High School



High School

Advanced Placement Microeconomics

Course Outline

Text: Economics, McConnell and Brue

Workbooks: Microeconomics: Student Activities, Morton and Goodman

Numerous supplementary resources and materials

Student Evaluation: Tests: 60%(6 unit tests & 1 cumulative final)

Homework & In-class assignments: 20%(Primarily from workbooks and text)

Term Paper: 20%(See Appendix I)

Chapter 20: Demand and Supply: Elastics and Applications (Weeks 1-2)

1. The price elasticity of demand measures the responsiveness, or sensitivity, of consumers to a change in the price of a product.

a. Elastic demand: consumers are highly responsive to price changes so that small changes in prices lead to much larger changes in the quantity purchased.

b. Inelastic demand: consumers are price-insensitive or unresponsive to price changes so that substantial price changes result only in small changes in the amount purchased.

2. Mathematically, the price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price that brings about the change in quantity demanded.

Price elasticity of demand = % change in quantity demanded

% change in price

Note: Ed always expressed in positive terms even though price/quantity is an inverse relationship.

a. If Ed > 1 demand is elastic: e.g. if prices increase 5% and quantity demanded falls 10% Ed = 2

b. If Ed < 1 demand is inelastic: e.g. if prices fall 5% and quantity demanded rises 2.5%, Ed = ½

c. If Ed = 1 demand is unit elastic: e.g. if prices rise 5% and quantity demanded falls 5%, Ed = 1

d. If Ed = ( demand is perfectly elastic

e. If Ed = 0 demand is perfectly inelastic

3. Price Elasticity and Total Revenue

Total Revenue = the total amount the seller receives form product sales = P(rice) x Q(uantity)

a. If demand is elastic, a fall in price will increase total expenditure (PxQ) and an increase in price will decrease total expenditure (PxQ) e.g. if price (P) declines 10% and quantity demanded (Q) increases 20%, PxQ will increase.

b. If demand is unit elastic, a change in price will leave total expenditure (PxQ) unaffected. E.g. if P declines by 10% and Q increases by 10%, PxQ will not change.

c. If demand is inelastic, a fall in price will reduce total expenditure (PxQ) and an increase in price will increase total expenditure (PxQ). E.g. if P declines by 10% and Q increases 5%, PxQ will decrease.

4. Determinants of Elasticity of Demand

Category More Elastic Demand More Inelastic Demand

1 Type of Good Luxury Goods Necessities

2 Availability of Close Subs Many close Substitutes Few Close Substitutes

3 Percentage of Budget Large Percentage Small Percentage

5. Income elasticity of demand measures the degree to which consumers respond to a change in their income by buying more or less of a particular good.

Ed = % change in demand

% change in income

a. normal goods: Ed will be positive

b. inferior goods: Ed will be negative

6. Price Elasticity of Supply

Es = percentage change in quantity supplied of product

Percentage change in price of product

If producers are relatively responsive to price changes, supply is elastic. If they are relatively insensitive to price changes, supply is inelastic. The most important determinant of price elasticity of supply is the amount of time available to producers to shift resources into the production of a particular good/service.

Chapter 21: consumer Behavior and Utility Maximization (Weeks 3-4)

1. Three reasons for the downward sloping demand curve

a. income effect If the price of a commodity falls, a consumer’s real income (purchasing power) will increase and quantity demanded of that commodity will increase. If the price of a commodity rises, a consumer’s real income (purchasing power) will decrease and quantity demanded of that commodity will decrease. (Note: the income effect assumes one’s income is constant and that price changes. This differs from when we assume constant prices and a rise/fall in income increases/decreases the demand for a normal good.)

b. substitution effect If the price of a commodity falls, such as donuts, relative to the price of some other commodity, such as muffins, a consumer whose real income has remained unchanged can be expected to buy more of the first – in this case donuts – and fewer of the one relatively more expensive – in this case muffins. Thus, if we consider the substitution effect alone, a decline in price of a good always increases its quantity demanded and a rise in price always reduces its quantity demanded.

c. The law of diminishing marginal utility asserts that additional units of a commodity are worth less and less to a consumer in money terms. That is, as the individual’s consumption increases, although total utility is greater, the marginal utility of each additional unit declines. Intuitively, it should make sense that because additional units of a good yield smaller and smaller amounts of marginal utility, then the consumer will buy additional units of a product only if its price falls.

