ECON 2000 Notes and Practice Exam
ECON 2000 Notes and Practice Exam ECON 2000
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Micro vs. Macro • Microeconomics: The study of how individual households and ﬁrms make decisions, interact with one another in markets. • Macroeconomics: The study of the economy as a whole. Ten Principles of Economics Chapter 1 PRINCIPLE #1: People Face Tradeoﬀs All decisions involve tradeoﬀs. Examples: • Going to a party the night before your midterm leaves less ▯me for studying. • Having more money to buy stuﬀ requires working longer hours, which leaves less ▯me for leisure. • Protec▯ng the environment requires resources that could otherwise be used to produce consumer goods. PRINCIPLE #1: People Face Tradeoﬀs • Society faces an important tradeoﬀ: eﬃciency vs. equality • Eﬃciency: when society gets the most from its scarce resources • Equality: when prosperity is distributed uniformly among society’s members PRINCIPLE #2: The Cost of Something Is What Y ou Give Up to Get It • Making decisions requires comparing the costs and beneﬁts of alterna▯ve choices. • The opportunity cost of any item is whatever must be given up to obtain it. • It is the relevant cost for decision making. PRINCIPLE #3: Ra▯onal People Think at the Margin Ra▯onal people • systema▯cally and purposefully do the best they can to achieve their objec▯ves. • make decisions by evalua▯ng costs and beneﬁts of marginal changes, incremental adjustments to an exis▯ng plan. PRINCIPLE #4: People Respond to Incen▯ves • Incen▯ve: something that induces a person to act, i.e. the prospect of a reward or punishment. • Ra▯onal people respond to incen▯ves. Examples: • When gas prices rise, (most) consumers buy more hybrid cars and fewer trucks & SUVs. • When cigare▯e taxes increase, teen smoking falls. Applying the principles You are thinking about selling your 1956 Oldsmobile 88… Applying the principles You are thinking about selling your 1956 Oldsmobile 88. You have already spent $4,000 on repairs. At the last minute, the transmission dies. You can pay $800 to have it repaired, or sell the car “as is.” In each of the following scenarios, should you have the transmission repaired? Explain. A. Blue book value (what you could get for the car) is $17,500 if transmission works, $16,500 if it doesn’t B. Blue book value is $17,000 if transmission works, $16,300 if it doesn’t PRINCIPLE #5: Trade Can Make Everyone Be▯er Oﬀ • Rather than being self-‐suﬃcient, people can specialize in producing one good or service and exchange it for other goods. • Countries also beneﬁt from trade and specializa▯on: • Get a be▯er price abroad for goods they produce • Buy other goods more cheaply from abroad PRINCIPLE #6: Markets Are Usually A Good Way to Organize Economic Ac▯vity • Market: a group of buyers and sellers (need not be in a single loca▯on) • “Organize economic ac▯vity” means determining • what goods to produce • how to produce them • how much of each to produce • who gets them PRINCIPLE #6: Markets Are Usually A Good Way to Organize Economic Ac▯vity • A market economy allocates resources through the decentralized decisions of many households and ﬁrms as they interact in markets. • Famous insight by Adam Smith in The Wealth of Na▯ons (1776): Each of these households and ﬁrms to promote general economic well-‐being. ” PRINCIPLE #6: Markets Are Usually A Good Way to Organize Economic Ac▯vity • The invisible hand works through the price system: • The interac▯on of buyers and sellers determines prices. • Each price reﬂects the good’s value to buyers and the cost of producing the good. • Prices guide self-‐interested households and ﬁrms to make decisions that, in many cases, maximize society’s economic well-‐being. • h▯p://www.youtube.com/watch?v=R5Gppi-‐O3a8 PRINCIPLE #7: Governments Can Some▯mes Improve Market Outcomes • Important role for gov’t: enforce property rights (with police, courts) • People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen. PRINCIPLE #7: Governments Can Some▯mes Improve Market Outcomes • Market failure: when the market fails to allocate society’s resources eﬃciently • Causes of market failure: • Externali▯es, when the produc▯on or consump▯on of a good aﬀects bystanders (e.g. pollu▯on) • Market power, a single buyer or seller has substan▯al inﬂuence on market price (e.g. monopoly) • Public policy may promote eﬃciency. Discussion Ques▯on In each of the following situa▯ons, what is the government’s role? Does the government’s interven▯on improve the outcome? a. Public schools for K-‐12 b. Workplace safety regula▯ons