Economics 101 Units 6-

Price Ceiling

A maximum price that sellers can legally charge

Price Floor

A minimum price that sellers can legally charge

Binding Price Ceiling

A price ceiling that prevents the market from reaching the market equilibrium price

• Highest sellers can charge is below equilibrium price

• Lower prices, but cause shortages (demand greater than supply)

Unintended Consequences of Price Ceilings

• Time wasted on searching for the good

• Black markets

• Add-Ons/Bundling: Creating complements (?)

• Discrimination

• Low quality products/knock offs

Usury

Maximum on the interests that can be charged on loans

There are shortages of available loans in these areas

Binding Price Floor

A price floor that prevents the market from reaching the equilibrium price

• The lowest price that sellers can charge is above equilibrium

• It raises prices and lowers quantity sold (creates surplus)

Ways to get rid of Price Floor Surplus

• Attempt to increase demand (advertisement)

• Government can purchase surplus product at price floor

  • Store it

  • Give it away domestically

  • Give it away as foreign aid

  • Destroy it

Mandate

A requirement to buy or sell a minimum amount of a good (not very common)

• Examples: COVID vaccines or electric cars in some places

Quota

A limit on the maximum quantity of a good that can be sold (somewhat common)

• Examples: Houses

• There’s also immigration, trade, and medical resident quotas

Taxes

Government collects money for each unit bought/sold

• Federal government collects most of its taxes in the form of income taxes

• States and localities often collect revenue through sales taxes

Subsidies

Government pays someone for each unit bought/sold

• Benefits are divided between buyers and sellers

Tax on Sellers

• Tax shifts supply curve to the left (up), reflects new higher marginal costs

• Tax leads to decrease in quantity sold

• Increases the price buyers pay decreases price sellers receive (tax is shared)

Tax on Buyers

• Demand curve shifts left (down)

• Tax leads to decline in quantity sold

• Tax increases price buyers pay and decrease the buyers receive

• tax is shared, once again

Statutory Burden

The burden of being assigned by the government the responsibility of sending a tax payment (buyer or seller)

• Doesn’t matter whether buyer or seller has the statutory burden, ignore it

Economic Burden

The burden created by the change in after-taxes faced by buyers and sellers (who pays what?)

Tax Incidence

The division of economic burden of a tax between buyers and sellers

• Depends on the price elasticity of supply and demand

  • Sellers bear a smaller share of economic burden when supply is elastic. They can produce something else instead.

  • Buyers bear a smaller share of economic burden when demand is elastic. They can buy something else instead.

• Whoever has a LESS elastic (steeper) curve pays more

Graph with Price Elasticity

• Consumers pay the top part of the graph in the area

• Producers pay the bottom part of the graph in the area

Evaluating Taxes

New tax is imposed

1. Find out which curve shifts

2. Move it up for supply, down for demand

3. Analyze it

Positive Analysis

Describes what is happening, explaining why or predicting what will happen

• What is going to happen if we adopt this policy?

• Purely objective. Can be supported or rejected with evidence

Example: Raising minimum wage will lead to an increase in unemployment

Normative Analysis

Prescribes what should happen, involves value judgments

• What is a better outcome, and what policy should the government adopt?

• Requires making a judgment

Example: Should minimum wage be raised or not?

Economic Surplus

The total benefits minus the total costs from a decision

• When economic surplus rises, it is possible for those who benefit to compensate those who were harmed in such a way that everyone is better off (redistribution)

Economic Efficiency

The more economic surplus that is generated, the more efficient the outcome is.

• Efficient outcomes are not equal and will not make everyone happy

• However, efficient outcomes hold potential to make everyone better off

Equity

And outcome has greater equity if it results in “fairer” distribution of economic benefits

• Ignored by efficiency

• Policies don’t always compensate those who are harmed

Pareto Efficiency/Pareto Optimal

A situation where no one can be made better off without making someone worse off (there will be a trade-off)

Pareto Improvement

When a change can make at least ONE person better off without making anyone worse off

• A net positive

• Might involve redistribution

Consumer Surplus

The difference between the maximum amount a person is willing to pay for a good price and its current market price

• The area of a triangle above the price line on a demand curve.

