MicroEcon Prin Notes

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Principles of Microeconomics

1 Chapter 1: Ten Principles of Economics

The study of economics is centered around the allocation of resources (land,labor, capital, etc.). The management of these resources is challenging dueto scarcity. This scarcity means that the limited resources available in theeconomy are unable to produce all the goods and services that people wishto have. Economics is the study of how society manages its scarce resources.The Economic Problem is allocating scarce resources in the face of unlimitedwants.

Although we will be covering several topics throughout the courses thatare some basic principles which will reoccur throughout the term. These tenprinciples form the basic understanding of economic ideas.

1.1 Principle 1: People Face Trade-offs

The expression There aint no free lunch is has some truth. Every choicehas some trade-off whether it be money, time or other things. One commonexample of a trade-off is the efficiency vs equality trade-off. Efficiency in-volves moving resources to the highest valued uses. Equality involves spread-ing these resources equally across the population. When the government re-

distributes labor income taxes to finance unemployment is one example of apolicy that prefers equality over efficiency.

1.2 Principle 2: The Cost of Something Is What YouGive Up to Get It

Because of trade-offs making decisions involves comparing the costs and ben-efits of alternatives. Economics decisions involve taking the highest valueditem. The second highest valued item is called the opportunity cost of thedecision. It is what is given up to select a certain item.

1.3 Principle 3: Rational People Think at the Margin

Economists make the general assumption that people are rational. Rationalmeans that people make decisions purposefully to achieve some objective.

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Total Cost= TotaFixedC+TotalVariableCAverageTC= AvgFixedC+AvgVariableCMC=(deltaTC)/(deltaQuantity)(how much the cost goes up for one more unit prod)


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This simply means people make decisions with their own best interest. This

does not imply that people never make mistakes. Information can change,and some decisions can be rational but eventually appear to be a mistake.Economic decisions are made on the margin. A marginal change is a smallincremental adjustment to an existing plan of action. Agents make theredecisions by comparing the marginal benefit and marginal cost of a decision.Consider and airline that has a 200 passenger plane that cost 100,000. Inthis case the average cost is 500 per person. So should a airline ever sell aticket below 500?? Yes if the plane has 10 empty seats and some standbypassengers are only will to spend 300 for a ticket, should the airline sell thetickets? Yes, because the marginal costs of adding a passenger are low (bagof peanuts, a little extra fuel) as long as these costs are below 300, the airline

will make a profit by selling the seats.

1.4 Principle 4: People Respond to Incentives

An incentive is something that induces a person to act. These things cancome in the form of a punishment or a reward. This mechanism is the keyas to why the price works as such a powerful tool in markets. As the priceof a good goes up, people tend to buy less of the item. Many tax policiesare structured in the form of incentives, just look at recent moves duringthe financial crisis: cash for clunks, 8000 home buyer credit, payroll taxreduction. Sometimes incentives has direct and indirect effects: seat belts.

1.5 Principle 5: Trade Can Make Everyone Better Off

Trade between people, households, or countries allows all parts to specializein there best activities while still satisfying their wants by trading with oth-ers. Competition and specialization allows for lower costs and thus allowseveryone to buy goods at lower prices and have more resources available forother things.

1.6 Principle 6: Markets Are Usually a Good Way to

Organize Economic Activity

Many countries have chosen to solve the Economic Problem by organizinginto a market economy. A market economy is made up of a the individualdecisions of millions or individuals and firms. The firms decide who to hire

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and what to make. Individuals decide which firms to work for and what to

buy with their income. The seemingly unorganized system gain structurethrough the invisible hand. The market price serves as a signal wherebuyer use the price to decide how much to buy and the sellers use the priceto decide how much to sell.

1.7 Principle 7: Governments Can Sometimes ImproveMarket Outcomes

Although government is not needed in most situations to allocate resources inthe best way. In some cases government action can improve market outcomes.The invisible hand works if the government enforces the rules and maintains

the institutions that are key in a market economy. On of the key provisionsis protected property rights. Property rights are the ability of an individualto own and control scarce resources. There are also situations where we seea market failure where the market fails to allocate resources efficiently. Onepossible cause is an externality where the action of one party influences thewell being of another and this situation is not captured in the market price.Another failure situation is when market power becomes concentrated in oneor a few individuals who can dictate market prices.

1.8 Principle 8: A Countrys Standard of Living De-

pends on Its Ability to Produce Goods and Ser-vices

In 2008, the average US citizen had an income of 47,000. In the same year, theaverage Mexican earned 10,000 while the average Nigerian earned about 1400.Not surprisingly high income countries also tend to have high quality of life.What explains these differences? Productivity. Productivity is the quantityof goods and services produced from each unit of labor input. To boostthe standard of living policymakers need to raise productivity by ensuringworkers are well educated and equipped.

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1.9 Principle 9: Prices Rise When the Government

Prints Too Much MoneyInflation is the increase in the overall price level of the economy. There is alarge tie between the an increase in the quantity of money and inflation.

1.10 Principle 10: Society Faces a Short-Run Trade-offbetween Inflation and Unemployment

Beyond the link between the money supply and inflation, there also appearsto be a short-run tie between inflation and unemployment. The general chainof events goes as:

1. Increasing the amount of money in the economy stimulates the overalllevel of spending and thus the demand for goods and services.

2. Higher demand may over time causes firms to raise their prices, butin the meantime, it also encourages them to hire more workers andproduce a larger quantity of goods and services.

3. More hiring means lower unemployment.

2 Chapter 2: Thinking Like an Economist

We can now proceed to discuss how an economists approaches the world andthe methodology used to address questions about it.

2.1 The Economist as Scientist

The first thing to observe is that an economists is a social scientist. As ascientist they tend to take a very systematic approach to questions, ideas,and theories. Many of the same techniques in style of thinking as biologists,chemist, etc, also apply to economists.

2.1.1 The Scientific Method: Observation, Theory, and More Ob-servation

Economics is a social science, and as a science there is a certain approach mosteconomists tend to use. The final objective of most economic endeavors is

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policy analysis. The approach to studying policy goes through the following

steps:

1. Know the data: Gather available data about the question of interest.

2. Proposes a theory: Uses a graph, words, or mathematical model of theeconomy.

3. Test the theory: Make sure that the proposed theory does a reasonablejob of matching the characteristics of the economy

4. Update theory if necessary and repeat steps 2 and 3.

5. Conduct the policy experiment: Send the policy through your modeland see the implied outcomes.

2.1.2 The Role of Assumptions

The role of assumptions is to simplify the complexities of the real world.Assumptions are typically made about side issues that are not directly tiedto the question that is being studied. Many times assumptions are built offof some empirically visible features taken from data from the real world.

2.1.3 Economic Models

Economists use model to learn about the world. The typical modeling ap-proach of economists is to use equations and diagrams. In this class we willfocus on graphical models. Just like any other field, economic models willdescribe only those details that are thought to be important to the currentanalysis. Other complications from the real world are omitted to keep thefocus on the main area of study.

2.1.4 Our First Model: The Circular-Flow Diagram

One simple way to get a visual of the entire economy is to build a circular

flow diagram. We simplify the world into two decision makers: householdsand firms. Firms produce goods and services using inputs from the house-holds (factors of production). Households own the factors of production andconsume all the goods produced by the firms. Households and firms inter-act into two types of markets: goods markets and resource markets. In the

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goods market firms are the sellers and the households are the buyers. In the

resource markets households are the sellers and the firms are the buyers. Thecircular flow simple tracks all pathways between households and firms.

2.1.5 Our Second Model: The Production Possibilities Frontier(PPF)

The production possibilities frontier is a graph that shows the combinationof outputs that the economy can possibly produce given the available factorsof production and the available production technology. This 2 dimensionalgraph has quantity of a good on each axis. Any combination outside of thePPF is deemed to be infeasible and not a possible allocation for the currenteconomy. An combination of goods on the PPF is an efficient allocation.

Another useful tool of the PPF is it allows us to visual the opportunity costassociated with the trade-off between making difference amounts of goods.Suppose there are two efficient allocations of Cars and Computers such thatA = (600, 2200) and B = (700, 2000) are both efficient. In this situationthe tradeoff for producing 100 additional cars is an opportunity cost of 200computers. The opportunity cost of cars varies across the PPF. For highernumber of cars each additional car would have a growing opportunity cost(i.e. you have to give up more and more computers on the margin).

Improvements in technology or additional resources can be shown as anoutward shift in the PPF. This makes some infeasible allocation now feasibleand currently efficient allocations now become inefficient.

