Principles of Economics
Principles of Economics ECON 2102
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This 27 page Class Notes was uploaded by Ora Rath on Sunday October 25, 2015. The Class Notes belongs to ECON 2102 at University of North Carolina - Charlotte taught by Ronald Madsen in Fall. Since its upload, it has received 160 views. For similar materials see /class/229018/econ-2102-university-of-north-carolina-charlotte in Economcs at University of North Carolina - Charlotte.
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The Role of Government 4252011 43600 PM Quick Review Market Failure o An imperfection in the market mechanism that prevents optimal outcomes o Occurs when the market mechanism causes the economy to produce a combination of goods different from the optimal mix of output or results in an inequitable distribution of income Market failure may prompt the government to intervene Optimal Mix of Output o The most desirable combination of output attainable with existing resources technology and social values Market mechanism o The use of market prices and sales to signal desired outputs or resource allocations o Changes in market prices direct resources from one industry to anothermoving us along the perimeter of the production possibilities curve Market failure implies that the forces of supply anddemand haven t led us to the best point on the production possibilities curve There are four specific sources of market failure o Public Goods o Externalities o Market power 0 Equity Public Goods o A good or service whose consumption by one person does not exclude consumption by others o Donut is a private good because I can eat that particular donut but everyone else is excluded o The technical capability to exclude nonpayers is the key factor in identifying public goods Private Goods o A good or service whose consumption by one person excludes consumption by others o National defense is a public good because nobody is excluded from its protection Private goods can be consumed exclusively by those who pay for the goods but public goods cannot Public goods such as national defense can be consumed jointly by everyone no matter who pays Because the link between paying and receiving is broken everyone seeks to be a quotfree rider and benefit from purchases made by others As a result the market underproduces public goods and government intervention is necessary to provide these goods Free Rider o An individual who reaps direct benefits from someone else s purchase Frostwire or if one valley farmer buys a dam then the others are free riders If public goods were marketed like private goods everyone would wait from someone else to pay Robert Heilbroner spoke of the market s deaf ear he was alluding to this kind of dilemma o The market tends to underproduce public goods and overproduce private goods o Athis is wear government steps in to have to provide public goods and services Then forces people to pay taxes then uses tax revenue to pay for the production of public goods and services for the people such as national defense flood control snow removal and etc Externalities o Costs or benefits of a market activity endured by a third party the difference between the social and private costs benefits of a market activity SOCIAL DEMAND MARKET DEMAND EXTERNALITIES o Externalities are costs or benefits of a market transaction borne by a third party Externalities cause a divergence between social costs and private costs and lead to sub optimal market outcomes In the case of externalities such as pollution which impose costsnegative effects on society too much of the polluting good is produced If the externality produces benefits too little of the good will be produced by the market alone In both cases government intervention may be needed to obtain the optimal mix of output If a product yields external benefits the social demand is greater than the market demand o The Market fails by 0 Overproducing goods that have external costs 0 Underproducing goods that have external benefits o If externalities are present the market won t produce the optimal mix of output To get that optimal mix we need government intervention Market Power o The ability to alter the market price of a good or a service o Monopoly is the most severe form of market power 0 A firm that produces the entire market supply of a particular good or service o AntiTrust is used to dismantle concentrations of market power 0 AntiTrust is government intervention to alter market structure or prevent abuse of market power or changing market behavior 0 Sometimes its beneficial and economically efficient to have one large firm supply an entire market this is a natural monopoly Natural monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply Ex Utility companies subway systems local telephone service and cable o Transfer payments 0 Payments to individuals for which no current goods or services are exchanged like social security welfare and unemployment benefits Merit good 0 A good or service society deems everyone is entitled to some minimal quantity of The micro failures of the marketplace imply that we re at the wrong point on the production possibilities curve or inequitably distributing the output produced Inflation Market power allows producers to ignore the signals generated in the marketplace and produce a suboptimal mix of output Antitrust policy and laws seek to prevent or restrict concentrations of market power The market mechanism tends to distribute output to those with the most