Unit 2 Exam - Economics

Chapter 5, 6, 7, & 16

welfare economics

measure of market efficiency; the study of how the allocation of resources affects economic well-being

want high economic welfare - more gains from trade

welfare

composed of two measures of market value: consumer surplus and producer surplus

consumer surplus

the difference between willingness to pay for a good and the price actually paid to get the good (WTP has to be greater than price in order to purchase the good)

law of demand

decrease in price results in an increase in quantity demanded → consumer surplus increases → at low prices, more consumers buy resulting in more gains from trade and higher economic welfare

producer surplus

the difference between willingness to sell a good and the price actually received for the good (price has to be greater than willingness to sell)

law of supply

as price goes up, quantity supplied goes up and producer surplus goes up

practice question #1: the height of the demand curve at any quantity be thought of as the: 

a. willingness to purchase

b. willingness to sell 

c. consumer surplus

d.producer surplus

a. willingness to purchase

practice question #2: the difference between the price the good was sold at and the minimum price the firm would have accepted for the good is called:

a. willingness to sell

b. product markup

c. producer surplus

d.price-cost margin

c. producer surplus

PS=price received-height of the supply curve

social welfare

total surplus=consumer surplus + producer surplus (want to maximize)

consumer surplus and producer surplus represent the gains from participating in the market

want to show how total surplus is maximized in the markets without government intervention

an outcome is efficient when an allocation of resources maximizes total surplus

excise tax

good/service-specific taxes

tax incidence

the burden of taxation on the party who pays the tax through higher prices

occurs regardless of whom the tax is actually levied on

deadweight loss

the loss of surplus

taxes hurt both buyers and sellers: buyers pay a higher price and sellers receive a lower price

deadweight loss: the decrease in economic activity caused by market distortions

comparison of taxes

tax levied on consumers: some burden is passed on to producers since the market price falls

tax levied on producers: firm attempts to raise prices to pass some of the burden to consumers

incidence is the same

inelastic demand

quantity demanded is relatively unresponsive to a change in price

the more inelastic demand is, the greater the burden on consumers and the smaller the deadweight loss

perfectly inelastic demand

quantity demanded doesn’t change no matter the price: consumer surplus decreases while producer surplus stays the same

burden of the tax falls on consumers but there is no deadweight loss

perfectly elastic demand

any price change eliminates quantity demanded

consumer surplus and producer surplus both get smaller (producer surplus falls, creating a larger deadweight loss)

somewhat elastic demand

tax burden falls more on producers and there is a deadweight loss; consumer surplus and producer surplus both get smaller

practice question #3: deadweight loss can be thought of as surplus that is transferred from producers or consumers and given to:

a. the government

b. competitors in other markets

c. taxpayers

d. nobody

d. nobody (deadweight loss is a loss)

to generate tax revenue and minimize loss

tax goods with perfectly inelastic demand

practice question #4: if the government wants to create tax revenues without generating any deadweight loss, what type of good should they tax?

a. a good with perfectly elastic demand

b. a good with relatively elastic demand

c. a good with a perfectly inelastic demand

d. a good with relatively inelastic demand

a. a good with perfectly elastic demand - has deadweight loss

b. a good with relatively elastic demand - has deadweight loss

c. a good with a perfectly inelastic demand - no DWL

d. a good with relatively inelastic demand

when the demand curve is more inelastic than the supply curve

consumers bear the incidence of the tax

when the supply curve is more elastic than the demand curve

producers bear the incidence of the tax

deadweight loss and tax revenue:

1. no tax: no deadweight loss, equilibrium, no tax

2. small tax: large revenue compared to DWL

3. moderate tax: larger deadweight loss

4. large tax: tax revenue is smaller than before, increase in deadweight loss

5. extreme tax: revenue is 0, deadweight loss will be all of it

why tax a good if it reduces efficiency in the market by creating deadweight loss?

raise revenue for public services, control production/consumption

tax on inelastic demand

• a high tax would affect consumption

• no deadweight loss and an increase in revenue

• fund public services

price controls

attempts to set or manipulate prices through government regulations in the market

price ceiling

used when a market price is too high to help consumers

legally established maximum price for a good or service

price floor

used when market price is too low to help producers

legally established minimum price for a good or service

nonbinding price ceiling

equilibrium point is legal

binding price ceiling

results in a shortage since price ceiling is below the equilibrium price

quantity demanded > quantity supplied, leads to a shortage since people want more than what is readily available

practice question #1: what will be the effect of a nonbinding price ceiling?

a. a surplus will be created

b. a shortage will be created

c. there will be no effect

d. the effect is unknown

c. there will be no effect

price ceilings in the long run

quantity demanded becomes larger and quantity supplied is less: shortage becomes larger

practice question #2: in the event of a binding price ceiling, what is one function than an illegal market serves?

a. it reduces the shortage caused by the price ceiling

b. it decreases the price even further

c. it creates a monopoly

d. it causes a surplus of the good

a. it reduces the shortage caused by the price ceiling

practice question #3: supply and demand generally become more elastic in the long run. this means that shortages caused by price ceilings ___ in the long run. 

