Chapter 10: Externalities
Externality: when a person’s actions affect well-being of bystander but does not pay for or receive compensation for that impact
-If effect on bystander is good, it is a positive externality
-If it is bad, it is a negative externality
“To move market equilibrium closer to social optimum, a subsidy is put into place Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a smaller quantity than is socially desirable. To remedy the problem, the government can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalities.” (Page 201)
Don't forget about the age old question of The number one reason that species are going extinct is what?
∙ Externalities make allocation of resources inefficient; policies are put into place to move allocation closer to social optimum
Command and control policies: Change the allowed market quantity
(Ex. Each supplier can only produce 0.6 widgets instead of 1)
-Not getting efficient allocation of production (A tax would be more efficient; there is government revenue)
Market based policies: align private incentives with social efficiency (taxes or subsidies) Policy 1:
∙ Corrective taxes and subsidies:
Taxes to deal with negative externalities
-Pigouvian tax: Optimal tax (tax = external cost) will make pie as big as possible Subsidies to deal with positive externalities
-An ideal corrective subsidy = external benefit
-Taxes in the presence of externalities raise revenue of government and enhance economic efficiency, moving it closer to social optimum. We also discuss several other topics like Create an analysis that uses critical thinking to assess the overall plausibility of the claim: “the conflict in bosnia is somebody else’s trouble. the u.s. should not intervene militarily.”
If you want to learn more check out What are the types of media sources that allow us to express ourselves without any harsh backlash?
∙ Cap and Trade
Distribute Allowances (similar to quotas)
Coase Theorem: If private parties can bargain over allocation, they can find solution to externalities on their own. The bargain reached will make everyone better off and be efficient.If you want to learn more check out What is ion-dipole interactions?
Chapter 3: Interdependence and the Gains from Trade (Page 47)
One of the Ten Principles of Economics is: Trade can make everyone better off.
∙ Rose and Frank both work 8 hours a day.
∙ Frank can produce 1 oz of potatoes in 15 minutes and 1 oz of meat in 60 minutes. ∙ Rose can produce 1 oz of potatoes in 10 minutes and 1 oz of meat in 20 minutes.
Time needed to make 1 oz (mins)
Amount produced in 8 hours
Don't forget about the age old question of Injected contraceptives, such as depoprovera or lunelle, may be injected once every?
(Production Possibilities Frontier graph shown on page 49)
∙ Frank can spend all 8 hours producing 8 oz of meat or all 8 hours producing 32 oz of potatoes. If he splits his time in half, he can produce 4 oz of meat and 16 oz of potatoes. We also discuss several other topics like Why are stereotypes used in the media?
∙ Rose can spend all 8 hours producing 24 oz of meat or 48 oz of potatoes. If she splits her time evenly, she can produce 12 oz of meat and 24 oz of potatoes.
Trade makes people better off because it allows them to specialize in what they do best.
In Rose and Frank’s situation…
-If Frank specializes in producing potatoes, he can produce 32 oz of potatoes and give 15 oz to Rose.
-Rose can spend 6 hours producing meat to get 18 oz of meat and 2 hours producing 12 oz of potatoes.
-Rose gets 15 oz of potatoes from Frank and Frank gets 5 oz of meat from Rose. (Page 51)
Absolute advantage: the producer who requires the least amount of input in order to produce a good
- Rose has the absolute advantage in both.
Opportunity cost: trade-off (ex. The time Rose takes up producing potatoes is time she could be producing meat)
Rose: For every 10 minutes taken to produce 1 oz potato, she could produce ½ oz meat. Rose’s opportunity cost= ½
Frank: For every 60 minutes taken to produce 1 oz of meat, he could produce 4 oz potatoes. Frank’s opportunity cost= ¼
Comparative advantage: Comparing opportunity costs between 2 producers -Frank has a comparative advantage in producing potatoes and Rose has a comparative
advantage in producing meat
∙ While one person can have an absolute advantage in both goods (Rose), one cannot have a comparative advantage in both goods. The greater the opportunity cost of one good, the lower the opportunity cost of the other.
∙ Gains from specialization and trade are based on comparative advantage, not absolute advantage.
∙ Trade increases the economic pie
How does each benefit?
-Frank gets 5 oz of meat in exchange for 15 oz of potatoes
5oz meat/15oz potatoes= 1oz meat/3oz potatoes ; for every oz of meat he gets from Rose, he pays her with 3 oz of potatoes
This is lower than his opportunity cost for an oz of meat which is 1oz meat/4 oz potatoes
-Rose gets 15 oz potatoes in exchange for 5 oz of meat
1 oz of potatoes costs her 1/3 oz of meat which is lower than her opportunity cost of potatoes which is ½
∙ For both parties to gain from trade, price at which they trade must be between the opportunity costs of each person.