income The government responds with a system of taxes and transfer payments to ensure a more equitable distribution of income and output Markets may also fail at the macro level In this case the problems include unacceptable levels of unemployment inflation and economic growth Government intervention is then necessary to achieve society s goals State and local government activity exceeds that of the federal government and has grown much more rapidly in recent decades Federal expenditures are supported mainly by personal income taxes and social security taxes State and local governments rely most heavily on sales taxes and property taxes respectively Government intervention that does not improve economic outcomes is referred to as a government failure Government intervention can be evaluated based on opportunity cost Cost benefit analysis can also be used to determine if government intervention is desirable An increase in the average level of prices of goods and services Opportunity Costs The most desired goods or services that are forgone in order to obtain something else The potential micro and macro failures of the marketplace provide specific justifications for government intervention The goal of macro intervention is to foster economic growth to get us on the production possibilities curvefuII employment maintain a stable price level price stability and increase our capacity to produce growth Most of the increase in federal spending has come from income transfers rather than public goods o The cost of government spending is measured by the private sector output sacrificed when the government employs scarce factors of production Taxation o The primary function of taxes is to transfer command over resources purchasing power from the private sector to the public sector in terms of goods and services Progressive tax o A tax system in which tax rates rise as incomes rise Proportional tax o A tax that levies the same rate on every dollar of income Regressive tax o A tax system in which tax rates fall as incomes rise Income taxes higher income higher tax Social security tax higher income lower tax The issue of government waste involves two distinct questions o Efficiency are we getting as much service as we could from the resources we allocate to government o Opportunity cost Are we giving up too many private sector goods in order to get those services Additional public sector activity is desirable only if the benefits from that activity exceed its opportunity costs o Voting mechanisms substitute for the market mechanism in allocating resources to the public sector and deciding how to use them o The value benefits of public services must be estimated because they don t have reliable market prices We don t know what the real demand for public services is and votes alone don t reflect the intensity of individual demands Public Choice o Theory of public sector behavior emphasizing rational self interest of decision makers and voters o A central tenet of public choice theory is that bureaucrats are just as selfish utility maximizing as everyone else Multiple Choice Quiz Online Market failure occurs when o The market mechanism does not produce the optimal outcome Which of the following would meet an economist s definition of a public good o National Defense An externality is an example of market failure because o The price of the product does not reflect all costs The social demand minus the externalities represents o The market demand Market power is a market failure because o Sellers will be able to reduce supply and raise price Which of the following is not regressive tax o Federal income tax Which of the following is the federal government s biggest source of tax revenue o Income taxes What part of federal government spending has grown the most rapidly over the last few years c Social security and medicare When government intervention causes society to move away from the optimal mix of output this is called o Government failure Economists would say that additional public sector activity is desirable only if c The benefits from the activity exceed its opportunity costs True Statements Market failure implies that the forces of supply and demand have not led to the best point on the production possibilities curve The existence of public goods and externalities causes resource misallocations If you have water standing in your yard that breeds mosquitoes and the mosquitoes infect your neighbor with West Nile virus this is an example of an externality Market power creates a flawed response to an accurate price signal The federal government has grown in absolute terms since the 1950 s but its relative share of production has declined ie it has grown more slowly than the private sector False Statements Government intervention is NOT necessary when the market mix of output equals the optimal mix of output May necessitate government intervention The free rider problem exists because some people would rather steal goods than pay for them Markets will over produce goods that yield external benefits and under produce goods that yield external costs markets will under produce goods that yield external benefits and over produce goods that yield external costs Monopolies will tend to over produce goods and charge a higher price than competitive markets When the government intervenes in the economy the market mix of goods and services is always improved Study Guide Questions In a market economy producers will produce the goods and services that o Consumers Demand Market failure