EDSPIRA’S GUIDE TO
MICROECONOMICS
By Mary Bryggman
How Make the Most of this Guide:
• Each concept from this guide is accompanied by an
Edspira video from the YouTube Microeconomics
playlist. Click the video icon next to a concept of
interest to be taken directly to the video! Find more
business school help at
https://www.youtube.com/c/Edspira and
https://www.edspira.com/
• If you ever want to go back to the table of contents,
click the Edspira icon in the bottom corner.
TABLE OF CONTENTS
1 Introduction to Economics
What is Economics? .................................................................................................................................. 1
Two Main Branches of Economics ............................................................................................................ 2
The Role of Government: Paternalism and Libertarianism....................................................................... 3
Scarcity, Poverty, and the Fundamental Economic Problem .................................................................... 4
Tradeoffs and Opportunity Costs .............................................................................................................. 5
2 The Production Possibilities Frontier
What is the Production Possibilities Frontier (PPF)? ................................................................................ 6
Graphing the PPF....................................................................................................................................... 7
Graphing the Marginal Cost Curve ............................................................................................................ 8
Graphing the Marginal Benefit Curve ....................................................................................................... 9
Production Efficiency .............................................................................................................................. 10
Specialization, Trade, and Comparative Advantage ............................................................................... 11
3 Supply and Demand
Law of Demand ....................................................................................................................................... 12
Law of Supply .......................................................................................................................................... 13
Market Equilibrium ................................................................................................................................. 14
How to Find the Equilibrium Mathematically ......................................................................................... 15
Changes to Demand ................................................................................................................................ 16
Changes in Demand vs. Change in Quantity Demanded......................................................................... 17
Changes to Supply ................................................................................................................................... 18
Changes in Supply vs. Change in Quantity Supplied ............................................................................... 19
Normal vs. Inferior Goods ....................................................................................................................... 20
Simultaneous Changes in Supply and Demand ....................................................................................... 21
4 Elasticity
Price Elasticity of Demand....................................................................................................................... 22
Income Elasticity of Demand................................................................................................................... 24
Cross Elasticity of Demand ...................................................................................................................... 25
Elasticity of Supply .................................................................................................................................. 26
5 Efficiency
Equity vs. Efficiency ................................................................................................................................. 27
TABLE OF CONTENTS CONT’D
5 Efficiency
Equity vs. Efficiency ................................................................................................................................. 27
Three Types of Economic Efficiency ........................................................................................................ 28
Six Types of Market Failure ..................................................................................................................... 28
6 Surplus and Price Restraints
Consumer and Producer Surplus............................................................................................................. 30
Effect of a Price Ceiling............................................................................................................................ 31
Effect of a Price Floor .............................................................................................................................. 32
Effect of a Price Support ......................................................................................................................... 32
How Countries Benefit from Free Trade ................................................................................................. 33
Effect of an Import Tariff......................................................................................................................... 34
7 Externalities
What are Externalities? ........................................................................................................................... 35
Pigouvian Tax .......................................................................................................................................... 36
Cap and Trade ......................................................................................................................................... 37
Cap and Trade vs. Carbon Tax ................................................................................................................. 38
Coase Theorem ....................................................................................................................................... 39
8 Public and Common Goods
Public Goods............................................................................................................................................ 40
The Efficient Provision of Public Goods .................................................................................................. 40
Common Goods....................................................................................................................................... 41
Individual Transfer Quotas (ITQs) ........................................................................................................... 42
9 Real World Examples
Pharmaceutical Drug Testing .................................................................................................................. 43
Airline Safety ........................................................................................................................................... 44
Fracking ................................................................................................................................................... 45
Housing Vouchers ................................................................................................................................... 46
EDSPIRA
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INTRODUCTION TO ECONOMICS
WHAT IS ECONOMICS?
2
1
This includes fields
such as sociology
or anthropology.
Similar to how psychology and
sociology student how groups make
choice. In economics, these choices
include more factors than just money.
A social science that examines how people make choices
where there are unlimited wants and desires but limited
resources available to fulfill those wants and desires.
3
Examples: better healthcare,
better schools, more money
Unfortunately, the means in
which to obtain these wants are
constrained in real world
situations that economist study.
4
Example: Clean Water and Electricity
Say we want to provide everyone around the world wants clean water and
electricity. Unfortunately, we have a limited supply of these resources. It is not
possible to give everyone an unlimited supply. Because of this, we must instead
ask “How do we go about allocating these supplies to individuals?” If the
production of clean water requires other resources such as coal, this decision
now includes a tradeoff between proving water and carbon emissions.
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INTRODUCTION TO ECONOMICS
TWO MAIN BRANCHES OF ECONOMICS:
Macroeconomics:
This branch examines aggregate economic indicators.
• Indicators: a country’s gross domestic product (GDP),
inflation, other large-scale measures.
Microeconomics:
•
•
•
1
Make decisions
Form markets
Form industries
•
•
How is price decided from this behavior?
If the free market does not produce at the
optimal level, we get externalities (see
Section 8).
This branch examines the behavior of individual
economic actors in the face of an event.
2
•
•
•
Person: Workers, investors
Firms: Companies
Society
3
•
•
•
Price change
Tax
Etc.
