Econ Exam #2

Products that generate negative externalities tend to be:

overproduced by private markets.

Products that generate positive externalities tend to be:

underproduced by private markets.

Positive externalities occur when:

market activity creates benefits that spill over to third parties.

Negative externalities occur when:

costs associated with an activity are borne by a third party.

Which of the following is a government solution to a positive externality?

The county uses tax revenue to fund public schools

When some of the costs of a good spill over to a third party:

a negative externality exists and the good tends to be overproduced by private markets.

Under which of the following scenarios would a park exhibit the characteristics of a pure public good?

Visitors can enter the park free of charge and the park is never crowded

The free-rider problem occurs when:

the benefits associated with pure public goods cannot be denied to those who do not pay for them.

The Tragedy of the Commons refers to:

the tendency to use common resources more than is desirable from society's point of view.

According to the Coase Theorem, an efficient outcome can be achieved without any need for active government involvement as long as:

property rights are clearly defined and transaction costs are sufficiently low.

Which of the following is not an example of government response to a market failure?

A privately-owned business that does not allow smoking

Which of the following is a likely government response to a positive externality?

Subsidizing the consumption of the good in an attempt to take advantage of the benefits that spillover to society

Assuming no externalities exist, an output that is rival and excludable is likely to be:

produced in an efficient amount by private markets.

From society's perspective, outputs that generate negative externalities tend to be:

overproduced by private markets.

Of the following, the best example of a public good is:

a fireworks display because many people can watch the display at the same time and it is difficult to prevent people who do not pay from enjoying the fireworks

Because a pure public good is:

nonexcludable, it is possible for some consumers to be free riders.

Many consumers may watch public TV and listen to public radio who do not contribute to fund-raising drives to help finance these organizations. This is an example of:

the free rider problem.

All of the following are functions of government in the U.S. except:

Promoting a perfectly equal distribution of income

According to the Coase Theorem, private negotiation to correct for negative externalities is likely to produce an efficient outcome only if:

property rights are clearly defined and transaction costs are low.

The tendency to use common resources more than is desirable from society's point of view is called the:

Tragedy of the Commons.

In order to model the behavior of firms in markets, it is assumed that the goal of a firm is to:

maximize profit.

If a sole proprietorship goes bankrupt:

owners lose their investment and personal assets are also at risk.

If a corporation goes bankrupt:

stockholders lose their investment but personal assets are not at risk.

Markets dominated by a few large firms are referred to as oligopolies.

True

Most real-world markets are perfectly competitive.

False

The assumed goal of firms in the marketplace is to:

maximize profit.

The wages paid to hourly workers are an example of:

an explicit cost.

Explicit costs are:

direct payments made to the factors of production.

Implicit costs are:

included in the calculation of economic profit but not included in the calculation of accounting profit.

If explicit and implicit costs are both greater than zero:

accounting profit is greater than economic profit.

Efficient decisions regarding the use of factors of production:

include both explicit and implicit costs.

Suppose Claude left a $60,000 per year job at a tax preparation firm to open his own tax preparation business. If Claude's total revenue in the first year of business is $55,000 and Claude's total cost is greater than zero, then:

Claude's economic profit for the first year of business will be negative.

Economic theory divides decisions into those made in the:

short run, when at least one input is fixed, and the long run, when all inputs are variable.

A firm that is deciding how many workers to hire in order to produce the profit-maximizing level of output in its current factory space is:

making a short-run decision.

Suppose a doggie day care business firm uses only two inputs: hourly workers (labor) and a building (capital). In the short run, the firm most likely considers:

labor to be variable and capital to be fixed.

When a firm uses additional inputs to increase output, these inputs are:

variable inputs.

Which of the following is most likely to be a fixed input for a movie theater?

A movie theater building

It is efficient to continue an activity as long as the marginal benefit exceeds the marginal cost.

True

Brett has agreed to sell a rare comic book to a collector who offered to pay $125 for it. Brett’s producer surplus is:

$50 if the minimum price he would have accepted is actually $75.

Assuming no externalities exist, when the efficient amount of output is being produced in a competitive market, all of the following are true except:

consumer surplus exceeds producer surplus by the greatest amount.

The difference between the maximum price consumers are willing to pay and the actual price consumers pay in the market measures:

consumer surplus

A demand curve can be interpreted as a:

marginal benefit curve

If haircuts are normal goods, then a decrease in consumer income leads to:

a decrease in the equilibrium price of haircuts, and producer surplus to barbers will decrease.

If marginal benefit decreases as the quantity of an item consumed increases

the demand curve for the item slopes downward to the right.

The intent of government policies designed to promote equity is to:

generate outcomes that are deemed to be more fair.

The purpose of setting a price floor above the equilibrium price is to:

maintain a high price for the sellers in the market.

