Economics Externalities, Market Failures, and Production Concepts

Externality

An externality occurs when a cost or benefit resulting from an economic activity affects individuals or businesses who are not directly involved in that activity.

Negative Externality

A negative externality exists when the private marginal cost of production or consumption is less than the social marginal cost.

Positive Externality

A positive externality occurs when the social marginal benefit exceeds the private marginal benefit.

Marginal Benefit

The benefit received by participants directly involved in the economic activity.

Social Marginal Benefit

The total benefit conferred on all members of society, including third parties.

Marginal Cost

The cost borne by participants directly involved in the economic activity.

Social Marginal Cost

The total cost imposed on all individuals in society, including those not directly involved.

Deadweight Loss

A loss of social welfare due to inefficiency, resulting from overproduction or underproduction.

Government Mandate

For negative externalities, the government can limit production or consumption directly through regulations to achieve the socially optimal quantity.

Pigouvian Tax

A tax imposed on activities generating negative externalities designed to increase private marginal costs and reduce quantity to the social optimum.

Pigouvian Subsidy

A subsidy granted for activities generating positive externalities, aiming to raise private marginal benefits and increase quantity toward the social optimum.

Coase Theorem

The Coase Theorem proposes that if property rights are well-defined and transaction costs are negligible, parties affected by externalities can negotiate directly to reach the socially optimal outcome without government intervention.

Cap-and-Trade

A market-based approach to controlling pollution by setting a maximum allowable level (cap) and permitting firms to buy and sell permits that allow them to emit a certain amount.

Excludability

A good is excludable if the supplier can prevent people who have not paid from consuming it.

Rivalry in Consumption

A good is rival in consumption if one person's use of the good diminishes others' ability to consume it.

Private Good

Characteristics: Excludable and rival. Examples: Most goods traded in markets.

Common Resource

Characteristics: Non-excludable and rival.

Socially Optimal Quantity

The quantity of production or consumption that maximizes social welfare.

Overproduction

The market produces a quantity greater than the socially optimal quantity.

Underproduction

The market produces a quantity less than the socially optimal quantity.

Herd Immunity

The indirect protection from infectious diseases that occurs when a large percentage of a population becomes immune.

Scientific Research

Research that provides benefits to society beyond the immediate researchers.

Pollution

An example of a negative externality where factories affect surrounding communities.

Vaccinations

An example of a positive externality that provides herd immunity benefits to others.

Club Good

Characteristics: Excludable but non-rival. Examples: Computer software, museum visits, uncongested toll roads.

Public Good

Characteristics: Non-excludable and non-rival. Examples: National defense, public health.

Free-Rider Problem

Since individuals can consume the good without paying, they lack incentive to contribute voluntarily. This often leads to under-provision of the good by private markets.

Tragedy of the Commons

People rationally overuse or deplete common resources since no one can be excluded and their individual use reduces others' availability.

Government Provision

The government can directly produce and supply public goods to correct market failure.

Examples of Government-Provided Goods/Services

National Defense, National and State Parks, Social Security, Medicare (health insurance primarily for the elderly), Medicaid (health insurance primarily for poor families).

Property Rights Enforcement

To make certain goods excludable, governments enforce property rights.

Subsidies

The government can increase the quantity of goods provided in the market by offering subsidies.

Production

Production refers to the process by which entities such as individuals, firms, governments, or non-profits utilize inputs to create goods or services.

Final Goods

Products purchased directly by consumers.

Intermediate Goods

Products used as inputs for further production by another firm.

Factors of Production

Factors of production are inputs used in the production process to generate output in the form of goods and services.

Primary Factors

Land, labor, and capital.

Other Factors

Entrepreneurial ability and natural resources.

Production Function

The production function expresses the relationship between the quantities of inputs used and the quantity of output produced.

Short-Run Production

At least one input is fixed. For instance, capital such as factory buildings or machinery remains constant while labor varies.

Long-Run Production

All inputs are variable. Firms can adjust labor, capital, and other inputs freely to optimize production levels.

Example Production Schedule

Level 1: Output (Q) 70, Capital (K) 5, Labor (L) 10; Level 2: Output (Q) 102, Capital (K) 7, Labor (L) 15; Level 3: Output (Q) 140, Capital (K) 10, Labor (L) 20; Level 4: Output (Q) 173, Capital (K) 12, Labor (L) 25; Level 5: Output (Q) 210, Capital (K) 15, Labor (L) 30.

Returns to Scale

Describes how output changes when all inputs are increased proportionally.

Constant Returns to Scale

Doubling inputs results in exactly double output.

Increasing Returns to Scale

Doubling inputs results in more than double output.

Decreasing Returns to Scale

Doubling inputs results in less than double output.

Total Revenue

Defined as the product of price and quantity sold.

Elastic Demand

Increasing quantity sold leads to an increase in total revenue.