Example:
2
1
3
Do households buy more peanut butter when the price of jelly decreases?
Note: There are additional branches such as family economics.
INTRODUCTION TO ECONOMICS
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THE ROLE OF GOVERNMENT:
PATERNALISM VS. LIBERTARIANISM
• The question we want to answer is: Should the
government intervene with policy?
• Paternalism: In certain situations, the government should
intervene when it knows best (also known as a nanny
state).
Example:
The government creates a law that requires everyone to wear a seatbelt
and a fine will be issued if someone does not follow this rule.
• Issues with paternalism:
1. What if the policy doesn’t work?
2. Government policy can be influenced by special
interests.
3. Government policy could subvert individual’s
freedoms.
• Libertarianism: The government should stay out of
people’s lives and respect their freedom.
• Issues with libertarianism:
1. What if your exercise of freedom affects someone
else?
This can lead to externalities (go to externalities
section to learn more).
INTRODUCTION TO ECONOMICS
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SCARCITY AND THE FUNDAMENTAL
ECONOMIC PROBLEM
• Scarcity: When the resources available are limited.
• Fundamental Economic Problem: How can we
allocate these limited resources to our infinite number
of wants?
SCARCITY VS. POVERTY
• Scarcity can affect everyone, no matter their
income level. It is not just associated with
poverty.
Example:
Suppose you are very wealthy and want to keep your day job, but also want
to become the best tennis player in the world. Even though you do not lack
physical resources, you may still be scarce in time and that prevents you
from achieving your goal.
INTRODUCTION TO ECONOMICS
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TRADEOFFS AND OPPORTUNITY COSTS
• Tradeoff: To get some of x, I have to give up some of
y.
Example:
A dollar spent on diabetes research can’t also be spent on military
defense.
• Opportunity Cost: What we are giving up, y, in order
to get some of x.
Example:
The opportunity cost of that dollar going to diabetes research is
what could’ve been done if we had given it to military defense.
Opportunity costs are not always monetary. In many
instances the opportunity costs in your life are time.
Example:
If you spend 1 hour playing video games, the opportunity cost of
that decision is the 1 hour you could have used to do your
homework.
We can use tradeoffs and opportunity costs to weigh
our options and come to a decision that is a balance
with the highest payoff.
THE PRODUCTION POSSIBILITIES FRONTIER
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WHAT IS THE PRODUCTION
POSSIBILITIES FRONTIER (PPF)?
• The production possibilities frontier is a graph that has
two axes, each one representing a single good or
opportunity, and a curve comprised of possible
combinations of the two (see page 7).
• Any point on the PPF is efficient, meaning that it is not
possible to produce and additional unit of one good
without giving up a unit of the other good.
• Points inside the curve are inefficient, meaning the
resources are either being wasted or not allocated
correctly.
• We can also look at the PPF to find the marginal
opportunity cost of a change in output combinations.
• The marginal cost is the reason for the bowed-out shape.
If the PPF was a straight line, it would represent a
constant marginal cost.
• Why do we use the PPF?
• The PPF is used to graph the tradeoffs and opportunity
costs introduced in the last section. It is created based
off the limited resources available and the
combinations created by making tradeoffs. We can use
the PPF to decide the combinations at which to
produce.
THE PRODUCTION POSSIBILITIES FRONTIER
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GRAPHING THE PPF
Remember: The PPF represents the maximum of each possible
combination that can be made from two goods.
When graphing this, one good is assigned to the x-axis and the other
is assigned to the y-axis. To illustrate, we will use an example:
Example: Desert Island
4.5
4
3.5
Food
3
2.5
2
1.5
1
0.5
0
0
2
4
6
8
10
Clothing
•
•
The table on the right shows a tradeoff between producing
food or clothing on the island because there are limited
resources available.
Graphing the PPF gives a visual of what this tradeoff is and
shows that the marginal cost of producing an additional
piece of clothing goes up by one each time. (Going from 0 to
1 units of food only costs one unit of clothing but going from
3 to 4 units of food costs 4 units of clothing).
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THE PRODUCTION POSSIBILITIES FRONTIER
GRAPHING THE MARGINAL COST CURVE
We can think of the marginal cost of an additional unit of one good
as the number of units of the other good we are giving up. In the
example below, we’ll look at the marginal cost in terms of clothing
of going from 0 to 1 units of food, 1 to 2 units of food and so on.
Example: Desert Island
5
4
Food
3
2
1
0
0
5
10
Clothing
•
We can use this new table
to graph the marginal cost:
The slope is positive
because not all resources
are productive. We may be
asking people who are
better at making food to
make clothing instead,
which is not productive.
Marginal Cost
•
4
3
2
1
0
0
1
2
Food
3
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THE PRODUCTION POSSIBILITIES FRONTIER
GRAPHING THE MARGINAL BENEFIT CURVE
Now that we know the all of the points on the curve are efficient, how do we
decide which to produce?
Allocative Efficiency: There is some point on the curve that aligns
with consumer preferences, we want to produce at that level of output.
Marginal Benefit: How much consumers are willing to pay for an
additional unit of a good.