2.1.6 Microeconomics and Macroeconomics

We generally break economics into two broad subfields: microeconomics andmacroeconomics. Microeconomics is the study of how individual firms andhouseholds make decisions and interact in specific markets. Macroeconomicsis the study of economywide phenomena.

2.2 The Economist as Policy Adviser

The final objective of most economic endeavors is policy analysis. Lets take

an introductory look are the economists role as a policy advisor.

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2.2.1 Positive versus Normative Statements

Positive economics what is; testable statements price x goes up people buy xless Normative economicswhat should be; statements that cannot be tested.Alcohol ads should not be allowed. Value judgements.

2.2.2 Economists in Washington

There are many economists who work in Washington D.C. The President hashis own Council of Economic Advisors. There are also several economistswork in other DC based organizations: Office of Management and Budget,Department of the Treasury, Department of Labor, Department of Justice.In addition we have the Congressional Budget Office, the Federal Reserve,the Bureau of Economic Analysis, the Bureau of Labor Statistics. This doesnot include other agencies like the IMF, the World Bank, the NIH, the FCC,and other. All of this organizations give economists a potential voice insteering policy.

2.2.3 Why Economists Advice is not Always Followed

Political realities and economic realities are different. Sometimes policy thatmay be economically attractive can involve a tradeoff that is undesirable to amajority of the population. In political environment, 51 percent of the votewins.

2.3 Why Economists Disagree

Although they agree on many things, there are several areas of disagreementamong economists. Sometimes they disagree about positive theories aboutthe way the world works. Sometime they disagree in values and have differentnormative views about what policy should try to accomplish.

2.3.1 Differences in Scientific Judgements

Sometimes economists disagree about the validity of alternative theories orabout important parameters in a model. Example: business cycles.

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2.3.2 Differences in Values

Sometimes economists have different values on what a policy should try andaccomplish: equality versus efficiency.

2.3.3 Perception versus Reality

This being said there are many things which economists generally agree Table1 on page 36 gives a list of many things.

2.4 Lets Get Going

We have gone through the basic ideas of economic thinking, lets now get into

the details started with thinking like an economist. Appendix on Graphing,if uncomfortable with graphs please review.

3 Chapter 3: Interdependence and the Gains

from Trade

As you go through your day you are using goods and services which wereproduced from people and firms all over the country if not all over the world.All of these benefits you are enjoying come from the gains from trade.

3.1 A Parable for the Modern Economy

Lets set up a simple world to get at the gains from trade and related issues.There are two people in the world: a cattle rancher and a potato farmer.Suppose the cattle farmer and potato farmer can both produce some beefand some potatoes. They just specialize in their obvious good, but canproduce some of the other.

3.1.1 Production Possibilities

Suppose both the farmer and the rancher can work 8 hours per day andcan devote time to raising cattle, growing potatoes, or a combination of thetwo. For the farmer if he spends all 8 hours raising cattle he can produce 8ounces of beef, on the other hand if he devotes all his time to Potatoes hecan produce 32 ounces of potatoes. If he evenly splits his time he makes 4

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ounces of beef and 16 ounces of potatoes. In other the farmer can make 1

ounce of beef per hour and 4 ounces of potatoes per hour. For the rancher ifhe spends all 8 hours raising cattle he can produce 24 ounces of beef, on theother hand if he devotes all his time to Potatoes he can produce 48 ouncesof potatoes. If he evenly splits his time he makes 12 ounces of beef and 24ounces of potatoes. In other the rancher can make 3 ounce of beef per hourand 6 ounces of potatoes per hour.

3.1.2 Specialization and Trade

Now consider the situation where both agent split their time evenly. Thiswould have world output of 16 ounces of beef and 40 ounces of potatoes.

Now suppose the rancher approaches the farmer with an idea. Suppose therancher suggests that the farmer devote all of his time to potatoes and hespends his time producing 18 ounces of meat and 12 ounces of potatoes. Ifthis occurs, we should have 18 ounces of meat and 44 ounces of potatoes.We could both gain an extra unit of both goods in the form of consumption.Seems impossible, but it does happen the world PPF moves out in bothgoods if these agents move towards their specializations.

3.2 Comparative Advantage: The Driving Force of Spe-cialization

How if the rancher is better at both raising cattle and growing potatoes, doesthe world improve he trades with the smaller farmer. The key is the conceptof comparative advantage. The question is about costs, who produces whatgoods at lowest costs.

3.2.1 Absolute Advantage

An agent has an absolute advantage if it has the ability to produce a goodusing fewer inputs than any other producer. In this case the rancher has theabsolute advantage he needs only 20 minutes to produce an ounce of meatwhile the farmer needs 60 minutes. In the case of potatoes, the rancher needs10 minutes for an ounce of potatoes while the farmer needs 15 minutes perounce.

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3.2.2 Opportunity Cost and Comparative Advantage

There is a second way to look ate the cost of producing potatoes. Rather thanlooking at inputs we can look at the opportunity cost. In this situation welook explicit at the trade-off involved with producing individual items. In thecase of the Farmer the production of an additional unit of beef involves givingup 4 ounces of potatoes, for the rancher this additional production involvesgiving up 2 ounces of potatoes. Thus the cost of producing beef are lower forthe rancher, thus he has a comparative advantage in beef production. If weswitch the analysis, if the farmer produces and additional unit of potatoeshe must give up 1/4 ounce of beef, for the rancher and additional unit ofpotatoes costs 1/2 unit of beef. So the cost of potato production are lower

for the rancher and he has comparative advantage in potato production.A comparative advantage is the ability to produce an item at the lowestopportunity cost.

3.2.3 Comparative Advantage and Trade

Gains from trade are made from comparative advantage, not absolute advan-tage. When each agent specializes in there comparative advantage, the totalproduction of the economy increases. Increasing the size of the economy leadsto the potential for all parties being made better off. In this case when therancher went to more meat production and the farmer went to more potato

production we saw an increase in the production and consumption of bothgoods.

3.2.4 The Price of Trade

Both parties can be made better off from trade, but what sets the price oftrade (ie how much of the benefit each party receives). The important thingto notice is that the gain need not be split equally.

3.3 Conclusion

We now have a basic understanding of the interdependence and gains fromtrade. Now we can begin to look at how parties negotiate their actionsand how prices are determined. We thus can move on to looking at marketbehavior.

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4 Chapter 4: The Market Forces of Supply

and DemandThis chapter introduces the key ideas behind the forces of Supply and De-mand and how these forces help to determine Market prices and quantities.

4.1 Markets and Competition

Supply and demand are the behavior of people as they interact with eachother in competitive markets.

4.1.1 What is a Market?A market is a group of buyers and sellers of a particular good or service.Market take on many different forms. Some are highly organized wherebuyers and sellers all meet at a specific time and place. So are less organizedwhether agents meet in many different locations.

4.1.2 What is Competition?

Competition is a situation the buyers know there are several sellers fromwhich to choose and each seller is aware that its product is similar to thatoffered by other sellers. No one seller or buyer has the power to determine

the market price. A competitive market is a market in which there are manybuyers and many sellers so that each has a negligible impact on the marketprice. A seller has little reason to offer a below market price and offeringmore would simply drive consumers away. In this chapter we will assumemarkets are perfectly competitive which means that (1) the goods offered bythe sellers are all identical and (2) the buyers and sellers are so numerousthat no single buyer or seller has any influence on the market price: they arewhat is called price takers. At the market price buyers can buy all they wantand sellers can sell all they want.

4.2 DemandWe begin by looking at the behavior of buyers.

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4.2.1 The Demand Curve: The Relationship between Price and

Quantity DemandedThe quantity demanded of any good is the amount of the good that buyersare willing and able to purchase. As the price of a good changes so doesthe quantity demanded. If the market price increase the quantity demandeddecreases and vice versa if the market price decreases. This relationship isgoverned by the law of demand which is the claim that, other things constant,the quantity demanded of a good falls when the price of the good rises. Thisrelationship can be summarized in table and graph form. A demand scheduleis a table that shows the relationship between the price of a good and thequantity demanded. The information from this table can be graphed into a

demand curve.

4.2.2 Market Demand versus Individual Demand

Market Demand is simply the summation of Individual Demands. You simplyhorizontally sum the demand curves of the individual curves to get the marketdemand.

4.2.3 Shifts in the Demand Curve

Because the demand curve holds other things constant, it need not be stableover time. As things change overtime, the demand curve can shift in orout. A rightward shift in the demand curve represents an increase in marketdemand.

1. Income an increase in income increases Market Demand: if the de-mand for a good moves with income it is a normal good, if an incomeincrease, decreases demand the good is inferior.