-- utility is what a good or service is worth to a consumer in terms of pleasure/satisfaction provided.

-- total utility of a quantity of goods to a consumer (measured in dollars) is the total amount of money she is willing to give in exchange for it.

-- marginal utility of a commodity to a consumer (measured in dollars) is the amount of money she is willing to pay for one additional unit of it.

KEY GRAPH 21-2 PAGES 426-427

2. Theory of Consumer Behavior

a. The optimal purchase rule states that it always pays the rational consumer to buy more of any commodity whose marginal utility (in dollars) exceeds its price (MU>P), and less of any commodity whose marginal utility is less than its price (MU MC, a firm can increase profit by producing more; if MR < MC, a firm can increase profit by producing less. Let us complete the table below and graph Narcissus’s marginal revenue and marginal cost curves. Thus where MR intersects MC total profit is maximized.

f. In a perfectly competitive market, marginal revenue equals price or MR = P. Thus the equilibrium of a profit-maximizing firm in a perfectly competitive market must occur at an output level at which marginal cost is equal to price (because price is equal o marginal revenue). Or P = MR = MC.

g. Economic profit can be calculated form the average-total-cost (ATC) data. KEY GRAPH 23-3 PAGE 475

Profit per-unit = Price or AR – ATC at the profit-maximizing output where MR = MC

Total economic profit = profit per-unit x total output at the profit-maximizing output where MR = MC.

4. Marginal Cost and Short Run Supply KEY GRAPH FIGURE 23-6 PAGE 479

a. A firm should continue to operate in the short run if TR exceeds total short-run variable cost (TVC). Since TR/Q = P and TVC/Q = AVC, P> AVC for a firm to operate. If a firm stops producing, both its revenues and short-run variable become zero, leaving only sunk costs. Thus, its loss if it shuts down = sunk costs = TC – TVC. If a firm continues to operate, it can receive enough total revenue to cover its TVC and still pay off some of its fixed costs.

b. A firm should nevertheless plan to shut down if TR is less than TVC or if P < AVC.

c. The short-run supply curve of the perfectly competitive firm is the portion of its marginal cost curve that is above the point where it intersects the average short-run variable cost curve; that is, above the minimum level of AVC. If price falls below that level, the firm’s quantity supplied drops to zero. But as the price/marginal revenue increases, a firm’s output of increases as it operates where MC = MR. Note that the MC is upward sloping due to the law of diminishing marginal returns.

d. A firm breaks even and achieves normal profits where (P = AR) = ATC. At any point where (P = AR) > ATC, a firm experiences economic profits in the short run.

e. An increase in variable costs will shift the MC up (left) along with the AVC and ATC curves resulting in lower output per firm, whereas a decrease in variable costs will shift the MC down (right) along with the AVC and ATC curves resulting in higher output per firm.

f. In the short run, the number of firms in a competitive industry is fixed because the period of time does not allow entry and exit. To derive the supply curve of the competitive industry, at any price we simply add up the quantities supplied by each firm to arrive at the industry-wide quantity supplied. Figure 23-7 Page 481

5. Profit Maximization in the Long Run

In the short run, there are a fixed number of firms who have a fixed size of operation. Firms may shut down by producing zero output, but they cannot liquidate and go out of business. In the long run, individual firms may expand or contact their plant capacities and the number of firms may change as new firms enter and old firms exit. After all long-run adjustments are completed, product price will be exactly equal to, and production will occur at, each firm’s minimum average total cost.

a. Long run equilibrium = S1 and D1 in industry where each firm operates at P = MR = MC = minimum ATC (normal profit).

b. Demand increases to D2 increasing price and quantity supplied in the industry

c. Each firm in short run accepts higher price ($60) and increases output where P = MR = MC

d. Each firm in the short run experiences economic profit.

e. In the long run firms enter the market to achieve economic profits shifting the industry’s short urn supply curve right to S2.

f. Due to the increase in supply (and the downward sloping market demand curve) the new market in higher output and lower prices (equal to original equilibrium price of o$50).

g. A new long run equilibrium occurs at S2 and D2 with more firms in the industry where each firm operates again where P = MR = MC = minimum ATC (normal profit).