Our goal is to find the point where the marginal benefit equals the marginal
cost.
Example: Desert Island
5
Units
4
3
2
1
0
0
1
2
3
Food
Marginal Cost
•
•
•
Marginal Benefit
We can use this new information on consumer willingness
to pay and add it to our marginal cost graph.
People want variety, so the marginal benefit is decreasing.
Looking at the graph, the allocatively efficient output is 2
food, which corresponds to 7 clothing in our original graph.
THE PRODUCTION POSSIBILITIES FRONTIER
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Production Efficiency:
• Production Efficiency: A situation where the
economy is producing so much that it cannot
produce an additional unit of one good without
decreasing the production of another unit.
• When looking at the PPF, every combination on the
curve is efficient in production.
• Points outside the curve are not feasible due to the
limited number of resources, so a tradeoff must be
made.
Example: Inefficient Production
•
Food
100
•
50
All the grey dots inside the curve
are considered inefficient because
we could produce more of either
good without having to give up
any units of the other good.
Possible Reasons:
• Misallocation of resources
• Resources being wasted
Steel
How can we increase this production efficiency line?
•
•
•
Technology- making goods would be easier, so we would be
able to produce more, pushing the curve outward.
Capital- increasing the resources required to produce a good
will increase the amount of the good that can be made.
Specialization and Trade-(discussed in the next section)
THE PRODUCTION POSSIBILITIES FRONTIER
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Specialization, Trade, and
Comparative Advantage
• Specialization and trade allow us to work outside of the
PPF curve.
• If your country has a comparative advantage over others
at producing one good, it is possible to only produce that
good at a level higher than the curve and then trade to get
the necessary amount of the other good.
Example: Desert Island
You are your economics professor are stranded on a desert island
and need to gather water and coconuts to survive. You have a
comparative advantage when it comes to collecting coconuts, so
for each hour of work, the potential outcomes are:
For you, the opportunity cost of
one coconut is .25 liters of water
and the opportunity cost of
producing one liter of water is 4
coconuts.
This means that coconuts cost you less, half the amount that it
costs your professor. You have a comparative advantage in
producing coconuts are your professor has a comparative
advantage of producing water because it costs them less coconuts.
If you both specialize in what your best at and trade, you can
produce more than if you don’t, putting you above the PPF curve.
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SUPPLY AND DEMAND
Law of Demand
• Law of Demand: If all else is held equal, if there is an
increase in the price of a good or service, quantity
demanded with decrease. Conversely, if the price
decreases, quantity demanded will increase.
Example:
If the price of a cool pair of shoes drops, more people will go and
buy them. If the price increases, fewer people will buy them.
• Demand Schedule: Table that maps the price of a good to
the quantity demanded.
Example:
As the price of chocolate bars changes, so does the quantity
demanded. This is reflected in the demand schedule:
6
5
Price
4
3
2
1
0
1
3
5
7
9
Quantity
The graph of this coordinates is called the Demand Curve which is
always downward sloping.
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SUPPLY AND DEMAND
Law of Supply
• Law of Supply: If all else is held equal, if there is an
increase in the price of a good or service, quantity supplied
with increase. Similarly, if the price decreases, quantity
supplied will decrease.
Example:
If the price of ice cream drops, suppliers are less willing to produce a large
quantity. If the price increases, they are more likely to supply it.
• Supply Schedule: Table that maps the price of a good to
the quantity supplied.
Example:
As the price of chocolate bars changes, so does the quantity
supplied. This is reflected in the supply schedule:
6
5
Price
4
3
2
1
0
0
5
10
Quantity
The graph of this coordinates is called the Supply Curve which is
always upward sloping.
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SUPPLY AND DEMAND
Market Equilibrium
• Equilibrium price: Price where quantity demanded is equal
to the quantity supplied.
Example:
As the price of
chocolate bars
changes, so does
the quantity
supplied. This is
reflected in the
supply schedule:
6
5
Price
4
3
2
1
0
0
5
Quantity Supplied
10
15
Quantity Demanded
Quantity
From the graph, we can
see that the market
equilibrium occurs when
the price is three
because both the
quantity demanded, and
quantity supplied is
equal to nine. This is the
price that will occur in a
free market, when there
is no intervention.
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SUPPLY AND DEMAND
How to Find the Equilibrium
Mathematically
• Now instead of graphing to find the equilibrium,
we can use equations.
Example:
Looking at the same chocolate bar example, we now use the
following equations for supply and demand:
18−𝑄
𝑄
Demand: P = 3 , Supply: P = 3 . These equations map the point
from the original table.
To solve, set these two equations equal and solve for Q:
18−𝑄 𝑄
=
3
3
The 3’s in the denominator cancel out:
18 − 𝑄 = 𝑄
Adding the Q on the left side to the right:
18 = 2𝑄
Divide both sides by two to get:
𝟗=𝑸
Plug this into the original equations to get the equilibrium:
𝐏=
𝟏𝟖−(𝟗) (𝟗)
= =3
𝟑
𝟑
The equilibrium is Q=9 P=3, which is the same as what we found
from the previous graphing example.
