Econ Exam #2

Market Failure

• The failure of a market to reach an efficient outcome where net benefits to society are maximized.

  • Occurs when the quantity transacted differs from the efficient (welfare-maximizing) quantity.

  • Results in deadweight loss

Externality

• When the activity of one entity (individual or firm) directly impacts the welfare of another in a way that is not reflected in the price

  • “External” to the market

  • Unintended impacts on others that are not taken into account by the individual decision-makers.

Negative Externality (AKA Cost Externality)

• An action that imposes net costs on others without their being compensated

• The individual decision-maker does not have to pay these costs, so often does not take them into account when making decisions.

Private Cost

Cost incurred by the individual decision maker only

Marginal Product Cost (MPC)

Incremental costs to private decision maker (supplier)

Marginal External Cost (MEC)

Uncompensated marginal costs imposed on others as a result of actions taken by individual decision makers

Social Cost

Total costs incurred by society

Marginal Social Costs

• Total marginal cost to society

  • MPC + MEC = MSC

Positive Externality (AKA Benefit Externality)

• An action that provides net benefits to others without them having to pay for it.

  • The individual decision-maker does not receive compensation for these benefits, so often does not take them into account when making decisions

Private Benefits

Benefits enjoyed by the individual decision-maker only

Marginal Private Benefit

• Incremental benefits to private decision-makers (demander)

  • Individual marginal willingness to pay

Marginal External Benefits (MEB)

Uncompensated marginal benefits provided to other as a result of actions taken by individual decision-maker

Social Benefit

Total benefits enjoyed by society

Marginal Social Benefit (MSB)

• Total marginal benefits to society

  • MPB + MEB = MSB

Private Solution to Externality

• Coase Theorem: If private bargaining can occur at a low cost between affected parties, then externalities could be solved by private negotiations

• Problem: Are bargaining costs low?

Government Intervention Solutions to Externality

• Positive Externality: The problem is that the market outcome results in an inefficiently low quantity

  • Solution: Find some way to increase the quantity transacted in the market

    • Subsidy & Mandates

• Negative Externality: Problem is that market outcome is resulting in an inefficiently high quantity

  • Solution: Find some ways to decrease the quantity transacted in the market (impose more costs)

    • Pollution: Corrective Tax

Concept of Comparative Advantage

• At the heart of why we choose to specialize and why this makes us better off is the concept of comparative advantage.

  • Some of us can produce things at a lower cost than other

  • Allows for specialization and gains from trade

Absolute Advantage

When one producer can produce more of a good or service than another producer in a certain period of time.

Comparative Advantage

When one producer can produce a good or service at a lower opportunity cost than another producer

Specialization

Concentrating one’s efforts in a specific activity or field

Production Possibility Frontier

• Illustrates all the possible combinations of goods that an economy or individual can produce in a certain period of time.

  • A graphical representation of what someone is capable of doing.

Limitations on Specialization

• Specialization is limited by the extent of the market

  • The market must be large enough to make it possible to exchange one's own production for that of another

    • More likely to occur as population grows and becomes more concentrated.

  • Big cities vs. rural areas

    • A large variety of goods and services become available

    • Niche markets can be successful

• Transportation costs must be low enough to make specialization worthwhile.

Comparative Advantage and International Trade

A country has a comparative advantage in producing a good or service if the opportunity cost of producing the good or service is lower for that country than for other countries.

Main Sources of Comparative Advantage Between Countries

• Differences in Climate: i.e., tropical countries grow and export tropical products (sugar, coffee, bananas)

• Differences in Factor Endowments: Proximity to resources, abundance of factors of production

• Differences in Education Level of Workers

  • Countries with highly educated workforces tend to export skill-intensive goods, while countries with less educated workforces tend to export goods whose production requires little skill.

• Differences in Technology

Supply & Demand Model of International Trade

Analyzes impact of international trade in individual markets.

