Practice Micro Test 2 03/06/2013 11:26:00 PM
Chapter 6 and 8
A price ceiling: is a legal maximum on the price at which a good can be sold
The price ceiling is not binding (not effective) if it is set above equilibrium
The price ceiling is binding (effective) if set below equilibrium price, leading
to a shortage
Ex: maximum rent
What if the province imposes a rent ceiling of $500?
Shortage = Qd-Qs
Sub in $500 for price
A price floor: a legal minimum on a price at which a good can be sold
The price floor is not binding if set below the equilibrium price.
The price floor is binding if set above the equilibrium price, leading to a
Ex: minmum wage
W= wage dollars
Labour measured in thousands of hours
Puts minimum wage of 10 bucks
Surplus of labour: Qs-Qd
A quota: a quantity control
An upper limit on the quantity of a good that can be sold
Government usually issues quota licenses that give producers a right to
produce a specified amount of a good
The number of taxis in a city is strictly controlled
The amount of fish you are allowed to catch and sell
Often seen with dairy products and agricultural products
Governments levy taxes to raise revenue for public projects. Tax incidence: The distribution of a tax burden
Taxes on beer
Notice that the burden of the tax doesn’t fall equally on consumers
Before the tax, the consumers paid $3.00 and sellers received
$3.00 per bottle.
After the tax,
Consumers pay $ .30 more per bottle.
Sellers receive $ .20 less per bottle.
o In this case, the consumers bear the larger burden of the tax:
$.30 versus $.20.
Tax on suppliers
Now, suppose instead that the government levies the tax on bar owners.
Sellers react by supplying less beer at every price.
The supply curve will shift up by the amount of the tax.
The burden of the tax is the same.
Consumers pay $ .30 more than before.
Sellers receive $ .20 less than before.
The consumer bears the larger burden of the tax.
Taxes on consumers and taxes on suppliers are equivalent = end results
doesn’t matter on whom the tax is levied
Taxes reduce the quantity traded, increase the price that consumers pay and
lower the price that suppliers recieve
In our example, the consumers bore the larger burden of the tax.
That’s because the demand curve is actually steeper than the supply curve.
This turns out to be a general rule:
The side of the market which is more inelastic (steeper curve) bears
a larger burden of the tax.
Inelastic means less responsive to change
Can’t adjust in the short run to compensate to any great extent
If you can’t adjust, you are stuck with the heavier burden of tax What determines the size of the deadweight loss from a tax?
Depends on the price elasticities of demand and supply; how responsive is
demand and supply?
The following examples show what happens to deadweight loss when the
size of the tax remains the same and the
demand curve is the same but supply elasticity changes.
supply curve is the same but demand elasticity changes.
DWL increases as supply becomes more elastic
As demand become more elastic the DWL increased
The greater the elasticities of demand and supply:
The larger the decrease in equilibrium quantity due to tax
The greater the DWL of a tax
Increasing tax = increase in DWL
But tax revenue is decreasing because less trading is happening
For the small tax, tax revenue is small.
As the size of the tax rises, tax revenue grows.
But as the size of the tax continues to rise, tax revenue falls because the
higher tax reduces the size of the market.
Subsidies: payments given to producers in order to increase market output
and / or decrease prices paid by consumers
Think of them as opposite of taxes levied on producers
They shift the supply curve out (to the right), resulting in a new equilibrium
with more output and a lower equilibrium price
DWL – money spent the government that does not benefit anyone in the
Chapter 7 Welfare economics: The study of how the allocation of resources affects
Buyers and sellers in the market receive benefits from participating in the
Equilibrium in the market results in maximum benefits and therefore,
maximum total welfare
Every buyer in an economy is only willing to pay up to a certain
amount for a good or service. We define:
Willingness-to-pay: the maximum amount that you are willing to
pay for a certain quantity of a good
Also called a reservation price
How much value you place in the good
Consumer surplus: the buyer’s willingness-to-pay minus the amount the
buyer actually pays
The market demand curve depicts the various quantities that
buyers would be willing and able to purchase at different prices
It depicts consumers’ willingness-to-pay; how consumers value the
Producer surplus: amount a seller is actually paid for a good (receives for a
good) minus the seller’s willingness-to-sell (lowest price a seller will take to
produce and sell a good); their cost
Willingness-to-sell: lowest price a seller will take to produce and
sell a good
Consumer Surplus = Value to buyers (D) – Amount buyer pays (pe)
Producer Surplus = Amount sellers receive (pe) – Cost to sellers (s)
Since amount buyer pays = amount sellers receive
Total Surplus = Consumer Surplus + Producer Surplus
Total Surplus = Value to buyers – Cost to sellers Free markets do 3 things:
Allocate the supply of goods to the buyers who value them the most (they
have the highest willingness-to-pay)
Allocate the demand for goods to the least cost suppliers
Produce the quantity of goods that maximizes total surplus = CS+PS
Sometimes there are benefits and costs that arise in the market that go
These are called externalities.
A positive externality: a benefit enjoyed by society but society doesn’t pay
to receive it (ie. I enjoy the shade from my neighbour’s tree but it does not
cost me a thing.)
A negative externality: is a cost suffered by society and the instigator whose
imposing this cost isn’t made to pay for the damage done (ie. The
neighbour’s dog barks all night and keeps me up, but my neighbor does not
Negative externalities lead markets to produce more than is socially
Positive externalities lead markets to produce less than is socially desirable.
The government can internalize an externality:
Impose a tax on producer to get them to produce less; to produce the
socially desirable quantity
A tax levied on each unity of output sold
The social value: not alone the private value but it also includes the value to
the rest of society The government can internalize the externality by subsidizing the production
of the good – get firms to supply more.
A property right: the exclusive authority to determine how a resource is
used, whether the resource is owned by the government or individuals; need
property rights in order to buy and sell
Private property rights have two other attributes in addition to determining
the use of a resource:
Transaction costs: costs of bargaining
These can be so high that private agreements are not possible
Profit = Total revenue – Total cost
P = TR - TC
Explicit and Implicit Costs
A firm’s cost of production include explicit costs and implicit costs.
Explicit costs: that require a direct outlay of money (you have a receipt for
Implicit costs: don’t require a direct outlay of money (like the money you
could have earned investing instead of updating your factories); no receipt
for what you COULD have made
Economists measure a firm’s economic profit as total revenue minus total
cost, including both explicit and implicit costs, i.e., total opportunity costs.
Accountants measure the accounting profit as the firm’s total revenue minus
only the firm’s explicit costs.
When total revenue exceeds both explicit and implicit costs, the firm earns
Economic profit is smaller than accounting profit because it includes implicit
costs. Production function: shows the relationship between quantity of input used
to make a good and the quantity of output of that good
Marginal product: The increase in output that arises from an additional unit
of that input
Ie. If L increases my inputs by one (one unit), how much will my total
product (total output) increase?
MP = change in total output = rQ
change in # of inputs rL
In other words, MP is the slope of the total product function.
Diminishing Marginal Product
Diminishing marginal product: the marginal product of an input declines as
the quantity of the input increases when you have fixed inputs too
Notice that TP is maximized when the slope of the TP function is zero.
Since the slope of the TP function is MP,
TP is maximized when MP = 0
Average Product, AP = ____Q_____
# of inputs
AP intersects MP at max AP
Whenever MP > AP, AP must be increas
Whenever MP < AP, AP must be decrease
When AP = MP, AP is at its maximum. TP is maximized when MP = 0
Costs of production may be divided into fixed costs and