Micro Review (including
externalities)
Econ 312
Credit to Emma Hutchinson for
putting these notes together. They
are useful for any microeconomics
course with a 103 pre-req
Review of Microeconomics
• Reading for Micro Review
– Your principles of micro text and/or notes
– O’Sullivan appendix
• In this course we will analyze market outcomes in urban settings
with an interest in policy that will correct market failures when such
failures occur
• Primary questions throughout:
– To what outcomes do markets lead?
– Under what circumstances are these outcomes desirable?
– If markets outcomes are undesirable, what would be the
desirable outcome? What is the correct policy response?
Econ 312--Farnham
2
Review of Microeconomics
• Analyzing what happens involves positive analysis
• Terms desirable and undesirable imply we are also interested in
normative analysis.
• Positive analysis involves asking what an outcome will be under
certain circumstances:
– Ex: in equilibrium, how far will people commute to work?
• Normative analysis involves asking questions about what outcomes
we would like to see. (what should be)
– Ex: what is the right (socially optimal) commuting distance? Is an
hour drive too long? Why?
• Points to the need for a normative criterion by which to judge
outcomes as “good” or “bad”.
Econ 312--Farnham
3
Review of Microeconomics
• Normative criterion we use in economics is typically that of economic
efficiency.
• Important to keep in mind that economic efficiency
– has utilitarianism as its philosophical base
– says nothing (much) about fairness or equity
– is only one of many criteria that we can (should?) use to judge
market outcomes.
• With these caveats in mind, in this class we will (usually) judge
outcomes in terms of whether or not they are economically efficient.
– Normative statements like “outcome X should happen” should be
read as shorthand for “outcome X should happen if we are using
economic efficiency as the sole criterion for decision-making.”
Econ 312--Farnham
4
Review of Microeconomics
•
Economic efficiency defined:
–
An outcome is efficient if it maximizes net benefits, where net benefits
are equal to total benefits minus total costs.
•
Tells us that, at its core, the analysis of economic efficiency is simply costbenefit analysis.
•
We will be analyzing efficiency in a variety of contexts, such as:
1.
What is the efficient level of provision of a public service?
• Ex: what is the efficient level of policing?
2.
Should we undertake a particular project (binary decision-making)?
• Ex: should Victoria build a light-rail transit system?
3.
How should we allocate a scarce resource across competing uses?
• Ex: how much land on the Saanich Peninsula should be used for
residential building vs. agriculture vs. public parks?
Econ 312--Farnham
5
Review of Microeconomics
•
We will focus on answering questions such as these by using cost-benefit
analysis to identify the outcomes that make net benefits as large as
possible.
•
Important point: we need to make sure we have correctly identified and
measured all of the costs and benefits associated with a given
activity/outcome.
•
An alternative characterization of efficiency (that we may pick up on at
various points throughout the term):
– An outcome is efficient if it is impossible to come up with an
alternative outcome in which at least one person can be made better
off without any one person being made worse off.
•
Although it may not be immediately obvious, we will see that this
characterization of efficiency will be satisfied if net benefits are
maximized.
Econ 312--Farnham
6
Review of Microeconomics
•
In order to answer normative questions such as those posed above, we
first need to understand how to answer positive questions.
–
For instance, we need to understand what market outcomes look like,
in order to work out whether they are desirable (efficient).
•
This means we need to recall some basic ideas we learned in principles of
microeconomics.
•
Specifically, we want to understand:
1. How consumers decide what goods to buy (demand).
2. How producers decide what goods to produce (supply).
3. How markets bring producers and consumers together
(equilibrium).
•
Once we understand this, we can assess whether consumers and
producers act in such a way as to achieve an economically efficient
outcome.
Econ 312--Farnham
7
Review of Microeconomics
1.
Review of Demand.
•
Three areas to cover on the demand side:
i. Interpreting an individual consumer’s demand curve
ii. Measuring consumer well-being using the demand curve
iii. Deriving aggregate demand from individual demand
Econ 312--Farnham
8
Review of Microeconomics: Demand
i.
•
Interpreting an individual’s demand curve
Recall that a demand curve maps out a relationship between price and
quantity.
