecontrolinamarket.Wewillseehowthisdistortstheequilibriumoutcomesinthesupplyanddemandmodel

PriceControlsIneconomics,weargue:• Bestpossibleoutcomesoccurwithnogov’tinterference• Yieldsmostefficientallocationofresources• Whenpoliciestocontrolthepriceinterfereinthemarket,theycreatedistortions

Thesedistortions cause:• Shortages• Surpluses

WhatarePriceControls?

Pricecontrols• Settingapricemaximum(priceceiling)orpriceminimum(pricefloor)inagivenmarket

• Non-bindingpricecontrol:theequilibriumisnotdistortedandthemarketoutcomesareefficient

• Bindingpricecontrol:theequilibriumcannotbereachedandthemarketoutcomesareinefficient(shortageorsurplus)

TestyourUnderstandingConsidertwolabormarkerswherealawyer’swagerateisapproximately$100/hr andahousecleaner’swagerateisapproximately$8/hr.• Thegovernmentdecidestoimposeaminimumwagelawof$12/hr.

1. Whatimpactdoesthishaveonthemarketforlawyers?Drawoutthesupplyanddemandmodel.

2. Whatimpactdoesthishaveonthemarketforhousecleaners?Drawoutthesupplyanddemandmodel.

MinimumWageLaws

MarketforLawyers MarketforHousecleaners

MarketEquilibrium

MinimumWageLaws

PriceFloorMin.Wage

$12 $12

MinimumWageLaws

PriceFloorMin.Wage

$12 $12

Qd =Qs Qd Qs

MinimumWageLaws

PriceFloorMin.Wage

$12 $12

Qd =Qs Qd Qs

Qd =Qs:Noeffectofthemarketforlawyers

MinimumWageLaws

PriceFloorMin.Wage

$12 $12

Qd =Qs Qd Qs

Qd <Qs:At$12:SurplusofHousecleaners

KeyTakeaways• Governmentpoliciescancausedistortionsinthemarketforgoodsandservicesbypreventingsupplyanddemandtoreachequilibrium

• Thesedistortionscreate• Shortages• Surpluses• Mismatchbetweenpricesforbuyersandsellers

• Policiesareputinplacemanytimesduetothesocialbenefitsoutweighingtheeconomiccosts

PriceElasticityofDemandandSupply

• Inthisvideo,wewillintroducetheconceptofelasticity– whichallowsustocalculatethesizeofchangesweobserveinthesupplyanddemandmodel

WaysthatDemandandSupplyChange

Changesindemandandsupplycomefrom:• Movementalongthecurve– somefactorchangesthatdoesnotdirectly

affectthewillingnessofbuyertopayorsellertosell

• Shiftinthecurve– somefactorchangesthatdirectlyaffects thewillingnessofbuyertopayorsellertosell

WaysthatDemandandSupplyChange

Changesindemandandsupplycomefrom:• Movementalongthecurve– somefactorchangesthatdoesnotdirectly

affectthewillingnessofbuyertopayorsellertosell

• Shiftinthecurve– somefactorchangesthatdirectlyaffects thewillingnessofbuyertopayorsellertosell

PriceElasticityPriceElasticityofDemand:• ByhowmuchdoesQd changewhenthereisapricechange?

• MovementalongthedemandcurvefromAtoB• Responsiveness ofquantitydemandedtopricechange

PriceElasticityofSupply:• ByhowmuchdoesQschangewhenthereisapricechange?

• MovementalongthesupplycurvefromAtoB• Responsiveness ofquantitysuppliedtopricechange

PriceElasticity

PriceElasticityofDemand:• ByhowmuchdoesQd changewhenthereisapricechange?

• MovementalongthedemandcurvefromAtoB• Responsiveness ofquantitydemandedtopricechange

PriceElasticityofSupply:• ByhowmuchdoesQschangewhenthereisapricechange?

• MovementalongthesupplycurvefromAtoB• Responsiveness ofquantitysuppliedtopricechange

MidpointMethodforPriceElasticityChangeinQuantity=!"#!$%&'%(

ChangeinPrice=+"#+$,&',()

PriceElasticity=𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑷𝒓𝒊𝒄𝒆

𝑄𝑏 − 𝑄𝑎𝑄𝑏 + 𝑄𝑎

2/𝑃𝑏 − 𝑃𝑎𝑃𝑏 + 𝑃𝑎

ElasticityofCurves

Anychangeinpriceyieldsalargechangeinquantitydemanded:

- Luxurygoods:designer jeansà notanecessity- Gourmet foods:$15lbcheeseà manysubstitutes- Kitkat barsà manysubstitutes

ElasticityofCurves

Changeinpriceyieldsasmallchangeinquantitydemanded:

- Medicine- Food- Peakrailroadtickets

ElasticityofCurves

Changeinpriceyieldsalargechangeinquantitysupplied:

• Firmoperatingbelowcapacity• Anyincreaseinprice– willdefinitely

producemore

ElasticityofCurves

Changeinpriceyieldsasmallchangeinquantitysupplied:

• Agriculture intheshortterm– can’timmediatelyproducemore

• Nuclearpower

PriceElasticityofDemand

Supposeagrocerystoreownerisdecidingtoincreasethepriceofsmokedsalmonby10%from$11.00to$12.10.Thequantityofsmokesalmonhecansellfallsfrom40unitsto25units.

• Whatisthepriceelasticityofdemandforsmokedsalmon?Isitelasticorinelastic?

PriceElasticityofDemand

• Ifheincreasesinthepriceofsmokedsalmonby10%from$11.00to$12.10,thequantityofsmokesalmonhecansellfallsfrom40unitsto25units.

ChangeinQ = LM#NO)P'QR)

= −0.462

ChangeinP = XL.XO#XXY).YR'YY

)= 0.095

Ped = − O.N]LO.O^M = | − 4.86| > 1 ELASTIC

PriceElasticityofSupplyNowsupposethatthisgrocerobservesthathisneighborhoodischanging,andmanynewpeoplearemovingin.Thenumberofbuyersisincreasing.

• Asaresult,thepriceofhisgoods,onaverageincreasesfrom$5to$7andthequantityofgrocerygoodssuppliedincreasesfrom1000to1250.

• Whatisthepriceelasticityofsupply?

PriceElasticityofSupplyNowsupposethatthisgrocerobservesthathisneighborhoodischanging,andmanynewpeoplearemovingin.Thenumberofbuyersisincreasing.

• Asaresult,thepriceofhisgoods,onaverageincreasesfrom$5to$7andthequantityofgrocerygoodssuppliedincreasesfrom1000to1250.

ChangeinQ =1250 − 10001250 + 100

2= 0.22

ChangeinP = c#Md'P)

= 0.33

Pes = O.LLO.gg = 0.667 < 1 INELASTIC

PrinciplesofMicroeconomicsModule2.2(C)

IncomeElasticityofDemandByhowmuchdoesQd changewhenthereisachangeinincome?

ChangeinQuantity=jL#jXk)'kY)

ChangeinIncome=lmnopqL#lmnopqXrstuvw)'rstuvwY)

IncomeElasticity=𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑰𝒏𝒄𝒐𝒎𝒆

𝑄2 − 𝑄1𝑄2+ 𝑄1

2/𝐼𝑛𝑐𝑜𝑚𝑒2 − 𝐼𝑛𝑐𝑜𝑚𝑒1𝐼𝑛𝑐𝑜𝑚𝑒2 + 𝐼𝑛𝑐𝑜𝑚𝑒1

IncomeElasticityMagicHatandsupposetheaverageincomeofa23year-oldis$45,000.The23year-oldconsumesonaverage5MagicHatsamonth.

• Whenhisincomerisesto$50,000,heconsumes9MagicHatspermonth.

• Whatishisincomeelasticityofdemand?• Isthisanormalgoodoraninferiorgood?

