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VIRGINIA TECH / Economics / ECON 2005 / What is the relationship between atc and mc?

What is the relationship between atc and mc?

What is the relationship between atc and mc?


School: Virginia Polytechnic Institute and State University
Department: Economics
Course: Principles of Economics
Professor: Steve trost
Term: Fall 2016
Cost: 50
Name: Econ Final Review Study Guide
Description: This covers everything we have learned!
Uploaded: 12/04/2017
30 Pages 104 Views 2 Unlocks

Final​ ​Exam​ ​Study​ ​Guide

What is the relationship between atc and mc ?

Exam​ ​1

Chapter 1 vocab:

● Economics- the study of how human beings coordinate their wants and desires given the decision making mechanisms, social customs, and political realities of the society ● Microeconomics- The study of individual choice, and how that choice is influenced by economic forces

Key questions to consider- What, and how much, to produce, How to produce it, For whom to produce it 

● Scarcity- The goods available are too few to satisfy individuals' desires ● Marginal Analysis- Additional cost or benefit of consuming one more 

○ Sunk costs- Costs that have already been incurred and cannot be resolved or recovered 

What is the increase in total cost that results from producing one more unit of output?

■ Marginal Benefit-The additional benefit above what you have already derived 

● Opportunity cost- The benefit that you might have gained from choosing the next best alternative 

● Efficiency- Achieving a goal as cheaply as possible 

● Positive economics- The study of what is and how the economy works ● Normative economics- The study of what the goals of the economy should be ● Production possibility model- conveys the tradeoffs involved in a choice of a what to produce If you want to learn more check out When does something have moral importance?

● Increasing opportunity cost- As you produce more and more of something, you have to give up more of something else 

What is monopoly?

● Comparative advantage- Better suited to the production of one good than to the production of another good 

Chapter 2: 

● Market economy- An economic system based on private property and the market in which, in principle, individuals decide how, what, and for whom to produce ● Socialism- An economic system based on individuals' goodwill towards others, not on their own self-interest, and in which, in principle, society decides what, how, and for whom to produce 

● capitalism-an economic system based on the market in which the ownership of the means of production resides with a small group of individuals called capitalists Demand: 

1. Willingness and ability to consume 

2. Schedule of quantities demanded at various prices at a specific period of time Law of demand: 

↓ Price, ↑ Quantity Demanded 

↑ Price, ↓ Quantity Demanded 

Shifts factors of demand:

1. Change in society's income We also discuss several other topics like What is a toxic substance that harms a fetus?

2. Prices of substitutes/ complements 

3. taste/preferences 

4. Expectations 

5. Taxes and Subsidies 

Supply- 1. Willingness and ability to produce something and bring it to the market for sale 2. Schedule of all quantities supplied at various prices at a specific time 

Law of supply 

↑ Price, ↑ Quantity Supplied 

↓ Price, ↓ Quantity Supplied 

Shift factors of supply: 

1. Costs of inputs 

2. Technology 

3. Expectations 

4. Taxes/Subsidies 

Market​ ​equilibrium-​ ​I​ntersection of Supply and Demand 

Chapter 3 Vocab: 

● Consumer surplus- The value the consumer gets from buying a product less than what they are willing to pay 

● Producer surplus-The price the producer sells a product for less than the cost of producing it We also discuss several other topics like In mitochondrial dna, how many genes it consists of?
If you want to learn more check out In bretton woods, when and for what purpose?

● Price elasticity of demand- The percentage change in quantity demanded divided by the percentage change in price. 

● Price elasticity of supply- Is the percentage change in quantity supplied divided by the percentage change in price 

● elastic -If the percentage change in quantity is greater than the percentage change in price (E>1) 

● Inelastic- If the percentage change in quantity is less than the percentage change in price (E<1) 

● Unit elastic- Percent change in demand is equal to the change in price (E=1) ● Perfectly elastic- Enormously responsive to change in price (E= ∞) 

● Perfectly inelastic- Quantity does not respond at all to price change (E=0) ● Chapter 4: 

● Income elasticity of demand- How responsive quantity demand is to a change in income. Percent change in Quantity Demanded divided by percent change in price Normal goods: 

a. Luxury (E >1) 

b. Necessity (0<E <1) 

Inferior goods: 

a. E <0 

● Cross price elasticity- measure of how much the quantity demanded of one good responds to a change in the price of another goodWe also discuss several other topics like What is the main definition of continuous outcomes?
We also discuss several other topics like What refers to anything generally accepted as a medium of exchange?

○ computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good 

● Utility- a measure of happiness or satisfaction 

● Substitutes- two goods for which an increase in the price of one leads to an increase in the demand for the other 

● Complements- two goods for which an increase in the price of one leads to a decrease in the demand for the other 

Exam​ ​2 

Ch.​ ​7 

-The firm will always choose inputs and technology to minimize the cost of producing their chosen quantity


● Land-​ ​all natural resources

● Labor​ ​(L)-​ ​all human inputs (ex. Engineers, janitors, salespeople, etc.) ● Capital​ ​(K)-​ ​all the physical equipment: machines, buildings, “goods used to make other goods”

○ This is not financial capital but financial capital is often used to buy it

● Entrepreneurial​ ​skill-​ ​the ability to pull all other inputs together, pay them, and then make some money out of the deal

-Production​ ​technology-​ ​the relationship between inputs and outputs-how inputs get turned into outputs

-Labor-intensive​ ​technology-​ ​technology that relies heavily on human labor instead of capital -Capital-intensive​ ​technology-​ ​technology that relies heavily on capital instead of human labor -Firms choose technology and inputs to minimize costs for each level of output -Marginal​ ​product-​ ​the additional output that can be produced by adding one more unit of a specific input, ceteris paribus

-Average​ ​product-​ ​the average amount produced by each unit of a variable factor of production (input)

-Law​ ​of​ ​diminishing​ ​marginal​ ​returns-​ ​when additional units of a variable input are added to fixed inputs, after a certain point the marginal product of the variable input declines ● In the short run, every firm will face diminishing returns, because of this every firm finds it progressively more difficult to increase its output as it approaches capacity production ● Same as the law of increasing marginal costs

● Example: more sandwich makers added to a fixed size kitchen

-Short​ ​run-​ ​the period of time for which two conditions hold: the firm is operating under a fixed scale (fixed factor) of production, and firms can neither enter nor exit an industry ● Example: rent or capital stock- not a set time like 1 year or 6 months

● It’s only in the short run that we make the FC/VC distinction

● In the short run, every firm is constrained by some fixed input that: leads to diminishing returns to variable inputs and limits its capacity to produce

-Long​ ​run-​ ​the period of time for which there are no fixed factors of production: firms can increase or decrease the scale of operation, and new firms can enter and existing firms can exit the industry

● All costs are variable

● New plants can be built, or the firm can decided to get out of the business or exit the industry

● The goal is to find the absolute lowest cost way to produce the chosen quantity of the good in question

-The definition of how long short run and long run are varies and is firm specific -Accounting​ ​costs-​ ​out-of-pocket costs or costs as an accountant would define them (explicit costs)

-Economic​ ​costs-​ ​costs that include the full opportunity costs of all inputs (implicit costs) Costs​ ​in​ ​the​ ​short​ ​run

● Fixed​ ​costs​ ​(FC)-​ ​any cost that does not depend on the firm’s level of output (Q), these costs are incurred even if the firm is producing nothing

○ Sunk​ ​costs-​ ​another name for fixed costs in the short run because firms have no choice but to pay them

● Total​ ​fixed​ ​costs​ ​(TFC​ ​or​ ​FC)-​ ​the total of all costs that do not change with output, even if output is zero

○ Average​ ​fixed​ ​cost​ ​(AFC)-​ ​total fixed cost divided by the number of units of output; a per unit measure of fixed costs

○ Spreading​ ​overhead-​ ​the process of dividing total fixed costs by more units of output, average fixed cost declines as quantity rises 