a. disappear completely

b. become smaller

c. become larger

d. become infinitely large

become larger

rent controls

a type of price ceiling on apartment rentals

consequences:

• reduction in the quality of apartments (either less maintenance or decay)

• landlords “nickel and dime” tenants with fees to increase revenues

• long-term investment in the building of new units decreases

• the policy often ends up hurting the very people it was supposed to help

• in the long run: shortage gets larger over time

price gouging laws

temporary price ceilings imposed during emergencies

example: a hurricane

• increases quantity demanded of generators → increase in price → increase in quantity supplied → market works to distribute to those who value them the most

• leads to a decrease in entrepreneurial activity

• delays in helped affected areas

practice question #4: what is one unintended consequence of rent control?

a. people in rent-controlled units will relocate more often

b. landlords may not maintain rental units

c. too many apartments will be built, creating a surplus of units

d. people will choose not to live in big cities

b. landlords may not maintain rental units

nonbinding price floor

below the equilibrium price so no influence (equilibrium is in the legal portion)

binding price floor

above the equilibrium price: quantity supplied > quantity demanded

binding price floor in the long run

surplus expands:

• consumers find substitutes

• supply and demand become more elastic

minimum wage

the lowest hourly wage rate that firms may legally pay their workers

rationale: 

• provides a “living wage”

• helps the working poor who are often unskilled

• provides skills and experiences

results in: 

• decrease in quantity demanded for labor and increase in quantity supplied of labor

• firms may replace low-skilled jobs with capital

• shortening of hours for workers

• firms may relocate where there is no minimum wage

proponents of the minimum wage advocate for: training, education, and job programs

externalities

the costs or benefits of a market activity that affect a third party (those not thought of)

market failure

occurs when there is an inefficient allocation of resources in a market (at equilibrium, total surplus is maximized)

externalities are one type of market failure

buyers and sellers don’t consider all the costs and benefits, resulting in inefficiency

internal costs

the costs of a market activity only paid by the participants

external costs

the costs of market activity imposed on people not participating in that market - third parties

social costs

the sum of the internal costs and external costs of a market

externalities exist when:

if the internal costs/benefits and external costs/benefits don’t match, an externality occurs

internal costs ≠ social costs

internal benefits ≠ social benefits

third party problems

occur when those not directly involved in a market activity experience positive or negative externaliteis

negative externalities

costs experienced by third parties

“too much” of the good is consumed and produced

(examples: too much perfume, a loud highway, leaning back in seat)

positive externalities

benefits experienced by third parties

“not enough of the good is consumed and produced”

examples: vaccines, education, hybrid cars

it’s a positive benefit to those around but one doesn’t make decisions based on that benefit

practice question #1: which of the following activities would most likely create a negative externality?

a. eating a slice of pizza

b. smoking a cigarette

c. taking a nap

d. getting a college degree

b. smoking a cigarette

practice question #2:which of the following activities is most likely to create a positive externality?

a. eating a slice of pizza

b. smoking a cigarette

c. taking a nap

d. getting a college degree

d. getting a college degree

correcting for negative externalities

make the firm recognize the external cost: 

• tax the product

• regulate production

• encourage research and development of alternative substitutes to the product

a producer makes more than they should

the social optimum is less than the market equilibrium

deadweight loss: produce too much of a good (absent government involvement), imposing a tax results in internalizing the externality, leading to increased cost of production, decreasing supply and price, leading to social optimum

the firm’s costs will equal the social cost - the supply curve shifts to the left

internalizing the externality

the individual involved in the activity takes into account the social costs/benefits of their actions → become aware of how his/her actions will impact the social welfare of the community (positively or negatively)

practice question #3: suppose good x creates a negative externality. which of the following would not be an appropriate way to correct the negative externality?

a. subsidize the production of good x

b. tax the production of good x

c. limit how much of good x can be produced

d. require the producers of good x to pay for external costs that arise

a. subsidize the production of good x

positive externalities

• social benefit > internal benefit

• dwl is due to insufficient demand - eliminate with internalization

correcting for positive externalities: help individuals realize external benefits

• finance or subsidize production and consumption of good (like tax credits)

• laws requiring consumption

• encourage research and development of similar goods

the consumer realizes the full, social benefit → demand curve shifts to the right

property rights

• externalities often arise because of a lack of clearly defined property rights

• property rights: give the owner the ability to exercise control over a resource - create incentives

incentives: 

• incentive to maintain

• incentive to protect - locks

• incentive to conserve - limitation of miles, drive gently

• incentive to trade with others

private property rights

provide exclusive right of ownership that allows for the use and exchange of property

coase theorem

how private individuals resolve externalities without government intervention

if there are no barriers to negotiations and if property rights are fully specified, interested parties will bargain to correct externalities