IncomeElasticityMagicHatandsupposetheaverageincomeofa23year-oldis$45,000.The23year-oldconsumesonaverage5MagicHatsamonth.

• Whenhisincomerisesto$50,000,heconsumes9MagicHatspermonth.

MagicHat:

ChangeinQ =9 − 59 + 52

= 0.571

ChangeinIncome= MO�#NM�PR�'QP�

)= 0.105

Ied =0.5710.105 = 5.43

MagicHatsareanormalgood95

CrossPriceElasticityofDemandByhowmuchdoesQd changewhenthereisachangeinthepriceofarelatedgood?

ChangeinQuantity(GOODA)=jL�#jX�k)�'k)�)

ChangeinPrice(GOODB)=�L�#�X��)�'�Y�)

CrossPriceElasticity=𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚𝒐𝒇𝑮𝒐𝒐𝒅𝑨𝑪𝒉𝒂𝒏𝒈𝒆𝒊𝒏𝑷𝒓𝒊𝒄𝒆𝒐𝒇𝑮𝒐𝒐𝒅𝑩

𝑄2𝐴 − 𝑄1𝐴𝑄2𝐴 + 𝑄2𝐴

2/𝑃2𝐵 − 𝑃1𝐵𝑃2𝐵 + 𝑃1B

CrossPriceElasticityConsider,onceagain,themarketforbeer.

• Whenthepriceofpretzelsmovesfrom$4to$3,theconsumptionofbeerincreasesfrom100unitsto120units.

1. Whatisthecrosspriceelasticityofdemandforbeerwhenthepriceofpretzelsrises?

2. Howarethesemarketsrelated?

CrossPriceElasticityConsider,onceagain,themarketforbeer.

• Whenthepriceofpretzelsmovesfrom$4to$3,theconsumptionofbeerincreasesfrom100unitsto120units.

BeerandPretzels:

ChangeinQ =120 − 100120 + 100

2= 0.182

ChangeinPriceofpretzels = g#NQ'�)= −0.287

XPed = O.X¡L#O.L¡c = −0.636

Pretzelsareacomplimentarygood tobeer

KeyTakeaways• Understandingelasticityallowsustoquantify thechangesindemandandsupply.

• Providesanadditionalanalysistounderstandhowresponsiveness demandandsupplyaretopricechanges,incomechangesandchangesinpricesofrelatedgoods.

ConsumerSurplusandProducerSurplus

WelfareEconomics• Howtheallocationofresourcesandmarketoutcomesaffecteconomicwell-being

• Reachingequilibrium:maximizeswelfare(inmostcases)

• WelfareEconomics:ConsumerSurplus,ProducerSurplusandTotalSurplus

ConsumerSurplus

Willingnesstopay– priceactuallypaid

• Everybuyerhasamaximumpricetheyarewillingtopayforeverygood

• Atlowerprices,hisconsumersurplusislarger– heis“betteroff”becausenotpayinghisfullmaximumprice

ConsumerSurplus

Willingnesstopay– priceactuallypaid

• Everybuyerhasamaximumpricetheyarewillingtopayforeverygood

• Atlowerprices,hisconsumersurplusislarger– heis“betteroff”becausenotpayinghisfullmaximumprice

ConsumerSurplus

• Ifthepriceofwaterisactually$2.50perbottle,wouldyoubuythewater?

• Ifyourmaxpriceis$5thenyes!Yourconsumersurplus is$2.50

• Ifyourmaxpriceis$2thenno

• Whathappensifthepricefallsto$70perday?

• Ifyourmaxpriceis$100:Yourconsumersurplusrisesto$30

• Ifyous maxpriceis$85– nowyoubuytheticketsandhavepositiveconsumersurplusof$15

Considerwhatyouwouldpayforabottleofwateratasummerconcert

$2.50CS

ConsumerSurplus

• Ifthepriceofwaterisactually$2.50perbottle,wouldyoubuythewater?

• Ifyourmaxpriceis$5thenyes!Yourconsumersurplus is$2.50

• Ifyourmaxpriceis$2thenno

• Whathappensifthepricefallsto$1.50perday?

• Ifyourmaxpriceis$5:Yourconsumersurplusrisesto$3.50

• Ifyourmaxpriceis$2– nowyoubuythewaterandhavepositiveconsumersurplusof$1

Considerwhatyouwouldpayforabottleofwateratasummerconcert

NEWCS$1.50

$2.50CS

ProducerSurplusPriceactuallyreceived– willingnesstosell

• Everysellerfacesaminimumvaluetheyarewillingtoaccepttoselltheirgoods

• Thisreflectsthecostofproduction

• Athigherprices,hisproducersurplusislarger– heis“betteroff”fromsellinghisgoodsabovecost

ProducerSurplusPriceactuallyreceived– willingnesstosell

• Everysellerfacesaminimumvaluetheyarewillingtoaccepttoselltheirgoods

• Thisreflectsthecostofproduction

• Athigherprices,hisproducersurplusislarger– heis“betteroff”fromsellinghisgoodsabovecost

ProducerSurplusConsiderindependentfoodandbeveragevendorsatthesummermusicfestival,eachwiththefollowingwillingnesstosellabottleofwater:

Willingness tosell

VendorA $3.00

VendorB $2.75

VendorC $2.00

ProducerSurplus• Ifthepriceofabottleofwateris$2.25,howmanyvendorswillsellwater?

• OnlyvendorC• P.S.willbe$0.25

• Whathappensifthepricerisesto$3.50perbottle?

• Allvendorswillsellwater• PSVendorA:$0.50• PSVendorB:$0.75• PSVendorC:$1.50

ProducerSurplus• Ifthepriceofabottleofwateris$2.25,howmanyvendorswillsellwater?

• OnlyvendorC• P.S.willbe$0.25

• Whathappensifthepricerisesto$3.50perbottle?

• Allvendorswillsellwater• PSVendorA:$0.50• PSVendorB:$0.75• PSVendorC:$1.50

TotalEconomicSurplus• Combinesconsumersurplusandproducersurplus

TotalSurplus=ValuetoBuyers– CosttoSellers

TotalSurplusandFreeMarketOutcomes

• GOODSWILLBEALLOCATEDTO:• Buyerswhovaluethemmosthighly,asmeasuredbytheirwillingnesstopay.

• Sellers whocanproducethematthelowestcost.

Thefreemarketyieldsanequilibriumquantityandpricethatmaximizesbothconsumerandproducersurplus

TotalSurplusandFreeMarketOutcomes

• GOODSWILLBEALLOCATEDTO:• Buyerswhovaluethemmosthighly,asmeasuredbytheirwillingnesstopay.

• Sellers whocanproducethematthelowestcost.

Thefreemarketyieldsanequilibriumquantityandpricethatmaximizesbothconsumerandproducersurplus

KeyTakeaways

• WelfareEconomicsistheanalysisoftheeconomicwell-beingofproducersandconsumers

• Assumethatmarketoutcomesleadtomaximizedtotalsurplus

Taxation

TaxesintheSupplyandDemandModel

Taxescause:Pricepaidbybuyer>PricereceivedbysellerInsert“wedge”intheSupplyandDemandmodel

Taxwedgecreatesdeadweightloss:Lossoftotalsurplusoreconomicwell-beingasaresultofthepolicy

SalesTaxes• Taxesinsertawedgebetweenthepricepaidbybuyers(Pb)andpricereceivedbysellers(Ps)

• Regardlessofwhopaysthetax(sellersorbuyers)bothsharethetaxburden

• Tax=Pb – Ps• Taxrevenue=Tax*Qt• Taxburden(buyer)=Pb – Pe• Taxburden(seller)=Pe - Ps

UnderstandingTaxesConsiderthemarketforsocks,wheretheequilibriumpriceofsocksis$5perpairandtheequilibriumquantityis300.Thegovernmentimposesa$1taxonthemarkettobepaidbytheseller,causingafallinthequantitysoldto200.