● Variable​ ​cost-​ ​a cost that depends on the level of production chosen (Q) examples: labor, lemons for a lemonade stand

○ Total​ ​variable​ ​cost​ ​(TVC​ ​or​ ​VC)-​ ​the total of all costs that vary with output in the short run

■ This cost curve embodies information about both factor, or input prices and technology

○ Average​ ​variable​ ​cost​ ​(AVC)-​ ​total variable cost divided by the number of units of output

■ Gives us the shutdown point- the boundary for whether a particular firm should stop production or continue to produce in the short run

■ If P<AVC, the firm should shut down in the short run

● Total​ ​cost​ ​(TC)-​ ​fixed costs plus variable costs (TC=FC+VC)

○ Average​ ​total​ ​cost​ ​(ATC)​ ​or​ ​average​ ​cost​ ​(AC)-​ ​total cost divided by the number of units of output

■ Gives us information about the level of profits (or losses) a firm will

receive for a given amount of output

■ Profits=TR-TC


■ In the long run, ATC=AVC (since all costs are variable)

■ A firm will need profits to be greater than or equal to zero to stay in

business in the long run, this is true if P is greater than or equal to ATC

○ Marginal​ ​cost​ ​(MC)-​ ​the increase in total cost that results from producing one more unit of output

■ Reflect changes in variable costs only since fixed costs do not change ■ Ultimately increase with output in the short run

■ TC/change in quantity

■ MC curve hits AC curve at its minimum

■ Firms produce where MR=MC in order to maximize profit

■ Allows us to say something about the economic efficiency of a certain level of output

■ The most important curve

-Law​ ​of​ ​increasing​ ​marginal​ ​costs-​ ​as a firm approaches its capacity to produce in the short run, it becomes increasingly costly to produce successively higher levels of output ● Marginal costs increase with output in the short run

The​ ​relationship​ ​between​ ​ATC​ ​and​ ​MC

● Exactly the same as the relationship between AVC and MC

● If marginal cost is below ATC, ATC will decline towards MC

● If marginal cost is above ATC, ATC will increase

● MC intersects ATC at ATC’s minimum point

-Long-run​ ​average​ ​cost​ ​curve​ ​(LRAC)-​ ​a curve that indicates the lowest average cost of production at each rate of output when the size or scale of the firm is allowed to vary ● Every possible short run AC curve is tangent to the LRAC, these tangency points show the lowest-cost way to produce each level of output

● A “planning curve”- the region below the curve is unattainable and the region above the curve is inefficient

● Answers the question: “Given a level of output, what is the lowest long run cost at which I can produce?”

-Increasing​ ​returns​ ​to​ ​scale​ ​(economies​ ​of​ ​scale)-​ a​ n increase in a firm’s scale of production leads to lower cost per unit produced

-Constant​ ​returns​ ​to​ ​scale-​ ​an increase in a firm’s scale of production has no effect on costs per unit produced

-Decreasing​ ​returns​ ​to​ ​scale,​ ​or​ ​diseconomies​ ​of​ ​scale-​ a​ n increase in a firm’s scale of production leads to higher costs per unit produced

-Minimum​ ​Efficient​ ​Scale​ ​(MES)-​ ​the lowest point on the LRAC, also known as the optimum plant size (where production occurs at the lowest possible cost), and varies for each firm/industry

● May occur over a range, rather than a point

● The lowest rate of output at which the firm takes full advantage of economies of scale -All of these cost curves are costs to society not just costs to the firm

-The market or societal demand curve tells us how much value society puts on a product and how much they are willing to pay at each quantity

***In any market, we must ALWAYS be on our demand curve or else a shortage or surplus will exist

Ch.​ ​8​ ​Perfect​ ​Competition-​ ​10​ ​problems​ ​(longest​ ​chapter) 

Perfectly​ ​competitive​ ​markets

1. There are many small firms and many small consumers

a. Price takers-firms that can change their level of output without affecting the price b. There are many small consumers who cannot affect the price either

2. The firms sell a homogenous product (commodity)

a. All firms must sell goods that are basically interchangeable-consumers will only care about the price of the good since there is no quality difference, examples: wheat, copper, stocks

b. Many goods do not fit this requirement, shoes, cars and hot dogs are NOT commodities

3. Everyone (buyers and sellers) has access to full information

a. All buyers and sellers can “see” the demand and cost curves and know what price they should buy or sell the good for

b. Buyers know exactly what they are buying

4. There is unrestricted entry and exit to the market, (but not necessarily “costless”) a. Entry may cost money but there are no barriers keeping firms from entering 5. Prices are not fixed or regulated by the state

a. Prices must be allowed to move to the equilibrium price for a market to be truly competitive

-A single firm’s demand curve in a perfectly competitive market is very elastic, maybe even perfectly elastic since there are many substitutes

-Perfectly competitive firms have no control over the price that it can charge -Price​ ​taker-​ ​perfectly competitive firms have no price policy- it cannot set price, it can only accept/react to it

● The price that is taken by the firm comes from the market equilibrium, the intersection of market supply and demand

-The firm’s only choice in perfect competition is to choose a level of output that will maximize profits

-In the short run, to maximize profits, the firm would choose the level of output such that MR=MC

-As long as MR is greater than MC, added output means added profit- the revenue gained by increasing output by one unit per period exceeds the cost incurred by doing so -PC firms will produce where P=MC

-In a PC market demand curve, a firm’s demand curve is flat (perfectly elastic), therefore P=MR since selling one more unit will increase revenue by the price of one unit -In​ ​the​ ​short​ ​run​ ​a​ ​PC​ ​firm​ ​can:

1. Earn positive or negative economic profits

2. Earn zero economic profits, when P=AC

3. Suffer economic losses but continue to operate to reduce or minimize those losses 4. Shut down and bear losses just equal to fixed costs

-Operating​ ​profit​ ​(or​ ​loss)​ ​or​ ​net​ ​operating​ ​revenue-​ t​ otal revenue minus total variable cost (TR-TVC)

● If revenues are smaller than variable costs, the firm has negative operating profit (loss) that push total losses above fixed costs, the firm can minimize its losses by shutting down

● Anytime price is below the minimum point on the AVC curve, TR will be less than TVC, and there will be a loss

-The​ ​shutdown​ ​point-​ ​when the price is less than AVC for all positive quantities, the firm should stop producing and bear losses equal to fixed costs, the lowest point on the AVC curve -Short-run​ ​industry​ ​supply​ ​curve-​ ​the sum of the marginal cost curves (above AVC) of all the firms in the industry

-In​ ​the​ ​long​ ​run​ ​of​ ​PC​ ​firms:

● All firms must earn ZERO profit

● The price will be pushed down to the minimum average cost (AC)- the point where MC=AC

● P=AC


-If firms in an industry earn positive economic profits in the short run (P>AC), then in the long run firms will enter this industry and existing firms will continue to expand as long as there are economies of scale to be realized ( as long as costs are falling)

● This will shift the supply curve out, thus forcing prices down

● Firms will keep entering until profits=zero

-If firms in an industry earn negative economic profits in the short run (P<AC), then in the long run firms will exit (drop out) of this industry

● This exit will shift the supply curve back, thus forcing prices up

● Firms will keep exiting until the remaining firms get profits=zero

-Long-run​ ​competitive​ ​equilibrium-​ ​when P=SRMC=SRAC=LRAC and profits are zero -Long-run​ ​industry​ ​supply​ ​curve​ ​(LRIS)-​ ​a graph that traces out price and total output over time as an industry expands

● In an increasing-cost industry, the LRIS rises as total Q rises

● In a decreasing-cost industry, the LRIS falls as total Q rises

● In a constant-cost industry, the LRIS stays flat as total Q rises

-PC is the “ideal” market structure

● A PC market achieves both allocative and productive efficiency

● The market supplies the right stuff (allocative) at the lowest possible cost (productive) ● Society will produce the efficient mix of output if all firms equate price (marginal benefit) and marginal cost

● Total (consumer+producer) surplus is maximized

Ch.​ ​9​ ​Monopoly 

-Monopoly-​ ​an industry composed of only one firm that produces a product for which there are no close substitutes and in which significant barriers exist to prevent new firms from entering the industry

-Imperfect​ ​information-​ ​the absence of full knowledge concerning product characteristics, available prices, and so forth

-Imperfectly​ ​competitive​ ​industry-​ ​an industry in which single firms have some control over the price of their output

● This does not mean that no competition exists in the market

● Firms can differentiate their products, advertise, improve quality, market aggressively, cut prices, etc.

