Term Test Three Study Package
(Micro 9-11, Macro 1-3)
Chapter 9: Monopoly Rules (Government Regulation, Competition, and
Natural Monopolies create a challenge for policymakers—gain the low-cost
efficiencies of economies of scale, but avoid the inefficiencies of monopolies restricted
output and higher price.
Economies of scale—average total cost falls as quantity of output increases
Natural Monopoly—technology allows only single seller to achieve lowest average
-Natural monopolies are based on current technology, when technology changes,
natural monopoly may change to more competitive market structure
Two major policies governments use to deal with challenge of natural monopoly are
public ownership and regulation
Crown corporations—publicly owned businesses in Canada, Achieve economies of
scale, but lac of competition weakens incentives to reduce costs or innovate
Rate of return regulations—set price allowing regulated monopoly to just cover
average total costs and normal profits
Strategic interaction among competitors complicated business decisions, creating two
smart choices—one based on trust and the other based on non-trust.
Game theory—mathematical tool for understanding how players make decisions,
taking into account what they expect rivals to do (Nash, beautiful mind)
-Gasoline pricing is a strategic decision that can be understood using game theory
Prisoners dilemma—game with two players who must each make a strategic
choice, where results depend on other players choice. Nash equilibrium—outcome of game where each player makes own best choice
given the choice if the other player
Two smart choices exists in a prisoners dilemma game; one based on non-trust and
one based on trust
-If other player cannot be trusted, smart choices is cheat/confess; all players driven
to Nash equilibrium outcome where everyone cheats/confesses
-If other player can be trusted smart choice is to cooperate/deny; all players driven
to equilibrium outcome where everyone cooperates/denies
-The prisoners “dilemma” is that each player (prisoner) is motivated to cheat
(confess) yet both would be better off if they could trust each other to cooperate
Cartels collude to raise prices and restrict output to increase economic profits.
Cartels are unstable because members can increase their individual profits by
cheating on the others.
Collusion—conspiracy to cheat or deceive others
Cartel—association of suppliers formed to maintain high prices and restrict
OPEC (organization of petroleum exporting countries) is international cartel
that acts like a monopoly
-Desirable competitive behavior—always an active attempt to increase profits and
gain market power of monopoly—is hard to distinguish from undesirable collusive
-The Competition Act, introduced by government to prevent anti-competitive
business behavior, raises expected costs to business of price fixing (through prison
time, fines, legal prohibition) relative to the expected benefits (profits)
-Criminal offences (punished by prison time, fines): price fixing, big rigging,
-Civil offences (punished by fines, legal prohibitions): Mergers, abusing dominate market position, lessening competition, competition
tribunal weighs costs of lessening competition against benefits of any increased
The discipline of market competition eventuality eliminates dangerous products, but in
the process people may be harmed. Three major forms of government regulation in
Canada address this problem.
Caveat emptor (“Let the buyer beware”)—buyer alone responsible for checking
quality of products before purchasing
Certain products—nuclear power, medicines, poisonous insecticides-regulated by
government because average consumer is not capable of knowing products quality
Major forms of government regulation in Canada: government departments,
government appointed agencies/boards, professional self-governing bodies.
There are two views of government regulation. The public interest view suggests
government action improve market failure outcomes. The capture view suggests
government actions produce government failure.
Public-interest view—government regulation eliminates waste, achieves
efficiency, promotes public interest
Capture view—government regulation benefits regulated businesses, not public
Evidence mixed on government regulation—some suggests public-interest view,
some supports capture view
Government failure—regulation fails to serve public interest, instead benefits
industry being regulated.
-Sometimes market outcome, even with monopoly power, will be better than
government regulation outcome if there is significant government failure.