• Whathappenswhenthetaxisimposed?Drawoutthesupplyanddemandmodelshowingthemarketbeforethetaxandafterthetax

UnderstandingTaxes

Pe =$5

Qe =300

UnderstandingTaxes

Pe =$5

Qe =300

Pb =$5.50

Pb =$4.50

Qt =200

Tax:Pb – Ps$1

UnderstandingTaxes

Pe =$5

Qe =300

Pb =$5.50

Pb =$4.50

Qt =200

Tax:Pb – Ps$1

TaxRevenue=Tax*Qt$1*200=$200

HowdotaxesaffectMarketParticipants?

Analyzethefollowingbeforetaxvs.aftertaxisimposed:• ConsumerSurplus• ProducerSurplus• TotalSurplus• GovernmentRevenue

Howdoesthetaxchangeeconomicwelfare?124

ConsumerSurplus

BEFORETAXES AFTERTAXES

ConsumerSurplus

ProducerSurplus

GovernmentTaxRevenue

ProducerSurplus

Gov’tTax

Revenue

DeadweightLoss

ProducerSurplus

ElasticityandtheTaxBurden

KeyTakeaways• Wecanthinkoftaxationinthecontextofsupplyanddemandmodelintermsof

• Howitaffectspricesandquantities• Howitaffectseconomicwell-beingviawelfareeconomics

• Sincetaxescausedistortionsinthemarket(taxwedge)theyyieldinefficientmarketoutcomes

• Whydowehavethem?Derivesomebenefitsfromgovernmentrevenue.

PrinciplesofMicroeconomicsModule3

TheoryofConsumerChoiceandDerivingthedemandcurve

UnderstandingConsumerChoice

Tounderstandhowconsumersmakedecisionsweneedtwofactors:1. BudgetConstraint- whataconsumercan buy2. IndifferenceCurves- whataconsumerwants tobuy

Combinationofincomeandpreferencesdeterminesconsumerchoices

BudgetConstraintAconsumer’sbudgetconstraint determineswhattheycanaffordtobuy

Allconsumershaveincome• Useincometopurchasegoodstheyneedandwant• Constrainedintheirchoicesbasedonhowmuchincometheyhave

BudgetConstraintExample

SupposeCharliehas$100/monthtospendontwogoods– pizzaandsoda.Thepriceofpizzais$10andthepriceofsodais$2.

• Howmuchpizzawouldhebuyifhespentallhismoneyonpizza?• Howmuchsodawouldhebuyifhespentallhismoneyonsoda?• Ifhewantstoconsumemorepizza,howmuchsodadoeshehavetogiveup?

BudgetConstraintExampleCont.

BudgetConstraint:limitstheconsumptionbundlesaconsumercanafford

Toconsumeonemorepizza,heneedstogiveup5sodas.

Slopeofthebudgetconstraint:rateatwhichaconsumercantradeonegoodforanother

YieldsrelativepriceofgoodXintermsofgoodY

Slope:ΔY/ΔX=-50/10=5Px =$10Py =$2Slope=Px/Py =10/2=5

ChangesintheBudgetConstraint

• Ifaconsumer’sincomechanges:canaffordmoreorless

• Ifthepriceofonegoodchanges:trade-offsbetweenthetwogoodschange– differentslope

• ConsumercanconsumeonlyONB.C.notpastit

ChangeinaConsumer’sIncome

WhatifCharlie’sincomefallsto$500/month?• Mustconsumelessofbothgoods• BudgetConstraintshiftsin• Nochangeinrelativeprices=nochangeinslopeofB.C.

ChangeinthePriceofaGoodWhatifthepriceofpizzarisesto$12.50?• Canconsumeonly8pies/monthatmax• Stillcanconsume50sodas/monthatmax• Relativepriceofpizzatosodahaschanged=changeinslope!

• Newslope=12.50/2=6.25

Nowpizzaismoreexpensiveintermsofsoda– giveupmoresodaforsameamountofpizza– biggertrade-off!

ConsumerPreferences• Incomeisnottheonlyfactorthatinfluencesconsumerchoice

• Eachconsumerhasdifferentpreferencesinwhattheywant toconsume

• CaptureconsumerpreferencesbyIndifferenceCurves

Consumerswillbeindifferentbetweentwobundlesgoodsifthebundlesequallysatisfyhisneeds/wants

ConsumerPreferences• Incomeisnottheonlyfactorthatinfluencesconsumerchoice

• Eachconsumerhasdifferentpreferencesinwhattheywant toconsume

• CaptureconsumerpreferencesbyIndifferenceCurves

Consumerswillbeindifferentbetweentwobundlesgoodsifthebundlesequallysatisfyhisneeds/wants

IndifferenceCurvesAconsumerisindifferent– orequallysatisfied – betweenconsumptionbundlesalongthesameindifferencecurve

• Alwaysprefer:D>B>A• IndifferentbetweenBandC• Alwayspreferanypointonahigherindifferencecurve

FourPropertiesofIndifferenceCurves

1. Higherindifferencecurvespreferredtolowerones2. Indifferencecurvesaredownwardsloping3. Indifferencecurvesnevercross4. Indifferencecurvesarebowedinward

MarginalRateofSubstitution• Rateatwhichconsumeriswilling totradeonegoodforanother

• MRS=slopeateachpointonindifferencecurve• Notconstant!• Dependsonhowmuchofeachgoodalreadyconsuming• Moreabundantgood– morewillingtotrade• Lessabundantgood– lesswillingtotrade

Consumer’sOptimalChoice

Optimalpointofconsumption– wheretheabilitytobuymeetsthe

willingnesstobuy

WherebudgetconstraintmeetsHIGHESTindifference

Consumer’sOptimalChoice• ICtangenttoBC• MRS=RelativePriceof2goods

• RelativePrice=rateatwhichthemarketiswillingtotradeonegoodforanother• MRS =rateatwhichtheconsumeriswilling totradeonegoodfortheother

𝑀𝑅𝑆 =�¥�¦

𝑀𝑅𝑆 = §¨¥§¨¦

�¥�¦ =

§¨¥§¨¦

§¨¦�¦ = §¨¥

Marginal Rate of Substitution is equal tothe relative price at the optimum

Marginal Rate of Substitution reflects therelative level of satisfaction in consumptionof Good X and Good Y

At the optimum:Marginal Utility per dollar spent on Good X isequal to the marginal utility per dollar spent onGood Y

Rate of satisfaction we get from each dollar wespend on Good X is equal to the satisfactionfrom each dollar spent on Good Y

IncomeandSubstitutionEffects• IncomeEffect:Thechangeinconsumptionthatresultswhenapricechangemovestheconsumertoahigherorlowerindifferencecurve

• WhenthepriceofGoodXfalls,incomedoesnotchangebutwe“feelwealthier”becauseeachdollarinourpocketcanbuymoreofGoodXandmoreofGoodY

• WithapricefallinGoodXàmovetoanewconsumption bundleonahigherindifferencecurve

• SubstitutionEffect:ThechangeinconsumptionthatresultswhenapricechangemovestheconsumeralongthesameindifferencecurvetoapointwithanewMRS

• WhenthepriceofGoodXfalls,GoodXisnowcheaperintermsofGoodY.TherelativepriceofGoodXhaschanged.

• Inotherwords– GoodYhasbecomemoreexpensiveintermsofgoodGoodX• ConsumemoreofGoodXandlessofGoodY

IncomeandSubstitutionEffects• IncomeEffect:Thechangeinconsumptionthatresultswhenapricechangemovestheconsumertoahigherorlowerindifferencecurve

• WhenthepriceofGoodXfalls,incomedoesnotchangebutwe“feelwealthier”becauseeachdollarinourpocketcanbuymoreofGoodXandmoreofGoodY

• WithapricefallinGoodXàmovetoanewconsumption bundleonahigherindifferencecurve

• SubstitutionEffect:ThechangeinconsumptionthatresultswhenapricechangemovestheconsumeralongthesameindifferencecurvetoapointwithanewMRS

• WhenthepriceofGoodXfalls,GoodXisnowcheaperintermsofGoodY.TherelativepriceofGoodXhaschanged.