2. Price of Related Goods if the drop in the price of a related goodincreases demand for the current good: these two goods are comple-ments (peanut butter and jelly). if a drop of the price of a relatedgood decreases the demand for the current good: theses two goods aresubstitutes (Coke vs Pepsi).

3. Tastes increased tastes for a good increases demand

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4. Expectations if you expect the price of the good to rise in the future,

your demand for the good today will increase.5. Number of Buyers more buyers means an increase in demand.

4.3 Supply

Now we can look at the behavior of the sellers.

4.3.1 The Supply Curve: The Relationship between Price andQuantity Supplied

The quantity supplied of any good or service is the amount that sellers arewilling and able to sell. As the price of a good changes so does the quantitysupplied. If the market price increase the quantity supplied increases andvice versa if the market price decreases. This relationship is governed by thelaw of supply which is the claim that, other things constant, the quantitysupplied of a good rises when the price of the good rises. This relationshipcan be summarized in table and graph form. A supply schedule is a table thatshows the relationship between the price of a good and the quantity supplied.The information from this table can be graphed into a supply curve.

4.3.2 Market Supply versus Individual Supply

Market Supply is simply the summation of Individual Supply curves. Yousimply horizontally sum the supply curves of the individual curves to get themarket supply.

4.3.3 Shifts in Supply

Because the supply curve holds other things constant, it need not be stableover time. As things change overtime, the supply curve can shift in or out. Arightward shift in the supply curve represents an increase in market supply.

1. Input Prices: An increase in input prices, decreases the supply curve(leftward shift)

2. Technology: An improvement in technology decreases the costs of pro-duction and increase the supply curve.

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3. Expectations: if the firm expects the price of the good to rise in the

future they will decrease supply today when the price is low.4. Number of Sellers: the higher the number of suppliers the greater is

the supply

4.4 Supply and Demand Together

We can now combine the behaviors to see how market price and quantity aredetermined.

4.4.1 Equilibrium

Market equilibrium is at the position where market supply and market de-mand intersect. The price at this point is the equilibrium price and thequantity at this point is the equilibrium quantity. At the equilibrium price,the quantity of the good that buyers are willing and able to buy exactlymatches the quantity that sellers are willing and able to sell. This is alsocalled the market clearing price. If you are at a price greater than equilibriumthe quantity supplied of the good will exceed the quantity demanded for thegood thus giving us a surplus of the good. If you are at a price less thanequilibrium the quantity supplied of the good will be less than the quantitydemanded for the good thus giving us a shortage of the good.

4.4.2 Three Steps to Analyzing Changes in Equilibrium

There are three steps to understanding a change in market equilibrium.

1. Decide whether the event shifts the supply or demand or both.

2. Decide in which direction the curve shifts.

3. Use the Supply-and-Demand diagram to see how the shift changes theequilibrium price and quantity.

4.4.3 Examples of Changes in Market Equilibrium

1. A Change in Market Equilibrium due to a change in Market Demand

2. Shifts in Curves versus Movements along Curves

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3. A Change in Market Equilibrium due to a change in Market Supply

4. Shifts in Both Supply and Demand

5 Chapter 5: Elasticity and Its Application

Thus far the Law of Demand tells us if a shock increases the price of the good,consumers are going to buy less. But suppose you wanted to know exactlyhow much less. This is answered by a concept called elasticity. This measureshow much buyers and sellers respond to changes in market conditions. Wewill find the concept useful in several applications.

5.1 The Elasticity of Demand

We know that we the price of a good decreases the quantity demanded forthe good increases. To get a sense on the quantitative size of the effect weneed to calculate the Price Elasticity of Demand for this good.

5.1.1 The Price Elasticity of Demand and Its Determinants

The Price Elasticity of Demand measures how much the quantity demandedof a good responds to a change in the price of that good. Demand is said tobe elastic if the quantity demanded changes significantly with price changes.Demand is said to be inelastic if the quantity demanded changes slightly withprice changes. Several different factors can influence the price elasticity ofdemand.

Availability of Close Substitutes: Goods that tend to have close sub-stitutes tend to be more elastic than those that do not. Butter is moreelastic than eggs.

Necessities versus Luxuries: Necessities tend to be inelastic and luxuriestend to be elastic. Gasoline versus vacations.

Definition of the Market: Narrowly defined markets tend to be moreelastic than broad markets. Food is a broad category is inelastic, Yel-low Duck Peeps would be very elastic because of the ease of finding asubstitute.

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Time Horizon: Things are more elastic in the long run. Gasoline short

run versus gasoline long run. The long run has more substitutes.

5.1.2 Computing the Price Elasticity of Demand

Now that we have a basic understanding of elasticity, lets now discusshow we actually compute elasticity. It is all about calculating percentagechange. Price Elasticity of Demand = (Percent Change in quantity de-manded)/(Percent Change in price)

Suppose as the price of coffee increases from 2 to 2.50 the quantity de-manded for coffee drops from 50 to 40. In this case the Price Elasticity of De-mand for Coffee would be ((2.50-2)/2)*100 /(40-50)/50))*100 which equals

25/-20 = -1.25. Given law of demand, price moves inversely with quan-tity demanded, the price elasticity of demand should be a negative number.Warning: the book drops the negative sign, I would not recommend that.

5.1.3 The Variety of Demand Curves

We typically describe demand curves by their elasticity. Demand is consid-ered elastic if the elasticity is greater than 1 in absolute value. Demandis considered inelastic when its absolute value is less than 1. If elasticityhappens to be 1 then demand is unit elastic. As elasticity rises the demandcurve becomes more horizontal. See Figure 1 on page 93. Inelastic curves are

vertical in nature and elastic curves tend to be more horizontal in nature.

5.1.4 Total Revenue and the Price Elasticity of Demand

Total revenue is the amount paid by buyers and received by sellers of a good,computed as the price of the good times the quantity sold. If demand isinelastic, then an increase in price would lead to a small decrease in quantitydemanded. Overall total revenue would increase. In increased revenue fromthe higher price more than offsets the drop in quantity. The story is reversedfor elastic demand curves. With elastic demand total revenue is increased bylowering the price of the good.

5.1.5 Elasticity and Total Revenue along a Linear Demand Curve

With a linear demand curve, the demand curve has a constant slope, it doesnot have constant elasticity. Price elasticity drops with the price of the good.

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This clearly shows elasticity is not the slope of the demand curve.

5.1.6 Other Demand Elasticities

In addition to price elasticity, we can use other elasticities to describe buyerbehavior.

The Income Elasticity of Demand: Income Elasticity of Demand is ameasure of how much the quantity demanded of a good responds to achange in a buyers income, computed as percentage change in quantitydemanded divided by percentage change in income. Most goods havea positive income elasticity (normal goods).

The Cross-Price Elasticity of Demand: Cross-price Elasticity of De-mand is a measure of how much quantity demanded of a good re-sponds to a change in the price of another good, computed as per-centage change in quantity demanded divided by percentage change inthe price of the other good. Complements have a negative cross-priceelasticity, substitutes have a positive cross-price elasticity.

5.2 The Elasticity of Supply

We know that we the price of a good decreases the quantity supplied for thegood decreases. To get a sense on the quantitative size of the effect we need

to calculate the Price Elasticity of Supply for this good.

5.2.1 The Price Elasticity of Supply and Its Determinants

The Price Elasticity of Supply measures how much the quantity supplied ofa good responds to a change in the price of that good. Supply is said tobe elastic if the quantity supplied changes significantly with price changes.Supply is said to be inelastic if the quantity supplied changes slightly withprice changes. Several different factors can influence the price elasticity ofsupply. The key determinant is the length of time, in the short run supplyis inelastic as suppliers have very limited ways to adjust production.

5.2.2 Computing the Price Elasticity of Supply

Now that we have a basic understanding of elasticity, lets now discuss howwe actually compute elasticity. It is all about calculating percentage change.

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Price Elasticity of Supply = (Percent Change in quantity supplied)/(Percent

Change in price). Given law of supply, price moves directly with quantitysupplied, the price elasticity of supply should be a positive number.

5.2.3 The Variety of Supply Curves

We typically describe supply curves by their elasticity. Supply is consideredelastic if the elasticity is greater than 1 in absolute value. Supply is consideredinelastic when its absolute value is less than 1. If elasticity happens to be 1then supply is unit elastic. As elasticity rises the supply curve becomes morehorizontal. See Figure 5 on page 100. Inelastic curves are vertical in natureand elastic curves tend to be more horizontal in nature.

5.3 Applications of Supply, Demand, and Elasticity

Lets now look at a variety of applications using elasticity.

5.3.1 Can Good News for Farming Be Bad News for Farmers

Consider an improvement in farmer technology which leads to an increasein the Supply of wheat. The supply and demand for wheat are both inelas-tic. This increase in supply causes a large drop in the market price witha relatively small increase in quantity. This would lead to a drop in total

revenue.