c. Public highways d. Patent laws, which allow drug companies to charge high prices for life-‐saving drugs PRINCIPLE #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services • Huge varia▯on in living standards across countries and over ▯me: • Average income in rich countries is more than ten ▯mes average income in poor countries. • The U.S. standard of living today is about eight ▯mes larger than 100 years ago. PRINCIPLE #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services • The most important determinant of living and services produced per unit of labor. • Produc▯vity depends on the equipment, skills, and technology available to workers. • Other factors (e.g., labor unions, compe▯▯on from abroad) have far less impact on living standards. PRINCIPLE #9: Prices Rise When the Government Prints T oo Much Money • Inﬂa▯on: increases in the general level of prices. • In the long run, inﬂa▯on is almost always caused by excessive growth in the quan▯ty of money, which causes the value of money to fall. • The faster the gov’t creates money, the greater the inﬂa▯on rate. PRINCIPLE #10: Society Faces a Short-‐run Tradeoﬀ Between Inﬂa▯on and Unemployment • In the short-‐run (1–2 years), many economic policies push inﬂa▯on and unemployment in opposite direc▯ons. • Other factors can make this tradeoﬀ more or present. but the tradeoﬀ is always Chapter 3 INTERDEPENDENCE AND THE GAINS FROM TRADE Interdependence ▯ One of the en Principles from Chapter 1: Trade can make everyone better off. ▯ We now learn why people—and nations— choose to be interdependent, and how they can gain from trade. Our Example ▯ Two countries: the U.S. and Japan ▯ Two goods: computers and wheat ▯ One resource: labor, measured in hours ▯ We will look at how much of both goods each country produces and consumes ▯ if the country chooses to be self-sufficient ▯ if it trades with the other country 2 Production Possibilities in the U.S. ▯ The U.S. has 50,000 hours of labor available for production, per month. ▯ Producing one computer requires 100 hours of labor. ▯ Producing one ton of wheat requires 10 hours of labor. The U.S. PPF Wheat (tons) The U.S. has enough labor 5,000 to produce 500 computers, 4,000 or 5000 tons of wheat, or any combination along 3,000 the PPF. 2,000 1,000 Computers 0 100 200 300 400 500 4 The U.S. Without Trade Wheat (tons) Suppose the U.S. uses half its labor 5,000 to produce each of the two goods. 4,000 Then it will produce and consume 250 computers and 3,000 2500 tons of wheat. 2,000 1,000 Computers 0 100 200 300 400 500 5 Problem 1 Derive Japan’s PPF Use the following information to draw Japan’s PPF. ▯ Japan has 30,000 hours of labor available for production, per month. ▯ Producing one computer requires 125 hours of labor. ▯ Producing one ton of wheat requires 25 hours of labor. Your graph should measure computers on the horizontal axis. Japan’s PPF Wheat Japan has enough labor to (tons) produce 240 computers, 2,000 or 1200 tons of wheat, or any combination along the PPF . 1,000 0 Computers 100 200 300 7 Japan Without Trade Wheat (tons) Suppose Japan uses half its labor to produce each good. 2,000 Then it will produce and consume 120 computers and 600 tons of wheat. 1,000 0 Computers 100 200 300 8 Consumption With and Without Trade ▯ Without trade, ▯ U.S. consumers get 250 computers and 2500 tons wheat. ▯ Japanese consumers get 120 computers and 600 tons wheat. ▯ We will compare consumption without trade to consumption with trade. ▯ First, we need to see how much of each good is produced and traded by the two countries. Problem 2 Production under trade 1. Suppose the U.S. produces 3400 tons of wheat. How many computers would the U.S. be able to produce with its remaining labor? Draw the point representing this combination of computers and wheat on the U.S. PPF . 2. Suppose Japan produces 240 computers. How many tons of wheat would Japan be able to produce with its remaining labor? Draw this point on Japan’s PPF . U.S. Production With Trade Wheat (tons) 5,000 Producing 3400 tons of wheat requires 34,000 labor hours. 4,000 The remaining 16,000 3,000 labor hours are used to produce 160 computers. 2,000 1,000 Computers 0 100 200 300 400 500 11 Japan’s Production With Trade Wheat Producing 240 computers (tons) requires all of Japan’s 30,000 labor hours. 2,000 So, Japan would produce 0 tons of wheat. 