See Figure 23-8 below reproduced from the text on page 482. Also see Figure 23-9 for decreased demand scenario

6. The long-run industry supply curve for a constant cost industry is horizontal or perfectly elastic. Figure 23-10 page 484 When demand for a product increases, price increases, economic profit increases, new firms enter, industry output increases, and price returns to the original equilibrium tangent to the minimum ATC. When demand falls, prices fall, economic profit falls, old firms exit, industry output decreases, and price returns to the original equilibrium tangent to the minimum ATC. Thus, the supply curve in the long run will reflect the price level where P = minimum ATC.

7. Pure Competition and Efficiency

The long run equilibrium of a purely competitive market will ensure that P = MR = MC = minimum ATC

A competitive market will ensure both productive efficiency (goods produced in the least costly way) and allocative efficiency (resources apportioned among firms and industries so as to yield the mix of products and services which is most wanted by society).

a. Productive Efficiency: P = Minimum ATC: In the long run, pure competition forces firms to produce at the minimum average total cost of production and to charge a price which if equal with that cost (guaranteeing a normal profit, but zero economic profit). Thus, purely competitive firms are forced to use the least-cost production methods and combination of inputs or they will not survive. The minimum amount of resources will be used and consumers will benefit by paying the lowest product price possible given existing conditions.

b. Allocative Efficiency: P = MC: Efficiency in the choice of output quantities requires that, for each of the economy’s outputs, the marginal cost (MC) of the last unit produced be equal to the marginal utility (MU) of the last unit consumed. At MC = MU, total benefit total utility) to society minus the total cost to society of producing the output quantities that are chosen will be maximized. (TU > TC by largest amount where MU = MC).

--Output where MU > MC is not optimal because society would be made better off by an increases in that output level. In pure competition, if MR = P > MC, there will be an under allocation of resources to this product, and a firm would maximize profits by producing more.

--Output where MC > MU is not optimal because society would be better off by a decrease in that output level. In pure competition, if MC > MR = P, there is an over allocation of resources to this product, and a firm would maximize profits by producing less.

--Under perfect competition, it is most profitable for each firm to produce where its marginal cost (MC) = price (P). Similarly, it is in the interest of each consumer to purchase goods at which the marginal utility (MU) is equal to the price (P) of that good. MC = P = MU or MC = MU. In other words, the uncoordinated decisions of producers and consumers can be expected automatically to tend to produce exactly the quantity of each good that satisfies the MC = MU rule for efficiency in deciding what to produce.

Unit Activity: Research and present an example of a business operating in a competitive market

Chapter 24: Pure Monopoly (Weeks 10-11)

1. A pure monopoly has the following characteristics:

a. Only one firm in the industry

b. No close substitute for the monopolist’s product

c. Firm is a “price maker”

d. Nonprice competition not necessary due to unique product, although it does exist

e. Impenetrable barriers to entry (e.g. economies of scale, legal restrictions, control of scare resource, etc.)

2. A specific type of monopoly is a natural monopoly – an industry in which advantages of large-scale production make it possible for a single firm to produce the entire output of the market a t lower average cost than a number of firms each producing a smaller quantity. However, this would only occur if the market demand curve intersected the LRATC in this region where economies of scale occurred.

3. Monopoly Demand

a. A monopolist faces the industry’s downward sloping demand curve and can select a higher price without losing all its customers like the perfect competitor. In fact, by controlling output, the monopolist can effectively determine the market price based upon existing elasticity of demand. (Thus, the monopolist is a price maker.)

b. Whereas the perfect competitor’s price (i.e. average revenue) will equal marginal revenue due to the perfect elasticity of demand, for the monopolist, his marginal revenue (MR) curve is always below the demand curve (=AR). Because the monopolist must set a lower price to obtain greater sales marginal revenue is less than price (AR) for every level of output except the first. Figure 24-2 Page 499

c. The monopolist prices in the elastic region of demand. When demand is elastic, a decline in price will increase total revenue (and thus marginal revenue is positive). If demand where inelastic, a price decline would cause total revenue to decrease (and marginal revenue would be negative).

4. Determining the Profit-Maximizing Output for a Monopolist KEY GRAPH Figure 24-4 Page 502

Step 1. Determine the profit-maximizing output b finding where MR = MC

Step 2. Determine the profit-maximizing price by extending a vertical line upward from the output determined in step1 to the pure monopolist’s demand curve.