5.3.2 Does Drug Interdiction Increase or Decrease Drug-RelatedCrime

Suppose the government institutes tougher penalties on illegal drugs, reducessupply of drugs. Suppose the government institutes drug education on ille-gal drugs, reduces demand of drugs. Now the effect on illegal drug marketdepends on the elasticity of demand, if inelastic, tougher penalties wouldactually increase total revenue in this market.

6 Chapter 21: The Theory of Consumer Choice

Thus far we have summarized consumer behavior with demand curves. Butthere is more to what lies a demand curve what set the height of the de-

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mand curve. The theory of consumer choice will allow us to gain a deeper

understanding of buyers decisions.

6.1 The Budget Constraint: What the Consumer canafford

As stated in the beginning of the course, consumers have unlimited wantsthey always want more goods and services. The main limitation to thesewants is typically their financial resources (income). Consider a situationwhere a consumer has 20 dollars in their wallet and wants to order foodthrough a fast-food restaurant. In this case hamburgers cost 4 dollars andFrench Fries cost 2 dollars. If the consumer spends their entire income on

hamburgers they can buy at most 5 hamburgers. If they choose only FrenchFries they could order 10 orders of fries. They could also afford any combi-nation in between as long as the total costs is no more than 20 dollars. Theline that traces out these combinations is called the consumers budget con-straint. The slope of this line represents the trade-off between goods whichin this case is 1 hamburger for every 2 orders of fries.

6.2 Preferences: What the Consumer Wants

We know what combinations the consumer can select. The next questions

is how do they choose the best one? That choice depends on consumerpreferences.

6.2.1 Representing Preferences with Indifference Curves

An indifference curve represents various consumption bundles that give theconsumer equal levels of satisfaction. We can draw an indifference curvewhich shows combinations of hamburgers and fries which yield equal satis-faction. The slope along the indifference curve equals the rate at which theconsumer is willing to substitute one good for another. The rate is calledthe marginal rate of substitution (MRS). In this case the MRS measures how

many hamburgers the consumer will have to be compensated for giving upan order of fries. The consumer is equally satisfied along the indifferencecurve. However, the consumer would be more satisfied with higher indiffer-ence curves which are combinations of higher satisfaction. There are somegeneral properties for indifference curves.

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6.2.2 Four Properties of Indifference Curves

Indifference curves represent preferences and follow four standard rules.

Higher indifference curves are preferred to lower ones.

Indifference curves are downward sloping.

Indifference curves do not cross.

Indifference curves are bowed inward.

6.3 Optimization: What the Consumer Chooses

We have seen the budget constraint and consumer preferences. We can nowcombine them together to see the optimization problem that consumers arecompleting.

6.3.1 The Consumers Optimal Choices

The optimization of the consumer is to attain the highest indifference curvewhich intersects the budget constraint. In the standard situations this willoccur with an indifference curve which is just tangent to the budget con-straint. At the point of tangency, the slope of the budget constraint will be

equal to the slope of the indifference curve (MRS). Given the slope of thebudget constraint is equal the relative price between the two goods, at theoptimal decision the relative price of the goods equates the MRS which isthe consumers valuation of the tradeoff between the two goods.

6.3.2 How Changes in Income Affect the Consumers Choices

An increase in income would be represented as an outward shift in the budgetconstraint, suppose income increases from 20 to 22 dollars. The consumercan now achieve a higher indifference curve and a higher consumer of bothgoods.

6.3.3 How Changes in Prices Affect the Consumers Choices

A change in the price of a good will rotate the budget constraint. If theprice of hamburger drops from 4 dollars to two dollars, the feasible number

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of hamburger that the consumer could possibly consume increases from 5 to

10, the budget constrain would rotate in the direction of the cheaper good.This outward rotation of the budget constraint will increase the consumptionof the cheaper good, the effect on the other good depends on preferences.

6.3.4 Deriving the Demand Curve

We can use this framework to derive demand curves. This is done by simplyfinding the optimal consumption of a good under several difference prices.As this is done we can use the implied decisions with the prices to map outa demand curve.

7 Chapter 6: Supply, Demand, and Govern-ment Policies

In chapter 5 we studied how markets used Supply and Demand to determinemarket prices and quantities. In this chapter we look at how policy can beused to manipulate these prices and quantities. There are two basic types ofpolicies we will be addressing: price controls, and taxes.

7.1 Controls on Prices

In some markets, the government can impose certain rules on how pricesbehave. The most common types of controls and price ceilings and pricefloors which place upper and lower bounds on the price of a good. There arealso controls which limit how fast a price may change. These policies canhave important implications on market allocations and lead to shortages orsurpluses depending on the policy in place.

7.1.1 How Price Ceilings Affect Market Outcomes

A price ceiling is a legal maximum on a price at which a good can be sold.If the price ceiling is set below the equilibrium price, the final outcome willbe that the good will be sold at the price ceiling. However, at this pricequantity demanded exceeds quantity supplied and thus we face a shortageof the good and the quantity supplied determines how much of the good isactually sold. If the price ceiling is set above the equilibrium price, then is

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it non-binding and the market will move the equilibrium price and quantity.

Common side-effects of price ceilings include: queueing, discrimination basedrationing, low turnover, poor maintenance, etc.

7.1.2 How Price Floors Affect Market Outcomes

A price floor is a legal minimum on a price at which a good can be sold. Ifthe price floor is set above the equilibrium price, the final outcome will bethat the good will be sold at the price floor. However, at this price quantitysupplied exceeds quantity demanded and thus we face a surplus of the goodand the quantity demanded determines how much of the good is actually sold.If the price floor is set below the equilibrium price, then is it non-binding

and the market will move the equilibrium price and quantity.

7.1.3 Evaluating Price Controls

Price controls do reduce market quantities, but for those still in the marketthere are measurable benefits that leads to a tradeoff between these benefitsand the lower quantities.

7.2 Taxes

Another common policy is the government to tax certain goods to generate

revenue. The government tends to use a variety of different taxes that canbe typically broken down into two categories: a sellers tax or a buyers tax.These tax can have large implications on markets.

7.2.1 How Taxes on Sellers Affect Market Outcomes

To study the influence of a sellers tax on a market, think of the same basicsteps as with any other shock to a market. If the tax is imposed on sellersthat should, holding all else constant, increase the costs for the seller andthus lead to a drop in the Supply of the good by the amount of the tax.Given this shock, we can study some implications on taxes. First, the market

quantity of the good will decrease with the introduction of a tax. Second,the equilibrium price of the good will increase. Third, the increase in theprice will not be equal to the total amount of the tax. Although the tax billfrom the government is collected from the sellers, the actual tax incidence,

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who really pays the tax, is shared between the buyers and sellers. Finally,

we can measure the amount of tax revenue is collected by the tax.

7.2.2 How Taxes on Buyers Affect Market Outcomes

To study the influence of a buyers tax on a market, think of the same basicsteps as with any other shock to a market. If the tax is imposed on buyersthat should, holding all else constant, decrease the desire for the buyer topurchase the good and thus lead to a drop in the Demand of the good bythe amount of the tax. Many of the implications of a buyers tax are thesame as a sellers tax. First, the market quantity of the good will decreasewith the introduction of a tax. Second, the equilibrium price of the good

will increase. Third, the increase in the price will not be equal to the totalamount of the tax. Although the tax bill from the government is collectedfrom the buyers, the actual tax incidence, who really pays the tax, is sharedbetween the buyers and sellers. Finally, we can measure the amount of taxrevenue is collected by the tax.

7.2.3 Elasticity and Tax Incidence

The general rule of thumb is whoever is more inelastic will face the largerburden of taxes.

8 Chapter 7: Consumers, Producers, and the

Efficiency of Markets

We have studied how supply and demand determine market prices and quan-tities. We have a sense of how the market allocates goods, but we have yetto discuss whether these allocations are desirable. To get at this we needto study welfare economics. This is the study of how the allocation of re-sources affects economics well-being. We will find that market equilibriumwill indeed maximize the total benefits received by buyers and sellers.

8.1 Consumer Surplus

We begin by looking at the benefits receive from participating in markets.