-In a monopoly there is truly NO competition

-Pure​ ​monopoly-​ ​an industry with a single firm that produces for a product for which: 1. There are no close substitutes- a monopolist can raise its prices without fear of consumers switching to a substitute-gives them control of price

a. The fewer substitutes there are, the less elastic the demand is and the more power the monopolist has

b. The more essential a product is, the more power a monopolist has

c. Inelastic demand=more power

2. Significant barriers to entry exist to prevent other firms from entering the industry to compete for profits

a. Barrier​ ​to​ ​entry-​ ​something that prevents new firms from entering and competing in imperfectly competitive industries

b. In order to maintain market power, the monopolist must be able to prevent other firms from entering this industry

c. If other firms enter the industry, there is no longer a monopoly

d. Because of these barriers, monopolists can maintain positive profits year after year

-Types​ ​of​ ​barriers​ ​to​ ​entry:

1. Government franchising or licensing

a. Examples: defense, ABC stores, USPS

2. Patents- grants exclusive use of patented product to its inventor for a limited period of time

a. Example: brand-name drugs

3. Economies of scale or other cost advantages (high start-up costs- aka “natural barrier) a. Example: the gas company

4. Ownership of a scarce factor of production

a. Example: De Beers in diamonds, Alcoa in bauxite

-Monopolists choose their own price and are sometimes called “price searchers” instead of price takers

-A Monopoly’s demand curve is the market demand curve since the firm is the entire market ● As a result of this, its demand curve slopes down

● If the firm wants to choose a higher quantity, it has to charge a lower price on ALL UNITS SOLD

● This causes marginal revenue to be less than price

● As quantity rises, the monopolist gains revenue by selling more, but loses revenue by lowering the price

● A monopoly will NEVER choose a quantity with negative marginal revenue, it will always choose to be on the elastic portion of its demand curve

-MR does NOT equal price or the demand curve since a monopolist must lower price in order to sell more

-To maximize profits, monopolists choose quantity such that MR=MC then choose price off the demand curve at its highest point

-If MR>MC, an increase in Q will increase profits

-Monopolists are NOT guaranteed to make a profit

-A monopoly firm has no supply curve that is independent of the demand curve for its product ● A monopolist sets both price and quantity, and the amount of output that it supplies depends on both its MC curve and the demand curve that it faces

-Monopolists choose a lower quantity and charge a higher price 

● By raising price and cutting quantity, monopolists steal surplus from consumers ● Some of this surplus goes to firms as “producer surplus” and some is lost completely “deadweight loss”

● This leads to an inefficient mix of output since price does not equal MC (Q too low P too high)

-Rent​ ​seeking-​ ​monopolies often spend resources to keep their power- makes deadweight loss higher

● The most obvious example is political lobbying

-PC firms have a big incentive to cut costs, monopolies do not

-Natural​ ​monopoly-​ ​an industry that realizes such large economies of scale in producing its product that single-firm production of that good or service is most efficient, a monopoly in a certain industry-government regulated

● Examples: public utilities (gas, electric, etc.)

● With government oversight, these monopolies are often forced to increase their production and lower their prices

● Sometimes the government pushes them too far and they end up with negative profits

-Price​ ​discrimination-​ ​charging different prices to different buyers

-Perfect​ ​price​ ​discrimination​ ​(First​ ​degree)-​ ​occurs when a firm charges the maximum amount that buyers are willing to pay for each unit, no consumer surplus ● While this is best for the firm, it is almost impossible to do

-Second​ ​degree​ ​price​ ​discrimination-​ ​occurs when firms charge prices based on unobservable consumer attributes

● By pricing in strategic ways, firms let consumers “self-select” into groups based on their willingness to pay

● Example: quantity discounts

● Example: costco or sam’s club- these firms extract some consumer surplus by charging membership fees that allow you to buy large quantities for cheap

-Third​ ​degree​ ​price​ ​discrimination-​ ​occurs when firms charge people different prices based on observable consumer attributes

● These factors may indicate, in some way, the consumers’ willingness to pay ● Example: cheaper movie tickets for students and senior citizens- firms know that these groups of people have less income than those in the working class, therefore they charge them less in an effort to maximize profits

-The ultimate goal of price discrimination is to divide the market into “segments” ● Which price you’re in depends on your price elasticity of demand

● The firm will charge those with less elastic demand (business travelers) more than those with more elastic demand (leisure travelers) who are more sensitive to price Ch.​ ​10​ ​Monopolistic​ ​Competition 

Monopolistic​ ​competition-​ ​a very common form of industry (market) structure in the United States, characterized by a large number of firms, none of which can influence market price by virtue of size alone

● Some degree of market power is achieved by firms producing differentiated products ● New firms can enter and established firms can exit such an industry with ease ● Like PC firms but with “differentiated products”

● Example: Pizza places in NYC

-Characteristics​ ​of​ ​monopolistic​ ​competition:

1. A large number of firms

2. No barriers to entry

3. Product differentiation- this is what makes monopolistic competition different from perfect competition

- Just like in a monopoly, in monopolistic competition you choose Q where MR=MC and price off the demand curve

● However this demand curve is just for one firm, not the whole market ● A m-comp firm acts as a monopolist of its particular “version” of the product -Monopolistic​ ​Competition​ ​vs.​ ​Monopoly

1. Firms cannot influence the market price by virtue of their size

2. Good (but not “perfect”) substitutes exist

3. There is unrestricted entry and exit (on average, firms in a monopolistically competitive industry will earn zero profits in the long run)

-Monopolistic​ ​Competition​ ​vs.​ ​Perfect​ ​Competition

1. Firms differentiate their products in MC

a. The product is not homogeneous- each firm sells a slightly different product b. Product​ ​differentiation-​ ​a strategy that firms use to achieve market power, often achieved through advertising (which is costly)

c. The demand curve in MC firms slopes down because of product differentiation d. Less elastic than PC firms but more elastic than monopolies

e. Advertising is costly but variety is good

-Types​ ​of​ ​Product​ ​differentiation

1. Physical differences

a. Appearance; quality

2. Location

a. Spatial differentiation

3. Services

4. Product image

a. Promotion, advertising, marketing, packaging

-To maximize profit, the monopolistically competitive firm will increase production until MR=MC -On average in the long run of MC firms, profits must equal zero (free entry), the firm’s demand curve must end up tangent to its ATC curve

● If profits are earned, more firms will enter, thus shifting each individual firm’s demand curve back until profits=zero

-Problems​ ​with​ ​Monopolistic​ ​Competition

● Once a firm achieves market power by differentiating its product, its profit-maximizing strategy is to hold down production and charge a price above MC (no allocative efficiency)

○ Not efficient since P>MC (Q too low, P too high) and not at minimum AC ● The final equilibrium in a monopolistically competitive firm is necessarily to the left of the low point on its ATC curve (no productive efficiency)

-Oligopoly-​ ​a form of industry (market) structure characterized by a few​ ​dominant​ ​and interdependent​ ​firms

● Products may be homogeneous or differentiated

● Can control price

● Interaction and interdependence between firms

● Often have significant barriers to entry (usually cost related by could be legal) ● When these barriers to entry come in the form of economies of scale, the oligopoly is sometimes called a (“natural oligopoly”)