• Inotherwords– GoodYhasbecomemoreexpensiveintermsofgoodGoodX• ConsumemoreofGoodXandlessofGoodY

IncomeandSubstitutionEffect

AGoodY

AssumethatthePriceofGoodXfalls

AGoodY

Budgetconstraintshiftsoutonabias

AGoodY

WiththesubstitutioneffectàGoodYisnowmoreexpensiveintermsofGoodX

MovetoanewpointofconsumptionontheexistingIC.1

AGoodY

BC.1 BC.2

A’’

WiththeincomeeffectàWecanbuymoreofboth!

MovetoanewpointofconsumptiononthenewIC

AGoodY

BC.1 BC.2

Inreality:BothIncomeandSubstitutionEffectoccursimultaneously!

ConsumermovesfromPointAtoPointB

Whichdominates?

A’’

AOranges

Apples

DeterminingDemand

IC.1IC.2IC.3

BC.2 BC.3

AsthePriceofGoodXfalls– Consumerwillhavenewoptimalpointsofconsumptionandnewquantitiesofapplesheconsumes

PriceofApples

QuantityofApples

A $1.99 5

B $1.49 8

C $0.99 10

5810159

AOranges

Apples

DeterminingDemand

IC.1IC.2IC.3

BC.2 BC.3

5810QuantityofApples

PriceofApples

DemandforApplesConsumerChoiceBetweenOrangesandApples

KeyTakeaways

• Consumer’soptimalchoicedependonbothhowmuchtheycanafford(budgetconstraint)andwhattheprefer(indifferencecurves)

• Changesinaconsumer’sincomeaswellaschangesinthepriceofgoodswillaffecttheoptimalconsumptionchoice

• Howconsumersrespondtothechangeinthepriceofagoodwilldeterminethedemandcurve

UnderstandingProductionCosts

ProductionChoicesofFirms• Allfirmshaveonegoalinmind:MAXPROFITS

PROFITS=TOTALREVENUE– TOTALCOST

• Twowaystoreachthisgoal:• Maximizetotalrevenue

TotalRevenue=PriceXQuantity• Minimizetotalcosts

TotalCosts=FixedCosts+VariableCosts

DeterminingProductionviaProductionFunction

ProductionFunction:Relationshipbetweenquantityofinputsandtotaloutput

Q=f(Land,Labor,Capital)

Example:DeterminetheproductionofgoodAifitsproductionfunctionis:Q=100K1/2 +25L1/2

Assumethefirmusesonemachineandincreasesitsworkersby10.

DeterminingProductionviaProductionFunction

ProductionFunction:Relationshipbetweenquantityofinputsandtotaloutput

Q=f(Land,Labor,Capital)

Example:DeterminetheproductionofgoodAifitsproductionfunctionis:Q=100K1/2 +25L1/2

ProductionFunctionExample

CAPITAL LABOR Prod.Function OUTPUT

1 5 100*11/2 + 25*51/2 156

1 6 100*11/2 + 25*61/2 161

1 7 100*11/2 + 25*71/2 166

1 8 100*11/2 + 25*81/2 171

1 9 100*11/2 + 25*91/2 175

1 10 100*11/2 + 25*101/2 179

Q=100K1/2 +25L1/2

No.ofMachinesConstant

1 5 100*11/2 + 25*51/2 156

1 6 100*11/2 + 25*61/2 161

1 7 100*11/2 + 25*71/2 166

1 8 100*11/2 + 25*81/2 171

1 9 100*11/2 + 25*91/2 175

1 10 100*11/2 + 25*101/2 179

Q=100K1/2 +25L1/2

No.ofWorkersIncreasingby1

1 5 100*11/2 + 25*51/2 156

1 6 100*11/2 + 25*61/2 161

1 7 100*11/2 + 25*71/2 166

1 8 100*11/2 + 25*81/2 171

1 9 100*11/2 + 25*91/2 175

1 10 100*11/2 + 25*101/2 179

Q=100K1/2 +25L1/2

UseProductionFunctionTocalculatehowmuchweproduce

ProductionCostsRentPriceofCapital=$800à FIXEDCOSTWagesofworkers=$25à VARIABLECOST

CostofCAPITAL Cost ofLABOR TOTAL COST

800 125 925

800 150 950

800 175 975

800 200 1000

800 225 1025

800 250 1050

MarginalProductofLaborMarginalProduct– Increaseinoutputresultingfroman

increaseinoneoftheinputsMPL=ChangeinOutput/ChangeinLabor

LABOR OUTPUT MPL

6 161 5.34

7 166 4.91

8 171 4.57

9 175 4.29

10 179 4.06

IncreasingLaborOnlyDiminishingMarginalReturns:Outputisincreasingatadecreasingrate

ProductionCosts

LABOR OUTPUT FIXEDCOST VARIABLECOST TOTALCOST AFC AVC ATC MC

5 156 800 125 925

6 161 800 150 950

7 166 800 175 975

8 171 800 200 1000

9 175 800 225 1025

10 179 800 250 1050

K*$100 L*$25 Fixed+Variable

Toanalyzetheproductiondecisionsofafirm,recallthatafirmconducts“marginalanalysis”Decisionsarebasedonper-unitcalculations

Therefore,needtocalculatecosts/unit

ProductionCosts

LABOR OUTPUT FIXEDCOST VARIABLECOST TOTALCOST AFC AVC ATC MC

5 156 800 125 925 5.13 0.80 8.34

6 161 800 150 950 4.96 0.93 8.68 4.686

7 166 800 175 975 4.82 1.05 9.03 5.095

8 171 800 200 1000 4.69 1.17 9.37 5.474

9 175 800 225 1025 4.57 1.29 9.71 5.828

10 179 800 250 1050 4.47 1.40 10.05 6.162

TC/QVC/QFC/Q

Costsperunitofoutputproduced

AverageFixedCostCurve

AverageVariableCostCurve

AverageTotalCostCurve

MarginalCostCurve

• WhenMC<ATCà ATCisfalling• WhenMC>ATCà ATCisrising• MCcrossesATCatminimum– EFFICIENTSCALE 177

Cost MC

LongRunvs.ShortRunTotalCost

SRATC1 SRATC2 SRATC3 LRATC1

Output

EconomiesofScale

ATCisfallingwithincreaseinoutput

DiseconomiesofScale

ATCisrisingwithincreaseinoutput

KeyTakeaways• Allfirmsareprofitmaximizingandthereforewanttominimizetheircosts

• Tomaketheirproductiondecisions– needtoconsiderATC,AVC,AFCandMC

• NEXT:Mergecostcurveswithrevenuetounderstandhowdifferenttypesoffirmsmakeproductiondecisions

UnderstandingProfit

EconomicCostsEconomicCostsforproducersincludeexplicitandimplicitcosts

- ExplicitCosts:Financialcosts- ImplicitCosts:Opportunitycosts

Example:Carolinecanuse$300,000ofhersavingstostartherfirmwhichisinasavingsaccountpaying5%interest.ORCarolineborrow$200,000fromabankatthesameinterestrateandused$100,000fromhersavings.Whichshouldshedo?

EconomicCostsEconomicCostsforproducersincludeexplicitandimplicitcosts

- ExplicitCosts:Financialcosts- ImplicitCosts:Opportunitycosts

Example:Carolinecanuse$300,000ofhersavingstostartherfirmwhichisinasavingsaccountpaying5%interest.(OR)Carolineborrow$200,000fromabankatthesameinterestrateandused$100,000fromhersavings.Whichshouldshedo?