(Example on page 55)
Another example: Suppose the Japan and the US can each produce 1 car a month. But Japan can only produce 1 ton of food while the US can produce 2 tons. In that case, the US has a comparative advantage in producing food and Japan has a comparative advantage in producing cars. (Page 58)
Chapter 9: Application: International Trade
To determine if a country will be an exporter or importer of a good, domestic price must be compared to world price before international trade is allowed.
-If the world price > domestic price, producers will export the good because they get a better price.
-If the world price < domestic price, consumers will import the good because it is cheaper
∙ International trade expands the size of the economic pie but might give some people a smaller piece.
Tariff: Tax placed on imported goods
-Raises price of imported goods above world price by the amount of the tariff (Ex. If Pworld = 3$ and tariff = 2$ then Price of good = 5$)
-A tariff reduces domestic quantity demanded and raises domestic quantity supplied -Domestic producers are better off and domestic consumers are worse off -Tariffs move domestic market closer to the equilibrium without trade
-A tariff causes a deadweight loss and total surplus falls
(Graph on page 178)
Quotas are similar to tariffs but revenue doesn’t go to government
Chapter 11: Public Goods and Common Resources
Goods can be thought of as having two characteristics:
Excludable: People can be prevented from using good
Rival in consumption: One person consuming it affects someone else’s ability to consume it (Ex. I eat it, so you can’t)
These two characteristics divide goods into 4 categories:
Free rider: Person who receives benefit of a good but doesn’t pay for it
-When people have incentive to be a free rider, market fails to provide efficient outcome -Government can pay for public goods with tax revenue to make everyone better off
Cost and benefit analysis: Study to estimate costs and benefits of a project to the society as a whole
-Efficient provision of public goods is more difficult than the efficient provision of private goods -Cost and benefit analysists do not have any price signals to indicate whether a public good should be provided and how much; they estimate costs and benefits of a public project (Example on page 222)
Tragedy of the Commons arises because of an externality. Due to externality, common resources are often used excessively.
-Government can solve this problem by using regulation or taxes to reduce consumption of the common resource or turn it into a private good.
(Tragedy of the Commons story on page 223)
Chapter 21: The Theory of Consumer Choice
Theory of Consumer Choice examines how consumers facing trade-offs make decisions and how they respond to changes in their environment
∙ Budget Constraint: What people can afford
Majority of people would like to consume more than they do, but they are constrained by their income.
Budget constraint curve shows all the combinations consumer can afford
∙ Preferences: What the consumer wants
-Consumer chooses bundle of pizza and Pepsi depending on her preferences -If two different bundles meet her tastes equally well, the consumer is indifferent Indifference curve: Shows the various bundles of consumption that make the consumer equally happy
Ex: If consumption of pizza is reduced, consumption of Pepsi must increase to make consumer equally satisfied
Marginal rate of substitution: Rate at which consumer is willing to trade one good for the other -Marginal rate of substitution is not the same at all points
-Consumer is equally happy at all points given on same indifference curve -Consumer prefers higher indifference curves to lower ones because she wants to consume more rather than less
Four Properties of Indifference Curves
1. Higher indifference curves are preferred to lower ones
-Higher indifference curves represent larger quantities of goods
2. Indifference curves slope downward
3. Indifference curves don’t cross
4. Indifference curves are bowed inward:
-The marginal rate of substitution depends on amount consumer is currently consuming -Curve bowed inward because people are more willing to trade away goods they have a lot of
-Indifference curves are less bowed if goods are more easily substituted; if the goods are harder to substitute, the indifference curves are very bowed
-The indifference curves are straight
Ex. If someone offered you bundles of nickels and bundles of dimes, you would only care about the total monetary value in each. Thus, you would be willing to trade 2 nickels for 1 dime. Marginal rate of substitution would always be 2.
-The indifference curves are right angles
Ex. If someone offered you bundles of shoes, you would only care about how many pairs there are. A bundle of 5 left shoes and 7 right shoes would only be 5 pairs, thus the right shoes are no use.
∙ The Consumer’s Optimal Choices
-A consumer wants to end up with the best combination of Pepsi and pizza. - Optimum: point at which the indifference curve and budget constraint touch -Anything above the budget constraint can’t be afforded
-Anything below the budget constraint would yield less satisfaction
-At the optimum, slope of indifference curve = budget constraint
-Consumer chooses the consumption where marginal rate of substitution = relative price Marginal rate of substitution: rate at which consumer is willing to trade one good for the other Relative price: rate at which the market is willing to trade
Two ways consumer might respond to decrease in price of good:
Income effect: Buy less of good
Ex. Because Pepsi is cheaper, you have more money so you can buy both more pizza and Pepsi Substitution effect: Buy more of good
Ex. Because price of Pepsi has fallen, pizza is relatively more expensive, so you should buy more Pepsi and less pizza
-If the two effects work at the same time, consumer will buy more Pepsi because both effects increase the purchasing of Pepsi, but it is ambiguous whether or not consumer buys more pizza.