● ****The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others (this is what e mean by interdependent)

● Not efficient since P>MC (Q too low, P too high)- strategies may be wasteful -Many different types of oligopolies but they all have one thing in common: ● The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry comprising the oligopoly

Types​ ​of​ ​oligopolies

● Collusion-​ ​the act of working with other producers in an effort to limit competition and increase joint profits- agreements are explicit 

○ The oligopolists band together and agree/conspire to act as a single seller (one big monopolist)

○ Cartel-​ ​a group of firms that gets together and makes joint price and output decisions to maximize joint profits

○ The colluding oligopoly will face market demand and produce only up to the point at which MR=MC for the entire market, and price will be set above MC

○ Tacit​ ​collusion-​ ​collusion occurs when price and quantity fixing agreements among producers are implicit 

○ For collusion to work, all firms must restrict their quantity

○ Because firms must restrict their output, the cartel sets production quotas for each individual firm

○ By joining the cartel and restricting output, the individual receives higher economic profit

○ For a cartel to be successful, entry into the industry must be blocked-this is not always possible

○ Cartels are inherently unstable because of cheaters and free riders ● Price​ ​leadership-​ ​a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its prices

○ Assumes that the industry is made up of one dominant firm and a number of smaller competitive firms

○ Assumes that the dominant firm maximizes profit subject to the constraint of the market and assumes that the dominant firm lets the smaller firms sell as much as they want at the price the leader has set

○ If the dominant firm knows the smaller firms will follow its lead, then it can derive its demand curve by subtracting from total market demand the amount of demand that the smaller firms will satisfy

○ The price leader chooses the quantity and price as a monopolist would but uses its “residual demand” curve rather than the market demand curve

○ Residual​ ​demand-​the demand the leader faces after all follower firms sell whatever they want to at the price chosen by the leader

● Cournot​ ​model-​ ​a model of a two-firm industry (duopoly) in which a series of output adjustment decisions leads to a final level of output between the output that would prevail if the market were organized competitively and the output that would be set by a monopoly

○ Based on 3 assumptions

■ There are just two firms in the industry (duopoly)

■ Each firm takes the output of the other firm as given

■ Both firms maximize profit

○ The two firms basically take turns adjusting their quantity in response to what the other firm has done

○ Bertrand​ ​competition-​ ​has firms choosing prices, the two firms keep underbidding each other in an attempt to steal market share

■ Results in P=MC=AC (the PC price)

■ Assumes homogeneous products and ample capacity to produce the PC quantity

● Perfectly​ ​contestable​ ​market-​ ​a market in which entry and exit are costless ○ Even large oligopolistic firms end up behaving like perfectly competitive firms ○ Prices are pushed to long-run AC by competition and positive profits do not persist

○ In some cases, merely the threat of competition can force prices down to the level seen under PC and profits down to zero

○ Price=ATC

Exam​ ​3 

Ch.​ ​10:​ ​Game​ ​Theory 

-game theory is a way of analyzing the behavior of oligopolistic firms

-Game​ ​theory-​ ​in all conflict situations, and thus all games, there are decision makers (players), rules of the game (the strategies available to the players), and payoffs (prizes). ● Players choose strategies without knowing with certainty what strategy the opposition will use

● The solution to the game is the nash equilibrium

● The payoff matrix contains all relevant info

-Dominant​ ​strategy-​ ​in game theory, a strategy that is best no matter what the opposition does a player will play the same thing no matter what the other player does

-Prisoner's’​ ​dilemma-​ ​a game in which the players are prevented from cooperating and in which each has a dominant strategy that leaves them both worse off than if they could cooperate

-If both players have a dominant strategy, they will both use it

-If only one player has a dominant strategy, the player without a dominant strategy can assume that the player with the dominant strategy will play that strategy and they will choose based on this fact

-Maximin​ ​strategy-​ ​used to avoid bad payoffs, ​ ​in game theory, a strategy chosen to maximize the minimum gain that can be earned, players choose the strategy that has the most attractive “worst case” scenario

-Nash​ ​Equilibrium-​ ​in game theory, the result of all players’ playing their best strategy given what their competitors are doing. In other words, neither player would want to change their strategy given what the other player has chosen

-Tit-for-tat​ ​strategy-​ ​a company’s strategy that lets a competitor know the company will follow the competitor’s lead. A player in one round simply mimics the other player’s behavior in the previous round-it’s the optimal strategy for getting the other player to cooperate

● If one firm deviates from the equilibrium, the other could use this strategy by also raising its price

-Coordination​ ​game-​ ​a game in which each party is better off doing the same thing as the other player

● There are 2 possible Nash equilibria

● Ex. you and a friend go to Cinebowl-you want to see a movie but your friend wants to bowl. BUT both of you would rather do something together than do what you really want to by yourselves

Ch.​ ​14:​ ​Random​ ​Firm​ ​stuff 

-Transaction​ ​costs-​ ​expenses incurred when buying or selling a good or service -Firms minimize transaction costs by making things on a large scale

● More complex products are easier to produce on a large scale

-Firms minimize production costs

-Firm’s​ ​scope​ ​of​ ​operation

● Insourcing (making your inputs yourself)- Vertical integration

○ Expansion into earlier/later stages of production

○ These firms control several stages of the production process

○ Lowers transaction costs and gives the firm more power, BUT:

■ It is hard for a manager to keep track of all the stages (bounded

rationality-managers’ brains get full)

■ A vertically integrated firm might not achieve minimum efficient scale (cheaper for someone else to make the input)

● Outsourcing (buying inputs from elsewhere)

○ More attractive if there is a “well-functioning” market for the needed input, this means:

■ The quality of the input product is easily verifiable

■ There are many producers of the input product-so your supplier doesn’t have power over you

○ Sometimes supplier firms can achieve economies of scale when vertically integrated firms cannot, it may be cheaper for a firm to buy from a supplier since the suppliers costs may be lower

○ Economies​ ​of​ ​scope-​ the ATC of production decreases as a result of increasing the number of different goods produced

■ It’s cheaper to produce lots of different stuff

■ AC per unit falls as the firm supplies more types of products (as the scope increases)

-Market​ ​failure-​ ​occurs when resources are misallocated, or allocated inefficiently, the result is waste or lost value

-Sources​ ​of​ ​market​ ​failure:

1. Imperfect market structure, or noncompetitive behavior

2. Imperfect information- the absence of full knowledge concerning product characteristics, available prices, and so forth- whenever one party in a transaction has more information than another party in a transaction

a. If you do not know everything about a product, you cannot know with certainty how much you would be willing to pay for it or how much benefit you would get from the product

i. This means that the demand curve is no longer a reliable measure of willingness to pay or marginal benefit

ii. This also means that people regret purchases and often get negative consumer surplus

b. Asymmetric​ ​information-​ ​normally the seller has more information about the product than the buyer

i. This can lead to adverse selection

ii. Often dealt with through signaling on the part of the worker and screening on the part of the employee

1. Signaling- an attempt by the informed side to communicate

valuable information that is otherwise hidden

a. An effective signal is one that is easier for the skilled or

smart worker to send than for the unskilled, lazy worker to


b. Examples: advanced degrees, good grades, good

recommendations, a well done C.V.