ExampleofEconomicCostsChoiceA:Caroline’scosttostartherbusiness:

• ExplicitCost=$300,000• ImplicitCost=($300,000X5%)=$15,000• TotalEconomicCost=$315,000• TotalAccountingCost=$300,000

ChoiceB:Caroline’scosttostartherbusiness:

• ExplicitCost=$200,000+$100,000+($200,000X5%)=$310,000• ImplicitCost=($100,000X5%)=$5,000• TotalEconomicCost=$315,000• TotalAccountingCost=$310,000

ExampleofEconomicCostsChoiceA:Caroline’scosttostartherbusiness:

• ExplicitCost=$300,000• ImplicitCost=($300,000X5%)=$15,000• TotalEconomicCost=$315,000• TotalAccountingCost=$300,000

ChoiceB:Caroline’scosttostartherbusiness:

• ExplicitCost=$200,000+$100,000+($200,000X5%)=$310,000• ImplicitCost=($100,000X5%)=$5,000• TotalEconomicCost=$315,000• TotalAccountingCost=$310,000

KeyEquations• TotalRevenue(TR)=PricexQuantity• MarginalRevenue=ChangeinTR/ChangeinQ• MarginalCost=ChangeinTC/ChangeinQ

MarginalRevenue– capturesthechangeinafirm’srevenuefromoneadditionalunitproduced

MarginalCost– capturesthechangeinafirm’scostfromoneadditionalunitproduced

KeyEquations• TotalRevenue(TR)=PricexQuantity• MarginalRevenue=ChangeinTR/ChangeinQ• MarginalCost=ChangeinTC/ChangeinQ

MarginalRevenue– capturesthechangeinafirm’srevenuefromoneadditionalunitproduced

MarginalCost– capturesthechangeinafirm’scostfromoneadditionalunitproduced

ProfitMaximizingPointofProduction• Firmswillmaximizetheirprofitsbyproducingatthepointwhere

MR=MC• IfMR>MC:Increaseprofitsbyproducingmore• IfMR<MC:Increaseprofitsbyproducingless

ProfitMaximizingPointofProduction

• WhereMR=MCtellsusthattheadditionalrevenuegeneratedfromthelastunitproducedisequaltotheadditionalcostofproducingit

• ThefirmcannotincreasetheirprofitsbyproducinganymoreoranylessthanatthepointwhereMR=MC,inotherwords– marginalprofit=0

ProfitMaximizingPointofProduction

• WhereMR=MCtellsusthattheadditionalrevenuegeneratedfromthelastunitproducedisequaltotheadditionalcostofproducingit

• ThefirmcannotincreasetheirprofitsbyproducinganymoreoranylessthanatthepointwhereMR=MC,inotherwords– marginalprofit=0

KeyTakeaways• Allfirmsareprofitmaximizing• PointofmaximizingprofitsiswhereMR=MCforallfirms

• WhereMR=MC,profitisatitshighestandthefirmcannotproduceanymoreorlesstoincreaseprofitfurther

PerfectCompetition

PerfectlyCompetitiveMarketsKeyCharacteristics:• Manybuyersandsellers• Goodsareidentical• Firmscanfreelyenterandexitthemarket

Nosinglefirmcanexertpricecontrolinthemarket.Allfirmsarepricetakers.

Tomaximizerevenue– canonlychangequantity!194

ProfitMaximizingPointofProduction• Firmswillmaximizetheirprofitsbyproducingatthepointwhere

MR=MC• IfMR>MC:Increaseprofitsbyproducingmore• IfMR<MC:Increaseprofitsbyproducingless

• NOTE:MarginalRevenueisconstantandequaltopriceONLY underperfectcompetition.

PerfectCompetitionConsiderFirmAwhichsellspingpongballs.Thefollowingtabledescribestheirrevenuesandcosts:

- HowmanypingpongballsshouldFirmAproducetomaximizeitsprofits?- WhatdoyouobserveaboutMRandMCatthispoint?

Output Price TotalRevenue

TotalCost Profit Marginal

RevenueMarginalCost

0 $3 $0.00 $1.501 $3 $3.00 $2.002 $3 $6.00 $3.003 $3 $9.00 $4.504 $3 $12.00 $6.505 $3 $15.00 $9.506 $3 $18.00 $12.757 $3 $21.00 $16.258 $3 $24.00 $20.009 $3 $27.00 $24.00

PerfectCompetition

Output Price TotalRevenue TotalCost Profit MarginalRevenue

MarginalCost

0 $3 $0.00 $1.50 ($1.50)1 $3 $3.00 $2.00 $1.00 3 $ 0.50 2 $3 $6.00 $3.00 $3.00 3 $ 1.00 3 $3 $9.00 $4.50 $4.50 3 $ 1.50 4 $3 $12.00 $6.50 $5.50 3 $ 2.00 5 $3 $15.00 $9.50 $5.50 3 $ 3.00 6 $3 $18.00 $12.75 $5.25 3 $ 3.25 7 $3 $21.00 $16.25 $4.75 3 $ 3.50 8 $3 $24.00 $20.00 $4.00 3 $ 3.75 9 $3 $27.00 $24.00 $3.00 3 $ 4.00

PerfectCompetition

Output Price TotalRevenue TotalCost Profit MarginalRevenue MarginalCost

0 $4 $0.00 $1.501 $4 $4.00 $2.002 $4 $8.00 $3.003 $4 $12.00 $4.504 $4 $16.00 $6.505 $4 $20.00 $9.506 $4 $24.00 $12.757 $4 $28.00 $16.258 $4 $32.00 $20.009 $4 $36.00 $24.00

Whatifthepriceincreasesto$4?

PerfectCompetition

NewPriceà NewMarginalRevenueNewoptimalpointofproduction

Output Price TotalRevenue TotalCost Profit MarginalRevenue MarginalCost

0 $4 $0.00 $1.50 ($1.50)1 $4 $4.00 $2.00 $2.00 4 $ 0.50 2 $4 $8.00 $3.00 $5.00 4 $ 1.00 3 $4 $12.00 $4.50 $7.50 4 $ 1.50 4 $4 $16.00 $6.50 $9.50 4 $ 2.00 5 $4 $20.00 $9.50 $10.50 4 $ 3.00 6 $4 $24.00 $12.75 $11.25 4 $ 3.25 7 $4 $28.00 $16.25 $11.75 4 $ 3.50 8 $4 $32.00 $20.00 $12.00 4 $ 3.75 9 $4 $36.00 $24.00 $12.00 4 $ 4.00

Whatifthepriceincreasesto$4?

GraphingProductionDecisions

• FirmAisapricetaker• Ifobservepricechange–increaseto$4– willrespondbyproducingmore

• NewMRà NewpointwhereMR=MC

Newprofitmaxpointofproduction

Firm’sShortRunDecisions• Intheshort– firmmustdecideifitshouldproduce ortemporarilyshutdown

• Temporaryshutdown≠Exitfrommarket• Firmissuspendingproductiontemporarily• Muststillpayfixedcosts• Nolongerpaysvariablecosts,nolongerreceivesrevenue

SHUTDOWNWHEN:TotalRevenue<VariableCost

TR=PXQAVC=VCXQ

Shutdown:P<AVC

Firm’sShortRunSupplyCurve

Because,intheshortrun,afirmwillproduceonlyifP ≥AVC,thefirm'sshortrunsupplycurvewillbeitsMCaboveAVC

If: TheFirmWill:P≥AVC ProduceoutputlevelwhereMR=MCP<AVC Shutdownandproducezerooutput

AVC AVC

ShortRunSupplyCurve

Quantity

P(Cost)

Quantity

Firm’sLongRunDecisionsFirmmustdecide:

• Enteramarket?• Continueproducing?• Exitamarket?