An example of a current binding price floor in the U.S. is:

the federal minimum wage.

The statutory incidence (burden) of a tax refers to:

which party has the legal obligation to send the tax dollars to the government.

If a product with a relatively elastic demand and a relatively inelastic supply is taxed, the economic burden of the tax is borne:

mostly by the sellers of the product.

If a given quantity of an item is jointly consumed, and those who do not pay for the item cannot be denied enjoying benefits, then the item is:

non-rival and non-excludable and therefore a public good.

Which of the following is not an example of a government response to a market failure?

A homeowner who does not allow smoking on their property

Many consumers may watch public TV and listen to public radio who do not contribute to fund-raising drives to help finance these organizations. This is an example of:

the free rider problem.

An example of a negative externality is

toxic chemicals dumped into a river that is used as a water supply.

A positive externality is associated with an output when:

a. the private benefits of the output are less than the social benefits of the output such that the private market level of output is less than the efficient level of output from society’s perspective.

When costs of producing an output spill over to third parties, from society’s perspective:

a negative externality exists and private markets will likely overproduce the output.

The tendency to use common resources more than is desirable from society’s point of view is called the:

Tragedy of the Commons.

Stella left her $45,000 per year job as an office manager to paint houses and be her own boss. In her first year, Stella received $50,000 in payments from customers and paid $5,000 for paint and supplies. Stella’s accounting profit in her first year is:

$45,000.

Stella left her $45,000 per year job as an office manager to paint houses and be her own boss. In her first year, Stella received $50,000 in payments from customers and paid $5,000 for paint and supplies. Stella’s economic profit in her first year is:

$0

If a firm is deciding how many workers to hire to operate its existing capital equipment, the firm is:

making a short-run decision because at least one input is fixed.

According to the law of diminishing marginal product, the marginal product of a variable input must eventually begin to decline because:

at least one input is fixed.

Marginal Benefit and Demand

Marginal Benefit (MB): The additional satisfaction or utility a consumer receives from consuming one more unit of a good or service.

Demand Curve: Represents the marginal benefit of consuming goods at different quantities. It typically slopes downward, indicating diminishing marginal benefit as quantity increases.

Consumer Surplus (CS):

Individual Unit: Difference between what a consumer is willing to pay and what they actually pay.

Market CS: The area below the demand curve and above the market price, representing total benefit to consumers over and above what they pay.

Marginal Cost and Supply

Marginal Cost (MC): The additional cost incurred from producing one more unit of a good or service.

Supply Curve: Represents the marginal cost of producing goods at different quantities. It typically slopes upward, indicating increasing marginal cost as quantity increases.

Producer Surplus (PS):

Individual Unit: Difference between the market price and the marginal cost of producing one unit.

Market PS: The area above the supply curve and below the market price, representing total benefit to producers over and above their production costs.

Changes in Producer/Consumer Surplus Due to Market Changes

Demand Increase

Raises both equilibrium price and quantity; consumer surplus might decrease, while producer surplus generally increases.

Supply Increase:

Lowers equilibrium price but raises equilibrium quantity; consumer surplus usually increases, while producer surplus may vary.

Demand Decrease:

Lowers equilibrium price and quantity; consumer surplus typically decreases, and producer surplus also decreases.

Supply Decrease:

Raises equilibrium price but lowers equilibrium quantity; consumer surplus generally decreases, while producer surplus may increase.

Efficient Market Condition: MB = MC

The market is considered efficient when marginal benefit equals marginal cost. This is the equilibrium point where total surplus (consumer + producer surplus) is maximized.

Total Surplus:

Sum of Consumer and Producer Surplus: Represents the total net benefit to society from the production and consumption of goods.

Deadweight Loss (DWL):

Occurs when total surplus is not maximized, often due to market distortions like taxes, subsidies, price floors/ceilings, or externalities.

Graphically: The area between the demand and supply curves that is lost when a market is not in equilibrium.

Efficiency vs. Equity

Efficiency: Achieved when resources are allocated in a way that maximizes total surplus, where marginal benefit equals marginal cost.

Equity: Focuses on fair distribution of resources or wealth, even if it means compromising efficiency.

Possible Sources of Inefficiency:

Market Failures: Include externalities, public goods, and information asymmetry.

Government Policies: Price controls, taxes, and subsidies can create inefficiencies.

Price Ceilings

A legal maximum price for a good or service (e.g., rent control).

• Effects:

  • Leads to shortages (quantity demanded exceeds quantity supplied).

  • Consumer surplus may rise for those who can buy at the lower price but falls overall due to reduced quantity exchanged.

  • Producer surplus decreases due to the lower price received.

  • Deadweight loss arises due to inefficiently low quantity exchanged.

Price Floor

A legal minimum price for a good or service (e.g., minimum wage).