2. Screening- the employer looking for these signals

c. Adverse​ ​selection​ ​(“hidden​ ​characteristics”​ ​problem)-​ ​can occur when a buyer or seller enters into an exchange with another party who has more information

i. If you don’t know if a product is good or bad, you are not willing to pay a high price- this pushes good products out of the market (hidden


ii. A result of adverse selection is that the lower priced or sometimes lower quality product ends up being the only product left in the market

iii. In labor markets, employers are better off offering a high wage so that good workers don’t walk away

1. As a result, the employer will end up hiring some bad workers and over-paying them, this is still better than getting only bad workers 2. Efficiency​ ​wage​ ​theory-​ ​high wages attract better employees and encourage all to work hard

d. Moral​ ​hazard-​ ​arises when one party to a contract alters their behavior in a costly manner because the cost of that behavior has been passed on to the other party to the contract

i. when one party in a contract passes the risk or cost involved with their behavior on to the other party (insurance)

ii. Example: after you have insurance, you have an incentive to not drive as cautiously

iii. Example: if visits to the doctor are free, why not go to the doctor for every little thing?

iv. Such behavior can often be inefficient- the cost that society bears when someone goes to the doctor needlessly mar far outweigh the benefit derived from that doctors visit

v. Moral hazard arises from the Principal Agent Problem

1. Principal-agent​ ​problem​ ​(hidden​ ​actions)-​ ​sometimes the goals of the agent (the person actually deciding what to do or how to

behave) are incompatible with those of the principal (the person

ultimately affected by the agent’s actions)

2. Example: managers (agents) and stockholders (principals) in a firm

3. Example: you (principal) and your mechanic (agent)

e. Winner’s​ ​curse-​ ​auctions for product of uncertain value (like some on ebay) create a special “imperfect info” problem where many “winners” end up “losers” i. The value of the product is not known for certain

ii. The winner posts the highest bid

1. Most optimistic-thinks the item is worth a lot

iii. If the item turns out not to be worth as much as you really think it is, then the “winner” of the auction is really a “loser”

iv. This happens in any situation with competitive bidding and imperfect information

f. The internet has helped with these information problems

3. The presence of external costs and benefits

4. The existence of public goods

Ways​ ​to​ ​solve​ ​the​ ​problem​ ​of​ ​imperfect​ ​or​ ​asymmetric​ ​information: ● Search​ ​method-​ ​where we try to increase the amount of info we have about a product ○ We must weigh the costs and benefits of such a search

○ The optimal amount (equilibrium) of searching happens where the MC of information is equal to the marginal benefit of information, MB=MC

■ l* is the optimal quantity of information

○ Marginal cost of search

■ Time is the biggest cost in any search

■ The MC of finding info increases- it is easy to find a little bit of info but gets much harder to find more detailed info, MC slopes up

■ The internet has made search much easier and much less costly

○ Marginal benefit of search

■ Better quality for a given price- find the best product

■ Lower price for a given quality- find the best deal

■ The marginal benefit of more info decreases, a little info helps a lot but more detailed info might not add much, the marginal benefit curve slopes down

○ When information is not free, additional information is acquired as long as its marginal benefit exceeds its marginal cost

○ Since search does have a cost, not everyone will take the time to find the same amount of information, this leads to:

■ Price dispersion- different prices for the same product

■ Quality differences across sellers

Ch.​ ​15:​ ​Antitrust​ ​Regulation 

-The government may regulate industries to insure health and safety (“social regulation”) -In a natural monopoly, AC is always falling in the long run (economies of scale), therefore, LRMC<LRAC

● If set at P=MC, a firm will lose money- the government will have to give it a subsidy for the monopoly to stay in business

-If set at P=AC, firm will earn zero economic profit- however this is not quite socially efficient ● The government does not have to subsidize the firm for it to stay in business

-Organizations responsible for making sure Monopolies don’t move too far from the “perfectly competitive outcome”:

● Federal​ ​Trade​ ​Commission​ ​(FTC)-​ ​a federal regulatory group created by Congress in 1914 to investigate the structure and behavior of firms engaging in interstate commerce, to determine what constitutes unlawful “unfair” behavior, and to issue cease-and-desist orders to those found in violation of antitrust law

● Antitrust​ ​Division​ ​(of​ ​the​ ​Department​ ​of​ ​Justice)-​ a​ lso empowered to act against violators of antitrust laws. It initiates action against those who violate antitrust laws and decides which cases to prosecute and against whom to bring criminal charges (FTC cannot bring criminal charges)

-Roles​ ​of​ ​the​ ​FTC​ ​and​ ​DOJ:

● Monitor competitiveness in US industries such as:

○ Price-fixing- when competitors get together and decide to raise the prices (like in cartels)

○ Tying contracts- making a customer buy something from someone else in order to be allowed to buy from you

○ Exclusive dealing- not letting your customers buy from a competitor

○ Interlocking directorates- when someone serves on the board for 2 competing firms

● If a firm is engaging in any of these actions, an “antitrust suit” is filed against them ○ Most of the time, either the DOJ or the FTC initiate antitrust suits against offending firms

○ However, individual people and firms can also bring charges

○ Example: coke and pepsi spearheaded a class-action suit against several producers for price-fixing in high fructose corn syrup

-Sanctions​ ​and​ ​remedies​ ​from​ ​the​ ​courts,​ ​they​ ​can:

1. Forbid the continuation of illegal acts

2. Force the defendants to dispose of the fruits of their wrong

3. Restore competitive conditions

-Consent​ ​decrees-​ ​formal agreements on remedies among all the parties to an antitrust case that must be approved by the courts

● These can be signed before, during, or after a trial

● Example: paying a fine and agreeing to stop whatever it is they are doing ● Example: selling off (divesting) some productive capacity or selling the right to market certain products to improve competition allow a merger to go through

-The FTC and DOJ also regulate mergers to keep firms from getting too much market power ● The primary tool they use to determine whether or not to challenge a merger is the HHI ● If a merger is challenged, the government and the merging firms each have teams of lawyers and economists that argue their case

● Herfindahl-Hirschman​ ​Index​ ​(HHI)-​ ​a mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government

● If HHI is less than 1,500, the industry is considered unconcentrated, and the proposed merger will go unchallenged

● If HHI is between 1,500 and 2,500, the industry is considered moderately concentrated and any merger that would increase the index by over 100 points “warrants scrutiny” by the DOJ or FTC

● If HHI is above 2,500, the industry is considered “highly concentrated,” and the DOJ or FTC will likely challenge any merger that pushes the index up more than 200 points almost always challenged

-Sherman​ ​Act-​ ​passed by Congress in 1890, the act declared every contract or conspiracy to restrain trade among states or nations illegal and declared any attempt at monopoly, successful or not, a misdemeanor. Interpretation of which specific behaviors were legal fell to the courts -Rule​ ​of​ ​reason-​ ​the criterion introduced by the Supreme Court in 1911 to determine whether a particular action was illegal (“unreasonable”) or legal (“reasonable”) within the terms of the Sherman Act.

● Under this rule, “mere size was not an offense” and behavior was the key ● This rule came about during the standard oil case

Ch.​ ​16:​ ​Public​ ​Goods 

-Public​ ​goods​ ​(social​ ​or​ ​collective​ ​goods)-​ g​ oods that are nonrival in consumption and/or their benefits are nonexcludable (or nonexclusive)

● They are nonrival in consumption- one person’s enjoyment of the benefits of a public good does not interfere with another’s consumption of it

● They are nonexclusive (non excludable)- once a good is produced, no one can be excluded from enjoying its benefits

● These public goods will be underprovided without government intervention since the economic incentive is missing and most people don’t have room in their budgets for many “voluntary” payments

● Examples: public art, national defense, clean air, a lighthouse, etc.