includes all of the following except o Transfer payments Market failure suggests that the market mechanism left alone will o Produce too many private goods and too few public goods The market will sometimes fail to produce society s optimum output for all of the following reasons except c When negative externalities are present producers tend to under produce goods When the market fails which of the following is definitely true o The market delivers a suboptimal outcome Which of the following is most likely a public good o Flood control on a river When public goods are marketed like private goods o Public goods are under produced Which of the following is NOT an example of a good or service that produces external benefits o Pollution The federal government s role in antitrust enforcement is designed to address o Potential exploitation by firms with market power The development of market power by a firm is considered to be a market failure because firms with market power o Produce less and charge a higher price than what is socially optimal Transfer payments are a mechanism for addressing o Inequity in the distribution of goods and services Social demand is equal to o Market demand minus external costs The primary function of taxes is to o Transfer command over resources from the private sector to the public sector Government intervention in the market o Involves an opportunity cost The largest single source of revenue for the federal government is o The personal income tax Which of the following is NOT classified as a regressive tax o The federal corporate income tax Which of the following is an example of a progressive tax o The federal personal income tax States receive most of their tax revenues from o Sales taxes An item is a public good if c Consumers cannot be excluded from consumption Which of the following would NOT support the theory of public choice o The governor of the state vetoes a highway bill even though the highway would enhance the value of property he owns Environmental Protection 4252011 43600 PM Quick Review Nearly everyone is concerned about the environment and agrees that we ought to protect it Air water and solid waste pollution result in both social and economic costs External costs are the costs of a market transaction endured by a third partyfor a power plant this is water and air pollution Externalities create a divergence between social costs and private costs and lead to sub optimal market outcomes In the case of externalities such as pollution too much of the polluting good is produced Most of the current pollution could be eliminated with known and available technology but businesses and consumers are influenced by market incentives Businesses are always attempting to maximize profits In making the efficiency decision the firm chooses the least cost method of production The existence of external costs means that a firm is able to avoid part of the costs of production by pushing some of the costs onto a third party In this case a private firm will not maximize social welfare and market failure will occur To correct this failure the government can intervene by altering market incentives or bypassing the market and using direct controls Marketbased options to reduce pollution include emissions charges higher user fees green taxes and pollution fines Tradable pollution permits provide incentives for new more cost efficient technologies to be developed Those with the highest marginal costs of pollution reduction purchase the right to pollute from those with the lowest marginal costs As a result the total resource cost of reducing pollution decreases The directregulation command and control approach specifies mandatory pollution reductions and the specific technologies for achieving them The optimal rate ofpollution occurs when the marginal costs of cleaning up the environment are equal to the value of the marginal benefits from the cleanup Production Decision o The selection of the short run rate of output with existing plant and equipment Market incentives play a major role in pollution behavior Efficiency Decision o The choice of a production process for any given rate of output least cost method Pollution reduction can be achieved but only at significant cost to the plant The behavior of profit maximizers is guided by comparisons of revenues and costs not by philanthropy aesthetic concerns or the welfare of sh External Cost o Cost of a market activity borne by a third party the difference between the social and private costs of a market activity Whenever external costs exist a private firm won t distribute its resources and operate its plant in such a way as to maximize social welfare Social Costs o The full resource costs of an economic activity including externalities Private Costs o The costs of an economic activity directly suffered by the immediate producer or consumer excluding externalities To maximize social welfare we need to equate social marginal cost to marginal revenue price If pollution costs are external firms will produce too much of a polluting good Emission Charge o A fee imposed on polluters based on the quantity of pollution Two general strategies for environmental protection o Alter market incentives in such a way that they discourage pollution o Bypass market incentives with some form of regulatory intervention An emission charge increases private marginal cost and encourages lower output and cleaner technology To determine the optimal rate of pollution we need to compare the marginal social benefits of