Demand curves usually slope downwards:
Price (P)
known as the “law” of demand
Demand
Curve (D)
Remember, on the horizontal axis we are
measuring units of the good consumed (Q),
while on the vertical axis we are
measuring the price per unit (P), in
some form of currency (dollars, cents
Quantity (Q) etc)
How to interpret this demand curve?
Two interpretations, each of which will be useful, depending on the
context.
Econ 312--Farnham
9
Review of Microeconomics: Demand
•
The first interpretation of the demand curve is probably the most familiar
to you:
P
Interpretation 1: the D curve tells us how many units of a
good a consumer wishes to buy in total, at a given price
per unit for the good.
D
For instance, the D curve tells us that if the
price per unit is P1, then the consumer
would like to buy Q1 units.
etc.
P1
P2
Q1
Q2
Q
We can think of this interpretation as reading the D curve horizontally:
that is, if we plug in values for P, we get out values for Q.
Econ 312--Farnham
10
Review of Microeconomics: Demand
•
The second interpretation of the demand curve may be less familiar to
you:
P
Interpretation 2: the height of the D curve at any given
point tells us how the consumer values additional units of
the good.
D
P1
P2
Q1
Q2
Q
For instance, the D curve tells us that if the
consumer currently has Q1 units of the
good, then a small increase in quantity
would be worth P1 per unit to the
etc.
consumer.
We can think of this interpretation as reading the D curve vertically:
that is, if we plug in values for Q,
we get out values for P.
We will elaborate on this interpretation by use of an example.
Econ 312--Farnham
11
Review of Microeconomics: Demand
Example: Suppose that demand is given by Q = 5 - (1/2)P.
From the D function, if P=$10, Q=0 will be demanded.
P($)
But if P = $8, Q = 1 will be demanded.
10
consumer’s maximum willingness to pay for the
first unit is greater than $8, but less than $10.
8
D
1
5
Q
Area of the rectangle ($10) thus gives an upper
bound on consumer’s willingness to pay for the
first unit.
So we know that the maximum willingness to pay for the first unit is
something less than $10. Can we do better than this?
Econ 312--Farnham
12
Review of Microeconomics: Demand
Now consider smaller changes in P. Say P from $10 to $9 so that Q
from 0 to 0.5.
Consumer did not buy the first half unit when it cost $5, but does
when it costs $4.50.
P($)
 consumer’s maximum willingness to pay for this first half
10
unit is something less than $5.
9
8
D
0.5 1
Now suppose P from $9 to $8, so that total Q from
0.5 to 1.
Consumer did not buy the second half unit when
it cost $4.50, but does when P falls.
5
Q
 consumer’s maximum willingness to pay for this second half
unit is something less than $4.50.
This tells us that the consumer’s maximum willingness to pay for
the first unit is in fact something less than $9.50 (as opposed to
$10).
Econ 312--Farnham
13
Review of Microeconomics: Demand
We could consider even smaller changes in prices and quantities.
For instance we could now lower the price in $0.50 increments,
rather than in $1.00 increments.
P($)
Doing this allows us to see that the consumer’s
maximum willingness to pay for the first unit is
something less than $9.25.
10
9
8
D
0.5 1
5
Q
In the limit, as we consider smaller and
smaller price changes, what we are doing here
is calculating the area under the demand
curve between Q=0 and Q=1.
This area tells us the exact maximum willingness to pay by this
consumer for the first unit of the good.
In this case, the area of that trapezoid is equal to $9.
 The consumer is willing to pay at most $9 for the first unit.
Econ 312--Farnham
14
Review of Microeconomics: Demand
By the same logic, the area under the demand curve as we increase Q
from 1 to 2 units tells us the maximum willingness to pay for the second
unit.
In this case, that area equals $7.
Indeed, the area under a D curve between any two
quantities tells us the maximum willingness to pay for
that additional quantity.
P($)
10
8
6
If we consider very small increases in quantity,
than the trapezoid representing the willingness
to pay has a very small base.
1
2
5
Q
In the limit, as we consider tiny tiny increases in Q, the base of the
trapezoid goes to zero, and the willingness to pay (per unit) for
these tiny tiny increases in Q is just equal to the height of the
demand curve.
Econ 312--Farnham
15
Review of Microeconomics: Demand
This is the logic behind the second interpretation of the demand curve,
that the height at any point tells us how consumers value small Q.