Domestic Demand Curve

Shows how the quantity demanded by domestic consumers depends on the price of that good.

Domestic Supply Curve

Shows how the quantity supplied of a good by domestic producers depends on the price of that good.

World Price

Price at which the good can be bought or sold on the world market.

Effects of Trade on Domestic Prices

When a market is opened to trade, competition among importers or exporters drives the domestic price to equality with the world price.

When Do Imports Happen

If the world price is lower than the domestic price, trade leads to imports and a fall in domestic price towards the world price.

Effect of Imports on Economic Surplus

• Consumer Surplus Increases

• Producer Surplus Decreases

• Total Net Benefits for the importing country increase because consumers’ gains exceed the producers’ losses.

• Winner vs. Losers

  • Winners: Domestic consumers, because the price falls

  • Losers:

    • Domestic producers, because the price received falls

    • Workers, because demand for workers falls; wages and employment also fall

When Do Exports Happen

If the world price is higher than the domestic price, trade leads to exports and a rise in the domestic price.

Effect of Exports on Economic Surplus

• Consumer Surplus Decreases

• Producer Surplus Increases

• Total Net Benefits for the exporting country increase because producers’ gains exceed the consumers’ losses.

• Winner vs. Losers

  • Winners:

    • Domestic producers, because the price received increases

    • Workers, because demand for workers rises; wages and employment also rise

  • Losers:

    • Domestic consumers, because the price they pay rises

Free Trade

• When the government does not attempt either to reduce or to increase the levels of exports and imports that occur naturally as a result of supply and demand.

• Two Most Common Protectionist Policies

  • Tariffs

  • Import Quota

Tariff

A tax levied on imports

Effects of a Tariff

• Raises the domestic price above the world price, leading to a fall in trade and total consumption and a rise in domestic production

• Domestic producers and the government gain, but consumers’ losses more than offset this gain, leading to a deadweight loss.

Firm

• An entity that converts inputs into outputs

  • Inputs: Land, Labor, Capital

    • Capital = Durable goods used in the production of other goods.

  • Outputs: Goods or services for consumers

Profit Maximization Assumption

We assume that firms attempt to maximize profits

Profit Equation, Total Revenue, and Total Cost

• Profit = Total Revenue (TR) - Total Cost (TC)

  • Profit = P*Q - C(Q)

• Total Revenue = Price * Quantity

• Total Cost = A function of Quantity [C(Q)]

Efficient Production

• In order to maximize profits, the firm must produce a given quantity as efficiently as possible

  • Getting the most output possible from a given set of inputs

    • In order to produce more output, they need to use more inputs.

The Production Function

• Describes the relationship between the quantities of inputs used and the maximum quantity of output that can be produced with those inputs.

  • Q = f (L, K)

  • Q = Quantity of Output

  • L = Units of Labor used as an input

  • K = Units of capital used as an input

    • For simplicity, assume land is included in (K)

Total Product and Average Product

• Total Product (TP) = Total amount of product (output) that factors of production create

  • Total product increases with increases in the amount of factors used (up to a point)

• Average Product (AP) = Ratio of total output to the number of inputs used to produce that output

  • AP (Labor) = APL = Q / L

  • AP (capital) = APk = Q / K

Marginal Product

• The change in output that occurs when an incremental unit of an input is added.

  • Marginal Product of Labor = MPL

    • Change in Quantity of Output / Change in Quantity of Labor

  • Marginal Product of Capital = MPk

Time Horizons

Firm’s Ability to Alter Inputs

Short-Run Time Horizons

• Period of time short enough such that at least one factor of production is fixed (cannot be changed).

  • Length of time depends on the firm or industry

  • Whether capital or labor is fixed in the short-run depends on the industry.

Long-Run Time Horizon

Period of time long enough that all factors of production can be varied.

Law of Diminishing Marginal Product

• As additional units of variable input are added to fixed inputs, eventually the marginal product of the variable input will decline.