Whenenteramarket– TR>0;TC>0• WillenterifTR>TCà P>ATC

Whenexitamarket– TR=0;TC=0• WillexitifTR<TCà P<ATC

Firm’sLongRunSupplyCurve

Because,inthelongrun,afirmwillremaininamarketonlyifP ≥ATC,thefirm'slong-runsupplycurvewillbeitsMCaboveATC

If: TheFirmWill:P>ATC EnterbecauseeconomicprofitsareearnedP=ATC NotenterorexitbecauseeconomicprofitsarezeroP<ATC Exitbecauseeconomiclossesareincurred

Firm’sLongRunSupplyCurveMC

AVC AVC

LongRunSupplyCurve

Quantity

P(Cost)

Quantity

Because,inthelongrun,afirmwillremaininamarketonlyifP ≥ATC,thefirm'slong-runsupplycurvewillbeitsMCaboveATC

If: TheFirmWill:P>ATC EnterbecauseeconomicprofitsareearnedP=ATC NotenterorexitbecauseeconomicprofitsarezeroP<ATC Exitbecauseeconomiclossesareincurred 205

PROFIT

MeasuringProfitorLossProfit=TR –TC

TR =P xQ TC =ATC xQ

Profit=(P – ATC)xQMC

P(Cost)

Quantity

P(Cost)

Quantity

ATC LOSSATC

LongRunEquilibrium

P(Cost)

Quantity

P= ATC MR

ZeroEconomicProfitsMR=MCP=ATC

ImpactofShiftinDemand

P(Cost)

Quantity

P.1 MR.1

IncreaseinDemandà IncreaseinPriceMRincreases

Intheshortrun:movementalongthesupplycurve(MC)becausenewprice=newMR

P(Cost)

Quantity

MR.2P.2 P.2

SHORTRUNPRODUCTION

Q.1 Q.2D.1

Q.1 Q.2

PROFIT

ImpactofShiftinDemand

P(Cost)

Quantity

P.1 MR.1

IncreaseinPriceàMRincreasesà ProfitsinShortRunInthelongrun:NewFirmsentertotakeadvantageofpositiveprofits

Shiftinthesupplycurvebecausechangeinnumberofsellers

P(Cost)

Quantity

MR.2P.2 P.2

LONGRUNPRODUCTION

Q.1 Q.2D.1

Q.1 Q.2

KeyTakeaways• Perfectlycompetitivefirmsarepricetakers– tochangetheirprofitmaxpointofproductiontheycanonlychangequantity

• Faceshortrunandlongrundecisionsonproduction

• Shortrunprofit/lossdependsonpricesandATC

• Firmswilloperateinthelongrunwithzeroeconomicprofitsbecauseofthefreeentryandexitoffirms

Monopoly

FundamentalCausesofMonopolyBarrierstoEntrycauseMonopolyPower• ResourceRestrictions:

Monopolyhassoleownershipofakeyresourceinproduction

• Gov’tcreatedMonopoliesMonopolyisgrantedexclusiverightstoproduceorsellagood

• NaturalMonopoliesOnefirmcanprovidethegoodatalowercostthantwoormorefirms

PricingandProductionDecisions• Amonopolyfirmhascompletepricecontrolbecausetheyarethesoleproviderofthegood

ConsideredaPriceMaker

• Monopolyfirm– stillfacesadownwardslopingdemandcurve

• Tosellmore=mustlowertheprice

Price:determinedbyfirmQuantity:determinedbydemand

UnderstandingMonopolyConsiderthemarketfordiamondswhereDeBeershasamonopoly.Itisdecidinghowmuchtosellandatwhatprice.

• Wherewillitgainpositiverevenue?

• Whatpriceshould itsetandwhereshould itproduce tomaximizeprofits?

• Whatwillbethesizeofitsprofitsatthispoint?

Price Quantity TR TC MR MC

2000 0 0 25,000

1800 100 180,000 100,000

1600 200 320,000 190,000

1400 300 420,000 290,000

1200 400 480,000 400,000

1000 500 500,000 525,000

UnderstandingMonopolyConsiderthemarketfordiamondswhereDeBeershasamonopoly.Itisdecidinghowmuchtosellandatwhatprice.

• Anywherebelow$2000

• $1400

• $130,000

Price Quantity TR TC MR MC

2000 0 0 25,000

1800 100 180,000 100,000 1800 750

1600 200 320,000 190,000 1400 900

1400 300 420,000 290,000 1000 1000

1200 400 480,000 400,000 600 1100

1000 500 500,000 525,000 200 1250

UnderstandingMonopolyMonopolycansetthepriceanywherebelow$2000

andgainpositiverevenue

Optimalpointofproduction?Needtoconsiderprofitmaximization

IfMR>MC:IncreaseprofitsbyincreasingQsIfMR<MC:IncreaseprofitsbydecreasingQs

UnderstandingMonopoly

Quantity

Price(Cost)

ProfitsforaMonopoly

Profits=TR– TC=(PxQ)– (ATCxQ)=Q(P– ATC)

Profits=300(1400– 966)ATC=290,000/300=966

UnderstandingQuickCheck

Foraprofit-maximizingmonopolythatchargesthesamepricetoallconsumers,whatistherelationshipbetweenprice (P), marginalrevenue (MR), andmarginalcost(MC) ?a) P=MRand MR=MC.b) P>MRand MR=MC.c) P=MRand MR>MC.d) P>MRand MR>MC.

UnderstandingQuickCheck

Foraprofit-maximizingmonopolythatchargesthesamepricetoallconsumers,whatistherelationshipbetweenprice (P), marginalrevenue (MR), andmarginalcost(MC) ?a) P=MRand MR=MC.b) P>MRand MR=MC.c) P=MRand MR>MC.d) P>MRand MR>MC.

WelfareCostsofaMonopoly• SincemonopoliessetpricesandquantitiesatMR=MCandMR≠P– themonopolyoutcomeissociallyinefficient.

• TotalsurpluswouldbemaximizedatP=D=MC• D=MCà SociallyEfficientOutcome• MR=MCà ProfitMaxOutcome

DifferencebetweenMonopolyOutcomeandSociallyEfficientOutcomeà Deadweightloss 222

WaystoRegulateMonopolyPower

• IncreasecompetitionwithAntitrustLaws

• Regulatenaturalmonopoliestobringpriceasclosetosociallyefficientpointaspossible

• PublicOwnershipà Governmenttakesover

• Donothing:Costtoregulation>Benefitofregulating

KeyTakeaways

• Monopoliesaretheleastcompetitivemarketstructurebuttheystilldependondemandtosetpricesandprofitmaximizingquantities

• Therearesocialcoststomonopolypower,includingdeadweightloss

• Therearemanyharmlessandharmfulexamplesofmonopolypowerintheworldtoday.

PrinciplesofMicroeconomicsModule5.4OligopolyandGameTheory

OligopolyMarketsFewsellers

Sellinganidenticalgood

• Becausefewsellers,theproductionchoicesofonefirmwillaffecttheoutcomesofallotherfirmsinthemarket

• Firmsmustactstrategicallybecauseprofitsnowdependon:• Howmuchitproduces• Howmuchallotherfirmsproduce

• Tensionbetweencooperation andself-interest

OligopolyandGameTheory• Oligopoly:bestoutcomeistocooperate andactasamonopoly

• ProducesmallquantityofoutputatP>MC• Yieldshighestprofits!

• Incentivetoactinownself-interest• Eachcaresonlyabouttheirownprofits• Ifonecheats:evenhigherprofits!

• Toreachthemonopolyoutcome– eachfirmreliesontheother(interdependent)

• Colludetosetpricesorquantitiesproducedtoreachthepointofhighestpossibleprofits

• Cartels:groupsoffirmsthatacttogetherandcollude227

UnderstandingOligopolyJackandJillowntheonlywaterwellintown.Eachcanbringinwatertotowntosellitbuttheyneedtoagreeonhowmuchtobringin.AssumeMC=0.