P($)
As we have seen, this is equivalent to telling us how
much the consumer is willing to pay for small Q.
We can also think about this as telling us how much
additional benefit a consumer would get from a
small Q.
Q
When we are thinking about the D curve in this
way, we will refer to it variously as the:
1. Marginal Value (MV) curve
2. Marginal Willingness to Pay (MWP) curve
3. Marginal Benefit (MB) curve
Econ 312--Farnham
Note that these
terms are
equivalent!
16
Review of Microeconomics: Demand
ii.
Measuring consumer well-being using the demand curve.
1st interpretation of D curve: tells us Q demanded at a given P.
2nd interpretation of D curve: area under the D curve measures
consumer’s willingness to pay for Q1 units.
P($)
But, how much did consumer actually have to pay for Q1?
A
Expenditure (price times quantity) given by area P1Q1.
P1
consumer willing to pay more than she has to pay.
Q1
Q
Difference between willingness to pay and
expenditure measures consumer well-being.
Definition: consumer surplus (CS) = what a consumer is willing to pay
minus what they have to pay.
In the diagram above, the CS from buying Q1 units at P1 per unit is equal
to the triangle A.
Econ 312--Farnham
17
Topic 1(b): Review of Consumer Theory
iii.
Deriving aggregate demand from individual demand
Suppose two individuals - A and B - each with D curves drawn below.
P
P
DA
DB
Aggregate D
P1
P2
QA1
QA2
QA
QB
QB1
QB2
QA1+QB1
QA2+QB2
At P1, A demands Q1A and B demands Q1B.
Aggregate demand at P1 therefore equals Q1A + Q1B.
At P2, A demands Q2A, B demands Q2B, and agg. D = Q2A + Q2B.
We are horizontally aggregating individual demands to get aggregate
demand.
Econ 312--Farnham
18
Topic 1: Introduction and Review
1.
Review of Supply.
•
Three areas to cover on the supply side:
i. Interpreting an individual producer’s supply curve
ii. Measuring producer well-being using the supply curve
iii. Deriving aggregate supply from individual supply
Econ 312--Farnham
19
Topic 1: Introduction and Review: Supply
i.
•
Interpreting a firm’s supply curve
Recall that a supply curve maps out a relationship between price and
quantity.
Supply curves usually slope upwards: known as
Price (P)
the “law” of supply
Supply
Curve (S)
NB: Throughout this class we will only be
looking at the supply behavior of
competitive firms.
i.e., firms that take the prices of
output and inputs as given.
Quantity (Q)
How to interpret this supply curve?
Like D curve, there are two interpretations of the S curve.
Econ 312--Farnham
20
Topic 1: Introduction and Review: Supply
•
P
The first interpretation of the supply curve is (again) probably most
familiar:
Interpretation 1: S curve tells us how many
units of a good a producer wishes to sell in
total, at a given price per unit for the good.
S
P1
If the price per unit is P1, then the firm
would like to sell Q1 units. etc, etc.
Q1
Q
We can think of this interpretation as reading the S curve horizontally:
that is, if we plug in values for P,
we get out values for Q.
Econ 312--Farnham
21
Topic 1: Introduction and Review: Supply
•
P
The second interpretation of the supply curve should also be (relatively)
familiar:
Interpretation 2: the height of the S curve at any given
point tells us how much additional units of the good cost
to produce.
P1
Q1
i.e., the supply curve is also a Marginal Cost (MC)
S curve.
If the firm is currently producing Q1 units
of the good, then a small increase in
quantity would cost P1 per unit to
produce.
Q
We can think of this interpretation as reading the S curve vertically:
that is, if we plug in values for Q,
we get out values for P.
Again, useful to work through an example.
Econ 312--Farnham
22
Topic 1: Introduction and Review: Supply
Example: Suppose that supply is given by Q = P - 5.
From the S function, if P=$5, Q=0 will be supplied.
But if P = $6, Q = 1 will be supplied.
P($)
 firm’s cost of supplying that first unit (the
MC of that unit) is somewhere between $5 and
$6.
S
7
6
$12
5
$5.50 $6.50
1
2
Q
Turns out that the exact cost of producing this
first unit = area under the S curve between Q=0
and Q=1.