● Markets do not provide these goods in an efficient manner

○ Free-rider​ ​problem-​ ​a problem intrinsic to public goods: because people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them

○ Drop-in-the-bucket​ ​problem-​ ​a problem intrinsic to public goods: the good or service is usually so costly that its provision generally does not depend on whether or not any single person pays

● Optimal​ ​level​ ​of​ ​provision​ ​for​ ​public​ ​goods-​ ​the level at which resources are drawn from the production of other goods and services only to the extent that people want the public good and are willing to pay for it

○ At this level, society’s willingness to pay per unit is equal to the marginal cost of producing the good 

● These goods must be provided by the government

○ Optimal provision: add up prices (willingness to pay) for each quantity

○ Market demand is the vertical sum of individual demand curves- we add the different amounts that households are willing to pay to obtain each level of output (as measured on the vertical axis)

-Private​ ​goods-​ ​rival in consumption, exclusive, provided by private sector ● Consumers decide what quantity to buy, market demand is the sum of those quantities at each price

● Market demand is the horizontal sum of individual demand curve- measured on the horizontal axis

● The price mechanism force people to reveal what they want, and forces firms to produce only what people are willing to pay for, this only works because exclusion is possible ● Example: pizza- rival because the amount consumed by one person is unavailable for others to consume, exclusive because only paying customers get pizza

● Example: crowded subway

-Natural​ ​monopoly​ ​(quasi-private​ ​or​ ​club)​ ​goods-​ a​ good that is nonrival, but exclusive ● You must pay, however the quantity is not limited

● With congestion, these can turn into private goods

● Provided by private sector or government

● Example: cable TV

● Example: uncrowded subway

-Open​ ​access​ ​(open​ ​resource​ ​or​ ​common​ ​resource)​ ​goods-​ a​ good that is rival in consumption but from which non payers can not be excluded easily

● Example: ocean fish

● Rival but nonexclusive

● Regulated by the government

-Public​ ​choice​ ​in​ ​representative​ ​democracy:

● Median-voter​ ​model-​ ​under certain conditions, the preferences of the median, or middle, voter will dominate the preferences of all other voters

○ The government should do what the median or “middle” voter wants

● Rational​ ​ignorance-​ ​a stance adopted by voters when they realize that the cost of understanding and voting on a particular issue exceeds the benefit expected from doing so

○ One reason we elect officials is that there is no way we can know about all the stuff that is decided in politics

○ Due to the large cost of knowledge (and often little benefit), it is rational for us to remain ignorant about most of the little things our politicians do

○ Unfortunately, this opens the doors for special interest groups to influence politicians more than they ought to (this can lead to a “principal-agent” problem ● Rent​ ​seeking-​ ​activities undertaken by individuals or firms to influence public policy in a way that increases their incomes

○ Special interest groups, such as dairy farmers, trial lawyers, and government employees seek from government some special advantage or some outright transfer or subsidy

○ Rent seeking is ​ ​the activity that interest groups undertake to secure these special favors or benefits (rent) from the government

○ Special interest groups spend millions of dollars lobbying government officials for support on issues that benefit the group

■ The benefits that result from the policy are called “rent” and the lobbying is called “rent seeking”

-Types​ ​of​ ​legislation,​ ​distribution​ ​of​ ​benefits​ ​and​ ​costs:

● Traditional​ ​public-goods​ ​legislation-​ ​legislation that involves widespread costs and widespread benefits

○ Nearly everyone pays and nearly everyone benefits

○ Positive impact on economy

■ Total benefits>total costs

○ Example: national defense

● Special-interest​ ​legislation-​ ​legislation with concentrated benefits but widespread costs ○ Harms the economy

■ Total costs> total benefits

○ Example: price supports for dairy products have benefitted a small group-dairy farmers

■ To benefit dairy farmers, a special interest, the program spread costs across nearly all taxpayers and consumers

○ Example: farm subsidies

○ Pork-barrel​ ​spending-​ ​special-interest legislation that has narrow geographical benefits but is funded by all taxpayers

● Populist​ ​legislation-​ ​legislation with widespread benefits but concentrated costs ○ Raising taxes on top income earners

○ Those who pay the cost fight this legislation, therefore this legislation usually has a tough time getting approved

○ Those who benefit usually see such little potential benefit that they remain rationally ignorant, so they provide little political support

○ Tort reform- the idea that economists have to limit product liability lawsuits, reduce insurance costs, and bring some goods to the market, that because of liability suits, have all but disappeared-such as personal aircraft

■ However, trial lawyers-the group that would be harmed by these limits, have successfully blocked these reforms for years

● Competing-interest​ ​legislation-​ ​legislation that confers concentrated benefits on one group by imposing concentrated costs on another group

○ Fierce political battles (labor unions vs. employers, sugar growers vs. industries such as soft drink bottlers that buy sugar by the truckload)- both sides have a heavy stake in the outcome

Ch.​ ​17:​ ​Externalities 

-Externality-​ ​a cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction

● Sometimes called spillovers, third-party effects, or neighborhood effects

● Example: pollution

-Marginal​ ​private​ ​cost​ ​(MPC)-​ ​the cost of consumption or production paid by the consumer or firm

-Marginal​ ​damage​ ​cost​ ​(MDC)-​ ​the additional harm done by increasing the level of an externality-producing activity (consumption or production) by one unit

● If producing product X pollutes the water in a river, MDC is the additional cost imposed by the added pollution that results from increasing output by one unit of X per period Marginal​ ​social​ ​cost​ ​(MSC)-​ ​the total cost to society of producing an additional unit of a good or service

● Equal to the sum of the marginal costs of producing the product (MPC) and the correctly measured damage costs involved in the process of production (MDC)


***A negative externality means that MSC>MPC 

● Difference is MDC

● Too much is being produced

-Fixed-production​ ​technology-​ ​the relationship between output and the generation of an externality is fixed

● The only way to reduce the externality is to reduce production

-Variable​ ​technology-​ ​occurs when the amount of externality generated at a given rate of output can be reduced by altering the production process

● ​ ​the amount of externality produced at a given rate of output can be reduced by changing production techniques

● You do not need to decrease quantity to produce less externality 

● Example: power companies can usually change their resource mix to reduce emissions for any given rate of electricity output

-Externality​ ​solutions:

1. Direct government regulation (aka “command and control”-put legal limits on the amount or type of externality produced

a. Example: very dangerous gasses are simply not acceptable externalities b. Take place at federal, state, and local levels

2. Government-imposed taxes and subsidies

a. Direct taxes-the government can force the firms to internalize the externality by directly taxing the product that is causing the externality

i. Taxes=MDC 

ii. These taxes do not induce new “cleaner” technologies since they are levied on the product, not the pollution-these work better if we have fixed technology

b. “Pollution tax”- instead, the government could tax the pollution rather than the product

i. This would encourage the firm to clean up the process but it is often difficult or costly to correctly measure pollution

3. Private bargaining and negotiation

a. Assign property rights and let the parties figure things out themselves (the more “free-market” approach)

b. No matter who you assign the rights to, you will end up with the same socially optimal level of production and pollution after the two parties negotiate a deal i. Who pays the cost of this adjustment depends on who is assigned the property rights; this is called the coase theorem

ii. Coase​ ​theorem-​ ​as long as property rights are clearly stated and

bargaining costs are minimal, private parties can arrive at the efficient

solution, regardless of how the property is assigned

1. The cheapest solution to the problem will always be chosen

c. Example: assigning a river to the paper mill or the fishery

i. If the river is assigned to the fishery, the fishery can then charge the paper mill for the right to dump into the river- the cost of dumping is

internalized by the paper mill

ii. If the river is assigned to the paper mill, the fishery would have to pay the paper mill to stop dumping

4. Legal rules and procedures

a. For the coase theorem to work, we need laws in place that define what action can be taken when your property is damaged

b. Laws, especially liability rules, can also provide firms with an incentive to stop polluting

c. Injunction-​ ​a court order forbidding the continuation of behavior that leads to damages

d. Liability​ ​rules-​ ​laws that require A to compensate B for damages imposed 5. Sale or auctioning of rights to impose externalities

a. Aka “cap and trade” and the “economic efficiency” approach

b. The government can decide how much total pollution is acceptable and then auction off or allocate tradable or marketable “pollution permits,” that give the owner the right to pollute a certain amount (or the seller can not use them and sell them instead)

c. This method is attractive because the firms for whom pollution abatement would be very expensive will bid high and buy the permits while the other firms will be forced to change their technology and cut pollution

d. In order to know how many pollution permits to auction off or allocate, the government needs to find the “optimal” level of pollution or externality

i. To do this, they need to consider the costs and benefits of pollution abatement

e. Fixed-production firms will buy the permits-will be willing to pay more f. Variable-production firms are more likely to change their production technology -Common​ ​Pool​ ​Problem​ ​(tragedy​ ​of​ ​the​ ​commons-​ u​ nrestricted access to a renewable resource results in overuse