Step 3. Determine the pure monopolist’s economic profit using one of two methods

Method 1. Find profit per unit by subtracting the average total cost of the profit-maximizing output from the profit-maximizing price. Then multiply the difference by the profit-maximize output to determine economic profit (if any).

Method 2. Find total cost by multiplying the average total cost of the profit-maximizing output by that output. Find total revenue by multiplying the profit-maximizing output by the profit-maximizing price. Then subtract total cost from total revenue to determine economic profit (if any).

5. Monopoly Supply Curve: Unlike the purely competitive firm where MC = supply curve above AVC, the monopolist has no supply curve. For a purely competitive firm which maximizes profit where MR = P = MC there is one and only one price at every level of output yet for a monopolist who does not maximize profit where P = MC, but maximizes profit where MR= MC, it is possible for there to be many prices at that level of output. Because we can have two (or more) prices for the same level of output, we cannot determine a supply curve for a monopolist.

6. Monopoly Pricing: A monopolist will not necessarily charge the highest price. A firm is more concerned with maximizing profit than price. Where MR = MC may not be the highest price, but it will be at the h highest profit.

7. Monopoly Economic Losses: In the short run, if demand falls or costs increase, a monopolist may experience economic losses. In the long run, however, a monopolist would not operate with losses. It is more typical for a monopolist to have positive economic profit. Figure 24-5 Page 504

8. A comparison of Monopoly and Perfect Competition Figure 24-6 Page 504

a. Excess monopoly profits In a perfectly competitive market, in the long run, free entry of other enterprising firms would increase supply, lower prices and economic profits until each firm earned zero economic profit (i.e. normal profit). But higher profits can continue for the monopolist due to barriers to entry.

b. Restricted output and higher prices As compared with the perfectly competitive ideal, the monopolist restricts output and charges a higher price.

9. Monopoly Leads to Inefficient Resource Allocation Figure 24-6 Page 504

a. Productive efficiency occurs where P = minimum ATC. Under pure competition, due to free entry and exit, in the long run, P = minimum ATC and economic profits will be zero (normal profits only). Since a monopolist produces at an output below the pure competition (Qc) where ATC is lowest and price is higher than the competitive price (Pc), then the price for a monopolist must e greater than minimum ATC. That is, Pm > minimum ATC for a monopolist and productive inefficiency is the result.

b. Allocative efficiency occurs where P = MC = MU That is, under pure competition, the price (a measurement of a product’s value or marginal benefit/utility to society) equals marginal cost (a measurement of the alternative products forgone by society in producing any given commodity). However, at the restricted monopolist’s output (Qm), price will be higher than marginal cost. In other words, because Pm = MU > MC, too small a share of society’s resources is being used to produce the monopolized commodity. Even though consumers are willing to pay for additional products (its MU) that exceed what it costs to produce that unit (its MC), the monopolist, is unwilling to increase production because if it raises output by one unit, the revenue it collects (the MR) would be less than its marginal cost (MC). Thus, the monopolist does not increase production and resources are allocated inefficiently.

10. Government Regulation of Natural Monopolies Figure 24-9 Page 510

a. Allocative Efficiency: P = MC. The price of a commodity should never be less than its marginal cost. The government could impose a price ceiling at Pr on the graph below in order to ensure that the natural monopolist increase output and lower price. If rational consumers equate P = MU then MU = MC and we have a socially optimal output/price. However, under this policy the monopolist will most likely face short-term economic losses and potential long run bankruptcy. Because of economies of scale the ATC is downward sloping and when ATC is declining, then marginal cost must be below average total cost. If P = MC under allocative efficiency, P must be below ATC and the firm will lose money. Thus the government would have to nationalize (own and operate) the industry, subsidize it, or permit some form of price discrimination to allow the monopolist to charge higher prices to some customers.

b. Fair Return Price: P = min. ATC. The price of a commodity should not be less than its average total cost. In this scenario, the government would not have to worry about economic losses for the monopolist because a fair-return price would be established at Pf = min ATC. Profits for the monopolist would be normal (P=AR=ATC) with output higher than without regulation. However, this does not ensure productive efficiency because P > minimum ATC or allocative efficiency because price is higher and output lower than where Pr = MC.