1,000 0 Computers 100 200 300 12 Exports & Imports ▯ Exports: goods produced domestically and sold abroad To export means to sell domestically produced goods abroad. ▯ Imports: goods produced abroad and sold domestically To import means to purchase goods produced in other countries. Problem 3 Consumption under trade Suppose the U.S. exports 700 tons of wheat to Japan, and imports 110 computers from Japan. (So, Japan imports 700 tons wheat and exports 110 computers.) ▯ How much of each good is consumed in the U.S.? Plot this combination on the U.S. PPF. ▯ How much of each good is consumed in Japan? Plot this combination on Japan’s PPF . U.S. Consumption With Trade Wheat computers wheat (tons) 5,000 produced 160 3400 + imported 110 0 4,000 – exported 0 700 = amount 3,000 consumed 270 2700 2,000 1,000 Computers 0 100 200 300 400 500 15 Japan’s Consumption With Trade computers wheat Wheat produced 240 0 (tons) + imported 0 700 – exported 110 0 2,000 = amount 130 700 consumed 1,000 0 Computers 100 200 300 16 Trade Makes Both Countries Better Off U.S. consumption consumption gains from without trade with trade trade computers 250 270 20 wheat 2500 2700 200 Japan consumption consumption gains from without trade with trade trade computers 120 130 10 wheat 600 700 100 17 Where Do These Gains Come From? ▯ Absolute advantage: the ability to produce a good using fewer inputs than another producer ▯ The U.S. has an absolute advantage in wheat: producing a ton of wheat uses 10 labor hours in the U.S. vs. 25 in Japan. ▯ If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade. Where Do These Gains Come From? ▯ Which country has an absolute advantage in computers? ▯ Producing one computer requires 125 labor hours in Japan, but only 100 in the U.S. ▯ The U.S. has an absolute advantage in both goods! So why does Japan specialize in computers? Why do both countries gain from trade? Two Measures of the Cost of a Good ▯ Two countries can gain from trade when each specializes in the good it produces at lowest cost. ▯ Absolute advantage measures the cost of a good in terms of the inputs required to produce it. ▯ Recall: Another measure of cost is opportunity cost. ▯ In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labor needed to produce one computer. Opportunity Cost and Comparative Advantage ▯ Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer ▯ Which country has the comparative advantage in computers? ▯ To answer this, must determine the opportunity cost of a computer in each country. Opportunity Cost and Comparative Advantage ▯ The opportunity cost of a computer is ▯ 10 tons of wheat in the U.S., because producing one computer requires 100 labor hours, which instead could produce 10 tons of wheat. ▯ 5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead could produce 5 tons of wheat. ▯ So, Japan has a comparative advantage in computers. Lesson: Absolute advantage is not necessary for comparative advantage! Comparative Advantage and Trade ▯ Gains from trade arise from comparative advantage (differences in opportunity costs). ▯ When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade. ▯ The same applies to individual producers (like the farmer and the rancher) specializing in different goods and trading with each other. Problem 4 Absolute and comparative advantage Argentina and Brazil each have 10,000 hours of labor per month. In Argentina, ▯ producing one pound coffee requires 2 hours ▯ producing one bottle wine requires 4 hours In Brazil, ▯ producing one pound coffee requires 1 hour ▯ producing one bottle wine requires 5 hours Which country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine? Chapter 4 THE MARKET FORCES OF SUPPLY AND DEMAND Markets and Competition A market is a group of buyers and sellers of a particular product. A competitive market is one with many buyers and sellers, each has a negligible effect on price. In a perfectly competitive market: All goods exactly the same Buyers & sellers so numerous that no one can affect market price—each is a “price taker” In this chapter, we assume markets are perfectly competitive. Demand The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal The Demand Schedule Demand schedule: Price Quantity of of lattes a table that shows the lattes demanded relationship between the $0.00 16 price of a good and the 1.00 14 quantity demanded 2.00 12 Example: 3.00 10 Helen’s demand for lattes. 