● A fisherman will fish until their personal marginal benefit meets their personal marginal cost

○ Each fish caught imposes a cost on all the other fisherman (they have fewer fish to catch now)

○ The cost to society (or all fishermen) is higher than the personal cost that the fisherman sees

● The problem is that the resource being used is not privately owned

-Positive​ ​externalities

● Sometimes, consumption of a good has external benefits for society

● The market equilibrium is less than the socially optimal quantity

○ Because of this underproduction, deadweight loss is created-the market is not socially efficient


● Often, the government will subsidize the consumption of such products in order to increase consumption to the socially optimal level

● Examples: public education, grants for students, free or cheap flu shots, etc. Ch.​ ​18:​ ​Income​ ​Distribution 

-The United States has more income inequality than any other developed country but less than most developing countries

● Gini coefficient of US is around 48

● Gini coefficient in Europe is around 30

● Highest gini coefficient is usually found in Africa

-Lorenz​ ​curve-​ ​a widely used graph of the distribution of income, with cumulative percentage of families plotted along the horizontal axis and cumulative percentage of income plotted along the vertical axis

● Any given distribution of income can be compared to an equal distribution of income among households

● Line in middle is called line of equality (straight diagonal)- 45 degree line ● The more bowed out the curve is, the more unequal it is

● The shaded area can be used to calculate the gini coefficient

● Gini coefficient=the shaded region divided by the shaded region+the region under it -Gini​ ​Coefficient-​ ​a commonly used measure of inequality of income derived from a Lorenz Curve

● It can range from 0 to a maximum of 1 and is measured as the area of the region between the Lorenz curve and the 45 degree line divided by the max possible area ● If income is equally distributed, there is no shaded area (because the Lorenz curve and the line of equality are the same) and the Gini coefficient is zero

○ Zero gini=zero inequality

● The lorenz curves for distributions with more inequality are farther down to the right, their shaded areas are larger, and their gini coefficients are higher

● Maximum gini coefficient is 1- as lorenz curve shifts down to the right, the shaded area becomes a larger portion of the total triangular area below the diagonal

○ If one family earned all the income (with no one else receiving anything), the shaded area and the triangle would be the same, and the ratio would equal 1

-Poverty​ ​line-​ ​the officially established income level that distinguishes the poor from the non poor

● It’s set at “money income” equal to three times the cost of the Department of Agriculture’s minimum food budget ($24,600 for a family of 4 in 2017)

● Income inequality is correlated with poverty

-Sources​ ​of​ ​Household​ ​Income:

1. Wages and salaries received in exchange for labor

a. Most of Americans’ income come predominantly from labor

b. Differences in wages are often a result of differences in skill or differences in working conditions

i. Human​ ​capital-​ ​the stock of knowledge, skills, and talents that people possess; it can be inborn or acquired through education and training

1. People with more human capital normally get paid more-this

explains a lot of the income inequality in the middle of this


ii. Compensating​ ​differentials-​ ​differences in wages that result from differences in working conditions

1. Risky jobs usually pay higher wages

2. Highly desirable jobs usually pay lower wages

2. Property-capital, land, etc.

a. Property​ ​income-​ ​income from the ownership of real property and financial holdings

i. It takes the form of profits, interest, dividends, and rents

ii. Differences in property income account for a large share of the inequality at the top of the distribution (the top 1% to the top 0.01%)

3. Government

a. Transfer​ ​payments-​ ​payments by the government to people who do not supply goods or services in exchange

i. Designed to provide income to those in need

ii. Not included in income stats

-Income-​ ​the amount of money that a person received in return for his services, sale of goods, or profit from investments

-Wealth-​ ​the net worth of a person, the total value of his assets minus his liabilities ***wealth has more inequality than income

-Redistribution​ ​Arguments

● Arguments against redistribution

○ Some people believe that the market, when left to operate on its own, is fair those who make more through the market should be allowed to keep what they earned

○ Redistribution removes incentives for both the rich and the poor to work harder ○ Some believe that the high income earners make investments that benefit everyone (“job-creators” or “trickle-down economics”)

● Arguments in favor of redistribution

○ A society as wealthy as the United States has a moral obligation to provide all its members with the necessities of life

○ Many people are born into situations that make it very hard for them to achieve wealth through the market

○ Redistribution helps correct for inequality of opportunity

-Redistribution​ ​theories:

● Utilitarian​ ​justice-​ ​the idea that “a dollar in the hand of a rich person is worth less than a dollar in the hand of a poor person”

○ If the marginal utility of income declines with income, transferring income from the rich to the poor will increase total utility

● Rawlsian​ ​justice​ ​(social​ ​contract​ ​theory)-​ ​a theory of distributional justice that concludes that the social contract emerging from the “original position” would call for an income distribution that would maximize the well-being of the worst-off member of society

○ Inequality is acceptable but only if the process that causes it also improves the lot of the poor

○ Policies that help the rich are OK as long as they also help (or at least not hurt) the poor

○ “Veil​ ​of​ ​ignorance”-​ ​assume we enter this world not knowing what our social situation will be (rich, poor, etc), choosing a system that maximizes the well-being of the worst-off member is the safest thing to do (much like the maximin strategy in game theory

● Labor​ ​theory​ ​of​ ​value​ ​(Karl​ ​Marx)-​ ​stated most simply, the theory that the value of a commodity depends only on the amount of labor required to produce it

○ Marx felt that labor should be paid its full value and profits from labor should be given to the workers and not to the firm, he argued that this would eliminate the main source of inequality

-Redistribution​ ​policies​ ​in​ ​the​ ​US

1. Social​ ​insurance​ ​programs-​ ​government programs designed to help make up for lost income of people who worked but are now retired, unemployed, or unable to work because of disability (payments from the system are related to payments into the system)

a. Social​ ​security-​ ​social insurance program that supplements retirement income of those with a record of contributing to the program during their working years i. By far the largest government redistribution- over $600 billion a year ii. The money you put away today funds retirement for those who are retired today, different from a normal retirement package

iii. It is funded by a tax on wages

iv. Becoming a problem since so many people are retiring now and in the next few years

b. Medicare-​ ​an in-kind government transfer program that provides health and hospitalization benefits to the aged and their survivors and to certain of the disabled, regardless of income

c. Unemployment​ ​compensation-​ ​a state government transfer program that pays cash benefits for a certain period of time to laid-off workers who have worked for a specified period of time for a covered employer

2. Income​ ​assistance​ ​programs-​ ​usually called welfare programs, provide cash and in-kind assistance to the poor, do not require recipients to have a work history or to have paid into the program (payments are based solely on need)

a. These programs are called “means-tested programs”

i. Means-tested​ ​program-​ ​a program in which, to be eligible, an

individual’s income and assets must not exceed specified levels

b. Cash​ ​transfer​ ​programs-​ ​direct transfer payments from the government of money to eligible

i. Temporary​ ​Assistance​ ​for​ ​Needy​ ​Families​ ​(TANF)-​ ​an income

assistance program funded largely by the federal government but run by the states to provide cash transfer payments to poor families with

dependent children

1. Limit is 5 years over your lifetime

2. Reforms placed more importance on finding jobs quickly

ii. Supplemental​ ​Security​ ​Income​ ​(SSI)-​ ​a federal program that was set up under the Social Security Administration in 1974, meant to help elderly

that receive little or not Social Security payments

1. Provides cash transfers to the elderly, poor, and disabled

2. A uniform federal payment is supplemented by transfers that vary

across states

c. In-kind​ ​transfer​ ​programs-​ ​in the form of goods and services; for free or at a reduced rate-rather than in cash-non cash benefits

i. Medicaid-​ ​an in-kind government transfer program that provides health and hospitalization benefits to people with low incomes

1. Like medicare for the poor

2. By far the largest welfare program

ii. Food​ ​stamps-​ ​vouchers that have a face value greater than their cost and that can be used to purchase food at grocery stores

1. Only low-income families and individuals are eligible


-Tax​ ​base-​ ​what is being taxed

● stocks-houses , properties, cars, “estates”

● Flows- income, sales (consumption), payroll, profits, etc.