• Effects:

  • Leads to surpluses (quantity supplied exceeds quantity demanded).

  • Consumer surplus falls due to higher prices.

  • Producer surplus may increase for those who sell but falls overall due to reduced quantity exchanged.

  • Deadweight loss arises due to inefficiently low quantity exchanged.

Tax Incidence

The distribution of the economic burden of a tax between buyers and sellers.

Economic Burden

• Statutory Burden: The legal obligation to pay the tax.

• Economic Burden: How the tax actually affects buyers and sellers, regardless of who pays it.

• Elasticity and Tax Burden:

  • If demand is more inelastic than supply, consumers bear a larger economic burden.

  • If supply is more inelastic than demand, producers bear a larger economic burden.

Impact of Tax on Price Paid by Consumer and Price Retained by Seller

Price Paid by Consumer: Increases by a portion of the tax, depending on demand elasticity.

Price Retained by Seller: Decreases by a portion of the tax, depending on supply elasticity.

Graphically: The vertical distance between the original supply curve and the new, upward-shifted supply curve represents the tax amount.

Impact of Tax on Output, Surplus, and Efficiency

Output (Quantity Exchanged): Decreases as the tax drives a wedge between the price buyers pay and the price sellers receive.

Consumer Surplus (CS): Falls due to higher prices and lower quantity.

Producer Surplus (PS): Falls due to lower prices received and lower quantity.

Total Surplus: Reduced by deadweight loss, indicating inefficiency caused by the tax.

Private Goods

Characteristics: Rival (one person's use reduces availability for others) and excludable (can prevent others from using it).

Examples: Food, clothing, cars.

Public Goods:

Characteristics: Non-rival (one person’s use doesn’t reduce availability for others) and non-excludable (cannot prevent others from using it).

Examples: National defense, clean air, public parks.

Free-Rider Problem

Definition: Occurs when individuals benefit from a good or service without paying for it.

Leads to under-provision of public goods.

Examples: People who benefit from national defense or clean air without contributing.

Government Response: Often provides public goods directly (e.g., national defense, street lighting) or uses taxes to fund them.

Externalities

Definition: Costs or benefits of a transaction that affect third parties not directly involved in the transaction.

Free Market Outcome: The market outcome without intervention, where marginal private benefit (MPB) equals marginal private cost (MPC).

Efficient Outcome for Society: Achieved when marginal social benefit (MSB) equals marginal social cost (MSC).

Common Resources

Rival (use by one person reduces availability for others) but non-excludable (cannot prevent others from using it).

Examples: Fisheries, forests, public roads.

Assumed Goal of the Firm

The firm’s goal is to maximize profit. This involves choosing levels of production and pricing that generate the highest possible difference between total revenue and total costs.

Profit:

Formula: Profit = Total Revenue (TR) - Total Cost (TC).

It measures the firm’s financial gain from production and sales.

Total Revenue (TR):

The total amount of money received from selling goods or services.

Formula: TR = Price × Quantity sold.

Total Cost (TC):

The total expense incurred in producing goods or services.

Components: Includes both explicit and implicit costs

Explicit Costs:

Direct, out-of-pocket expenses for production (e.g., wages, rent, materials).

Easily measurable and recorded in financial statements.

Implicit Costs:

Indirect, non-monetary opportunity costs of using resources owned by the firm.

Examples include the foregone salary of the owner or the rental income lost by using the owner’s building.

Accounting Profit:

Measures financial gain using only explicit costs.

Formula: Accounting Profit = Total Revenue - Explicit Costs.

Generally higher than economic profit since it does not include implicit costs.

Economic Profit:

Measures the firm’s true profitability by including both explicit and implicit costs.

Formula: Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs).

Positive economic profit indicates that the firm is doing better than its next best alternative, while zero economic profit means the firm is earning just enough to cover all costs, including opportunity costs.

Short Run:

A period in which at least one input is fixed (e.g., capital).

Firms can only adjust variable inputs like labor.

Long Run:

A period where all inputs are variable.

Firms can adjust both labor and capital to change production levels.

Law of Diminishing Marginal Product (Diminishing Returns)

Definition: As more units of a variable input are added to a fixed input, the additional output from each extra unit of the variable input eventually decreases.

Occurs in the short run when one input is fixed.

Average Product (AP):

The output produced per unit of a variable input.

Formula: AP = Total Output / Quantity of Variable Input.

Marginal Product (MP):

The additional output produced by using one more unit of a variable input.

Formula: MP = Change in Total Output / Change in Quantity of Variable Input.

Productivity:

Measures the efficiency of input use. High productivity indicates effective input use, while diminishing MP indicates decreasing productivity.

Costs in the Long Run

In the long run, all inputs and costs are variable, allowing firms to adjust all factors of production to minimize costs and optimize output.