11. Price Discrimination is the practice of selling a specific product at more than one price when the price differences are not justified by cost differences. Three conditions are necessary for effective price discrimination:

• monopoly power in order to control price/output

• market segregation of buyers who have different elasticities of demand

• no resale of product/service by original purchaser in low-price segment

As a result of price discrimination, the monopolist will

a. Earn more total economic profit

b. Increase production (thereby reducing some, but not all, allocative inefficiency)

c. Increase prices for some consumers

d. And lower prices for other consumers

For a perfectly discriminating monopolist its marginal revenue equals its demand curve. If this monopolist can identify what each customer is willing to pay, it does not have to lower its price on all preceding units to sell more output. Thus, MR would equal demand curve at all levels of output. Figure 24-8 Page 509

Unit Activity: Research and present an example of a business operating in a monopolistic market

Chapter 25: Monopolistic competition and Oligopoly (Weeks 12-13)

1. Monopolistic Competition

Features Similar to pure Competition

a. Many sellers each with a relatively small percentage of market share

b. Freedom of entry and exit due to relatively small size of firms

c. Zero economic profit in the long run (P = ATC)

Features Similar to Monopoly

a. Product differentiation (e.g. quality, packaging, brand name, location, service, etc.)

b. Some control over price due to product differentiation and brand loyalty –therefore, downward sloping demand curve

c. Allocative and productive inefficiency

2. Price and Output Determination Under Monopolistic Competition KEY GRAPH figure 25-1 Page 519

a. Due to product differentiation and a smaller number of rivals compared to pure competition, a monopolistic competitor does not have a perfectly elastic demand curve like a perfectly competitive producer. On the other hand its demand curve is more elastic than a pure monopolist because of the large number of competitors.

b. Like all other firms, a monopolistic competitor will maximize its profit or minimize his loss where MR = MC. If there are short-run economic profits, new firms will enter the industry which will cause an individual firm’s demand curve (and thus, the marginal revenue curve) to shift to the left because each firms will have a smaller share of total demand due to the arrival of more close substitutes. If firms exit, each firm’s demand curve shifts right.

c. Long-run equilibrium under monopolistic competition requires that the firm’s demand curve be tangent to its average curve where economic profit will be zero (normal profits only). If output were any greater or less than this long equilibrium, average cost would be greater than price and the firm would have economic losses. Only where P = ATC there no longer be an incentive to enter the industry. However, note that this is NOT productive efficiency since P > minimum ATC at this point where demand is downward sloping.

3. An oligopoly is a market dominated by a few sellers (of a homogenous or differentiated product) at least several of which are large enough relative to the total market to be able to influence price. Mutual interdependence is important in oligopolies as each firm’s profit depends upon the price and sales strategies, but also those of its rivals. Like a monopoly, there are many barriers to entry.

4. The Kinked Demand Curve Model KEY GRAPH Figure 25-4 Page 528

If one firm in an oligopoly decides to lower its price, t is likely the other two firms will also lower their prices in order to prevent their customers from switching companies (thus, the relevant demand curve for price cuts would be inelastic). If, on the other hand, one firm decides to raise its price, it is likely the other two firms will not increase their prices in order to gain some of that firm’s customers (thus, the relevant demand curve for price increases would be elastic). Due to the kinked demand curve, each oligopolist has an incentive not to change prices. If one firm raises its prices, the others won’t and its total revenue will fall (elastic demand). If one firm lowers its prices, the others will too and its total revenue will fall (inelastic demand).

5. One specific type of oligopoly is a cartel or a group of sellers of a product who have joined together to control its production, sale, and price in the hope of obtaining the advantages of a monopoly. (e.g. OPEC – the Organization of Petroleum Exporting Countries). If a cartel is successful, it may end dup charging monopoly prices and obtaining monopoly profits, but without any offsetting benefits of economies of large-scale production since each firm operates separately.

Unit Activity: Research and present an example of a business operating in an oligopolistic market

Chapter 27: The Demand For Resources and (Weeks 14-15)

Chapter 28: Wage Determination

1. The expenditures firms make in acquiring economic resources flow as wage, interest, rent, and profit (WIRP) to those households which supply these resources (labor, capital, land, and entrepreneurship).