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SUPPLY AND DEMAND
Changes to Demand
• Possible reasons for change in demand:
• Changes in people’s income
• Changes in people’s preferences
• Changes in the price of substitutes or complements
Example: Home Heating
If the price of natural gas decreases the demand for it will increase
and the demand for coal will decrease because these are
substitutable goods, both used to heat homes.
• How Demand Shifts:
Increase in demand: shift right
Decrease in demand: shift left
Example: Pink Jeans
If a famous musician starts a trend of wearing pink jeans, more people will
want to buy them so demand will increase. This will lead to the demand
curve shifting to the right. Because of this shift, the equilibrium will also be
changed because supply and demand do not intersect at the same point
anymore. The new equilibrium will have a higher price and quantity.
EDSPIRA
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SUPPLY AND DEMAND
Changes in Demand vs Change in
Quantity Demanded
1. Change in Price
Change in Quantity Demanded
• This leads to movement along the demand curve.
2. Change in something other than price
Change in Demand
• This leads to a shift in the demand curve.
1.
2.
Example: Pink Jeans
Let’s revisit the pink jeans example to learn the differences between these
two changes:
1.
Price
Quantity
Demanded
2.
Price
Quantity
Demanded
100 200 300 400 500
12
9
6
3
0
100 200 300 400 500
15
12
9
6
3
Moving from a price
of 100 to 200 is
movement down
the original curve.
An increase in
quantity demanded
shifts the curve to
the right, making a
new curve.
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SUPPLY AND DEMAND
Changes to Supply
• Possible reasons for change in supply:
•
•
•
•
Changes in the number of supplies
Changes in the price of factors of production
Technology
Weather
Example: Technology
The introduction of fracking has led to an increase in the supply of
natural gas.
• How Supply Shifts:
Decrease in supply: shift left
Increase in supply: shift right
Example: Weather
If a tsunami hits Costa Rica, this will greatly reduce the supply of coffee
because many coffee plantations were destroyed. This would move the
supply curve to the left, resulting in a new equilibrium that has a higher
price and lower quantity.
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SUPPLY AND DEMAND
Changes in Supply vs Change in
Quantity Supplied
1. Change in Price
Change in Quantity Supplied
• This leads to movement along the supply curve
2. Change in something other than price
Change in Supply
• This leads to a shift in the supply curve
1.
2.
Example: Coffee
Let’s revisit the coffee example to learn the differences between these two
changes:
1.
2.
Price
1
2
3
4
5
Quantity
Demanded
3
6
9
12
15
Moving from a price of
1 to 2 is movement up
the original supply
curve.
If the tsunami wipes out
Price
1 2
3
4
5
the coffee plantations,
the supply decreases. A
Quantity
0
3
6
9
12
Demanded
decrease in quantity
supplied shifts the curve to the left, making a new curve.
SUPPLY AND DEMAND
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Normal vs. Inferior Goods
• Normal Goods: If an individual’s income increases, they
will demand more of this good. (Positive correlation)
Example:
If everyone’s income increases, the demand for sports cars will
increase.
• Inferior Goods: If an individual’s income increases, they
will demand less of this good. (Negative correlation)
Example:
If everyone’s income increases, the demand for inexpensive ramen
noodles will decrease. They will want to buy the more expensive
option.
How Substitutes and Complements
Affect Demand
• Idea: A change in price of one good can affect the price of
another good.
• Substitutes: If the price of a substitute
(increases/decreases), the demand for the good
(increases/decreases). (Positive Correlation)
• Complement: If the price of a substitute
(increases/decreases), the demand for the good
(decreases/increases). (Negative Correlation)
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SUPPLY AND DEMAND
Simultaneous Changes in Supply and
Demand
Effect on
Quantity:
1 Increase Demand, Increase Supply
Effect on Price:
Increase Indeterminant
2 Decrease Demand, Decrease Supply Decrease Indeterminant
3 Increase Demand, Decrease Supply Indeterminant Increase
4 Decrease Demand, Increase Supply Indeterminant Decrease
Example: Wind Energy
1 Technological advances make it easier to produce wind energy.
2 Consumer preferences are changing- more consumers want
renewable energy.
The market reacts to
1
and
2
New equilibrium has the same price, increased
quantity because supply and demand change
were equal
ELASTICITY
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Price Elasticity of Demand
• Price Elasticity of Demand: Unitless measure of how
responsive consumers are to a change in price.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
Example: Ice Cream
If there was a 10% decrease in the price of ice cream and as a result
the quantity demanded increased by 50%, then the price elasticity
of demand would be 5.
• Elastic: >1, consumers are very responsive to a change in price.
• Inelastic: <1, consumers are not going to react as much to a
change in price.
• Unit Elastic: when elasticity is equal to exactly 1.
Example: Movie Theater
You own a movie theater and are deciding which price to set for
tickets. You currently sell tickets for $9 each and the quantity
demanded at that price is 20,000. The price you are considering is
instead selling tickets for $11 each. Experts in the movie theater
industry predict that the quantity demanded for these will be
15,000.
ELASTICITY
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Example: Movie Theater Continued
At the current price you make $9*20,000=$180,000 and at the
new price you make $11*15,000=$165,000.
Why?