  • Holds only if other factors are held fixed (short-run only)

  • Holds even if all variable inputs are identical

  • The decline does not necessarily happen right away

    • Over some initial range, adding additional units of an input may lead to an increase in marginal product.

  • Must happen eventually as more inputs are added to fixed inputs

Short-Run Total Product Curve

• Shows how the quantity of output depends on the quantity of the variable input, for a given quantity of the fixed input

  • Although the Total Product Curve will slope upward, the slope isn’t constant

    • As you move up the curve to the right, it flattens out due to changing Marginal Product of Labor.

• The more realistic Short-Run Total Product Curve shows increasing marginal product initially due to specialization, but eventually diminishing marginal product occurs.

Short-Run Marginal Product Curve

• Shows the diminishing returns to labor.

  • The 1st worker generates 19 units of output, while the 2nd generates only 17, the 3rd only 15, and so on.

• The more realistic Marginal Product Curve shows that marginal product rises initially, then falls.

Economic Costs

• Explicit Cost (EC) = cost that involves a monetary payment.

  • Direct, out-of-pocket payments for inputs into the production process

• Implicit Cost (IC) = does not involve a monetary payment

  • Measured by the value, in dollar terms, of the benefits that are foregone by using an input that has alternative uses.

Accounting Profit

• Business’ revenue minus the explicit cost.

  • Used for reporting or tax purposes

Economic Profit

• Business’ revenue minus the full opportunity cost (implicit + explicit) of its resources.

  • Used to identify how to optimize the use of resources in order to maximize profits

Sunk Cost

• Costs incurred in the past that cannot be recovered regardless of current decision-making

  • Should be ignored when making decisions about future actions

Cost Structure of a Firm

• Technology Available (The Production Function) = The amount of output produced by the inputs

• Prices Paid for Factors of Productions (Inputs)

Cost Maximization

• If a firm wants to produce a given quantity, there are several input combinations that it could use, each with its own cost.

• Cost Maximization: Using the input combination that produces at the lowest possible cost

Fixed Cost (FC)

• Cost that does not depend on the quantity of output produced

  • Does not change with output

  • Expenditures on factors that are fixed in the short-run

Variable Cost (VC)

• Cost that does depend on the quantity of output produced

  • Increases with increased output

  • Expenditures on factors that are variable in the short run

Total Cost (TC)

• The total cost of producing a given quantity of output. The sum of the fixed cost and the variable cost.

  • TC = FC + VC

Total Cost, Variable Cost, and Fixed Cost Curves

• As output increases, total cost increases because you are spending more on inputs

• Total cost is increasing at a decreasing rate because of diminishing marginal product

  • Each additional unit starts to cost you a little bit more

• Variable Cost curve will look similar to Total Cost cuve

Marginal Factor Cost (MFC)

• The additional cost to a firm of hiring one more unit of a factor of production (input)

  • Labor = Wage

  • Capital = Rental rate of Capital

    • 1. Rental of machinery

    • 2. Opportunity Cost of buying your own machinery because you can’t rent it to someone else if you're using it.

Marginal Cost

• The cost due to the production of an additional unit of output

  • Marginal Cost = Change in Total Cost / Change in Quantity of Outputs

• The shape of the marginal cost curve in the short run is determined by the production function

• Marginal product and marginal cost are inversely related.

Marginal Cost Equation Formulation

• MC = Change in TC / Change in Q

• MC = (Change in VC + Change in FC) / Change Q

• MC = (Change in VC + 0) / Change in Q

• MC = (Change in L x MFCL) / Change in Q

• MC = MFCL x (Change in L / Change in Q)

• MC = MFCL / (Change in Q / Change in L)

• MC = Wage / MPL

Average Fixed Cost (AFC)

• Fixed costs per unit of output

  • Falls as output rises because fixed cost is spread over more units (Spreading Effect)

  • AFC = FC / Q = Fixed Cost / Quantity of Output

Average Variable Cost (AVC)

• Variable cost per unit of output

  • The shape is determined by marginal cost.