2. Marginal Productivity Theory of Resource Demand

a. The marginal revenue product (MRP) of an input (e.g. labor) is the additional revenue that the producer earns from the increased sales when she uses an additional unit of the input.

MRP = MP (marginal product) x Price of Product or the change in total revenue/change in resource quantity

b. The marginal resource cost (MRC) is the amount by which each additional unit of a resource adds to the firm’s total (resource) cost. In equation form:

MRC = change in total (resource) cost/change in resource quantity

c. When the marginal revenue product (MRP) of an input exceeds its price, the firm can increase profits if it uses more of that input. Similarly, when the marginal revenue product of the input is less than its price, the firm can increase profits by using less of that input. Only when the MRP of an input has been reduced (by diminishing returns) to the level of the MRC (i.e. the price of the input) has the proper amount of the input been employed, because then the firm will be wasting no opportunity to add to its profit.

According to the optimal purchase rule, the optimal quantity of an input is where MRP = MRC.

(Note: this is the same profit-maximizing principle of MR = MC for firms in the product market).

d. MRP as a Resource Demand Schedule Figure 27-1 Page 567

The demand curve for any input is the downward-sloping portion of its marginal revenue produce (MRP) curve and indicates the number of workers the firm would hire at each possible wage rate.

e. The wage rate (MRC) in a perfectly competitive resource market is established by the market forces of supply and demand. In a perfectly competitive resource market, each firm hires such small fraction of workers, it cannot influence the market wage rate (i.e. it is a “wage taker” not a “wage maker.”) Thus, resource “price” (the market wage rate) and resource “cost” (marginal resource cost) are equal for a firm hiring a resource in a purely competitive labor market. KEY GRAPH 28-3 Page 586 (reproduced below).

3. Determinants of Resource Demand

a. price of the product: Because the demand for labor (like other inputs) is a derived demand, anything that raises or lowers the demand for a particular product will tend to raise or lower the wages of the workers that produce that product. Here are the linkages:

--An increase or shift right in the demand curve for a product results in

--an in increase n the price of the product and

--an increase in marginal revenue which increases MRP and

--shifts right the demand curve(MRP) for factors used in producing that commodity.

b. Marginal physical product: A worker’ MPP or productivity depends on several factors, including a worker’s ability, degree of effort, and other factors of production she has to work with (e.g. technology, natural resources, etc.). An increase in productivity will increase MRP and thus increase the demand for the resource.

4. change in quantity demanded for a resource A common error occurs when students think that resource demand changes due to change in the wage rate. However, this is NOT a change in demand (a shift in the MRP), but a movement along the MRP curve. If wages increase in the labor market, the quantity demanded for cupcake workers would decrease.

5. Optimal Input combinations

a. A firm is producing a specific output with the least-cost combination of resources when the last dollar spent on each resource yields the same marginal product. In equation form, for any two inputs, such as capital (c) and labor (l) a competitive firm will minimize its total cost of a specific output when

MP c/P c = MP l / P l

b. In a purely competitive resource market, the profit-maximizing condition is MRP = MRC where the MRC was equal to the resource price (P). In competitive markets, a firm will therefore achieve its profit-maximizing combination of resources when each resource is employed so that MRP = P = 1. If the firm is in a profit-maximizing position, it MUST be using the least-cost combination of inputs. However, the converse is NOT true. If a firm is operating at least cost, it may not be operating at the output that maximizes profit.

Chapter 30: Government and market Failure: Public Goods and Externalities (Week 16-17)

1. An efficient allocation of resources requires that each product’s price be equal to its marginal cost or P = MC. In a free market, the price of any good reflects the money value to consumers of an additional unit (its marginal utility or MU). Similarly, the marginal cost (MC) measures the value (opportunity cost) of the resources needed to produce an additional unit of the good. If prices are set equal to marginal costs, then consumers, by using their own money in the most effective way to maximize their own satisfaction, will automatically be using society’s resources in the most effective way. That is, the market in pure competition will satisfy the MC = MU rule for efficient resource allocation.

