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Midterm

Econ 101 Midterm 2 Review.docx

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Department
Economics
Course
ECON 101
Professor
Wokia Kumase
Semester
Fall

Description
Chapter 5: Efficiency and Equity Alternative Methods of Allocating Resources - Market Price: used to allocate resources that two kinds of people buy o Those who can afford it but choose not to buy o Those who cannot afford it and therefore cannot buy o Does not work well with essentials that cannot be afforded - Command: used to allocate resources by the order of someone in authority o Works well when it is easy to monitor and responsibilities are clear o Not good when the range of activities that is to be monitored are large o Used in North Korea for a negative impact to the community - Majority Rules: when a majority of the voters choose where to allocate resources o Works well when decisions being made affect large number of people and self-interest has to be suppressed to allocate resources most efficiently o Society uses this method to select government to make big choices - Contest: the resource is allocated to the winner of an event o Works well when the efforts of the players are hard to monitor and reward o Sporting events use this method to get standings in playoffs - First-Come: First-Serve: allocates resource to those who are first in line o Works well when a scarce resources can serve just one user at a time o Used in the highway or restaurants to serve the first user - Lottery: Allocate resource to lucky individual who picked a winning number o Works well when there is no effective way to distinguish among potential users of a scarce resource o Used in casinos, OLG lottery companies and airport landing spaces - Personal Characteristics: allocate resources based on personal characteristics  Where person with the “correct” characteristics get the resources o No ways that it can be done “well” o Used in marriage proposals and discrimination against certain races - Force: allocation of resources done by lack of free will o Positive force: provides the state with an effective method of transferring wealth from rich to the poor o Negative force: the taking of property of others without their consent that causes billions of dollars worldwide to be reallocated  Example: War between nations Consumer Surplus - The excess of benefit received from a good over the amount paid for it o Area under the demand curve but above the price paid Producer Surplus - The excess of amount received from sale of a good over the cost of producing it o Area above the supply curve but below the price sold Connection between Demand and Marginal Benefit - Price is what we pay while Value is what we get out of it - Value of one more unit of a good is marginal benefit - Willingness to pay determines demand o Demand curve is a marginal benefit curve - Market Demand curve is the horizontal sum of the individual demand curves and is formed by adding the quantities demanded by all the individuals at each price - Societies marginal benefit is the marginal social benefit and the market demand curve is also the marginal social benefit curve (MSB) Connection between Supply and Marginal Cost - Cost is what a firm gives up to produce a good - Price is what a firm receives when it sells a good - Marginal cost is the minimum price that a firm is willing to accept - Minimum supply-price determines supply. - Supply curve is a marginal cost curve - Market Supply Curve is the horizontal sum of the individual supply curves and is formed by adding the quantities supplied by all the producers at each price - Societies marginal cost is the marginal social cost and the market supply curve is also the marginal social cost curve (MSC) Conditions in which Market is Efficient and Inefficient - Allocative efficiency is obtained at equilibrium o When MSB = MSC (Demand curve = Supply Curve) When the efficient quantity is produced, total surplus is maximized Total surplus is the sum of the consumer surplus and producer surplus The Invisible Hand: competitive market sends resources to their highest valued use - Assumes that consumers and producers act in their own self-interest o Market transactions generate an efficient use of resources Market Failure: when markets do not achieve an efficient outcome - Occurs due to too little of an item produced or too much of an item o Too little = Underproduction o Too much = Overproduction  These create dead weight losses  Decrease in total surplus that results from an inefficient level of production Sources of Market Failure - Price and Quantity Regulations o Puts a cap on the maximum price they can sell it for o Lead to underproduction - Taxes o Increase the prices paid by buyers and lower prices received by the sellers o Lead to underproduction - Subsidies o Decrease the price paid by buyers and increase prices received by producers o Lead to overproduction - Externalities o A cost or benefit that affects others than the seller or the buyer o When external cost arises, leads to overproduction  Electric company pollutes without considering climate change o When external benefit arises, leads to underproduction  Fire alarm installed in condominium protects himself without considering that he protects everyone - Public Goods o Consumed simultaneously by everyone even if they don’t pay for it  National defense and oxygen that we breathe is an example  Leads to under produced national defense since everyone wants to freeload off of it - Common Resources o Owned by no one but is available for everyone to be used  Atlantic salmon is an example  Leads to over used resources since it’s in everyone’s self interest to fish Atlantic salmon but they ignore extinction - Monopoly o A firm that is a sole provider of a good leads to underproduction  Local water supply or television cable company is an example  Monopolies try to maximize profit and self interest  To accomplish this, they produce little and charge high - High Transaction Costs o The cost of the services that enable a market to bring buyers and