• CS = Marginal Benefit - Price

Diamond-Water Paradox

1. The things with the greatest value in use frequently have little or no value in exchange (like water)

2. The things with the greatest value in exchange frequently have little or no value in use (like diamonds)

Producer Surplus

The difference between the current market price and the marginal cost of production for the firm (lowest price you’d sell for)

• PS = P - MC

• The area above the supply curve and below the price

Voluntary Exchange

Buyers and Sellers exchange money for goods only if they both want to

• Ensures both buyer and seller enjoy the gains from trade

Economic/Total Surplus

• Consumer Surplus + Producer Surplus

• = Marginal Benefit - Marginal Cost

The 3 Central Questions Markets Provide “Efficient” Answers to

1. Who makes what

2. Who gets what

3. How much gets bought and sold?

Efficient Production

Producing a given quantity of output at the lowest possible cost

• Requires allocating production so that each item is produced at the lowest marginal cost

Competitive Markets

Competitive Markets distribute production across firms in a way that minimizes cost

• Whoever can produce the next unit at lowest price will produce it

Efficient Allocation

Allocating goods to create the largest economic surplus

• Requires that each good goes to the person who will receive the highest MARGINAL BENEFIT from it (but this isn’t 100% accurate)

• (Professor Interpretation): Markets allocate to those willing and able to pay

Efficient Quantity

The quantity that produces the largest possible economic surplus

Rational Rule for Markets

Produce until consumer’s marginal benefit (demand) equals producers’ marginal cost (supply)

Market Failure

• When forces of supply and demand lead to an inefficient outcome

5 Sources of Market Failure

1. Market power

2. Externalities

3. Information Problems

4. Irrationality

5. Government regulations

Deadweight Loss

How far economic surplus falls below the surplus realized at the inefficient outcome

• DWL = Economic surplus at efficient quantity - actual economic surplus

• Quantities rather than prices create deadweight loss (so it’s mostly determined by how much is being produced)

Government Failure & Deadweight Loss

• Occurs when government policies lead to worse outcomes

• Government failure limits the extent to which we should rely on government

Critiques of Economic Efficiency

1. Distribution matters, so it’s also important to account for equity. (How the cake is cut, not just the size)

2. Willingness to pay reflects ability to pay, not just marginal benefit.

3. “The means matter, not the ends.” Political structure, institution, treatment of labor, and other ways on HOW things are produced (I think).

Gains From Trade

The benefits that come from reallocating resources, good, and services to better uses.

• Arise largely from opportunity costs

• Done by effectively allocating tasks (?)

Absolute Advantage

A producer has Absolute advantage over another if it can produce that product using fewer resources

Comparative Advantage

A producer has a comparative advantage over another in the production of a good/service if it can produce that product at a lower opportunity cost.

(Law of) Specialization

Each person should do what they have a comparative advantage in.

Output Approach (Listed as “per hour,” “per day,” etc.)

The opportunity cost is what you are giving up over what you are getting

Input Approach (“can do [something] in [time]”)

The opportunity cost is time of what you are doing over time of what you are not

Division of Labor

Each person specializes in one small part of the production process.

→ Creates comparative advantage and leads to increased productivity

• Downsides: Repetitive and tedious

Law of Comparative Advantage

The country that has a lower opportunity cost of producing a good should specialize in the production of that good.

• Free Trade equalizes prizes

Terms of Trade

The ratio at which a country can trade domestic products for imported products, or how much of one good can be exchanged for one unit of another good.

Consumption Possibilities Frontier

Results from trade between two countries

• Can only theoretically be on or above the PPF

• By specializing in a good & trading, a country can expand its possible consumption. PPF no longer limits consumption.

Theory of Comparative Advantage

Specialization and free trade will benefit all trading partners. Real wages will rise

• Caveat: Countries involved must have different opportunity costs of production for the goods in question

Reasons for Comparative Advantage - 1. Differences in Resource (Factor) Endowments (Types of Labor)

Different countries have different endowments of things like minerals, land, labor, climate, etc.

that effect production of good and thus comparative advantage.

• Obviously, the country that is better at making/doing “A” will continue producing/selling/giving “A”

Heckscher-Olin Theorem

A country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.

Reasons for Comparative Advantage - 2. Skills/Technology

• Certain countries will get good at certain skills or have certain technology, giving them the comparative advantage

Reasons for Comparative Advantage - 3. Economies of Scale/Mass Production

When economies of scale are present, such that per-unit (average) cost is decreasing with output, then countries can lower costs through increasing the size of firms and industries.

• Seen a lot with very capital-intensive goods.

• (Comparative advantage can change over time)

Trade and Tastes

• Different tastes between nations can also explain trade

• Humans like to have a different variety of things.

Exchange Rate

The ratio at which two currencies are traded; the price of one currency in terms of another.