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8.1.1 Willingness to Pay

Consider the possibility of purchasing a laptop. Four students A, B, C, andD are looking into purchasing the laptop. Before considering the price of thetickets each student has a maximum price at which they would be willingto spend on the laptop. This price represents their willingness to pay andshows how much each buyer values the good. Every student would buy thegood for any price up to a equal to their willingness to pay. Suppose thatstudent A is willing to spend 2000 for a laptop and the current price of thelaptops is 1250. In this case if A buys the laptop they are earning a consumersurplus of 2000 - 1250 = 750. The consumer surplus is the amount a buyeris willing to pay for the good minus the amount the buyer actually pays for

the good. Suppose B values a laptop at 1500, student C values it at 1300,and student D values it at 1000. In this case the 3 students would buy alaptop and student D would not. Student B has a consumer surplus of 250and consumer C has surplus of 50.

8.1.2 Using the Demand Curve to Measure Consumer Surplus

We can use the willingness to pay to line up the students demand for laptops.Graphically, consumer surplus is the vertical distance between the demandcurve and the market price. If smoothed out the total consumer surplus isthe triangle area between the demand curve, y axis, and the market price.

8.1.3 How a Lower Price Raises Consumer Surplus

If the market price drops the triangle gets bigger because the consumer sur-plus for each buyer goes up and thus total consumer surplus goes up.

8.1.4 What Does Consumer Surplus Measure

Consumer surplus measures the perceived benefit that consumer gets fromengaging in the market. The total consumer surplus gives some sense of thebuyers well-being in the market.

8.2 Producer Surplus

This concept measures the benefits for the sellers from participating in amarket. This is similar to consumer surplus.

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8.2.1 Cost and the Willingness to Sell

Consider the possibility of selling a laptop. Four sellers A, B, C, and Dare looking into selling a laptop. Before considering the price of a laptopeach student has a minimum price at which they would be willing to sell thelaptop. This price represents their willingness to sell and shows how muchis costs each seller to produce the good. Every seller would sell the good forany price above their willingness to sell. Suppose that it cost seller A 600 tobuild a laptop and the current price of the laptops is 1250. In this case ifA sells the laptop they are earning a producer surplus of 1250 - 600 = 650.The producer surplus is the amount a seller sells the good minus his willingto sell (costs) for the good. Suppose B has a cost of laptops for 750, seller

C has a costs of 1200, and student D has a cost of 1500. In this case the3 sellers would sell laptops and seller D would not. Seller B has a producersurplus of 500 and seller C has surplus of 50.

8.2.2 Using the Supply Curve to Measure Producer Surplus

We can use the willingness to sell to line up the sellers supply for laptops.Graphically, producer surplus is the vertical distance between the supplycurve and the market price. If smoothed out the total producer surplus isthe triangle area between the supply curve, y axis, and the market price.

8.2.3 How a Higher Price Raises Producer Surplus

If the market price rises the triangle gets bigger because the producer surplusfor each seller goes up and thus total producer surplus goes up.

8.3 Market Efficiency

So, given these measurements of benefits, is the market allocation of resourcesdesirable?

8.3.1 The Benevolent Social Planner

Suppose you could step back and allocate the market. You could chose whoreceives and sells the goods in the market. The benevolent social planneris an all-knowing, well-intentioned planner who allocates the market is sucha way that he wants to maximize the economic well-being of everyone in

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society. How should the planner allocate the market. First he must measure

well-being. One possible measure is to calculate the sum of consumer andproduce surplus which is called total surplus. So,Total Surplus = Consumer Surplus + Producer SurplusTotal Surplus = (Value to Buyers - Price Paid by Buyers) + (Amount

Received by Sellers - Cost to Sellers)or Total Surplus = Value to Buyers - Cost to SellersThe planner could strive to maximize total surplus, and if achieved the

market is considered efficient. Given that the planner knows every sellerscosts and buyers value he can always arrange an efficient allocation.

8.3.2 Evaluating the Market Equilibrium

So, how about the market allocation where the price allocates goods andnot the planner. We can simply draw a market in equilibrium. When thishappens we can see consumer and producer surplus which forms the areato the left of the equilibrium. Is the allocation of goods efficient? Is totalsurplus maximized? Well every buyer to the left of equilibrium has a valueat or greater than the price and every seller has a costs at or below theprices so what we first see is that market allocated goods to those with thehighest value and lowest cost. Also, note that every quantity to the rightof equilibrium is in the opposite position. The cost to the seller exceed theprice and the value to the buyer is below the price. Thus any quantity to

the right would decrease total surplus and should not be allocated. Thus,yes the market outcome is efficient every positive contribution toward totalsurplus receives the good.

8.4 Conclusion: Market Efficiency and Market Failure

In this situation we found that market do generate an efficient allocation, thatdoes not mean that every market will generate an efficient solution. We hadto use a few assumptions in this situation. First, we used perfect competitionwhere no one seller has power over the market price. In some markets a single

or small group of sellers could have market power and potentially distortthe allocation. Second, we assumed that the outcome in the market onlyinfluenced the buyers and sellers in the market. In some real-world markets,the decision of buyers and sellers can affect people who are not participatingin the market. Think about pollution as a classic example. These two ideas

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can lead to the possibility of a market failure where the market is unable to

allocate resources efficiently. We will study this idea in more depth startingin chapter 10.

9 Chapter 8: Application: The Costs of Tax-ation

In this chapter we study how tax influence the welfare of buyers and sellerin a market. In this cost benefit type analysis we need to weigh the lostquantities and drop of total surplus against the amount the tax revenuewhich is collected and used in other, potential welfare improving, ways. We

begin by considering the cost of taxation.

9.1 The Deadweight Loss of Taxation

Recall from our previous work that given a tax of a particular size, the totalquantity of the good allocated in the market will drop. The amount of thedrop is not dependent on who is taxed (buyer or seller). The tax generatesa wedge the price buyers pay for the good and the amount sellers receive forthe good. This wedge creates the drop in quantity.

9.1.1 How a Tax Affects Market ParticipantsWe can now apply our tools of welfare economics to measure the gains andlosses from the introduction of a tax. To get this correct we need to seehow the tax influences the buyers, sellers, and the government. Total sur-plus measures the overall benefit across all three types. For the governmentwe consider the tax revenue generate as public surplus which goes towardsgovernment goods. So,

Total Surplus = Consumer Surplus + Producer Surplus + Tax Revenue

Welfare without a tax: Without a tax Total Surplus is simply the

triangle area to the left of equilibrium. Welfare with a tax: With a tax the Total Surplus is the total area to the

left of the newly reduced quantity and between the Supply and DemandCurves. The middle section in tax wedge is the tax revenue. The

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area above the tax revenue and below the demand curve is consumer

surplus and the area below the tax revenue and above the supply curveis producer surplus.

Changes in Welfare: We do find the some of the total surplus is lostwith a tax. The triangle area between the original equilibrium andtax revenue is no longer included and these good are no longer traded.This are is called the deadweight loss of the tax and is the fall in totalsurplus that results from a market distortion, such as a tax.

9.1.2 Deadweight Losses and the Gains from Trade

Taxes generate deadweight losses because the tax prevents buyers and sellerfrom realizing some of their gains from trade. For some buyers and sellers,these lost gains actually drive them out of the market and thus the marketquantity falls. For everyone else, the total gain from trade is reduced.

9.2 The Determinants of the Deadweight Loss

What makes the deadweight loss of a tax large or small. Once obviousthing is the size of the tax. Holding all else constant, the larger the tax,the larger the deadweight loss. The second important determinant is theelasticity of demand and supply. Generally, as the market becomes more

elastic, sensitive to price changes, the deadweight loss from a tax get larger.This is mostly because more elastic markets will face larger drops in quantitywith the introduction of a tax.

9.3 Deadweight Loss and Tax Revenue as Taxes Vary

As stated before the size of the deadweight loss of a tax partially depends onthe size of the tax. Doubling the size of a tax will double the base and heightof the triangle which measures deadweight loss so the area of deadweight losswould increase by a factor of 4. This is not the only area which varies by thesize of the tax, revenues also change and do not always go up with the size of

the tax. In most situations as the size of the tax increases, so will revenuesup to some point. After this point, if taxes increase again the increases indeadweight loss and the loss in quantity actually reduces tax revenues. Thistype of behavior is summarized in a Ladder Curve. This curves biggest claim

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to fame is the whole Supply-Side economics of the 1980s. If you believe we

are on the downward side of the Laffer curve, then a reduction in tax ratescan actually generate increases in tax revenues through a large increase inquantity.

10 Chapter 10: Externalities

In this chapter we study situations where government action may improvemarket allocations. In this chapter we will explicit look at the market failureknow as externalities. An externality is the uncompensated impact of onepersons actions on the well-being of a bystander. If the impact on the by-

stander is adverse it is a negative externality. Is the impact on the bystanderis beneficial it is a positive externality. Because buyers and sellers neglectthe external effects of their actions when deciding how much to demand orsupply, the market equilibrium is not efficient. The total surplus in the mar-ket is not maximized. Some examples of externalities include: car exhaust,restored historic buildings, barking dogs, research.