-Income effect shifts consumption to higher indifference curve
-Substitution effect is a movement along indifference curve
∙ Deriving the Demand Curve
-A consumer’s demand curve is a summary of the optimal decision that arises from budget constraints and indifference curves.
Giffen Good: A good that violates the law of demand
-Usually when the price of a good rises, people buy less but if people buy more, good is considered a Giffen good
-Giffen goods are inferior goods where the income effect dominates the substitution effect causing demand curves to slope upward
-Giffen goods are very rare
Carrie has 100 hours a week to divide her time between working and leisure. She gets 50$ an hour. If she spends all her time relaxing, she has no consumption. If she works for all 100 hours, she makes $5,000 but no leisure. If she works 40 hours a week, she makes $2,000 and enjoys 60 hours of leisure. If her pay increases to 60$, she can work less or more.
Substitution effect would say Carrie works more because the trade-off between leisure and consumption becomes more costly. Curve slopes upward
Income effect would say Carrie works less because she wants to enjoy both higher consumption and more leisure. Curve slopes backward
∙ How Do Interest Rates Affect Household Saving?
If the interest rate is 10% and Saul makes $100,000 when he’s young and working before he’s old and retired, then for every dollar saved, he can consume $1.10 when he’s retired. At the optimal combination of consumption based on his preferences, Saul consumes $50,000 when he’s young and $55,000 when he’s old.
-If interest rate increases to 20%, two things are possible:
Substitution effect: Because consumption when old becomes less costly relative to consumption when young, Saul saves more.
Income effect: Because of the higher interest rate, Saul is better off than he was. As long as both goods are normal goods, Saul will want to enjoy an increase in consumption both when he’s young and old so he saves less.
Q- quantity AFC - average fixed cost
FC - fixed cost AVC – average variable cost
VC - variable cost ATC – average total cost
TC - total cost MC - marginal cost
TC = FC + VC
AFC = FC / Q
AVC = VC / Q
Chapter 13: The Costs of Production
Total revenue: Amount of money firm receives for its good (output)
Ex. Caroline bakes 10,000 cookies and sells the for 2$ each
Her total revenue is 10,000*$2= $20,000
Total cost: Amount of money firm spends on input (ingredients, labor, etc.) Profit: Profit = firm’s total revenue – total cost
Opportunity cost: Everything that is given up in order to acquire an item Ex. Caroline pays $1,000 for flour; $1,000 is her opportunity cost
Explicit costs: Input costs that require outlay of money (Ex. Paying for flour) Implicit costs: Input costs that don’t require cash outlay
Ex. If Caroline is a computer expert, she could earn $100 /hour as a programmer; for every hour Caroline works at the cookie factory, she gives up $100 which is an implicit cost Accountants only measure explicit costs
Economists measure both implicit and explicit costs
Total cost= implicit + explicit costs
∙ Important implicit cost of almost every business: opportunity cost of financial capital invested in business
- Ex. If Caroline invested $300,000 in her business when she could have saved it in a savings account with a 5% interest rate, she is giving up $15,000 in interest income a year; this is an implicit cost
-If Caroline spends $100,000 of her own money and takes out a loan for $200,000 with a 5% interest rate, her opportunity cost would be an explicit cost of $10,000 (interest paid to bank) plus loss of interest on savings of $5,000 (implicit cost)
Production function: relationship between quantity of inputs and quantity of outputs
Marginal product: increase in output from adding one unit of input
Ex. When one more worker is added, how much does cookie production increase?
-When # of workers goes from 1 to 2, cookie production increases from 50 to 90 -Marginal product of the second worker is 40 cookies
-Third worker has marginal product of 30 cookies
Diminishing marginal product: As # workers increases, marginal product decreases Ex. Kitchen becomes more crowded, workers have to share equipment, and they get in each other’s way
Fixed costs: Costs that don’t change with quantity produced (costs incur even if production is 0) Ex. rent
Variable costs: Costs that do change if quantity changes
Ex. Cost of ingredients to make coffee (the more coffee Conrad makes, the more ingredients he has to buy)
Firm’s total cost = fixed + variable costs
Firm must decide how much of a good to produce
Two questions have to be considered:
∙ How much does it cost to make 1 unit of the good?
∙ How much does it cost to increase production by 1 unit?