additional pollution abatement with the marginal social costs of additional pollution control expenditure Optimal rate of pollution o The rate of pollution that occurs when the marginal social benefit of pollution control equals its marginal social cost Optimal rate of pollution marginal benefit of pollution abatement marginal cost of pollution reduction True Statements Polution reduction imposes opportunity costs on society since some of society s scarce resources are used in the process Market incentives are typically more efficient than direct government regulation Polution permits rely on market incentives Pollution is the result of rational responses by producers to market incentives ie private costs Pollution also occurs as a result of government failure when government planners place a low priority on environmental quality Firms that are able to push part of their costs onto society by polluting will produce a greater output of their product than society desires Externalities are a measure of the divergence between social costs and private costs When externalities exist firms will not allocate their resources to maximize social welfare The optimal rate of pollution is attained when the marginal benefits received from lowering the pollution level are equal to the marginal costs that must be incurred to achieve it An emission fee closes the gap between marginal social cost and marginal private cost Study Guide Questions In making the production decision polluting firms equate o Marginal revenue and private marginal costs Social Costs are c The full resource costs of an economic activity When social costs and private costs of consumption and production diverge then inevitably o Both producers and consumers have an incentive to produce and consume too much When external costs result from the production of some good the output level of that good tends to be c Larger than is desirable The market will over produce goods that have external costs because o Producers experience lower costs than society A firm that dumps its waste products into our waterways will o Sell its product at a lower price than if it cleaned up its waste Other things being equal if a perfectly competitive firm is forced to switch to a more expensive non polluting production process c Total profits will decrease When firms are allowed to pollute the environment without bearing the costs of polluting then their o Marginal cost curve is too low The solution to the pollutionabatement problem involves all of the following except o Forcing polluters to pay all social costs If emission chargers were affixed to all production and consumption activities o The relative price of highly polluting activities would increase An emission charge increases o Private marginal cost and encourages lower output From an economic standpoint the principal advantage of tradable pollution permits is their incentive to o Minimize the cost of pollution control The 1990 Clean Air Act relied on which of the following strategies to clean up the environment o Command and control options When there are external costs of production then the social optimum occurs where marginal revenue equals o Social marginal costs An optimal amount of pollution can be described as o The amount for which a 1 increase in pollution control expenditures creates a 1 in additional social welfare A 5cent container deposit on bottles o Decreases the price of recycled materials and thus encourages their use The pursuit of a pollution free environment is o Probably not in society s best interest in view of the extremely high opportunity cost In cost benefit analysis the government should intervene as long as o Government s improvement of market outcomes exceeds costs of government intervention Who pays the costs of pollution control o Both producers and consumers depending on factors such as the price elasticity of demand When human lives are involved a cost benefit ratio o Provides a measure of the opportunity costs of government policies Online Multiple Choice Quiz In making the production decision polluting firms equate o Marginal revenue and private marginal costs The choice of the least cost production process is o The efficiency decision When social costs and private costs of consumption and production diverge inevitably o Both producers and consumers have an incentive to produce and consume too much When external costs are present o Firms will not have an incentive to improve social welfare When external costs result from the production of some good the output level of that good is o Larger than is desirable If an electric company does not have to pay for its contribution to acide rain then it will produce o Too much electricity from a social viewpoint If emission charges were affixed to all production and consumption activities o The relative price of highly polluting activities would increase Tradable pollution permits o Allow a firm to purchase the right to pollute Research has shown that o The benefits of pollution cleanup exceeds the cost If the tax on gasoline is increase to provide incentives to curb air pollution then the tax serves as o A user fee The Labor Market 4252011 43600 PM Quick Review The motivation to work comes from a variety of social psychological and economic forces The need to have income to purchase desired goods and services is of course very important Working imposes opportunity costs on the worker because leisure time must be given up when one chooses to work An increase in the wage rate motivates people to work