4.00 8 Notice that Helen’s 5.00 6 6.00 4 preferences obey the law of demand. Helen’s Demand Schedule & Curve Price of Price Quantity Lattes of of lattes lattes demanded $6.00 $5.00 $0.00 16 1.00 14 $4.00 2.00 12 $3.00 3.00 10 $2.00 4.00 8 5.00 6 $1.00 6.00 4 $0.00 Quantity 0 5 10 15 of Lattes Market Demand versus Individual Demand The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. Suppose Helen and Ken are the only two buyers in the Latte market. (Q = quantity demanded) Price Helen’s Qd Ken’s Qd Market Qd $0.00 16 + 8 = 24 1.00 14 + 7 = 21 2.00 12 + 6 = 18 3.00 10 + 5 = 15 4.00 8 + 4 = 12 5.00 6 + 3 = 9 6.00 4 + 2 = 6 The Market Demand Curve for Lattes d P Q P (Market) $6.00 $0.00 24 $5.00 1.00 21 $4.00 2.00 18 3.00 15 $3.00 4.00 12 $2.00 5.00 9 $1.00 6.00 6 $0.00 Q 0 5 10 15 20 25 Demand Curve Shifters The demand curve shows how price affects quantity demanded, other things being equal. These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price). Changes in them shift the D curve… Demand Curve Shifters: # of Buyers Increase in # of buyers increases quantity demanded at each price, shifts D curve to the right. Demand Curve Shifters: # of Buyers P Suppose the number of buyers increases. $6.00 Then, at each P, $5.00 Q will increase $4.00 (by 5 in this example). $3.00 $2.00 $1.00 $0.00 Q 0 5 10 15 20 25 30 Demand Curve Shifters: Income Demand for a normal good is positively related to income. Increase in income causes increase in quantity demanded at each price, shifts D curve to the right. (Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.) Demand Curve Shifters: Prices of Related Goods Two goods are substitutes if an increase in the price of one causes an increase in demand for the other. Example: pizza and hamburgers. An increase in the price of pizza increases demand for hamburgers, shifting hamburger demand curve to the right. Other examples: Coke and Pepsi, laptops and desktop computers, CDs and music downloads Demand Curve Shifters: Prices of Related Goods Two goods are complements if an increase in the price of one causes a fall in demand for the other. Example: computers and software. If price of computers rises, people buy fewer computers, and therefore less software. Software demand curve shifts left. Other examples: bagels and cream cheese, eggs and bacon Demand Curve Shifters: Tastes Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to the right. Summary: Variables That Influence Buyers Variable A change in this variable… Price …causes a movement along the D curve # of buyers …shifts the D curve Income …shifts the D curve Price of related goods …shifts the D curve Tastes …shifts the D curve Problem 1 Demand Curve Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why? A. The price of iPods falls B. The price of music downloads falls C. The price of CDs falls Supply The quantity supplied of any good is the amount that sellers are willing and able to sell. Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal The Supply Schedule Supply schedule: Price Quantity of of lattes A table that shows the lattes supplied relationship between the price of a good and the $0.00 0 1.00 3 quantity supplied. 2.00 6 Example: 3.00 9 Starbucks’ supply of lattes. 4.00 12 5.00 15 Notice that Starbucks’ 6.00 18 supply schedule obeys the law of supply. Starbucks’ Supply Schedule & Curve Price Quantity P of of lattes lattes supplied $6.00 $0.00 0 $5.00 1.00 3 $4.00 2.00 6 $3.00 3.00 9 $2.00 4.00 12 $1.00 5.00 15 6.00 18 $0.00 Q 0 5 10 15 Market Supply versus Individual Supply The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. Suppose Starbucks and Dunkin’ Donuts are the only two sellers in this market.(Q = quantity supplied) Price Starbucks DD Market Qs $0.00 0 + 0 = 0 1.00 3 + 2 = 5 2.00 6 + 4 = 10 3.00 9 + 6 = 15 4.00 12 + 8 = 20 5.00 15 + 10 = 25 6.00 18 + 12 = 30 The Market Supply Curve S P Q (Market) P $0.00 0 $6.00 1.00 5 $5.00 2.00 10 $4.00 3.00 15 $3.00 4.00 20 $2.00 5.00 25 $1.00 6.00 30 $0.00 Q 0 5 10 15 20 25 30 35 Supply Curve Shifters The supply curve shows how price affects quantity supplied, other things being equal. These “other things” are non-price determinants of supply. Changes in them shift the S curve… Supply Curve Shifters: Input Prices Examples of input prices: wages, prices of raw materials. A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right. Supply Curve Shifters: Input Prices Suppose the P price of milk falls. $6.00 At each price, $5.00 the quantity of $4.00 lattes supplied will increase $3.00 (by 5 in this $2.00 example). $1.00 $0.00 Q 0 5 10 15 20 25 30 35 Supply Curve Shifters: Technology Technology determines how much inputs are required to produce a unit of output. A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the right. Supply Curve Shifters: # of Sellers An increase in the number of sellers increases the quantity supplied at each price, shifts S curve to the right. Summary: Variables that Influence Sellers Variable A change in this variable… Price …causes a movement along the S curve Input Prices …shifts the S curve Technology …shifts the S curve # of Sellers …shifts the S curve Problem 2 Supply Curve Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide. Supply and Demand Together P $6.00 D S Equilibrium: P has reached $5.00 the level where quantity supplied $4.00 $3.00 equals quantity demanded $2.00 $1.00 $0.00 Q 0 5 10 15 20 25 30 35 Equilibrium price: the price that equates quantity supplied with quantity demanded P $6.00 D S D S P Q Q $5.00 $0 24 0 $4.00 1 21 5 2 18 10 $3.00 3 15 15 $2.00 4 12 20 $1.00 5 9 25 $0.00 6 6 30 Q 0 5 10 15 20 25 30 35 Equilibrium quantity: the quantity supplied and quantity demanded at the equilibrium price P $6.00 D S D S P Q Q $5.00 $0 24 0 $4.00 1 21 5 2 18 10 $3.00 3 15 15 $2.00 4 12 20 $1.00 5 9 25 $0.00 6 6 30 Q 0 5 10 15 20 25 30 35 Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P $6.00 D Surplus S Example: If P = $5, $5.00 then $4.00 QD = 9 lattes $3.00 and Q S= 25 lattes $2.00 resulting in a $1.00 surplus of 16 lattes $0.00 Q 0 5 10 15 20 25 30 35 Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P $6.00 D Surplus S Facing a surplus, sellers try to increase $5.00 sales by cutting price. $4.00 This causes D S $3.00 Q to rise and Q to fall… $2.00 …which reduces the surplus. $1.00 $0.00 Q 0 5 10 15 20 25 30 35 Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P $6.00 D Surplus S Facing a surplus, sellers try to increase $5.00 sales by cutting price. $4.00 This causes D S $3.00 Q to rise and Q to fall. Prices continue to fall $2.00 until market reaches $1.00 equilibrium. $0.00 Q 0 5 10 15 20 25 30 35 Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P $6.00 D S Example: If P = $1, $5.00 then $4.00 Q D = 21 lattes $3.00 and Q S = 5 lattes $2.00 resulting in a $1.00 shortage of 16 lattes $0.00 Shortage Q 0 5 10 15 20 25 30 35 Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P $6.00 D S Facing a shortage, sellers raise the price, $5.00 causing Q to fall $4.00 and Q to rise, $3.00 …which reduces the shortage. $2.00 $1.00 Shortage $0.00 Q 0 5 10 15 20 25 30 35 Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P $6.00 D S Facing a shortage, sellers raise the price, $5.00 causing Q to fall $4.00 and Q to rise. $3.00 Prices continue to rise until market reaches $2.00 equilibrium. $1.00 Shortage $0.00 Q 0 5 10 15 20 25 30 35 Three Steps to Analyzing Changes in Eq’m To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply—demand diagram to see how the shift changes eq’m P and Q. EXAMPLE: The Market for Hybrid Cars P price of hybrid cars S1 P1 D1 Q Q1 quantity of hybrid cars EXAMPLE 1: A Shift in Demand EVENT TO BE ANALYZED: P Increase in price of gas. S1 STEP 1: P2 D curve shifts because price of gas STEP 2: P1 D shifts right for hybrids. S curve does not price makes hybrids D1 D2 more attractiveprice Q of gas does notce Q 1 Q2 affect cost offer cars. producing hybrids. EXAMPLE 1 : A Shift in Demand Notice: P When P rises, producers supply S1 a larger quantity P 2 of hybrids, even though the S curve P 1 has not shifted. Always be careful to distinguish b/w D 1 D 2 a shift in a curve Q Q 1Q 2 and a movement along the curve. Terms for Shift vs. Movement Along Curve Change in supply: a shift in the S curve occurs when a non-price determinant of supply changes (like technology or costs) Change in the quantity supplied: a movement along a fixed S curve occurs when P changes Change in demand: a shift in the D curve occurs when a non-price determinant of demand changes (like income or # of buyers) Change in the quantity demanded: a movement along a fixed D curve occurs when P changes EXAMPLE 2: A Shift in Supply EVENT: New technology reduces cost of P producing hybrid cars. S1 S2 STEP 1: S curve shifts because event affects STEP 2: P1 S shifts righttion. P 2 D curve does not shift, because reduces cost, D 1 makes productionology Q is not one of the Q1Q 2 factors that affecte. any given price. demand. EXAMPLE 3 : A Shift in Both Supply EVENTS: and Demand P Price of gas rises AND new technology reduces S1 S 2 production costs STEP 1: P 2 Both curves shift. P 1 STEP 2: Both shift to the right. STEP 3: D 1 D 2 Q rises, but effect Q on P is ambiguous: Q 1 Q2 If demand increases more than supply, P rises. EXAMPLE 3: A Shift in Both Supply and Demand EVENTS: P Price of gas rises AND new technology reduces S1 S 2 production costs STEP 3, cont. P1 But if supply increases more P2 than demand, D P falls. D1 2 Q Q1 Q2 Problem 3 Shifts in supply and demand Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads. Event