○ Most taxes are on flow

-Tax​ ​structure-​ ​how it is being taxed

● Per unit or as a % of value (ad-valorem)

● Flat, progressive, regressive

-Tax​ ​revenue-​ ​the amount of money collected by the government from the tax -Taxes​ ​on​ ​flows:

1. Income​ ​tax-​ ​tax on personal income

a. Proportional​ ​income​ ​tax​ ​(flat​ ​tax)-​ ​a tax whose burden is the same proportion of income for all households

b. Progressive​ ​tax-​ ​a tax whose burden, expressed as a percentage of income, increases as income increases

i. Most income tax is progressive- tax on labor

c. Regressive​ ​tax-​ ​a tax whose burden, expressed as a percentage of income, falls as income increases

i. The social security tax is regressive since the tax drops to zero after $118.5k

ii. Many state and local taxes are regressive

iii. By having a lower tax rate on capital gains and on high income earners, it encourages investment

1. High income earners can pay less tax by investing their money

and earning income as cap gains instead of salary

2. But if individuals or firms don’t invest that money in real productive resources, or if the money goes abroad, then it does not help the


2. Sales​ ​tax-​ ​aka consumption tax, regressive since lower income households spend more of their income on consumption- this is why many groceries have zero sales tax-to alleviate the regressiveness of the tax

a. Tax​ ​Incidence​-who pays the tax, the ultimate distribution of a tax burden. Who pays what?

i. Just because you pay the sales tax when you buy a good doesn’t mean you are actually paying the entire tax

ii. A tax basically shifts up the MC curve (or supply curve) by the amount of tax-the producers see it as an additional cost of selling the good

iii. While firms would like to pass the entire tax onto consumers, they cannot do so and still sell the quantity they want to, so both consumers and

producers normally pay part of the tax

1. Consumers: pay a higher price in the store

2. Producers: receive less money “net-of-tax”

iv. Determined by the relative elasticities of supply and demand

1. As demand gets more elastic, consumers are unwilling to pay the

higher prices and the firm is forced to bear the tax incidence

2. As supply gets more elastic, firms are unwilling to absorb the tax

and consumers are forced to bear the incidence

3. Whoever has a less elastic (steeper) curve pays more of the tax 

b. Distortion-​ ​how the tax affects behavior

i. When the prices of things change, this changes people’s behavior ii. The distortion can move us away from efficiency (causing deadweight loss) or can move us closer to efficiency (for example if we have a

negative externality)

c. revenue=total sales times the size of the tax

-Average​ ​(aka​ ​effective)​ ​tax​ ​rate-​ ​total amount of tax paid divided by total income -Marginal​ ​tax​ ​rate-​ ​the tax rate paid on the next dollar earned (any additional income earned) -Ways​ ​to​ ​apply​ ​sales​ ​taxes

1. Per unit

a. Example: $1000 per car

2. Ad-Valorem (percentage)

a. xxxExample: 10% of the price of what you buy

-Sales taxes are regressive since lower income households spend more of their income on consumption

-Just because you pay the sales tax when you buy a good doesn’t mean you are actually paying the entire tax

● The firm has to lower the price they charge due to the tax as well

***right now in the US, most of the tax collected is in the form of income tax (“ability to pay”) -Excess​ ​burden​ ​(deadweight​ ​loss)-​ ​the amount by which the burden of a tax exceeds the total revenue collected

● The more elastic the demand, the more distortion and the more deadweight loss ● The more elastic the supply, the more distortion, and the more deadweight loss -Principle​ ​of​ ​neutrality-​ ​all else equal, taxes that are neutral with respect to economic decisions (taxes that do not distort economic decisions) are generally preferable to taxes that distort economic decisions

● Taxes that are not neutral impose excess burdens

● Neutral taxes are better because they create less distortion

● More inelastic demand=ldess distortion=less excess burden

-Principle​ ​of​ ​second​ ​best-​ ​the fact that a tax distorts an economic decision does not always imply that such a tax imposes an excess burden

● If there are previously existing distortions (such as an externality or another tax), such a tax may actually improve efficiency

● Optimal​ ​taxation-​ ​the idea that taxes can affect behavior in predictable ways has led tax theorists to search for optimal taxation systems in which distortions basically cancel each other out

Extra​ ​Notes: 

-in a repeated game, the tit-for-tat strategy is most consistent with cooperation on part of the players involved

-horizontal​ ​mergers-​ ​involve the same product but different firms

-vertical​ ​mergers-​ ​one firm demands inputs from the other firm

-conglomerate​ ​mergers-​ ​two firms from different industries merge

-economic​ ​efficiency​ ​approach​ ​(cap​ ​and​ ​trade)-​ g​ ives firms the option to reduce emissions or buy additional permits at prices determined by the market

-positive externality- MSB>MPB 

-negative externality- MSC>MPC 

-tying​ ​contracts-​ ​a requirement that buyers of one service also purchase another service from the same seller (or a different seller)

-less elastic demand=more tax revenue

-If demand is less elastic than supply, the incidence of a sales tax will largely by borne by consumers 

-If supply is very elastic, a sales tax will be borne mostly by the consumer -special-interest​ ​legislation-​ ​concentrated benefits and widespread costs -rawlsian​ ​justice-​ ​focuses on the worst-off member of society

-in a natural monopoly, if the government forces a firm to set price at P=MC, they will earn negative economic profit 

-in a natural monopoly, if the government forces a firm to set price at P=AC, they will earn zero economic profit 

-if a negative externality is present, MSC=MPC+MDC

-capture​ ​theory-​ ​producers “capture” regulatory agencies so that regulation favors producers -demand curve of a public good is the vertical sum

-a private, competitive market allocates too few resources for a public good -populist​ ​legislation-​ ​concentrated costs and widespread benefits

-rational​ ​ignorance-​ ​the decision NOT to acquire information because the MC of doing so exceeds the expected MB

-If an industry has an HHI of 800, it is a competitive market

-adverse​ ​selection​ ​(hidden​ ​characteristics)-​ w​ hen a buyer or a seller enters into an exchange with another party who has more information

-principal-agent​ ​problem​ ​(hidden​ ​actions)-​ ​goals of the agent are incompatible with those of the principal

-when considering the search model, the internet lowered the cost of information, thus raising the optimal level of information gathered

-pollution tax=MDC

-a tradable pollution permit allows firms to buy and sell the right to pollute -economic​ ​income-​ ​the sum of consumption and the change in net worth -excess​ ​burden-​ ​amount by which the burden of a tax exceed the total revenue collected -principle​ ​of​ ​second​ ​best-​ ​if previously existing distortions exist, a distortionary tax may actually improve efficiency

-winner’s​ ​curse-​ ​auctions for product of uncertain value (like ebay) create a special “imperfect info” problem where many winners end up losers- they pay too much

-the efficient level of public good provision is determined where the market demand curve intersects the MC curve

-derived​ ​demand-​ ​demand for a resource derived from the demand for the product produced by that resource

-MRP​ ​of​ ​labor​= change in total revenue/change in units of labor

-by saving, households are supplying loanable funds

-when the free market produces less than the socially optimal quantity of a good, there has been a market failure 

-competing-interest​ ​legislation-​ ​both concentrated costs and concentrated benefits -in a PC labor market, a profit-maximizing firm will hire labor up to the point at which the wage rate= MRP of labor 

-the optimal level of pollution is the level at which MSC=MSB

-marketsforpollutionrights, enablethosewhovaluethemthemosttopollute

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