10.1 Externalities and Market Inefficiency

We can use the tools of welfare economics to examine how externalities affecteconomic well-being. We can see how market allocations are changed in the

presence of externalities.

10.1.1 Negative Externalities

Consider a situation of pollution, for each unit produced a certain amountof smoke enters the air. Because this smoke create a health risk for others,it is a negative externality for this market. This smoke implies that thesocietys true cost of production are higher than those implied by the seller.This would make the true cost higher and the supply curve decreased whencompared to that the seller is using. Thus the optimal output is lower thanthe market quantity and the optimal price is higher than the market price.

Thus the market allocation is inefficient. How could the market reach theefficient outcome? The common strategy is to internalize the externality.Internalizing the externality is altering incentives so that people take accountof the external effects of their actions. In this case one possibility would beto tax the seller to push the supply curve up to match the social cost.

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10.1.2 Positive Externalities

Some externalities are actually positive. Consider education which leads toother things such as: more informed voters, lower crime rates, developmentof technology. All of these are in addition to the higher income one receivesfrom education. These extra benefits of education to society are not nor-mally consider in the market for education. The true, society, demand foreducation is actually higher than what the buyer perceives. This implies thatthe market quantity and price for education is actually lower than what isoptimal. How to line up demand curve? Subsidies could do it.

10.2 Public Policies toward Externalities

We have seen how externalities alter allocations, now we can consider howgovernment and private policies could be used to move the market towardsthe efficient allocation.

10.2.1 Command-and-Control Policies: Regulation

These type of policies directly regulate market behavior. One possible strat-egy is to simply eradicate the externality causing activity. You could attemptto remove certain types of pollution to eliminate these types of costs, how-ever, this can be difficult and remove all pollution is practically impossible.

Thus the best we can do most of the time is to regulate and inform aboutthe behavior.

10.2.2 Market-Based Policy 1: Corrective Taxes and Subsidies

Market policies provide incentives so that decision makers choose to solve theproblem on their own. The general strategy is to tax, through whats calleda corrective tax, negative externalities and subsidized positive externalitiesto simply try and line up the market supply and demand with the optimalsupply and demand.

Consider two possible solutions to pollution. One: regulation to cap

pollution at some level. Corrective tax which taxes the firm for each ton ofpollution. Which way should work better? Most economist argue that thetax is the way to go. While both policies should indeed reduce pollution,only the tax creates the incentive to continually lower pollution to lower

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costs. Those firm who could easily reduce will have a larger incentive to

reduce pollution.

10.2.3 Market-Based Policy 2: Tradable Pollution Permits

Another possible solution to the pollution problem is to allow firms to tradeamount of pollution for a price. The benefit of this approach is that thegovernment can set the cap on pollution versus trying to guess size of a taxthat would generate the same amount of pollution.

10.3 Private Solutions to Externalities

Government need not be to only solution maker for externalities, people canalso develop private solutions.

10.3.1 The Types of Private Solutions

Moral code and social sanctions most people dont litter. Charities used toreallocate markets. There can also be contracts between parties to directlyinternalize the externality.

10.3.2 The Coase Theorem

The Coase Theorem reinforces the idea that private solutions can solve ex-ternalities. The Coase Theorem states that if private parties can bargainwithout cost over allocation of resources, they can solve the problem of ex-ternalities on their own.

10.3.3 Why Private Solutions Do Not Always Work

The Coase Theorem only works if parties have no trouble in reaching anagreement that is enforceable. Sometimes due to transaction costs bargainingis costly and can cause the Coase Theorem to fail. If the number of peopleis large or if the cost are not clear the bargaining gets really difficult to

complete.

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11 Chapter 11: Public Goods and Common

ResourcesNot all good have price, things like rivers, beaches, roads, and other itemshave some value but buyers do not have to pay a price to use them. Whengoods are available free of charge, the market forces which normally deter-mine efficient allocations are no longer present. This chapter talks aboutthese types of goods.

11.1 The Different Kind of Goods

Goods do vary by types. There are two basic characteristics which generallydictate what type a good is described as. The first trait is whether the goodis excludable. A good is said to be excludable if a person can be preventedfrom using it. The second trait is whether the good is rival in consumption.A good is rival in consumption if one person using a good diminishing anotherpersons ability to use the good.

Private Goods: are both excludable and rival in consumption. Icecream and other basic consumption goods.

Public Goods: are neither excludable or rival in consumption. tornadosiren.

Common Resources: are rival in consumption but are not excludable.Fish in the ocean, roads to a degree,.

Club Goods: are excludable but not rival in consumption. Cable TV,toll road (not congested).

This chapter will focus on non-excludable goods: public and common.Both of these types of goods face externalities both positive for public goodsor negative for common goods.

11.2 Public Goods

Public goods are those that are neither excludable or rival in consumption.These goods have their own complications.

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11.2.1 The Free-Rider Problem

One of the main allocation issues with public goods is that they could facea free-rider problem. This is a problem someone can receive the benefitof a good, but avoids paying for it. Suppose a town wants to put on afireworks display. The display will cost 10,000 dollars and the citizen puta value of 25,000 on the display, so the show should happen as the benefitsexceed the costs. Suppose the town tries to use a private firm to setup thedisplay. Would this arrangement create an efficient allocation? Probablynot, how would the firm collect the 10,000 dollars? Selling ticket wont reallywork because someone can still see the show without buying a ticket, whichwould be a classic free-rider problem. The solution to the problem, let the

government use public funds for the show and eliminate any free-riders. Everdone group work?

11.2.2 Some Important Public Goods

There are several common examples of public goods in our everyday life.

National Defense

Basic Research: General knowledge cannot be patented. We have in-stitution like NIH and NSF the subsidize basic research.

Public Roads Not Congested:

11.2.3 The Difficult Job of Cost-Benefit Analysis

Economist often use cost-benefit analysis to justify whether or not a programshould be introduced or maintained. When analyzing public goods, estimat-ing benefits can become tricky as there is no price to judge the value of thegood. Using other means to estimate the benefits of the good will often leadto bias estimate of the value: user would have an incentive to exaggeratetheir benefits, and non-user would have the same incentive to overstate theircosts. In other situation morals can cloud the benefits of a good if it is for

public safety.

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11.3 Common Resources

Common resources, like public goods are not excludable, but are rival inconsumption. One persons use of the good can limit another persons use ofthe good.

11.3.1 The Tragedy of the Commons

The Tragedy of the Commons is that common resources are used more thanis desirable from the standpoint of society as a whole. Since these goods arerival in consumption there is an incentive to want to use it first. This leads toeither over use of the good or early use of the good before it is ready. Thinkabout a public garden if you dont get the crop early there may be none foryou later. So their is an incentive to harvest early before fully ripe.

11.3.2 Some Important Common Resources

There are several common resources we use everyday.

Clean air and water:

Congested Roads:

Fish, Whales, and Other Wildlife:

11.4 Conclusion: The Importance of Property Rights

What the chapter shows is how important it is to have a well establishedsystem of private property and right in place to create the proper incentiveson both the benefits and cost of goods. Without these rights, the governmentcan attempt to provide goods (public and common) but as we have discussedthere is a potential for large allocation issues with these goods which werenot present in private markets.

12 Chapter 12: The Design of the Tax Sys-tem

In 1789 Ben Franklins coined the famous phrase that in this world nothing iscertain but death and taxes. At the time of this quote the average American

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paid less than 5 percent of their income in taxes. This stayed true for about

the next 100 years. In the 20th century the role of taxes in the typical livesof citizens has changes greatly. Today, once all taxes are counted, taxes makeup about 1/3 of the average Americans income. In Europe taxes are evenhigher in many countries. Taxes come about by the fact that we expect ourgovernment to provide goods and services. Taxes pay for these items. Inthis chapter we will discuss the design of the US tax system. We begin bylooking at the basic finances of taxes and then consider some of the basicprinciples which guide the design of the tax code. Most people agree thattaxes should be both efficient, low deadweight loss, and equitable. However,these two goals sometimes behave as a tradeoff.

12.1 A Financial Overview of the US Government

Since 1900 government revenues have increased substantially. Around 1900federal tax was around 2.5 percent of GDP and state and local tax wasaround 3 percent of GDP. By World War II, the federal share had increasedto 17 percent and the state and local was 5 percent. The federal share hasremained in the range of 15 to 18 percent. Today the state and local share isabout 10 percent. The current US burden of taxation is roughly 30 percent.Lets look more closely and the receipts and spending of both the federal andstate and local governments.