A: A fall in the price of CDs Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. Event C: Events A and B both occur. Chapter 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES Government Policies That Alter the Private Market Outcome Price controls Price ceiling: a legal maximum on the price of a good or service Example: rent control Price floor: a legal minimum on the price of a good or service Example: minimum wage Taxes The govt can make buyers or sellers pay a specific amount on each unit. We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and eq’m quantity). EXAMPLE 1: The Market for Apartments Rental P S price of apts $800 Eq’m w/o price controls D Q 300 Quantity of apts How Price Ceilings Affect Market Outcomes A price ceiling P S above the Price eq’m price is $1000 ceiling not bindin— has no effect $800 on the market outcome. D Q 300 How Price Ceilings Affect Market Outcomes The eq’m price P S ($800) is above the ceiling and therefore illegal. $800 The ceiling is a binding Price $500 ceiling constraint on the price, shortage causes a D Q shortage. 250 400 How Price Ceilings Affect Market Outcomes In the long run, P S supply and demand are more $800 price-elastic. Price So, the $500 ceiling shortage shortage D is larger. Q 150 450 Shortages and Rationing With a shortage, sellers must ration the goods among buyers. Some rationing mechanisms: (1) Long lines (2) Discrimination according to sellers’ biases These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly. In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (no personal discrimination). EXAMPLE 2: The Market for Unskilled Labor Wage W S paid to unskilled workers $6.00 Eq’m w/o price controls D L 500 Quantity of unskilled workers How Price Floors Affect Market Outcomes A price floor W S below the eq’m price is not binding – has no effect $6.00 on the market Price outcome. $5.00 floor D L 500 How Price Floors Affect Market Outcomes labor The eq’m wage ($6) W surplus S is below the floor Price and therefore $7.25 floor illegal. $6.00 The floor is a binding constraint on the wage, causes a D L surplus (i.e., 400 550 unemployment). The Minimum Wage Min wage laws unemp- do not affect W loyment S highly skilled Min. workers. $7.25 wage They do affect $6.00 teen workers. Studies: A 10% increase in the min wage raises teen D L unemployment 400 550 by 1–3%. Problem 1 Price controls The market for 140 hotel rooms S Determine 130 120 effects of: 110 A. $90 price 100 ceiling 90 B. $90 price 80 D floor 70 60 C. $120 price 50 floor 40 050 60 70 80 90 100 110 120 130 Evaluating Price Controls Recall one of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices. Price controls often intended to help the poor, but often hurt more than help. Taxes The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. The govt can make buyers or sellers pay the tax. The tax can be a % of the good’s price, or a specific amount for each unit sold. For simplicity, we analyze per-unit taxes only. EXAMPLE 3: The Market for Pizza Eq’m w/o tax P S 1 $10.00 D1 500 Q A Tax on Buyers Hence, a tax on buyers Effects of a $1.50 per shifts the D curve downn unit tax on buyers by the amount of the tax. P P would have to fall S1 by $1.50 to make $10.00 buyers willing Tax to buy same Q as before. $8.50 E.g., if P falls D 1 from $10.00 to $8.50, D 2 Q buyers still willing to 500 purchase 500 pizzas. A Tax on Buyers New eq’m: Effects of a $1.50 per unit tax on buyers Q = 450 P Sellers S 1 receive PB= $11.00 Tax PS= $9.50 $10.00 P = $9.50 Buyers pay S PB= $11.00 D Difference 1 between them D2 Q = $1.50 = tax 450 500 The Incidence of a Tax: how the burden of a tax is shared among market participants P In our example, P = $11.00 S1 B Tax buyers pay $10.00 $1.00 more, PS= $9.50 sellers get $0.50 less. D1 D 2 Q 450 500 A Tax on Sellers The tax effectively raises Effects of a $1.50 per sellers’ costs by unit tax on sellers P S $1.50 per pizza. $11.50 2 Sellers will supply Tax S1 500 pizzas $10.00 only if P rises to $11.50, to compensate for this cost increase. D1 Hence, a tax on sellers shifts the Q 500 S curve up by the amount of the tax. A Tax on Sellers New eq’m: Effects of a $1.50 per unit tax on sellers Q = 450 P S2 Buyers pay S1 PB= $11.00 PB= $11.00 Tax Sellers $10.00 P = $9.50 receive S PS= $9.50 D Difference 1 between them Q = $1.50 = tax 450 500 The Outcome Is the Same in Both Cases ! The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! What matters P is this: S PB= $11.00 1 A tax drives Tax $10.00 a wedge P = $9.50 between the S price buyers D1 pay and the price sellers receive. 