Inelastic Demand

Increasing quantity sold leads to a decrease in total revenue.

Marginal Revenue (MR)

The additional revenue gained from selling one more unit of output.

Perfect Competition

In this market structure, MR equals price.

Monopoly

In this market structure, MR decreases as quantity increases.

Fixed Costs (FC)

Costs that do not change with the quantity of output produced.

Variable Costs (VC)

Costs that change with the level of output.

Total Cost (TC)

The sum of fixed and variable costs.

Primary Factors of Production

Includes land, labor, and capital.

Other Factors of Production

Includes entrepreneurial ability and natural resources.

Average Total Cost (ATC)

Total cost divided by output.

Average Fixed Cost (AFC)

Fixed cost per unit.

Average Variable Cost (AVC)

Variable cost per unit.

Marginal Cost (MC)

The cost of producing one additional unit, calculated as the change in total cost divided by the change in quantity.

Economies of Scale

Long-run average cost decreases as output increases due to improved efficiency.

Diseconomies of Scale

Long-run average cost increases as output increases often due to management complexity.

Accounting Profit

Total revenue minus explicit costs (actual monetary expenses like wages, rent).

Economic Profit

Total revenue minus both explicit and implicit costs (including opportunity costs such as foregone alternatives).

Profit Maximization

Firms aim to maximize economic profit, denoted as the condition for profit maximization is where marginal revenue equals marginal cost.

Marginal Revenue

The slope of total revenue.

Factors of Production (Inputs)

1. Land: Natural resources (land, oil, minerals, water). 2. Labor: Human effort (physical and mental). 3. Capital: Machines, tools, buildings, equipment used to produce goods. 4. Entrepreneurship: Risk-taking and management ability needed to organize production.

Production Function (Q = f(L, K))

Shows the relationship between inputs (labor L and capital K) and output Q.

Short-Run

Time period where at least one input is fixed (usually capital K).

Long-Run

Time period where all inputs are variable (both labor and capital).

Constant Returns to Scale (CRS)

Inputs doubled → output doubles.

Increasing Returns to Scale (IRS)

Inputs doubled → output more than doubles.

Decreasing Returns to Scale (DRS)

Inputs doubled → output less than doubles.

Total Revenue (TR)

TR = P × Q, where P = price per unit and Q = quantity sold.

Cost Function

C = wL + rK where: w = wage rate (cost of labor), L = amount of labor, r = rental rate of capital (cost of machines/buildings), K = amount of capital.

Relationship Between Average Costs

ATC = AFC + AVC.

Profit Formula

π = TR - TC.

Profit Maximizing Condition

MR = MC. If MR > MC → produce more; If MR < MC → produce less; If MR = MC → profit is maximized.

Average Revenue (AR)

AR = TR / Q.

Shutdown Condition

Shutdown: P < AVC.

Break-even Condition

Break-even: P = ATC.

Derived Demand

Derived Demand: The demand for inputs (like workers or machines) comes from the demand for the final product.

Total Product of Labor

The total amount of goods produced when a certain number of workers are hired.

Average Product of Labor

Average Product of Labor = Total Product / Number of Workers. This tells you how much output each worker produces on average.

Marginal Product of Labor

Marginal Product of Labor = Change in Total Product / Change in Number of Workers. This tells you how much EXTRA output is produced by hiring one more worker.

Law of Diminishing Marginal Returns

As you add more workers while keeping other inputs fixed, the extra output produced by each new worker eventually declines.

Marginal Revenue Product of Labor

Marginal Revenue Product of Labor = Marginal Product of Labor × Marginal Revenue. This tells you how much extra money the firm earns from hiring one more worker.

Hiring Rule

Firms hire workers until Marginal Revenue Product of Labor = Wage Rate. If MRPL > wage → hire more; If MRPL < wage → hire fewer; If MRPL = wage → profit-maximizing number of workers.

Labor Demand

Labor demand increases when the price of the final good increases, technology improves, or the amount of capital increases.

Wage Rate

The opportunity cost of leisure.

Leisure

A normal good; people want more leisure as their income increases.

Substitution Effect

When wages increase, leisure becomes more expensive, leading people to work more.

Income Effect

Higher wages make people richer, allowing them to buy more leisure and work less.

Backward-Bending Labor Supply Curve

Occurs when the income effect dominates at very high wages.

Labor Supply

Labor supply increases if worker preferences change or immigration increases the number of workers.

Marginal Revenue Product of Capital

Measures the extra revenue from adding one more unit of capital, calculated as Marginal Product of Capital times Marginal Revenue.

Hiring Rule for Capital

Firms invest in capital until Marginal Revenue Product of Capital equals the Rental Rate of Capital.

Capital Allocation Across Industries

Capital flows to industries earning the highest return until Marginal Revenue Product of Capital is equal across industries.

Hiring Rule for Labor

Hire workers until Marginal Revenue Product of Labor equals the Wage Rate.