  • AVC = VC / Q = Variable Cost / Quantity of Output.

Average Total Cost (ATC)

• Total cost per unit of output

  • ATC = TC / Q = Total Cost / Quantity of Outputs

  • ATC = AFC + AVC

Four Cost Curves

1. Marginal Cost = Eventually goes upward sloping due to diminishing marginal product

2. Average Variable Cost = Shape determined by marginal cost

3. Average Fixed Cost = Always downward sloping due to spreading effect

4. Average Total Cost = Determined by AFC and AVC

Spreading Effect

• As output increases, fixed costs are spread over more units.

  • AFC decreases as outputs increase

Diminishing Returns Effect

• As output increases, eventually diminishing marginal product sets in

  • As MP falls, MC rises, pulling up AVC

At Low Levels of Output

• AFC is dropping “rapidly”

• AVC may also be dropping —> may fall initially if the production function has increasing marginal product initially

• ATC dropping

At High Levels of Output

• AFC still falling, but having smaller impact on ATC

• AVC rising due to diminishing marginal product

• ATC rising

Long-Run Average Total Cost Curve

• The common pattern that is expected is a general “U” shaped curve with a slightly flattened-out bottom.

  • But it doesn’t necessarily have to be shaped this way because we don’t have fixed inputs.

Return to Scale

• This is what happens to your output with a scale increase.

  • Scale Increase = Proportional increase in inputs (e.g., doubling all inputs or tripling or halving, etc.)

• Determined by the production function

• 3 Kinds:

  • Constant Returns to Scale (CRS)

  • Increasing Returns to Scale (IRS)

  • Decreasing Returns to Scale (DRS)

Constant Returns to Scale (CRS)

• A proportional increase in all input levels leads to output growth of the same proportion (e.g., doubling all inputs = doubling the output).

  • Q1 = f(L,K) = Initial level of inputs and output

  • Q2 = f(2L, 2K) = Output when all inputs are doubled.

• f(2L, 2K) = 2 f(L,K) —> Q2 = 2 Q1

Increasing Returns to Scale (IRS)

• A proportional increase in all input levels leads to greater-than-proportional output growth. (e.g., doubling all inputs results in more than double the output).

• f(2L,2K) > 2 f(L,K) —> Q2 > 2 Q1

• Reasons

  • Greater Specialization = As you double workers, more people specialize, or more people in a team make the product faster

  • Learning By Doing = You begin to fix mistakes you made the first time.

Decreasing Returns to Scale (DRS)

• A proportional increase in all inputs leads to a less-than-proportional increase in output. (e.g., doubling all inputs results in less than double the output).

• f(2L,2K) < 2 f(L,K) —> Q2 < 2 Q1

• Reasons

  • Organizational Difficulties = Having problems conveying information when going from a small to a large workforce.

Economies of Scale

• Exists when a firm's average total cost to produce a good or service decreases as they increase their quanity of output.

• Reason: If a firm has increasing returns to scale in production

  • If input prices stay constant, then total costs double, but spread out over more than double output, so the ATC falls.

Reasons for Economies of Scale

• Increasing Returns to Scale: Specialization & Learning by Doing

• Large Set-Up Costs

  • Massive investment or infrastructure is necessary in order to begin producing.

  • Often paired with relatively low per-unit costs.

• Bulk Purchase of Inputs

  • Large layer of inputs necessary for production often provides the ability to negotiate a lower price.

Constant Economies of Scale

• The average cost of production is constant as output expands.

• Reason: If a firm has constant returns to scale in production

  • If input prices stay constant, then total costs double and total output doubles, so ATC remains constant.

  • Flat AC curve

Diseconomies of Scale

• Average cost of production rises as output expands

• If a firm has decreasing returns to scale in production

  • If input prices stay constant, then total costs double, but output increases by less than double, so ATC rises as output expands.