We can figure out what is going on by calculating the price
elasticity:
1. Find percent change in quantity demanded (midpoint method):
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
20,000 − 15,000
=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
(20,000 + 15,000)/2
5,000
=
= 28.6%
17,500
2. Find percent change in price demanded (midpoint method):
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
11 − 9
2
=
=
= 20%
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑖𝑐𝑒
(11 + 9)/2 10
3. Plug these values into our price elasticity equation to get:
28.6%
= 1.43
20%
Even though you raised the price, you end up making less money
because the price is elastic (1.43>1), and customers are very
responsive to the price change.
For more examples, refer to Elastic vs. Inelastic Demand video
on Edspira's YouTube page.
ELASTICITY
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Income Elasticity of Demand
• Income Elasticity of Demand: Unit free measure of
responsiveness of demand due to a change in income.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
Example: Candy
If there was a 10% increase in your income and as a result your
quantity of candy demanded increased by 50%, then the income
elasticity of demand would be 5.
• % change in quantity= change in quantity/average quantity
• % change in income= change in income/average income
Example: Clown
You currently make $200/month working as a clown at children’s
parties. A video of you getting hit by a car while dressed as a clown
goes viral and people start sending you donations, resulting in an
increased income of $350/month. This increase will affect the food
that you eat and the quantities at which you are able to purchase it.
We can look specifically into your consumption of rice, pasta, and
chocolate.
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ELASTICITY
Example: Clown Continued
Food Item Type of
Good
Income
Income
Income
$200/month $350/month Elasticity
Rice
Inferior
10
5
-1.22
Pasta
Normal
(inelastic)
8
10
0.41
Chocolate
Normal
(elastic)
2
15
2.8
With a higher income, we can now afford to buy more of the
expensive items like chocolate as well as buy a higher quantity of
food in general.
Cross Elasticity of Demand
• This can tell you if two goods are substitutes or
complements. If it is positive, they are substitutes, if it is
negative, they are complements.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑟𝑒𝑙𝑎𝑡𝑒𝑑 𝑔𝑜𝑜𝑑
Example: Concession Stand
A baseball team concession stand decides to raise the price of
hotdogs by 20%. As a result, the quantity of hamburgers demanded
increases by 25%. The cross elasticity of demand of hamburgers is
thus 1.25, meaning hamburgers and hotdogs are substitutes.
ELASTICITY
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Elasticity of Supply
• Price Elasticity of Supply: Unit free measure of
responsiveness of supply when there is a change in price.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
Example: Natural Gas
If there was a 10% increase in the price of natural gas and as a
result your quantity natural gas supplied increased by 15%, then
the elasticity of supply is 1.5, meaning it is price elastic.
• Elasticity depends on how substitutable the good is and if
consumers can purchase it from a competitor at a lower
price.
• The ability to shift to a different resource is also a factor. If
it takes a long time to change from one supplier to another,
it may be less elastic than initially thought.
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EFFICIENCY
Equity vs. Efficiency
• Efficient Allocation (Pareto Efficiency): At a point where
no one can be made better off without at least one person
being worse off.
• Equitable Allocation: Is the distribution of goods fair?
Example: Cars
Pareto efficiency includes every
point on the PPF curve, even at
(0,100), but this would not be fair.
To make it more fair though, we
might end up running into a “leaky
bucket” problem where the
outcome is under the curve and
thus inefficient. This is an example
of the efficiency/equity tradeoff.
Jay Leno
100
Everyone else
• How do we overcome the efficiency/equity tradeoff?
• Try to grow the pie: We may not be able to mess with the
percentage of goods that goes to each party, but we may be
able to increase the size of the entire pie, leading to an
increase in the size of each slice.
EFFICIENCY
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Three Types of Economic Efficiency
• Efficiency in Consumption (Exchange Efficiency): The
goods produced go to the people who value them the most.
• Efficiency in Production (Production Efficiency): You
cannot produce one additional unit of one good without
making less of another good.
• Product Mix Efficiency (Allocative Efficiency): Those
goods produce correspond to what people want or need.
• All three of these are necessary to have Pareto Efficiency.
Six Types of Market Failure
• Market Failure: A case in which the free market is not
Pareto efficient; we could make someone better off
without making anyone worse off.
1
Externalities
Negative: A group is imposing a cost on another
group without reimbursing them.
Ex.) Pollution
Positive: A group is giving a benefit to another
group without reaping any benefits.
Ex.) Getting a vaccine and protecting those
around you.
EFFICIENCY
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2 Public Good
3
4
5
6
Requirements:
Nonrivalrous: Someone’s actions toward a good do not
prevent anyone else’s access to that good.
Ex.) One person moving to the US does not
prevent a resident’s access to the national
defense.
Nonexcludable: Someone cannot be excluded from
accessing that good.
These two together can lead to a free rider problem.
Monopoly
A single firm supplies the entire market, meaning
there is a lack of competition, so this firm can set
their own price.
Incomplete Market
A market doesn’t develop even though individuals’
willingness to pay is greater than the cost. This could
be because of adverse selection or information
asymmetry. Ex.) Insurance
Incomplete Information
The market does not supply enough information to
the consumer. Ex.) Loans/lending
High Unemployment or Inflation
If many people are unable to find work or there is
very high inflation, this could be an indication that
there is a market failure and can be a serious
macroeconomic problem.