And area under S curve from Q=1 to Q=2 equals cost of producing 2nd unit.
And area under S curve from Q=0 to Q=2 tells us how much the firm’s costs
increase going from Q=0 to Q=2.
Econ 312--Farnham
23
Topic 1: Introduction and Review: Supply
•
Area under S curve up to a given Q actually tells us the Variable Cost (VC)
of producing that Q.
•
Recall that a firm’s Total Costs (TC) have 2 components:
TC = Fixed Costs + Variable Costs
= FC + VC.
•
By definition, FC don’t change as Q changes, while VC do.
•
So MC = ΔTC/ΔQ = Δ (FC+VC) /ΔQ = ΔVC /ΔQ.
 area under the S curve up to a given Q = MC of 1st unit + MC of 2nd
unit + MC of third unit etc. etc.
•
And adding up MCs is the same as calculating VC.
Econ 312--Farnham
24
Topic 1: Introduction and Review: Supply
ii.
Measuring producer well-being using the supply curve.
1st interpretation of S curve: tells us Q supplied at a given P.
2nd interpretation of S curve: area under S curve
measures VC of producing Q1 units.
P($)
If producer sells Q1 units at P1 per unit, then Total Revenue
(TR) received = area of rectangle P1Q1.
P1
 producer receives revenue greater than VC.
A
Q1
Q
Difference between TR and VC provides a
measure of producer well-being.
Definition: producer surplus (PS) = TR - VC.
In the diagram above, the PS from selling Q1 units at P1 per unit is equal
to the triangle A.
Econ 312--Farnham
25
Topic 1: Introduction and Review: Supply
ii.
•
•
Measuring producer well-being using the supply curve.
More common measure of producer well-being is profit (π).
–
What is the relationship between PS and π?
Recall:
PS = TR - VC; and
π = TR - TC
π = TR - VC - FC
PS
 π = PS - FC
or PS =
π + FC.
Econ 312--Farnham
26
Topic 1: Introduction and Review: Supply
•
Recall that CS measures the NB to consumers from consuming.
•
Similarly, we can think about PS as telling us about the NB to producers
from producing.
•
That is, tells us how much better off the firm is by choosing Q>0.
•
If Q = 0, TR=0 and TC=FC.
 π = -FC.
π as Q = PS
as Q
•
If Q>0, TR>0 and TC=FC+VC.
 π = PS - FC.
•
Tells us that maximizing π is equivalent to maximizing PS.
•
So even though π is the “true” measure of firm well-being, we can use PS
instead.
Econ 312--Farnham
27
Topic 1: Introduction and Review: Supply
iii.
Deriving aggregate supply from individual firm supply
Suppose two firms - A and B - each with S curves drawn below.
P
SA
Aggregate S
SB
P1
P2
QA2
QA1
QA
QB2
QB1
QB
QA2+QB2
QA1+QB1
At P1, A supplies QA1 and B supplies QB1.
Aggregate supply at P1 therefore equals QA1 + QB1.
At P2, A supplies QA2, B supplies QB2, and agg. S = QA2 + QB2.
We are horizontally aggregating individual firm supplies to get
aggregate supply.
Econ 312--Farnham
28
Topic 1: Introduction and Review
•
Final topic in Intro/Review: Equilibrium.
–
Bringing both sides of the market together.
•
Definition of equilibrium:
–
a state of balance or rest;
–
a state where there is no tendency for change.
•
In our supply and demand model, an equilibrium is where:
1. Consumers are choosing the Q that makes them happiest, given P.
(Consumers choose Q to set MB=P)
– i.e., maximizing CS.
2. Producers are choosing the Q that makes them happiest, given P.
(Producers choose Q to set MC=P)
– i.e., maximizing PS.
3. Prices are such that consumer and producer behavior are
consistent.
– Usually means supply equals demand. (Qs=Qd)
Econ 312--Farnham
29
Topic 1: Introduction and Review: Equilibrium
•
Example: take the S and D curves illustrated below
At price P1,
consumers want to buy Q1 units,
producers want to sell Q1 units
 consumer and producer behavior
is consistent.
P
S
A
P1
B
D
Q1
Q
If P > P1, S > D and there would be
pressure on P to fall.
At equilibrium of P1 and Q1,
NB to consumers = CS = area A and
NB to producers = PS = area B.