• government intervention isn’t always necessary to correct externalities

• when the size of the externality is large enough to justify the expense of bargaining → the externality gets internalized

excludable

it’s possible to prevent consumers who haven’t paid for it from having access to it

rival

the good cannot be enjoyed by more than one person at a time

private goods

• rival and excludable

• most goods we purchase are private goods

• example: sandwich, burgers, watches, cars

public goods

• nonexcludable and nonrival

• can be consumed by many

• difficult to exclude nonpayers from consumption

• free-rider problem: someone has the ability to receive the benefit of a good without paying for it

• examples: national defense, mosquito abatement, street performers

practice question #4: which of the following is an example of a public good?

a. a free outdoor christmas light display

b. college football game

c. parking spot with parking meter

d. college education

a. a free outdoor christmas light display

club goods

• nonrival and excludable

• examples: streaming services (many people can watch at the same time but exclude non-payers), country clubs, satellite tv

common resource goods

• rival and nonexcludable

• example: fish in a lake, alaskan king crab, sharing a large popcorn at movies, congested roads and beaches

practice question #5: what type of good is this park?

• excludable - have to pay for entry to get in

• rival 

- > private good

practice question #6: what type of good is membership at your local fitness facility?

• excludable - only paying members can use it

• nonrival

• club good

cost-benefit analysis

proceeds to determine whether the benefits of providing a public good outweigh the costs

the costs are easier to compute than the benefits are (people might misrepresent the value of the good to them)

tragedy of the commons

• occurs when a rival (but nonexcludable good) becomes depleted or ruined

• the commons get destroyed, even though this was in no one’s best interest

common property incentives

incentive to neglect, incentive to overuse

possible solutions to the tragedy of the commons

proactive management:

• impose taxes

• regulations

• other ways to internalize the negative externality

cap and trade: 

• a system of pollution “permits that are traded on an open market”

• firms that can control emissions cheaply will sell their permits on an open market

• firms that face very high costs to reduce emissions will purchase permits

• creates property rights for pollution - internalize the externality

utility

“happiness” - a measure of relative levels of satisfaction consumers enjoy from consumption of goods and services

utils

used to quantify satisfaction

utility

internally consistent - can’t measure across individuals

the goal of the consumer is to maximize utility

everyone has a different utility scale

can’t say one person is more satisfied than another

cardinal utility

state with numbers how much more we prefer one good to another

ordinal utility

we can rank goods in order of preference but we can’t say how much we like one good over another

complete consumer preferences

prefer a to b, b to a, or indifferent

transitive consumer preferences

prefer a to b, b to c, must prefer a to c

total utility

the overall amount of happiness from consumption

marginal utility

additional utility gained from consuming one more unit of a good or service

diminishing marginal utility

occurs when marginal utility declines as consumption increases

practice question #1: which of the following statements is true?

a. marginal utility generally diminishes with additional consumption of a good

b. marginal utility generally becomes negative with a additional consumption of a good

c. marginal utility equals total utility

d. individuals avoid consuming goods in which they experience diminishing marginal utility

a. marginal utility generally diminishes with additional consumption of a good

• still enjoy additional consumption - just not as much as previous units

practice question #2: which of the following would most likely illustrate an example of the negative marginal utility?

a. studying for another hour

b. sleeping in late on a weekend

c. eating too much food at an all-you-can-eat buffet

c. eating too much food at an all-you-can-eat buffet

• negative marginal utility means you’v e consumed up to a point where further consumption makes you worse off

• if MU<0, then TU decreases

rule for maximizing utility

allocate income by choosing goods that give you the most utility per dollar spent

consumer optimum

all income is spent

more than two goods (maximizing utility)

in general - people behave in ways that maximize marginal utility

conditions might not hold with perfect equality - end up with fractions

price changes effect on marginal utility

• lower prices increase the marginal utility per dollar so consumers buy more of the good

• higher prices decrease the marginal utility per dollar so consumers buy less of the good

substitution effect

occurs when consumers substitute a product that has become relatively less expensive as the result of a price change

real-income effect

occurs when there is a change in purchasing power as result of a change in the price of a good - almost negligible

• either the price change has to be substantial

• the good takes up a large part of consumer budget

practice question #3: If I consume more of good z, what happens

a. the price of good z will rise

b. the price of good z will fall

c. my marginal utility of good z will fall

d. my marginal utility of good z will rise

c. my marginal utility of good z will fall

practice question #4: suppose you get more utility per dollar when you eat hamburgers than when you eat hot dogs. which action makes the most sense?

a. eat more hot dogs - cheaper than hamburgers

b. get something to drink with food

c. eat more hamburgers

d. eat at five guys

c. eat more hamburgers

suppose that:

mu - x/price - x < mu - y/price - y

a. buy more of good x

b. buy less x

c. buy more x and less y

d. buy more y and less x

d. buy more y and less x (get more of y for cheaper)

practice question #6: if the price of a good rises, consumers tend to purchase less of that good and instead purchase more of another good. this illustrates?

the substitution effect