more initially and the individual s supply curve of labor slopes upward to the right At a point higher wages allow people to work fewer hours and still earn the same income When the income effects become greater than the substitution effects the labor supply curve bends backwards The demand for labor is derived from the demand for the goods and services that the labor produces The quantity of labor demanded will increase as the wage rate decreases The marginal physical product MPP of labor is the change in total output because of an additional worker The demand curve for labor is the marginal revenue product MRP curve it combines the productivity of labor with the price of the output The law of diminishing returns affects both MPP and MRP The hiring decision requires that managers consider the contribution of labor to the firm s revenues called its marginal revenue product and what it costs to hire the labor The marginal revenue product thus sets an upper limit to the wage that will be paid to labor Labor should be hired until the marginal revenue product declines to the level of the wage rate Increases in the productivity of labor and increases in the market price of the output will shift the demand for labor MRP Curve to the right The market equilibrium wage is determined by the intersection of the market supply and market demand curves A minimum wage is set above the market equilibrium wage and causes the quantity of labor supplied to exceed the quantity of labor demanded When choosing amongst alternative production processes the efficiency decision a producer must compare input costs and then choose the least cost method of production The most cost effective input is the one that produces the most output per dollar spent not necessarily the cheapest one It is sometimes difficult to determine the wages of certain individuals because their marginal revenue product is so difficult to calculate In this situation opportunity wages custom power tradition and the like are used to determine the wage Labor Supply o The willingness and ability to work specific amounts of time at alternative wage rates in a given time period The opportunity cost of working is the amount of leisure time that must be given up in the process Higher wage rates are required to compensate for the increasing opportunity cost of labor The marginal utility of income may decline as you earn more People do supply more labor when offered higher wages Substitution effect of wages o An increased wage rate encourages people to work more hours to substitute labor for leisure Income effect of wages o An increased wage rate allows a person to reduce hours worked without losing income If income effects outweigh substitution effects an individual will supply less labor at higher wages Market supply of labor o The total quantity of labor that workers are willing and able to supply at alternative wage rates in a given time period The determinants of labor supply include o Tastes for leisure income and work o Income and wealth o Expectations for income or consumption o Prices of consumer goods o Taxes Elasticity of labor supply ercent of change in guantity of labor supplied Percent of change in wage rate Elasticity of labor supply o The percentage change in the quantity of labor supplied divided by the percentage change in wage rate Demand for labor o The quantities of labor employers are willing and able to hire at alternative wage rates in a give time period Derived demand o The demand for labor and other factors of production results from depends on the demand for final goods and services produced by these factors The quantity of labor demanded depends on its price the wage rate Marginal physical product MPP o The change in total output associated with one additional unit of input Marginal physical product change in total product Change in quantity of labor Marginal revenue product MRP o The change in total revenue associated with one additional unit of input Marginal revenue product change in total revenue Change in quantity of labor marginal revenue product sets an upper limit to the wage rate an employer will pay the marginal physical product of labor eventually declines as the quantity of labor employed increases Law of diminishing returns o The marginal physical product of a variable factor declines as more of it is employed with a given quantity of other fixed inputs A firm that s a perfect competitor in the labor market can hire all the labor it wants at the prevailing market wage The grower will continue hiring pickers until the MRP has declined to the level of the market wage rate There s a trade off between wage rates and the number of workers demanded To get higher wages without sacrificing jobs productivity MRP must increase Increased productivity implies that workers can get higher wages without sacrificing jobs or more employment without lowering wages Market Equilibrium o The market demand for labor depends on o The number of employers o The marginal revenue product of labor in each firm and industry o The market supply of labor depends on o The number of available workers 0 Each worker s willingness to work at alternative wage rates The intersection of the market supply and demand curve establishes the equilibrium wage Competitive employers act like price takers with respect to wages as well as prices Equilibrium Wage o The wage rate at which the quantity of labor supplied in a given time period equals the quantity of labor demanded Minimum wage o Reduces the quantity of labor demanded