2. Many economic activities provide incidental benefits to others for whom they are not specifically intended. A positive or beneficial externality (spillover benefits) provides pleasure to people who do not pay (a free ride) whereas a negative or detrimental externality (spillover costs) imposes a cost on others. Figure 30-2 Page 625

3. The presence of externalities causes the price system to misallocate resources because some of the costs and benefits of economic activities are left out of the profit calculation. If a firm imposes a cost on others (e.g. polluting a river) for which it does not have to pay, it will use up more resources than socially desirable. Similarly, if a firm provides benefits to others for which it receives no payment (e.g. street music) it will allocate too few resources to the activity, even if socially desirable.

a. Negative externalities. In figure A below, we can illuminate this concept by introducing the concept of marginal social cost (MSC) which includes a) marginal private cost (MPC) which is the share of marginal cost caused by an activity that is paid for by the persons who carry out the activity; and b) incidental cost, which is the share borne by others. With negative externalities, since neither the producer nor immediate consumers pay for these costs, there is an overallocation of resources devoted to theses goods. With negative externalities, MSC > MPC. If in equilibrium, efficient resource allocation occurs when MU = MPC, then when negative externalities exist, MSC > MU, and society would be better off if output of the product were produced. That is, smaller outputs than those that maximize profits would be socially desirable. Three basic solutions to this problem of negative externalities include

i) government tax on the producer’s good/service (e.g. cigarette tax) which will increase costs, shift the MPC left, and increase price and reduce output until the MPC curve coincides with the MSC curve

ii) legal restriction on the sale/reduction of item

iii) lawsuits

b. Positive externalities In figure B below, MSC < MPC due to spillover benefits. If MU = MPC, then MU > MSC and society would be better off if output of the product were increased. That is, lager outputs than those that maximize profits would be socially desirable; however, since the producer does not receive financial compensation for these spillover benefits, she ahs no incentive to increase production. There are three basic solutions to this problem of positive externalities:

i) Subsidies to the producer of the good/service which will reduce costs, shift the MPC curve to the right, and decrease prices and increase output until the MPC curve coincides with the MSC curve.

ii) Subsidies to the buyers of the good/service

iii) Government provision of the good/service using tax dollars.

4. Public Goods – A second area in which the market fails to perform adequately is in the provision of public goods. Public goods contrast with private goods in two important.

a. Depletability: Unlike a private good, a public good’s benefits are not depleted by an additional user

b. Excludability: Unlike a private good, is generally difficult or even impossible to exclude people from the benefits of a public good.

c. There are two implications of these characteristics of public goods.

--Since non paying users usually cannot be excluded from enjoying a public good, suppliers of such goods will find it difficult or impossible to collect fees for the benefits they provide (a “free rider” problem). In essence, people will not pay for what they can get for free and businesses will not give away goods/services for nothing.

--Since the supply of a public good is not depleted by an additional user, the marginal (opportunity) cost of serving an additional user is zero. With marginal cost equal to zero, the basic principle of optimal resource allocation (P = MC) calls for provision of public goods and services to anyone who wants them at no charge.

Thus, not only is it often impossible to charge a market price for a public good, it is often undesirable as well since any non zero price would discourage some users form enjoying the public good. This would be inefficient, since one more persons’ enjoyment of the good costs society nothing. As a result, the government supplies many public goods.

Appendix I: Term Paper

Microeconomics Term Paper

Overview:

This paper is designed to be a position paper on a contemporary microeconomic issue. You are required to select an issue that has social significance in today’s society and take a stance on that issue using economic reasoning as the foundation of your argument. All research will be from sources no earlier than September 1, 2004 and will be properly cited.

Research Paper:

The paper will have 3 basic components:

1) A detailed description of the problem

2) A clear position about the issue

3) A recommendation to the government about how to handle the position. (Anti-Trust Legislation for Monopolies, Minimum Wage for labor e.g.)

Article Analyses:

You will be required to turn in 6 Article Analyses (1 per week) as the foundation for your paper. You will use the designated summary sheet, including each of the following:

1. Name of the article

2. Source of the article-including page number, website, or location of the article.

3. Date of the article

4. Is the source of the article in any way bias-why?

5. Summary

a. What does the article say?

b. Is the source credible?

c. Do you agree or disagree with the article and why?

d. How will you use the information for your paper?

Requirements:

Typed 5-6 pages

Bibliography

Title Page

9 Sources (Including 6 Article Analyses)

Grading:

Topic: 5 points

Article and Analysis: 5 points each (30 points)

Title Page: 5 points

Bibliography: 10 points

Term Paper: 50 points

Total Points: 100 points

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download