Ex.) The Great Depression
SURPLUS AND PRICE RESTRAINTS
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Consumer and Producer Surplus
• Consumer Surplus: The difference between the
consumer’s willingness to play and the price actually paid.
Example: Guitars
You find a guitar you really like being sold online for $550 but you
were ready to spend up to $800. In this case you have a surplus of
$250.
• Producer Surplus: The difference between the amount
the producer receives and the cost of producing the good.
Example: Drum Kits
It costs a producer $300 to make a drum kit and they sell it for
$700. The producer surplus is $400.
• Instead of only looking at individuals, we can also find the
total surplus of all producers and consumers in a market.
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SURPLUS AND PRICE RESTRAINTS
Example: Surfboards
7
Equilibrium: (9,3)
6
1
Area: [ 6 − 3 ∗ (9-0)]=13.5
2
5
4
Price
Consumer Surplus:
Below demand curve
and above price.
Producer Surplus:
Below price and above
supply
1
Area: [ 3 − 0 ∗ (9-0)]=13.5
3
2
1
0
0
5
Quantity Supplied
10
15
Quantity Demanded
2
Quantity
Effect of a Price Ceiling
Price Ceiling: A level at which no price can be set higher.
Before Price Ceiling
After Price Ceiling
Deadweight loss
Price
Ceiling
Shortage
The price ceiling prevents the price being set at equilibrium and as a result, consumer surplus increases and producer surplus
decreases. A shortage will occur because the quantity demanded is higher than what is being supplied.
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SURPLUS AND PRICE RESTRAINTS
Effect of a Price Floor
Price Floor: A level at which no price can be set lower.
Before Price Floor
After Price Floor
Surplus (Excess Supply)
Price
Floor
Deadweight loss
The price floor prevents the price being set at equilibrium and as a result, consumer surplus decreases and
producer surplus increases. A surplus will occur because the quantity demanded is lower than what is being
supplied. Deadweight loss is lost value that occurs as a result of a price floor or ceiling that would’ve been
captured in consumer or producer surplus if there was no price restriction in place.
Effect of a Price Support
Price Support: A price floor where the government promises to buy up the excess
supply.
Before Price Support
Surplus (Excess Supply)
After Price Support
Surplus (Excess Supply)
Price
Floor
Price
Floor
Total cost to the
government
Deadweight loss
The producer surplus is greatly increased, leading to a total surplus what was larger than the original surplus triangle before
the price floor and support were implemented. This additional space is being paid for by the government, meaning the
taxpayers. The total cost of gaining this additional space is the entire rectangle that is the width of the excess supply.
SURPLUS AND PRICE RESTRAINTS
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How Countries Benefit from Free Trade
Gains from Imports: By trading, it is possible to get a lower price
than what the good can be made at without trading.
Without Trade
With Trade
New
Price
Imports
The total surplus (consumer surplus plus producer surplus) has increased, but producers now have less surplus. It is
possible to achieve the quantity and price shown by the grey dot because the number of imports makes up the
difference between the quantity supplied and the quantity demanded. Consumers are much better off in the trade
scenario.
Gains from Exports: A company that has a comparative advantage
producing a good can set a higher price by trading with other companies.
Without Trade
With Trade
Exports
New
Price
Similar to what happens with imports, the total surplus increases, but this time it is the consumer surplus that decreases.
Consumers are not seeing as much of a benefit because the price has increased. It is possible to achieve the quantity and price
shown by the grey dot because the number of exports makes up the difference between the quantity supplied and the
quantity demanded.
SURPLUS AND PRICE RESTRAINTS
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The Effect of an Import Tariff
Import:
Without Trade
With Trade
New
Price
Imports
The total surplus (consumer surplus plus producer surplus) has increased, but producers now have less surplus. It is
possible to achieve the quantity and price shown by the grey dot because the number of imports makes up the
difference between the quantity supplied and the quantity demanded. Consumers are much better off in the trade
scenario.
Tariff:
Using a tariff will increase the price of
the good being imported or exported. It
is no longer possible to buy at the new
import price. The lowest option now is
the import price plus that tariff cost.
With Tariff
Imports
Price + Tariff
Tariff
Amount
Tariff
Revenue
Deadweight Loss
Price
The tariff results in a decreased number
of imports, revenue that is received by
the country’s government, and two
areas of deadweight loss. The
deadweight loss represents the loss in
total surplus from implementing the
tariff.
The government is gaining revenue
from the tariff and producers are better
off, but the overall surplus is decreased.
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EXTERNALITIES
What are Externalities?
• Externality: You do something that affects the well-being
of another person, but you are neither harmed nor
rewarded for what you did.
Negative Externality: One person imposes a cost on another person
without reimbursing them.
Example: Pollution
Marginal
Social Cost
Marginal
Private Cost
Price
A company upstream pollutes a river and
those downstream get sick because of it.
The company has created a negative
externality by not addressing this problem.
The company will set equilibrium where
marginal social benefit is equal to their
private marginal cost instead of the
marginal social cost (marginal private cost
plus externalities). The company does not
take these externalities into consideration
when making their decision.