o Increases the quantity of labor supplied o Creates a market surplus The further the minimum wage rises above the market s equilibrium wage the greater the job loss Cost efficiency o The amount of output associated with an additional dollar spent on input the MPP of an input divided by its price cost Cost efficiency Marginal physical product of an input Cost of an input Outsourcing o The relocation of production to foreign countries Production process o A specific combination of resources used to produce a good or service The most cost efficient factor of production is the one that produces the most output per dollar Efficiency decision o The choice of a production process for any given rate of output Opportunity wage o The highest wage an individual would earn in his or her best alternative job True Statements For wages to be higher without sacrificing jobs productivity must increase The demand for labor is downward sloping due to diminishing marginal productivity caused by the fact that the amount of capital and space available to each worker decreases as more workers are hired in the short run land and capital are limited so workers must share the existing facilities Thus according to the law of diminishing returns as more workers are hired assuming all workers have equal skills and work ethic the additional contribution to output declines Howerver total output can still increase The intersection of supply and demand establishes the equilibrium wage The minimum wage is typically set above the equilibrium wage by the government The supply curve for labor bends backward when the income effect of wages exceeds the substitution effect of wages Higher wage rates are required to compensate for the increasing opportunity cost of labor The value of additional income decreases as total income increases The concept of derived demand means that the demand for bricklayers for example is determined by the demand for new brick houses The labor demand curve is equivalent to the marginal physical product multiplied by the price of the product being produced If salary caps were placed on CEO wages below their opportunity wage there would be a shortage of CEO s Study Guide Questions The number of hours that a worker is willing to work is determined by the tradeoff between o Increasing lowservice for leisure and decreasing marginal utility for income One reason why an individual s labor supply curve is upward sloping is because o Increasing opportunity cost of labor as leisure time decreases If consumers wanted to increase wages and the number ofjobs available for apple pickers the best strategy would be to o Buy more apples An upwardsloping labor supply curve illustrates ceteris paribus that o A greater quantity of labor would be supplied at higher wage rates The elasticity of labor supply does not depend on o The demand for labor If household income and wealth increases over time the supply of labor will o Shift to the left Which of the following is NOT a determinant of the market supply of labor o The MRP of labor A competitive firm should continue to hire workers until the o MRP is equal to the market wage rate If Kendra s income effect outweighs her substitution effect her labor supply curve will o Bend backward Which of the following is true about the equilibrium market wage c There is no unemployment in the market at this wage At the market equilibrium wage o The market demand curve for labor intersects the market supply curve of labor The cost efficiency of labor is equal to the o MPP of labor divided by the wage The marginal revenue product of labor establishes o An upper limit on the wage rate an employer is willing to pay The diminishing returns to a factor may be due to o Crowding or overuse of other factors as production is increased The efficiency decision involves choosing the input combination or process that o Results in a given rate of output for the least cost If the elasticity of labor supply is 025 a 12 percent increase in wage rates will induce a o 300 percent increase in the quantity of labor supplied Employment will definitely rise when productivity o Rises and wages fall A change in the wage rate causes a o Movement along the labor demand curve When the minimum wage is raised in a competitive market o Some workers are better off and some are worse off Opportunity wage is defined as o The highest wage an individual would earn in his or her best alternative employment Multiple Choice Online Quiz In the labor market labor demand refers to o How many workers that businesses are willing to hire at various wages The labor supply curve is upward sloping because o At lower wages employees want to work fewer hours per week The constraint that is most important in determining the tradeoff between leisure and work is o Time The substitution effect of wages refers to o An increased wage causes individuals to work more hours The elasticity of labor supply does not depend on o The demand for labor In a backward bending supply curve for labor o The income effect dominates If immigration increases in a specific labor market then o The supply curve for labor will shift right The demand for labor is a derived demand which means o The demand for labor is derived from the demand for the product that the labor produces A competitive firm should continue to hire workers until o MRP is equal to the market wage rate The efficiency decision o Is the amount of output associated with an additional dollar spent on input
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