Cost of 1 unit produced or average total cost = TC / Q
-If firm produces 2 cups of coffee, its total cost is $3.80
Average total cost: 3.80/ 2 = $1.90
Average fixed cost = FC / Q
Average variable cost = V / Q
Marginal cost: Amount total cost increases by when firm increases production by 1 unit Marginal cost = change in TC / change in Q
(See chart below)
-When Conrad increases production from 2 cups to 3 cups, total cost increases from $3.80 to $4.50
-Marginal cost of 3rd cup of coffee is $.70
Efficient scale: quantity at minimum of ATC (bottom of U-shaped ATC) -When MC < ATC, ATC falls.
-When MC > ATC, ATC rises.)
-MC curve crosses ATC at its minimum
∙ For most firms, marginal product does not fall immediately after hiring first worker -2nd and 3rd worker might have higher marginal product because a team can divide work and be more productive
-Therefore, firms have increase in marginal product and then a decrease in marginal product (Page 270-271)
∙ MC eventually rise with quantity of output
∙ ATC is U-shaped
∙ MC curve crosses ATC curve at its minimum
-Many decisions of a firm are fixed in the short run but variable in the long-run Ex. In the short run, Ford can’t expand its car factories to increase output so cost of factories is fixed in short run
In long run, Ford can expand factory size so cost of factories is variable
Average total cost may rise more in the short run than the long run
Economies of scale: long run TC decreases as Q increases (Higher production level allows specialization among workers)
Diseconomies of scale: long-run ATC rises as Q increases (Occurs because of coordination problems)
Constant returns to scale: long-run average total cost doesn’t change with level of output
Chapter 14: Firms in Competitive Markets
∙ Competitive market/perfectly competitive market:
-There are many buyers and sellers
-Goods offered are largely the same
-Firms can freely enter or exit the market
Price takers: Buyers and sellers in competitive markets must accept the market price
Average revenue: price of good
Marginal Revenue: change in total revenue from sale of each additional unit of output marginal revenue = Price of good
Three general rules for profit maximization:
1. If marginal revenue > marginal cost, a firm should increase quantity of production to increase profit
2. If marginal revenue < than marginal cost, a firm should decrease production 3. At the profit-maximizing level of output, marginal revenue = marginal cost
∙ Marginal cost curve determines quantity of good that firm is willing to supply, thus it also acts as the supply curve.
Shutdown: The temporary decision of a firm not to produce anything (still has to pay fixed costs)
-Firm shuts down if P < AVC
-Firm’s short-run supply curve is part of MC that is higher than AVC
Sunk cost: Costs that have already been committed to so can’t be recovered -Sunk costs are ignored when firm decides how much to produce
(Example on page 287)
Exit: Decision to leave market permanently (firm doesn’t have to pay any costs) -Firm will exit market if P < ATC or price < average total cost
-Firm will enter market if P > ATC
-A firm’s long-run supply curve is that part of its marginal-cost curve that lies above average total cost
Profit = (P – ATC) * Q
-If price is higher than ATC, new firms will enter market.
-If price is less than ATC, some firms will exit.
-If price equals ATC, there is no exit or entry.
∙ In long-run equilibrium of competitive market with free entry and exit, firms must be operating at their efficient scale (level of production with lowest ATC) If firms are competitive and profit-maximizing, price = marginal cost so firm is maximizing profit
If firms can freely enter and exit, price will also = lowest possible average total cost so profit is 0
∙ Number of firms in market adjusts to price = minimum of ATC
Ex. To increase quantity of painting services, price must rise because new entrants with higher costs won’t enter unless it’s profitable for them
Typically, long-run supply curve is more elastic than short-run supply curve
In the long run, firms will enter or exit the market until profit is driven to zero. As a result, price equals the minimum of average total cost, as shown in panel (a). The number of firms adjusts to ensure that all demand is satisfied at this price. The long-run market supply curve is horizontal at this price, as shown in panel (b).
∙ Firms stay in market when profit is 0 because in economics, both explicit and implicit costs (opportunity costs) are factored in. Accountants only include explicit costs Ex. In order to farm, farmer gave up another job that would have paid him $30,000 -This is an opportunity cost included in equation for economic profit
-If farmer’s total revenue is $30,000, profit is 30,000 – 30,000 = 0
-Accountant profit wouldn’t include the explicit cost of $30,000 thus accountant profit $30,000 30,000 – 0 = $30,000
∙ Response of a market to a change in demand depends on time horizon -Firms can enter and exit market in long run but not short run
-Because all firms have same price, long-run market supply curve is horizontal, that is perfectly elastic
Long-run supply curve might slope upward because:
∙ Resources used in production is limited
Ex. Land is a limited resource
Demand in farm products ???? cost of land increases as more people become farmers ???? farmers’ costs increase ???? rise in price
∙ Firms have different costs
Ex. Painters have different costs because some people work faster and some have better ways to spend their time
-Those with lower costs are more likely to enter market