Agg NB = CS + PS
=A+B
Note that area A is aggregate CS and area B is aggregate PS.
That is, CS is sum of all individual consumers’ CS and PS is sum of all
individual producers’ PS.
Econ 312--Farnham
30
Topic 1: Introduction and Review: Equilibrium
•
One very important thing to note: aggregate NB always the same if Q
the same, no matter what happens to P.
•
Another way of saying this is that aggregate NB function only of total Q,
while the distribution of NB depends on P.
P
P2
P1
P3
Example: here equilibrium would be P1, Q1.
S
A
B
But, if government imposes a quota at Q2,
new equilibrium would be at P2, Q2 where:
C
D
D
Q2
Q1
CS = A
PS = B + C + D
Q
Agg NB = CS + PS
=A+B+C+D
But now suppose that (instead of quota), government instead says P
cannot rise above P3 (“price ceiling”).
Equilibrium still Q2 but with different P. Now we have:
CS = A + B + C
Agg NB = A + B + C + D
PS = D
Same in total, distribution different.
Econ 312--Farnham
31
Summary:
Topic 1: Introduction and Review
•
We have seen that (absent quotas, price ceilings etc):
–
Consumers choose Q such that P = MB
• i.e., choose to consume where P cuts D curve.
• NB to consumers = CS.
–
Producers choose Q such that P = MC
• i.e. choose to produce where P line cuts S curve.
• NB to producers = PS.
–
Producer and consumer decisions are such that S=D
• Aggregate NB = sum of individual NB
• Sum of individual NB = CS + PS (if consumers and producers are
the the only agents affected by the market).
•
Note that these are positive questions - describing the way in which
markets DO work.
•
Can also ask corresponding normative questions.
Econ 312--Farnham
32
Topic 1: Introduction and Review
•
Normative questions of interest are:
1.
What quantity of goods should be produced?
•
We know that in equilibrium Q is where S=D.
•
Under what circumstances is this the “right” Q in total (the one that
maximizes NB)?
2.
Which firms should produce these goods?
•
We know that in equilibrium each firm produces until P=MC.
•
Under what circumstances is the the “right” Q for each firm (the one
that minimizes aggregate production costs)?
3.
Which consumers should get to consume these goods?
•
We know that in equilibrium each consumer chooses Q such that
P=MB.
•
Under what circumstances is the the “right” Q for each consumer (the
one that maximizes aggregate benefits from consumption)?
Econ 312--Farnham
33
Topic 1: Introduction and Review
•
We will focus primarily on question (1). The efficient allocation will occur
(in all cases discussed in this course) where MC=MB.
–
Try to understand the intuition for this:
•
•
•
–
If MC>MB, this tells us the last little bit produced cost more to produce that it
gave to consumers in added benefit. Society would be better off with less of the
good (Q should fall).
If MC<MB, this tells us the last little bit produced cost less to produce that it gave
to consumers in added benefit. This suggest that increasing output would raise
overall well-being in society (Q should rise).
If MC=MB, this tells us the last little bit produced cost exactly the same amount
to produce as it gave consumers in added benefit. This tells us this unit made
society no better off than it was before (nor any worse off). This is the efficient
point.
Note that MC=MB in the equilibrium diagram 4 slides back. In a wellfunctioning market, MC=MB at equilibrium so that the equilibrium is
efficient. However, this does not always have to be the case!
•
•
When market failure occurs (due to something like the presence of an externality
or due to monopolistic control of an industry), it may not be the case that
MC=MB at equilibrium
In such a case, the equilibrium quantity may be different from the efficient
quantity.
Econ 312--Farnham
34
Externalities—A Typical Cause of Market Failure
in Urban Settings
• Externalities occur when some market transaction involves
costs and/or benefits that accrue to people outside the
transaction
– This means consumers and producers aren’t taking all of the relevant
costs and benefits into account==>Social MB may not equal Social MC
in equilibrium.
– In such a case, equilibrium is inefficient
• In the ideal case we just examined, the only people affected
by market transactions were producers and consumers: all
costs and benefits in the market were internalized. So (Social
MB)=(Social MC) in equilibrium and, therefore, the
equilibrium was efficient.