12.1.1 The Federal Government

The federal government collects about 2/3 of their money through taxesin our economy. Here are the different ways the federal government raisesmoney and spends it.

Receipts: In 2009 the federal government collect 2.105 trillion dollarsin taxes. Individual income taxes made up 43 percent of the total,social insurance tax was 42 percent, corporate income tax was 7 per-cent, and other taxes were 8 percent. Average amount per person was6846 dollars. The largest piece, income tax, is a sort of a proportionaltax. The actual calculation of tax liability depends on an individu-als tax bracket, marginal tax rate, and deductions. Other taxes likesocial security and medicare are proportional at a single rate up to acap. Corporations also pay taxes on their profits. These profits are

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actually taxed twice, once at the corporate level, and then again at the

individual level depending on who gets the profits. Spending: In 2009 the federal government spent at total of 3.518 tril-

lion dollars or 11441 dollars per person. The largest piece was SocialSecurity which was 19 percent of the total or 683 billion dollars, de-fense was second at 661 billion. This number was higher than usualdue to Iraq and Afghanistan. Income security was 533 billion and wasonce again higher because of the recession. Medicare and other healthspending, including Medicaid, totaled 764 billion. Net interest pay-ments totaled 187 billion and other spending, including federal courts,the space program, highways, housing credits, and federal salaries, to-

talled 690 billion. In this year spending was 1413 billion more thanreceipts, that would imply a budget deficit. This was financed by gov-ernment bonds.

Future Fiscal Challenges: Although the budget deficit in 2009 waslarge, it is the future which is really concerning. As a percentage ofGDP tax collection is forecast to stay relatively constant. However,many federal programs are not. Spending is forecast to grow as apercentage of GDP mainly due to liabilities tied to Social Securityand Medicare. The population is getting older. Today the 21 percentof the population is 65+, by 2060 that number should be around 40

percent. This would imply that government spending on just SocialSecurity, Medicare, and Medicaid would be about 15 percent of GDPwhich is roughly equal to the amount of taxes gathered by the federalgovernment.

12.1.2 State and Local Government

State and local governments collect nearly as much tax as the federal gov-ernment. However, they tend to collect and spend their money in differentways.

Receipts: Total revenues in 2009 were 2.329 trillion dollars or 7574per person. State and locals tend to get most of their taxes from acombination of property taxes, sales taxes, and income tax. They alsoreceive substantial funds from the federal government.

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Spending: Total spending in 2009 totaled 2.265 trillion dollars or 7367

per person. Education is the big ticket item accounting for over 1/3of all spending. Contrary to the federal government, the state andlocal level primarily buys goods and does little in the way or transferprograms. You will also notice that due to many balance budget rulesthe total spending is basically equal to receipts.

12.2 Taxes and Efficiency

We have now seen how the government raises and spends its money. Howdo we evaluate tax policy and the design of the tax system? The primarygoal of the system is to raise revenue. However there are also two important

secondary issues to thinking about with a tax design: efficiency and equity.We start by looking at efficiency. By efficiency we mean to minimize thedeadweight loss that result when taxes distort decisions and minimize theadministrative burden that results from the taxpayers trying to comply withtax laws.

12.2.1 Deadweight Losses

Because taxes distort supply or demand, they create a deadweight loss. Dead-weight loss is smaller in inelastic markets, so many taxes tend to show up inthese markets. Income versus consumption debate. Taxing interest income

can create a distortion against saving as it reduces the interest rate. Someeconomist call for a consumption tax that has no such distortion.

12.2.2 Administrative Burden

How costly is it to fill out tax forms? Between the time associated withfilling out the forms and the time needed to keep the records for those forms,there appears to be a substantial cost of just complying with tax laws. Theresources used to comply with the tax code represent a deadweight loss.

12.2.3 Marginal Tax Rates vs Average Tax Rates

Marginal tax rate measure the taxes gathered on the next dollar earned. Theaverage tax rate is the total taxes paid divided by total income. Suppose thetax code is 20 percent tax on the first 50,000 and 50 percent of all income over50,000. Suppose the person makes 60,000. His total tax bill is = .20*50000

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+ .5*(60000-5000)= 15000. So his average tax rate is 15000/60000 = 25

percent. His marginal tax rate is 50 percent as the next dollar earned wouldbe taxed at that rate. The average tax rate measure the sacrifice of thetaxpayer. The marginal tax rate does more to measure the distortion oftaxes on decisions.

12.2.4 Lump-Sum Taxes

These are taxes where everyone pays the same amount. It is the most efficienttax possible as it does not distort decisions. The next dollar is taxed at zeromarginal tax rate. So why dont we use them? Efficiency is not the onlygoal in tax design. Equity is another big player. Consider a situation where

the flat tax rate is 5000. Now look at two people, one makes 20,000 and onemakes 100,000. Both face a zero marginal tax rate, but their average taxrates are different. The first person has an average rate of 5000/20000= 25percent. The second person has an average rate of 5000/100000 = 5 percent.

12.3 Taxes and Equity

Now lets consider the equity of the tax system. How should the burden oftaxes be spread across the population? Most people agree in some of equity,but there is much disagreement over what equity means.

12.3.1 The Benefits Principle

The benefits principle is the idea that people should pay taxes based ontheir benefits they receive from government services. In private markets, themore you buy the more you pay. This idea would seem like is should alsoapply to public goods, and in some cases in does (excise taxes, toll roads,etc...) Those you use the public good are being charged for using that good.This could even be used to argue why the wealthy citizens should pay highertaxes. They receive more benefits from government (police protection, thesocial value of lower poverty, etc.).

12.3.2 The Ability to Pay Principle

The ability to pay principle is the idea that taxes should be levied on a personaccording to how well that person can shoulder the burden of the taxation.The idea is that those who are wealthier are better able to deal with the

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burden of taxation and thus should pay more than those who cannot. There

are two other related items which spin off of this topic.

Vertical Equity: This is the idea that taxpayers with greater abilityto pay taxes should pay larger amounts. How much more is the bigdebate. Is is an amount, average rate, or percentage, marginal rate?This leads different styles of tax systems. Proportional taxes are rep-resented as fixed fractions. A regressive tax is one where the rich pay alower percentage. A progressive tax is one where the rich pay a higherpercentage. This is typically a huge issue in politics. 2006 numbers arepresented on page 248, any way you slice it the tax code is progressiveand this does not include government transfers which will make the

system even more progressive. If someone receives more in transfersthan it pays in taxes, that person is paying a negative tax rate.

Horizontal Equity: This is the idea that taxpayers with similar abilitiesto pay taxes should pay the same amount.

12.3.3 Tax Incidence and Tax Equity

We also have to think about tax incidence when evaluating a tax system.The burden of tax is not always the person who gets the tax bill from thegovernment. Taxes move supply and demand and thus change equilibrium

prices. Most discusses of tax equity leave out this discussion. Does an excisetax on fur coats stay on the wealthy? It seems to be vertically equitable asmost buyers are probably rich. However, there are lots of substitutes for furcoats. The demand for furs coats is probably more elastic than the supply,so most of the tax incidence will be passed on to the suppliers of fur coatswho are probably not a wealthy as the buyers.

12.4 Conclusion: Tradeoff between Equity and Effi-ciency

Equity and efficiency are the two most important goals of the tax system. Po-litical parties often differ on there relative importance and definition of thesegoals. Recent political history shows many examples of shifting tax rateswhich show each partys beliefs. Issues beyond economics help to determinethe best way to balance these goals.

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13 Chapter 13: The Costs of Production

Up until this point we have simplified the actions of the firm to a supply curve.How is the supply curve determined? That is the topic of this chapter. Nowwe turn our attention to firm behavior. This behavior centers around theconcepts of cost minimizations and profit maximization. This behavior isdetermined by the type of market and length of time in which the firm isengaged in. We start with an understanding of a firms costs.

13.1 What Are Costs?

We begin by looking at what we can call basic cost and revenue accounting

for a firm and understanding certain definitions which will be used in thenext several chapters.

13.1.1 Total Revenue, Total Cost, and Profit

Total revenue is the amount a firm receives for the sale of its output. Totalcost is the market value of the inputs a firm uses in production. Profit issimply total revenue minus total costs. The objective of most firms is tomaximize profit.

13.1.2 Costs as Opportunity Costs

It should be noted that the costs facing the firm are measured as opportunitycosts. Opportunity cost of an item refers to all those things that must beforgone to acquire that item. Some costs for the firm involve direct moneypayouts, these are considered explicit costs. Other items, workers skills, donot require direct payments and are considered implicit costs of production.These costs turn out to be important when thinking about a firm economi-cally vs accounting. Accounting costs are only explicit. Economic costs arethe sum of explicit and implicit costs.