Marginal Social Benefit
Quantity
Positive Externality: One person confers benefits on another person
without being compensated.
Example: Education
Marginal
Social Cost
Price
When a person is deciding whether or not
to go to college, they are weighing their
marginal private benefit with cost. This
results in a lower number of college
graduates, but at this equilibrium level,
society is at a higher marginal benefit. The
individual will gain knowledge and higher
wages by going to college and society will
experience less crime for example.
Education ends up being undersupplied.
Marginal
Social Benefit
Marginal Private
Benefit
Quantity (# of College Graduates)
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EXTERNALITIES
Pigouvian Tax
• Pigouvian Tax: One strategy that can be used against
negative externalities. This is a corrective tax that is set
equal to the marginal external cost (marginal social cost
minus marginal private cost). This can bring about the
efficient outcome being the equilibrium in the market.
Example: Traffic Congestion
•
MSC (private cost plus external Cost)
Marginal
Private Cost
Price
An individual has to decide what type of
transportation to take to work and will
make this decision based on their marginal
private cost like price of fuel or commute
time for example.
Adding the Pigouvian tax decreases the
difference between MSC and MPC to zero
to get the efficient equilibrium.
Individuals are now being charged the
amount that they are charging others
through externalities.
Pigouvian Tax
Marginal Social Benefit
Quantity (miles driven)
Double Dividend: By using this Pigouvian tax, we increase tax revenue
(blue box above) in addition to achieving an efficient outcome.
EXTERNALITIES
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Cap and Trade
• Cap and Trade: A system of marketable permits that are
used to address negative externalities.
Example: Pollution
A company’s sulfur dioxide pollution creates acid rain that affects
the fishermen in the waterways nearby. There is a market failure
because of this overproduction of sulfur dioxide.
• How Cap and Trade Works
1 Cap the Amount of Production
2 Set up market for firms to trade permits
Example: Pollution
The market is capped at 200,000 tons of sulfur dioxide. Firm A gets really
good at efficient production and only needs half of the cap, leaving an extra
100,000 tons. If firm B is struggling to meet this cap and still pollutes at a
level of 300,000 tons, firm A could sell its permit for the excess 100,000 to
firm B. The total emissions cap between the two firms remains the same at
200,000*2=400,000, but it is divided up differently with firm A at 100,000
and firm B at 300,000. There is an inventive for companies to invest in
cleaner technology so they can sell these permits to other companies. In
this case, the quantity is set and price adjusts to the efficient level. This
leads to the same outcome as the Pigouvian tax where the price is set first
and quantity adjusts.
EXTERNALITIES
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Cap and Trade vs Carbon Tax
• Both policies are used to address a negative externality.
• The carbon tax uses a pricing mechanism to reach the
socially efficient level of carbon while Cap and Trade uses a
quantity mechanism.
• Cap and Trade:
• Pros:
•
•
•
•
Can predetermine quantity based on science
Can easily adjust to reflect the cost of abatement (clean-up costs)
Creates a unit of exchange for international harmonization
Could easily raise revenue if auctions are used
• Cons:
•
•
•
•
Difficult to determine how to allocate the initial credits
Distribution controlled by politicians
Need to set up a market
Can’t be used for personal vehicles, heating homes, etc.
• Carbon Tax:
• Pros:
• Easy to administer, don’t have to set up a market
• Avoids volatility of a market
• Generates a large amount of revenue
• Cons:
• Does not cap emissions
• Legislative battles could ensue over the tax rate
Determining which is the better option depends on the situation.
For the sulfur dioxide example, it may be easier to use a carbon tax.
EXTERNALITIES
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Coase Theorem
• A negative externality can be resolved through bargaining
between the parties involved to reach the socially
efficient outcome if:
1
Property rights are clearly defined
2
Transaction costs are low
Example: Pollution
A company is polluting a nearby river and the fishermen downstream are
not able to catch as many fish because the pollution is killing them off.
1 If the fishermen have it in their property rights that they have
the right to clean water, then they will be able to come to an
agreement with the factory without government intervention.
2 In this case transaction costs are low because it is only one
factory and one person being harmed. Transaction costs can
become much higher when more people are involved.
PUBLIC AND COMMON GOODS
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Public Goods
• Public Good: Any type of good that is both nonrivalrous and
nonexcludable.
• Nonrivalrous: The marginal cost of providing this good to
one extra person will be zero. Someone’s actions toward a
good do not prevent anyone else’s access to that good.
• Nonexcludable: People can not be prevented from enjoying
that good.
The Efficient Provision of Public
Goods
What is the best way for the government to provide public
goods while also minimizing the free rider problem?
Free Rider Problem: Individuals benefit from public goods while
not contributing themselves.
The efficient quantity if when marginal social benefit (MSB) is
equal to marginal social cost (MSC). To do this, we can:
1 Ask each individual what they would pay for an
additional unit.
2 Construct a demand curve for each individual.
3 Sum up the individual demand curves to create a
collective demand curve to find the MSB.
PUBLIC AND COMMON GOODS
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Common Goods
• Common Good: Any type of good that is both rivalrous and
nonexcludable.