Econ 312--Farnham
35
Some Urban Externalities
• Negative externalities (external costs)
– Pollution (noise, light, emissions)
– Congestion (traffic, sidewalks, parks, etc.)
– Spread of disease (especially where water treatment is poor)
• Positive externalities (external benefits)
– Knowledge spillovers (arguably huge in cities)
– “Energy” one feels from being in a bustling city
• When externalities are present, market outcomes will
typically be inefficient; if the inefficiency is large, this
provides solid justification for government intervention in
the market (i.e. policy)
– In equilibrium, markets produce too much of goods with negative
externalities; policy should discourage production
– In equilibrium, markets produce too little of goods with positive
externalities; policy should encourage production
36
Externalities—Some Definitions
• We defined private costs and benefits previously—those
that occur to producers and consumers
• Now consider external costs and benefits: those accruing
to people outside a market transaction
– e.g. Pollution hurts people--it imposes costs on them
– Just as we can show the private marginal cost curve for producers
in an industry, we can think of the marginal external cost imposed
on others by different levels of production.
– If we add up the marginal private costs and marginal external
costs of production, we get the overall marginal social cost of
production. (mpc+mec=msc)
• Marginal social cost curve describes the costs, on the margin, imposed on
both producers and people external to the transaction, for different levels of
production. Note that mec can be positive (in the case of negative production
externalities) or negative (in the case of positive production externalities—like
information spillovers between firms)
37
Externalities—Some Definitions
• Similarly marginal social benefits are the marginal private
benefits plus marginal external benefits (mpb+meb=msb)
– meb can be positive (in the case of positive consumption
externalities) or negative (in the case of negative consumption
externalities)
• We show production externalities using MC curves.
• We show consumption externalities using MB curves
38
Consider a negative production externality
(MEC>0)
• MEC is vertical distance
between MPC and MSC
• Equilibrium at Qeq where
S=D
• But is this efficient?
MSC
P
S=MPC
– MSC=MPC+MEC
– MSC>MSB at Qeq implies that
too much is being produced
– Want MSC=MSB!
– Qeff is efficient level of
production
Peq
Econ 312--Farnham
D=MSB
Qeff
Qeq
Q
39
Neg Production Externality--Welfare Analysis
• What does society gain
from moving from Qeq to
Qeff?
loss=
E
=gain
– Loses total social benefits of E
– Gains total social cost
reduction equal to D
– Net gain of F
– Note that F is equilibrium
deadweight loss
– Social Welfare (SW) society
could have if only it moved
from Qeq to Qeff.
P
MSC
D
S=MPC
F
Peq
D=MSB
Qeff
Econ 312--Farnham
Qeq
Q
40
Policy Example: Using a per unit tax to correct a
pollution externality
• Taxes generally reduce SW
when equilibrium is
efficient (market success)
• Taxes Can be SW improving
for mkt failure
– w/neg externality, can restore
Qeff
– Impose tax that sets t=MEC at
Qeff
• SW after tax equals areas
CS+PS+GR-TEC
CS=
PS=
GR=
TEC=
MSC
P
S(w/tax)
t=MEC(Qeff)
Pc
S=MPC
Peq
Ps
D=MSB
Q’eq=Qeff
Econ 312--Farnham
Qeq
Q
41
SW With Tax-Corrected Externality
• Social welfare in this
case is the area shown
to the right.
• Social Welfare
SW
– It’s CS plus the part of
GR not cancelled out by
TEC.
– Note that PS is cancelled
out by part of TEC
Econ 312--Farnham
CS+GR+PS
TEC
=
-
42
Now Consider a Positive Production
Externality
• Suppose a constant MEB
results from production
activity (knowledge
spillovers?); show
externality with S curve
– Vertical shift (down) of S
curve by amount of MEB
– MSC=MPC-MEB
– MSB=MPB because no
externality on consumption
side
– Too little produced in
equilibrium
Positive production
externality
P
S=MPC
MSC
Peq
MEB
Qeq Qeff
Econ 325--Martin Farnham
D=MPB=MSB
Q
43
What is correct policy response?
• Work this out on your
own
• Do graphical welfare
analysis
– Remember, you want to
encourage increased
production of this good
Econ 312--Farnham
– Show how a policy
instrument can be used
to correct the market
failure.
44