13.1.3 The Cost of Capital as an Opportunity Cost

One of the largest implicit costs facing every firm is the opportunity cost ofthe capital used for the firm. Suppose a firm used one million dollars to buya building. If that money were left in a bank that is thousands of dollars of

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interest income that is being given up for this firm. Accountants would not

count this as a cost for the firm and economist would.

13.1.4 Economics Profit vs Accounting Profit

Given the difference in measuring costs, it should be obvious that economicand accounting profit would be different. Economic profit is total revenueminus total costs which include both explicit and implicit costs. Accountingprofit is total revenue minus explicit costs. Accounting profit will always belarger than economic profit. Firms which make a positive economic profit willhave the incentive to stat in business. If not, and those conditions persist,the firm will eventually close.

13.2 Production and Costs

Firms incur costs when they buy inputs for production. Some of these costs,over the short run, are fixed no matter how much quantity is produced (fac-tory). Others vary with quantity (ingredients). Lets look at the tie betweenproduction and costs.

13.2.1 The Production Function

The production function describes the relationship between quantity of in-

puts used to make a good and the quantity of output of that good. Thefollowing describes the production function of a hypothetical firm.

Workers Output Marginal Product of Labor Cost of Factory Cost of Workers Total Cost0 0 30 0 30

1 50 50 30 10 402 90 40 30 20 503 120 30 30 30 60

4 140 20 30 40 705 150 10 30 50 806 155 5 30 60 90

The only unknown column here is the marginal product of labor. Marginalproduct measures the increase of output that arise from an additional unitof input. The typical pattern of marginal product is that it is high for lownumbers of inputs, however eventually, as the number inputs rises, marginalproduct will decrease. The basic idea here is that the most productive in-

puts are used first and less productive ones will be used as the amount ofproduction increases. This concept is called diminishing marginal product.We can use the columns of this table to display both the production functionand total cost curve of this firm. The production function increases as inputs

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increase, however, because of diminishing marginal product, the function is

increases at a decreasing rate. On the flip side as quantity increases, totalcost increase at an increasing rate.

13.2.2 From the Production Function to the Total-Cost Curve

These two curves are basically two sides of the same coin. As the productionfunction flattens out the total costs curve gets steep.

13.3 The Various Measures of Cost

We can further breakdown a firms costs into important components which

will greatly help us understand firm behavior. Consider the following tableof costs for a hypothetical firm.Q ua nt ity To ta l Co st F ix ed Co st Va ri abl e C os t A FC AVC ATC M C

0 3.00 3 0 1 3.30 3 0.30 3.00 0.30 3.30 0.30

2 3.80 3 0.80 1.50 0.40 1.90 0.503 4.50 3 1.50 1.00 0.50 1.50 0.704 5.40 3 2.40 0.75 0.60 1.35 0.90

5 6.50 3 3.50 0.60 0.70 1.30 1.106 7.80 3 4.80 0.50 0.80 1.30 1.30

7 9.30 3 6.30 0.43 0.90 1.33 1.508 11.00 3 8.00 0.38 1.00 1.38 1.709 12.90 3 9.90 0.33 1.10 1.43 1.90

10 15.00 3 12.00 0.30 1.20 1.50 2.10

13.3.1 Fixed and Variable Costs

The costs of a firm can be broken down into two basic types. Fixed costswhich do not vary with output, things like rent, property taxes, some wages.Variable costs which do vary with output like the basic inputs needed forproducing goods and some wages. A firms total costs are the sum of fixedand variable costs.

Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC)In this table Total Costs, column 2, is the sum of columns 3 and 4.

13.3.2 Average and Marginal Cost

When it comes to deciding how much to produce, costs are going to be a key

component of that decision.How much does a typical unit of the good cost to produce?How much will it cost the firm to produce another unit of the good?

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These two different, yet both important questions, will go a long way to

explaining production decisions. The first question is asking about the av-erage cost of production To measure average cost we simply need to dividetotal cost by quantity to get average total cost (ATC). We can also get theaverage of each of the components by performing similar calculations. Aver-age variable cost (AVC) is total variable cost divided by quantity. Averagefixed cost (AFC) is total fixed cost divided by quantity. These costs measurestell us the cost of the typical unit of the good or service, but it does not tellus how much the next unit will cost.

To measure the cost of the next unit we need to calculate marginal cost(MC). Marginal cost is the increase in total cost that arise from an extraunit of production. To calculate Marginal Cost we simply need to measure

the change in total cost and divide that by the change in quantity.

13.3.3 Cost Curves and Their Shapes

All of these average and marginal costs curves have standard patterns whichwe will become accustomed to over time. The graph to plot these curvesshould be quantity on the horizontal axis and cost on the vertical axis. Hereare some of the typical patterns you will find in a complete cost curve graphof a firm.

Rising Marginal Cost: Because the most productive units of inputs are

typically employed first, as a firm increases its quantity the requireduse of less productive inputs implies that marginal cost must eventuallyrise with quantity.

U-Shaped Total Cost: The typical ATC curve is U-shaped. For lowquantities AFC are high keeping ATC high, for high quantities AVCare high keeping ATC high. The region of lowest ATC is somewhere inthe middle. There is a firm level trade-off between Variable and FixedCost. The bottom of the ATC curve is sometimes called the efficientscale.

Relationship between Marginal Cost and Average Total Cost: There isa relationship between MC and ATC. If MC is below ATC then ATCwill be decreasing, if MC exceeds ATC, ATC will be increasing. TheMC of a firm pulls on the ATC of the firm.

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13.3.4 Typical Cost Curves

This picture of cost curves is the typical patten exhibited by most firms.There will be special cases in which we will discuss, but this is the standardgraph that should be thought of when discussing the costs of a firm.

13.4 Costs in the Short Run and in the Long Run

Lets see how time horizon influences a firms cost considerations.

13.4.1 The Relationship between Short-Run and Long-Run Av-erage Total Cost

The key thing about the long run is that there are no fixed costs. Since thefirm can change anything over the a long enough period of time all costs areconsidered variable and the costs of the firm can simply be summarized by along run average total cost curve (LRATC) which is simply the bottom of allthe short run ATC curves. The definition of the long run is simply the timeneeded to make everything variable and will vary by firm type and industry.

13.4.2 Economies and Dis-economies of Scale

We can summarize the basic cost/quantity relationship of a firm by lookingat the LRATC curve. We say that a firm is exhibiting economies of scale ifit has the property where is LRATC is falling at quantity is increasing. Inthis case it is better to be a bigger firm. If the LRATC is upward slopingthe firm is displaying diseconomies of scale and costs are lower if the firmis smaller. If the LRATC is flat that is considered constant returns to scaleand a firms long run cost are not influenced by change the size of the firm.Just like the ATC in the short run, the LRATC also tends to be U-shapedfor most firms.

13.5 Conclusions

This chapter has set up the tools to understand the costs that firms face. Wecan now turn to how these costs are use to a firms decisions on quantity andentry/exit into a market. We will start by looking at firms in competitiveenvironment.

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14 Chapter 14: Firms in a Competitive Mar-

ketsIn this chapter we will analyze the profit maximization and market entry/exitbehavior in an environment of heavy competition. This environment has thecharacteristic of one where the firms in the market have little to no abilityto change prices in such a way that deviates from the general price of theother firms. If they raise there price about the group norm, the firm wouldbasically loss all sales and generate no revenue. In this environment eachfirm is small and had no power over the market price.

14.1 What Is a Competitive Market?Lets quickly review the idea of a competitive market.

14.1.1 The Meaning of Competition

A competitive market is a market with many buyers and sellers tradingidentical products so that each buyer and seller is a price taker. Since everyseller is a small fraction of the total market and there are many sellers, if afirm raises their price, they will lose all of their sales. Since they can prettymuch sell all their product at the given market price, and they are strivingfor maximum profits, there is no incentive to lower their price.

In addition to other characteristics, a competitive market is also denotedas have the quality of free market entry and exit. Given that the firms aresmall the cost of starting new one are low.

14.1.2 The Revenue of a Competitive Firm

To get a profit maximize we need to look at the total revenue and cost of afirm in this competitive market. There are two basic questions a firm needsto address when analyzing revenue.

How much does the firm receive from selling a typical unit of the good?

How much will the firm receive from selling the next unit of the good?Consider the following example.

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Quantity Price Total Revenue Average Revenue Marginal Revenue

1 10 10 6 62 10 20 6 63 10 30 6 64 10 40 6 65 10 50 6 66 10 60 6 67 10 70 6 68 10 80 6 6

Note that the price set by the firm does not change w

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