Quantity Price TotalRevenue0 120 010 110 110020 100 200030 90 270040 80 320050 70 350060 60 360070 50 350080 40 320090 30 2700

OligopolyOutcomeIfcooperate: reachmonopolyoutcome

P=60;Q=60;Profit=3600JackProfitsà P=60,Q=30,Profit=1800JillProfitsà P=60,Q=30,Profit=1800

Ifonecheats: cangainmore!P=50,Q=70,Profit=3500

Cheaterà P=50,Q=40,Profit=2000Cooperatorà P=50,Q=30,Profit=1500

OligopolyOutcomeIfbothcheat:lowerprofitsbutoligopolyoutcome

P=40,Q=80,Profits=3200JackProfits:P=40,Q=40,Profits=1600JillProfits:P=40,Q=40,Profits=1600

OligopolyOutcome:Bothcheat!

Actinownself-interestFailtocooperate

NashEquilibriumAgentsthatinteractwithoneanotherwillchoosetheiroptimalstrategygiventhestrategiesthatallother

agentshavechosen

àOnefirm’soptimalstrategytakesintoaccountallotherfirms’choices

à NashEquilibrium:BothCheatCan’tdoanybetterregardlessofwhattheotherpersondoes

OligopolyOutcome&NashEquilibrium

N=Numberoffirms

Note: Asthenumberoffirmsgrows– theoligopolyoutcomereachescompetitiveequilibrium

• Largernumberoffirms– eachbecomeslessconcernedabouthowtheyimpactallotherfirms

• Moreincentivetoactintheirownself-interest

𝑶𝒍𝒊𝒈𝒐𝒑𝒐𝒍𝒚𝑶𝒖𝒕𝒄𝒐𝒎𝒆 =𝑵

𝑵 + 𝟏 𝒙𝑪𝒐𝒎𝒑𝒆𝒕𝒊𝒕𝒊𝒗𝒆𝑶𝒖𝒕𝒄𝒐𝒎𝒆

OligopolyOutcome&GameTheory

Ifcooperate,collectivelygainhighestprofitsbutindividuallyirrational– becausepotentialtomakeevenmorebycheating!

Regardlessofwhattheotherpersondoes– besttocheat!- Avoidlowerprofits($1500)- Potentialforevenhigherprofits($2000)

CHEAT COOPERATE

CHEAT Jack Profits:$1600 Jack Profits:$1500

JillProfits:$1600 JillProfits:$2000

COOPERATE Jack Profits:$2000 Jack Profits:$1800

JillProfits:$1500 JillProfits:$1800

OligopolyOutcomes

• Whenthereareonlyafewfirmsinamarket– eachfirmactsstrategically

• Gametheory– guidesthestrategiesthatfirmschoose• Willactintheirownself-interestdespitethepotentialtogainwhencooperate

• Cooperationispossibleinrepetitivegameswhentherulesdon’tchange

PrinciplesofMicroeconomicsModule5.5MonopolisticCompetition

MonopolisticCompetition• MonopolisticallyCompetitiveMarkets:

• Havemanybuyersandsellers• Sellsimilarbutdifferentiatedproducts• Freeentryandexitinthemarket

• Firms:• Havesomepricecontrol• Inshortrun:experienceeconomicprofits+actasmonopoly• Inlongrun:zeroeconomicprofits+actasperfectcompetition

Intheshortrun…• Marketoutcomelookssimilartomonopoly

• ProfitMaxPoint:MR=MC• Price>MR=MC

DeterminesquantitybasedonMR=MCDeterminesprice basedondemand

IfP>ATCPOSITIVEECONOMICPROFITSPossibleinShortRun

Inthelongrun…•Marketoutcomesimilartoperfectlycompetitivemarkets

•Reason:FREEENTRY/EXIT

Firmsinthelongrunoperateat:P>MC

Duetofirmfacingadownwardslopingdemandcurve

P=ATCDuetofreeentryandexit intothemarket

LongRunwhenP>ATC• IfP>ATC:Shortrunpositiveprofits• Overtime:morefirmsentertotakeadvantageofprofits

• Increasevarietyofgoodsasmorefirmsenter• Decreaseindemandforeachfirm’sdifferentiatedgood• DecreaseinpriceforfirmsuntilP=ATC

ZeroEconomicProfitsInlongrun

• AdjustuntilP=ATCinLongrun

LongRunwhenP>ATC

Quantity

Price(Cost)

Quantity

LongRunwhenP>ATC

Quantity

Price(Cost)

Quantity

D.2MR.2

Asnewfirmsenterà supply inthemarketgoesupButforeachindividualfirmà demandgoesdownNochangeincostsà adjustmentuntilP=ATC

LongRunwhenP<ATC• IfP<ATC:Shortrunnegativeprofits– Loss!• Overtime:firmsexitmarkettoavoidlosses

– Decreasevarietyofgoodsasmorefirmsexit– Increaseindemandforeachfirm’sdifferentiatedgood– IncreaseinpriceforfirmsthatstayinmarketuntilP=ATC

ZeroEconomicProfitsInlongrun

• AdjustuntilP=ATCinLongrun

LongRunwhenP<ATC

Quantity

Price(Cost)

Quantity

LongRunwhenP<ATC

Quantity

Price(Cost)

Quantity

D.2MR.2

Asfirmsexità supply inthemarketgoesdownButforeachindividualfirmà demandgoesupNochangeincostsà adjustmentuntilP=ATC

WelfareandMonopolisticCompetition

• BecauseP>MCà somecoststosocietyaswithmonopolyoutcome• Regulationofthesefirmswouldbeverydifficultà toomanyfirmstoregulate

• TwoexternalitiesarisefromM.C.outcome:• Product-varietyexternality• Business-stealingexternality

KeyTakeaways

• MonopolisticallyCompetitivefirmsactasbothmonopolies(inSR)andperfectlycompetitivefirms(inLR)

• Havesomeexcesscapacityandmarkupbecausehavesomepricecontrol

• Advertisingonlyworkswhentherearesimilarbutdifferentiatedproducts– onlyinM.C.markets

MarketforInputsinProduction

FactorsofProduction

• Factorsofproduction:theinputsusedtoproducegoodsandservices.

• Similartothemarketsforgoodsandservicesdiscussedearlier,buttheyaredifferentinoneimportantway.

• demandforafactorofproductionisaderiveddemand,• meaningthatthefirm'sdemandforafactorofproductionisderivedfromitsdecisiontosupplyagoodinanothermarket.

DemandforLabor

• Householdssupplylabor• Firmsdemandlabor

• Needtodeterminehowmanyworkerstheymusthiretoreachtheirprofitmaximizingpointofproduction

DemandforLaborWage

QuantityofLabor

DemandbyFirms

ShiftsinDemandforLabor

• Changeinoutputprice• Priceofgoodincreasesà Firmwillproducemoreà demandmorelabor

• TechnologicalChange• Techprogressà workersmoreproductiveà firmneedslesslabor

• Supplyofotherfactors• Ifotherfactorsbecomescarceà firmcanproducelessoverallà lessdemandforlabor

SupplyofLaborWage

QuantityofLabor

SupplybyHouseholds

ShiftsinSupplyofLabor

• Changeinnumberofworkers• Moreworkersinterestedinajobàmorelaboravailable• Influxofworkersà shiftssupplycurve

EquilibriumforLaborWage

QuantityofLabor

DemandbyFirms

SupplybyHouseholds

LinkagesamongtheFactorsofProduction

• Factorsofproductionareusedtogether• Productivityofeachfactordependsonthequantitiesoftheotherfactorsavailable

• Changeinthesupplyofanyonefactorcanchangetheearningsofallofthefactors.

• Changeintheearningsofanyfactorcanbefoundbymeasuringtheimpactoftheeventmarginalproductofthatfactor.