• Rivalrous: The marginal cost of providing this good to one
extra person will not be zero. Someone’s actions toward a
good prevent anyone else’s access to that good.
• Nonexcludable: People can not be prevented from enjoying
that good.
Price
Example: Fishing
Fishing in the ocean is nonexcludable because it is very difficult to
exclude people from going into the ocean. However, if I catch 10
fish, those are 10 fish that you are no longer able to catch, making it
rivalrous.
The fisherman is not
Marginal Private Benefit
(avg. Return per Boat)
taking into account
the fact that the fish
they catch are no
Cost of a Boat
longer available for
others to catch. They
are only worried
about when cost is
Marginal Social Benefit
equal to MPB.
Quantity (number of boats catching fish)
Instead, the socially optimal level (the grey dot) is less than what
the fisherman will choose, leading to an oversupply of boats.
PUBLIC AND COMMON GOODS
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Individual Transfer Quotas (ITQs)
• Individual Transfer Quotas (ITQs): These try to solve
the problem of overuse that collective goods often face.
• Three characteristics of a good ITQ:
1 Quotas entitle you to a specific number of a specific
good
2 Sum of all quotas is equal to the socially efficient
quantity
3 Quotas can be bought and sold
• Two ways to allocate ITQs:
1 Auction
2 Based on history
Ex.) Those in the past that have caught a large number
of fish get more ITQs this year.
• Challenges:
• It may be hard to separate the specific goods.
Example: Bycatch
A fisherman has a cod quota, but a shark was caught in one of the
nets. The fisherman will receive a fine for catching it if they don’t
have a shark quota, but there is also a chance that it will die after it
has been released and it will be wasted.
• High-grading: only keeping the best of the specific good, and
potentially wasting the ones of lower grade.
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REAL WORLD EXAMPLES
Pharmaceutical Drug Testing
• A company creates a drug that will help combat cancer.
• The next step is to take it to a regulatory agency (In the United
States that is the Food and Drug Administration).
• This agency then has to deal with a tradeoff between minimizing
delay of the rollout and maximizing safety.
Number of
Deaths
Total Deaths
Deaths Due
to Delay
Deaths Due
to Unsafe
Drug
Years of Testing
From society’s
perspective, the goal is to
minimize the number of
deaths by determining
how long the FDA has to
test and approve a drug.
Looking at the total
deaths curve, we can see
it is minimized when
deaths due to unsafe drug
is equal to deaths due to
delay.
From the regulator’s perspective, deaths due to unsafe drugs are
publicized much more and so they will be more focused on this
than deaths due to delay. This could result in the number of
years of testing being higher than the socially optimal level.
REAL WORLD EXAMPLES
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Airline Safety
• Airlines also have to think about tradeoffs when it comes to
safety.
• A safety feature will be added if the incremental benefit
outweighs the incremental cost.
• One example of this is how many pilots should be placed on each
flight.
$
The marginal cost
increases because more
pilots requires more space
on the plane, whether
Marginal Cost that is in the form of an
additional seat or a larger
cockpit.
From the airline’s
Marginal
perspective, the ideal
Benefit
number would be when
marginal cost is equal to
Number of Pilots
marginal benefit.
From the regulator’s perspective (FAA in the United States), they
may want more pilots present to increase the safety and avoid
problems. This could lead to a different outcome than what the
airlines want to do.
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REAL WORLD EXAMPLES
Fracking
• Fracking: Hydraulic Fracturing where a firm will drill a well into
the ground and spray water into the rock to brake up the shale
and be able to extract oil and natural gas.
• Coal and natural gas are substitutes for each other because
they both serve the similar purpose of heating people’s
homes, etc.
Natural Gas
Fracking technology is more
efficient at extracting natural
gas, so there is going to be a
rightward shift in the supply
curve. This results in a new
equilibrium that has a higher
quantity and lower price.
Coal
Because coal is a substitute
for natural gas, its demand
curve will shift to the left
when there is a decrease in
the price of natural gas. This
new equilibrium has a lower
quantity and a lower price.
• In this scenario, natural gas is displacing some of the coal that
used to be used to heat homes. Introducing new technology
thus impacts more than just natural gas.
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REAL WORLD EXAMPLES
Housing Vouchers
• A “fair market rent” is decided upon for a neighborhood
and a tenant will contribute 30% of their income towards
this value and the voucher will cover the rest (a subsidy
from the government).
Market for Housing
Marginal
Social Cost
Marginal
Social Benefit
With these vouchers, more
people are now able to afford
housing and thus there is an
increase in demand, shifting the
curve to the right. This results in
an increased quantity of housing
which is exactly what we wanted,
but it also results in an increased
price. There are positive
externalities associated with this
as well such as increased chance
of graduating high school and
becoming productive workers if
children have stable housing.
Marginal
Private Benefit
The positive externalities are
represented by the difference
between the marginal social
benefit and the marginal private
benefit that individuals receive
from these vouchers. Neighbors
and society itself are better off if
there is less crime, more high
school graduates, etc. Using
vouchers moves the equilibrium
up to the socially optimal level
and bridges the gap between
MPB and MSB.