450 500 Q Problem 2 Effects of a tax The market for 140 hotel rooms Suppose govt S imposes a tax 130 120 on buyers of 110 $30 per room. 100 Find new 90 Q, P , P , 80 D B S and incidence 70 of tax. 60 50 40 050 60 70 80 90 100 110 120 130 Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand It’s easier P for sellers PB than buyers Buyers’ share S to leave the of tax burden Tax market. Price if no tax So buyers bear most of Sellers’ share P S of tax burden the burden of the tax. D Q Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply It’s easier P S for buyers Buyers’ share than sellers of tax burden PB to leave the Price if no tax market. Tax Sellers bear Sellers’ share most of the of tax burden P S burden of D the tax. Q CASE STUDY: Who Pays the Luxury Tax? 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. Goal: raise revenue from those who could most easily afford to pay—wealthy consumers. But who really pays this tax? CASE STUDY: Who Pays the Luxury Tax? The market for yachts Demand is price-elastic. P S Buyers’ share In the short run, of tax burden PB supply is inelastic. Hence, Tax Sellers’ share companies that build of tax burden PS yachts pay D most of Q the tax. Problem 3 The 2011 payroll tax cut Prior to 2011, the Social Security payroll tax was 6.2% taken from workers’ pay and 6.2% paid by employers (total 12.4%). The Tax Relief Act (2010) reduces the worker’s portion from 6.2% to 4.2% (for 2011 only), but leaves the employer’s portion at 6.2%. QUESTION: Will the typical worker’s take-home pay rise by exactly 2%, more than 2%, or less than 2%? Explain. CONCLUSION: Government Policies and the Allocation of Resources Each of the policies in this chapter affects the allocation of society’s resources. Example 1: A tax on pizza reduces eq’m Q. With less production of pizza, resources (workers, ovens, cheese) will become available to other industries. Example 2: A binding minimum wage causes a surplus of workers, a waste of resources. So, it’s important for policymakers to apply such policies very carefully. Chapter 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS Welfare Economics Recall, the allocation of resources refers to: how much of each good is produced which producers produce it which consumers consume it Welfare economics studies how the allocation of resources affects economic well-being. First, we look at the well-being of consumers. Willingness to Pay (WTP) A buyer’s willingness (and ability) to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good. name WTP Example: 4 buyers’ WTP Anthony $250 for an iPod Chad 175 Luke 300 John 125 WTP and the Demand Curve Q: If price of iPod is $200, who will buy an iPod, and what is quantity demanded? A: Anthony & Luke will buy an iPod, Chad & John will not. name WTP Hence, Q = 2 Anthony $250 when P = $200. Chad 175 Luke 300 John 125 WTP and the Demand Curve Derive the P (price demand of iPod) who buys Qd schedule: $301 & up nobody 0 251 – 300 Luke 1 name WTP Anthony $250 176 – 250 Anthony, Luke 2 Chad 175 Chad, Anthony, 126 – 175 3 Luke 300 Luke John, Chad, John 125 0 – 125 Anthony, Luke 4 WTP and the Demand Curve P $350 P Qd $300 $301 & up 0 $250 $200 251 – 300 1 $150 176 – 250 2 $100 126 – 175 3 $50 0 – 125 4 $0 Q 0 1 2 3 4 About the Staircase Shape… P This D curve looks like a staircase $350 with 4 steps – one per buyer. $300 If there were a huge # of buyers, as in a competitive market, $250 $200 there would be a huge # of very tiny steps, $150 and it would look $100 more like a smooth $50 curve. $0 Q 0 1 2 3 4 WTP and the Demand Curve P Luke’s WTP At any Q, $350 the height of $300 Anthony’s WTP the D curve is the WTP of the $250 Chad’s WTP marginal buyer, $200 John’s WTP the buyer who $150 would leave the market if P were $100 any higher. $50 $0 Q 0 1 2 3 4 Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays: CS = WTP – P name WTP Suppose P = $260. Luke’s CS = $300 – 260 = $40. Anthony $250 The others get no CS because Chad 175 they do not buy an iPod at this Luke 300 price. John 125 Total CS = $40. CS and the Demand Curve P $350 Luke’s WTP P = $260 Luke’s CS = $300 $300 – 260 = $40 $250 Total CS = $40 $200 $150 $100 $50 $0 Q 0 1 2 3 4 CS and the Demand Curve P Luke’s WTP Instead, suppose $350 P = $220 $300 Anthony’s WTP Luke’s CS = $250 $300 – 220 = $80 $200 Anthony’s CS = $250 – 220 = $30 $150 Total CS = $110 $100 $50 $0 Q 0 1 2 3 4 CS and the Demand Curve P $350 The lesson: Total CS equals $300 the area under $250 the demand curve $200 above the price, $150 from 0 to Q. $100 $50 $0 Q 0 1 2 3 4 CS with Lots of Buyers & a Smooth D Curve Price The demand for shoes P per pair$60 At Q = 5(thousand), the marginal buyer 50 is willing to pay $540 for pair of shoes. 