sellers together o Leads to underproduction Alternatives to the Market - Often, majority rules might been used in order to improve allocation of resources o However, a majority can pursue self interest - Managers in firms might use command to avoid high transaction costs o they would receive every time they needed a job done - First come first serve might be used as well Fairness and how Market Results in Unfair Outcomes Two main points It’s not fair if the results aren’t fair - General idea is that it isn’t fair if the incomes of people are too different within a company - Believes everyone deserves an equal piece of the pie per person o Example: Bank president makes millions while teller makes less is not fair - Efficiency requires equality of incomes - Utilitarianism is a principle that states we should strive to achieve the greatest happiness for the greatest number  Jeremy Bentham, John Stuart Mill; were utilitarian’s - 1) Everyone has the same basic wants and the similar capacity to enjoy one’s life - 2) The greater the persons income, the less marginal benefit and lesser the persons income, greater the marginal benefit - Big problem with utilitarianism is that it ignores the cost of making income transfers o The big trade off is the cost of making income transfers which is a trade between efficiency and fairness  Income can be transferred from rich to poor by taxing the rich only  However, taxing peoples income makes them work less than they would originally  This shrinks the economic pie o Trade off is between the size of the economic pie and the degree of equality with which it is shared It’s not fair if the rules aren’t fair - Based on the symmetry principle which is the requirement that people in similar situations be treated similarly - “Behave towards other people the way you wish to be treated” o This principle translates to Equality of Opportunity - Fairness obeys two rules o The state must enforce laws to protect private property o Private property may be transferred from one person to another, only by voluntary exchange - Fairness and Efficiency states that if private property rights are enforced and voluntary exchanges take place, resources will be allocated efficiently if there are no sources of market failure o Prices and quality regulations o Taxes and Subsidies o Externalities o Public Goods and common resources o Monopolies o High transaction costs Chapter 6: Government Actions on Market How rent ceilings create shortages and inefficiency - Price Ceilings or Price Cap is a regulation that makes it illegal to price higher than it o Effects are crucial when the ceiling is put below the equilibrium price  Above has no effect  Below produces a powerful effect - Rent ceiling is a price ceiling on housing o Shortage in housing  A rent ceiling makes it so that the quantity demand exceeds the quantity supplied in housing  When there is a shortage, quantity supplied is the quantity available which must be allocated to frustrated buyers o Increase of search in houses (Search Activity)  Causes the opportunity cost to not only be equal to the price, but to the time spent looking for the good  Might make the total cost of the housing to be more than what it would have been without the rent ceiling o A black market  An illegal market in which the equilibrium price exceeds the rent ceil  The more enforced the rent ceiling, the higher the price above equilibrium price  The less enforced the rent ceiling, the closer to the price of the equilibrium price  Eventually end up paying more than the equilibrium price - Inefficiency in Rent Ceilings o Causes underproduction of housing o Creates a dead weight loss as the marginal social benefit exceeds the cost  Producer surplus and consumer surplus shrinks  Also a potential loss from search activity - Are rent ceilings fair? o Using lottery, first come first serve, and discrimination, it allocates resources to decrease the quantity of scare housing  None of which are deemed fair How minimum wage create unemployment and inefficiency - Price floor is a regulation that makes it illegal to trade at a lower price than specified o When applied to labour market, it is called a minimum wage  If set below equilibrium wage, no effect is produced  If set above equilibrium wage, powerful effect is produced  Leads to unemployment o Quantity of labour supplied exceeds demanded  Demand for labour determines the level of employment - Inefficiency of minimum wage o The supply of labour measures the marginal social cost of labour to workers  The leisure time that they could have had o The demand for labour measures the marginal social benefit from labour  The value of the goods produced o The potential loss from increased job search decreases both workers’ surplus and firms’ surplus.  The total loss is the sum of the red and gray areas Tax Incidence and Elasticity of Demand - Tax incidence is the division of the burden of tax between buyers and sellers - Perfect Inelastic Demand o Demand for this good has a vertical demand curve  When a tax is imposed, buyers pay the entire tax - Perfect Elastic Demand o Demand for this good has a horizontal demand curve  When a tax is imposed, sellers pay the entire tax Tax Incidence and Elasticity of Supply - Perfectly Inelastic Supply o Supply for this good has a vertical supply curve  When a tax is imposed, sellers pay the entire tax - Perfectly Elastic Suppy o Supply for this good has a horizontal supply curve  When a tax is imposed, buyers pay the entire tax Tax on Sellers - Is like an increase in cost, it decreases the supply - We add the tax to the minimum cost and move it upwards / leftwards Tax on Buyers - Lowers the amount they are willing to pay sellers o Decreases demand and shifts the demand curve leftward - We subtract the tax from the maximum price that buyers are willing to pay for each Taxes and Efficiency - Except in extreme cases of Perfectly inelastic demand or perfectly inelastic supply when the quantity remains the same, imposing a tax creates inefficiency Taxes and Fairness
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