Externalities

Externalities• Theuncompensatedimpactofoneperson’sactionsonthewell-beingofabystander isanexternality

• PositiveExternality:Beneficialforthebystander• NegativeExternality:Adverselyeffectsbystander

RecaponSupplyandDemand• Recallthatsupplyreflectsthecosttoprovidethegood/serviceforthefirm

• Reflectsonlyprivatecost• Ifexternalitiesexist– alsoneedsocialcost:thecoststothirdpartiesassociatedwiththeprovisionofthegood

• Recallthatdemandreflectsthevaluebuyersassigntoagood/service• Reflectsonlyprivatevalue• Ifexternalitiesexist– alsoneedsocialbenefit/value:thevaluetothirdpartiesassociatedwiththeprovisionofthegood

Pollution:NegativeExternality

Consideracoal-poweredmanufacturingplantmakingwidgets

Pollutionisanegativeexternalityassociatedwiththeproductionofwidgets

FirmswillproducewhereS=DTheydonotaccountforthesocialcost

Toforcethemtoaccountforthecosttosocietyofhigherpollution,governmentcanimposetaxes/quotas

QuantityofWidgets

PriceofWidgets Supply

(PrivateCost)

SocialCost

Demand

Education:PositiveExternality

Considerthevalueofeducationtoanindividualandtosociety

Educationyieldspositiveexternalitiesbecausebetter-educatedvotersleadtoabettergovernment.Crimeratesalsodropastheeducationlevelofthepopulationrises.

Toensurehighlevelsofeducation,governmentcansubsidizeeducation,provideitforfree,and/orimposeregulationtoensureallchildrenreceiveit

QuantityofSchooling

ValueofSchooling

Supply

Demand(PrivateValue)

SocialValue

Internalizinganexternality

Alteringtheincentivessothatpeopletakeaccountoftheexternaleffectsoftheiractions.

• Becauseprivatecostsdonotaccountforsocialcosts-->governmentcanimposetaxesorregulationtoincreaseprivatecosttomatchsocialcosts

• Bydoingso,theinternalizationforcesthefirmtoproducelessandthereforelowerthesizeofthenegativeexternality

• Becauseprivatebenefitdoesnotaccountforsocialbenefit-->governmentcanintroducetaxbreaks,subsidies,andregulationtoenhancetheprivatebenefit

• Bydoingso,theinternalizationforcestheeconomicagentclosertothehighersocialbenefitpoint.

PublicPolicytowardsExternalities

Command-and-control:• Externalitiescanbecorrectedbyrequiringorforbiddingcertainbehaviors.

• IntheUnitedStates,theEnvironmentalProtectionAgency(EPA)developsandenforcesregulationsaimedatprotectingtheenvironment.

• EPAregulationsincludemaximumlevelsofpollutionallowedorrequiredadoptionofaparticulartechnologytoreduceemissions.

Market-basedPolicies:• Externalitiescanbeinternalizedthroughtheuseoftaxesandsubsidies.• Correctivetax:ataxdesignedtoinduceprivatedecisionmakerstotakeaccountofthesocialcoststhatarisefromanegativeexternality.

• Thesetaxesarepreferredbyeconomistsoverregulation,becausefirmsthatcanreducepollutionwiththeleastcostarelikelytodoso(toavoidthetax)whilefirmsthatencounterhighcostswhenreducingpollutionwillsimplypaythetax.

• Thus,thistaxallowsfirmsthatfacethehighestcostofreducingpollutiontocontinuetopollutewhileencouraginglesspollutionoverall.

Market-basedPolicies:

• TradablePollutionPermits• EPAregulationsrestricttheamountofpollutionthattwofirmscanemitat300tonsofglopperyear.FirmAwantstoincreaseitsamountofpollution.FirmBagreestodecreaseitspollutionbythesameamountifFirmApaysit$5million.

• SocialwelfareisincreasediftheEPAallowsthissituation.Totalpollutionremainsthesamesotherearenoexternaleffects.Ifbothfirmsaredoingthiswillingly,itmustmakethembetteroff.

• IftheEPAissuedpermitstopolluteandthenallowedfirmstosellthem,thiswouldalsoincreasesocialwelfare.Firmsthatcouldcontrolpollutionmostinexpensivelywoulddosoandselltheirpermits,whilethosewhoencounterhighcostswhenreducingpollutionwouldbuyadditionalpermits.

KeyTakeaways

• Externalitiesaretheoutcomesofdecisionsmadebyeconomicagentsthataffectbystanderswhoarenotpartofthedecision-makingprocess

• Externalitiescanbebothbeneficialandharmful

• Thesizeoftheexternalitycanbecontrolledbygovernmentinterventionintheformorcommand-and-controlpoliciesormarket-basedpolicies

PublicGoodsandCommonResources

TypesofGoodsintheEconomy

• Excludable:Apersoncanbepreventedfromusingthegood• RivalinConsumption:Oneperson’suseofthegooddiminishesotherpeople’suseofthegood

TypesofGoodsintheEconomyRivalinconsumption

Yes No

Excludable

YesPrivateGoods- Ice-creamcones- Clothing

ClubGoods- Movie theaters- CableTV

NoCommonResources- Fishintheocean- Theenvironment

PublicGoods- Nationaldefense- Knowledge

ProvisionofPublicGoods

• Becauseitisdifficulttogetanyonetopayforpublicgoods(becausenon-excludable)à noindividualfirmwillbewillingtoprovidethegood

• FreeriderProblem:apersonwhoreceivesthebenefitofagoodbutavoidspayingforit.

• Example:pavingmainstreetintown• everyonebenefits,• noone’susediminishesanyoneelse’suse• Can’tstoppeoplefromusingit• Thereforeàwillafirmpay?NO!

• Duetothismarketfailureà needthegovernmenttostepintoprovidepublicgoods

CommonResources

• Non-excludablebutrivalinconsumption• Can’tstoppeoplefromusing• Themorepeopleusethegood– thelessitcanbeusedbyothers

• Fishinginthelocalpond(orocean)• Limitedfishinthepond• Everyonecancomeandfish• Themorepeoplefishà thelessfishforeveryoneelse!

RegulatingCommonResources

• Economistshavestruggledwithidentifyingthebestsolutionsforavoidingtheproblemwithcommonresources

• Regulatingquantityfished/used• Vouchersystem• Timeoffishing

• Needregulationandgovernmentinvolvementtosolvethesemarketfailures

KeyTakeaways

• Therearemanytypesofgoodsinoureconomy• Wecangroupthemintofourcategoriesbasedon“excludability”and”rivalryinconsumption”

• Becauseoftheproblemsassociatedwiththeprovisionofpublicgoodsanduseofcommonresources– theseareconsideredmarketfailures

• Needgovernmenthelptocontrolandregulatemarketfailures

IncomeInequality

• Incomeinequalityreferstotheunevendistributionofincomeinacountry

• Reflectsthegapbetweentherichandeveryoneelse

• IntheUS– thisgaphasbeengrowingrapidly

AverageIncomeinUnitedStates

http://inequality.org/wp-content/uploads/2014/10/Figure-1-e1455723650211.png

Bottom90%

$33,068

Top10%

$295,845

$448,489

$1,260,508

$6,087,113

Top0.1%

IncomeInequalityintheUS– OntheRise

Realwageshavenotgrownformost

PovertyintheUnitedStates

In2014:• 46.7millionpeople(14.8%)wereinpoverty.• 15.5million(21.1%)childrenundertheageof18wereinpoverty.• 4.6million(10%)seniors65andolderwereinpoverty.

http://www.feedingamerica.org/

PovertyintheUnitedStates

• 48.1millionAmericanslivedinfoodinsecurehouseholds,including32.8millionadultsand15.3millionchildren.

• 14%ofhouseholds(17.4millionhouseholds)werefoodinsecure.

• 6%ofhouseholds(6.9millionhouseholds)experiencedverylowfoodsecurity.

• Householdswithchildrenreportedfoodinsecurityatasignificantlyhigherratethanthosewithoutchildren,19%comparedto12%.

http://www.feedingamerica.org/

PoliciestoReducePoverty

• Minimumwagelaws• In-kindtransfers• Welfareandhousingassistance• Negativeincometax

DonotsolvethelargerissueofgrowinginequalityintheUS

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