30 Suppose P = $30. 20 1000s of pairs Then his consumer of shoes 10 surplus = $20. D 0 Q 0 5 10 15 20 25 30 CS with Lots of Buyers & a Smooth D Curve CS is the area b/w P The demand for shoes P and the D curve, from 0 to Q. $60 Recall: area of h50 a triangle equals 40 ½ x base x height 30 Height = $60 – 30 = $30. 20 So, 10 D CS = ½ x 15 x $30 0 Q = $225. 0 5 10 15 20 25 30 How a Higher Price Reduces CS If P rises to $40, CS = ½ x 10 x $20 P 60 1. Fall in CS = $100. due to buyers Two reasons for the 50 leaving market fall in CS. 40 30 20 2. Fall in CS due to remaining buyers 10 paying higher P D 0 Q 0 5 10 15 20 25 30 Problem 1 demand curve Consumer surplus 50 A. Find marginal buyer’s WTP at $45 Q = 10. 40 35 B. Find CS for P = $30. 30 Suppose P falls to $20. How much will CS 20 increase due to… 15 C.buyers entering 10 the market 5 D.existing buyers 0 paying lower price 0 5 10 15 20 25 Cost and the Supply Curve Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost). Includes cost of all resources used to produce good, including value of the seller’s time. Example: Costs of 3 sellers in the lawn-cutting business. A seller will produce and sell name cost Jack $10 the good/service only if the price exceeds his or her cost. Janet 20 Hence, cost is a measure of Jerry 35 willingness to sell. Cost and the Supply Curve s P Q Derive the supply schedule from the cost data: $0 – 9 0 10 – 19 1 20 – 34 2 name cost 35 & up 3 Jack $10 Janet 20 Jerry 35 Cost and the Supply Curve P P Qs $40 $0 – 9 0 $30 10 – 19 1 $20 20 – 34 2 $10 35 & up 3 $0 Q 0 1 2 3 Cost and the Supply Curve P At each Q, $40 Jerry’s the height of cost the S curve $30 is the cost of the Janet’s marginal seller, $20 cost the seller who would leave $10 Jack’s cost the market if the price were $0 Q any lower. 0 1 2 3 Producer Surplus P PS = P – cost $40 Producer surplus (PS): the amount a seller $30 is paid for a good minus the seller’s cost $20 $10 $0 Q 0 1 2 3 Producer Surplus and the S Curve P PS = P – cost $40 Jerry’s Suppose P = $25. cost $30 Jack’s PS = $15 Janet’s PS = $5 Janet’s $20 cost Jerry’s PS = $0 $10 Jack’s cost Total PS = $20 Total PS equals the $0 Q area above the supply 0 1 2 3 curve under the price, from 0 to Q. PS with Lots of Sellers & a Smooth S Curve Price The supply of shoes P per pair 60 Suppose P = $40. 50 S At Q = 15(thousand), 40 the marginal seller’s cost is $30, 30 20 1000s of pairs and her producer of shoes surplus is $10. 10 0 Q 0 5 10 15 20 25 30 PS with Lots of Sellers & a Smooth S Curve PS is the area b/w P The supply of shoes P and the S curve, from 0 to Q. 60 S The height of this 50 triangle is 40 $40 – 15 = $25. 30 So, h PS = ½ x b x h 20 = ½ x 25 x $25 10 = $312.50 0 Q 0 5 10 15 20 25 30 How a Lower Price Reduces PS If P falls to $30, P 1. Fall in PS PS = ½ x 15 x $15 60 due to sellers = $112.50 leaving market S 50 Two reasons for 40 the fall in PS. 30 2. Fall in PS due to0 remaining sellers getting lower P 10 0 Q 0 5 10 15 20 25 30 Problem 2 supply curve Producer surplus 50 A. Find marginal seller’s cost 45 at Q = 10. 40 35 B. Find total PS for P = $20. 30 25 Suppose P rises to $30.20 Find the increase in PS due to: 15 C. selling 5 10 additional units 5 D. getting a higher price on the initial 10 units0 5 10 15 20 25 CS, PS, and Total Surplus CS = (value to buyers) – (amount paid by buyers) = buyers’ gains from participating in the market PS = (amount received by sellers) – (cost to sellers) = sellers’ gains from participating in the market Total surplus = CS + PS = total gains from trade in a market = (value to buyers) – (cost to sellers) The Market’s Allocation of Resources In a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers. Is the market’s allocation of resources desirable? Or would a different allocation of resources make society better off? To answer this, we use total surplus as a measure of society’s well-being, and we consider whether the market’s allocation is efficient. (Policymakers also care about equality, though our focus here is on efficiency.) Efficiency Total = (value to buyers) – (cost to sellers) surplus An allocation of resources is efficient if it maximizes total surplus. Efficiency means: The goods are consumed by the buyers who value them most highly. The goods are produced by the producers with the lowest costs. Raising or lowering the quantity of a good would not increase total surplus. Evaluatin
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