-Sometimes government outcome, especially with public interest regulations, will be
better than market outcome if there is significant failure. Chapter 10: Acid Rain on Others Parades (Externalities, Carbon Taxes,
Free Riders, and Public Goods)
Negative or positive externalities make smart private choice different from smart
-Smart choices require that all additional benefit and additional opportunity costs—
including externalities—be counted
Negative externalities (external costs)—costs to society from your private choice
that affect others, but that you do not pay
Positive externalities (external benefits)—benefits to society from your private
choice that affect others, but that others do not pay for
-Externalities occur when no clear property rights exist
-When externalities exist, prices don’t accurately reflect all social cost and benefits,
preventing markets from coordinating private smart choices with social smart
choices. Market fail:
-Producing too much of things we don’t want (second hand smoke, pollution,
-Producing to little of things we don’t want (vaccinations, education)
To coordinate smart private choices that generate negative externalities, with smart
social choices, choose the quantity of output where marginal social cost equals
marginal social benefit
As we reduce pollution, “efficient pollution”, balances additional environmental
benefits with additional opportunity costs of reduced living standards
Socially desirable amount of pollution is not zero; at some point additional
opportunity costs of reduction in pollution are greater than additional benefits
For any product/service that generates an externality, rule for a smart choice is:
Choose quantity of output where marginal social costs equal marginal social
benefit Marginal social cost (MSC) marginal private costs plus marginal external cost
Marginal social benefit (MSB) marginal private benefit plus marginal external
Markets overproduce products/services with negative externalities; price is too low
because it does not incorporate external costs.
Government policies can force polluting businesses and individuals to pay the marginal
external cots of their pollution. As a result, polluters internalize their
externalities/costs into their private choices, creating smart social choices
-Without property rights to the environment, businesses have incentives to save
money and improve profits but ignoring external costs like pollution and global
-Governments can remedy market failures from externalities by creating social
property rights to environment, making pollution illegal, penalizing polluters.
Emissions tax—tax to pay external costs emissions
Carbon tax—emissions tax on carbon-based fossil fuels
Cap-and-trade-system—limits emissions businesses can release into environment
Internalize the externality—transform external cots into costs producer must pay
privately to government
-By giving pollution a price reflecting marginal external cost of damage done, smart
individual and business choices become smart social choices.
-Carbon taxes and cap-and-trade systems are smart policies for efficient pollution,
but may also be inequitable in hurting lower-income consumers most.
Positive externalities create a free-rider problem when neither buyers nor sellers are
paid for external benefits their exchange creates. The market-clearing price is too high
for buyers to be willing to buy the socially best quantity of output, and too low for
sellers to be willing to supply Public goods—provide external benefits consumed simultaneously by everyone, no
one can be excluded.
-Public goods like lighthouses and national defense are extreme examples of
-Free-rider—someone who does not have to pay for external benefits
For any product/service that generates an externality, rule for a smart choice is:
choose quantity of output where marginal social cost equals marginal social
Because of free-rider problem, markets under produce products/services with
-Price charged to buyers is too high
-Price received by sellers is to low
-Market price does not incorporate external benefits
Government policies can reward businesses and individuals creating positive
externalities. As a result, these businesses and individuals internalize the
externalities/rewards, turning smart private choice into smart social choices.
Subsides and public provision are government policy tools to get everyone to
voluntarily choose output where marginal social befit equal marginal social cost.
Subsidy—payment to those who create positive externalities
Public provision—government provision products/services with positive
externalities, financed by tax revenue
Subsides and public provision remove the wedge positive externalities drive
between prices for buyers and for sellers, inducing individuals and businesses to
voluntarily chose quantity of output best for society
Chapter 11: What Are You Worth (Demand and Supply in Input Markets,
and Income and Wealth Distributions) Incomes are determined by prices and quantities in input markets. In the input market
of the circular flow of economic life, households supply to businesses labor, capital, and
land, and entrepreneurships in exchange for wages, interest, rents, and profits.
-In input markers, households are sellers and businesses are buyers.
-Income—what you earn—is a flow.
Flow: Amount per unit of time
-Income for labor, capital, and land = price of input x quantity of input
-Wealth—total value of assets you own—is a stock
Stock: Fixed amount at a moment in time
Entrepreneurs incomes are not determined by price x quantity. Entrepreneurs earn
profits. Economic profits are a residual—what is left over from revenues after all
opportunity costs of production (including normal profits) have been paid for other
For maximum profits, businesses should hire additional labor as long as labors
marginal revenue product (additional benefit) is greater than wage paid for labor
-To hire labor, businesses must pay market wage, which reflects best opportunity
cost of person supplying labor,
-Businesses demand for labour is derived demand—demand for output and profits
business can derive from hiring labor.
Marginal Products: Additional oupit from hiring one more unit of labour
-When businesses hire additional labourers to work within fixed inputs, there is
diminishing marginal productivity—each additional laborer has lower marginal
product and previous laborer.
Marginal Revenue Product: Additional revenue from selling output produced by
-To calculate labourers marginal revenue product
Multiply marginal product x price of output -Marginal revenue product diminishes for additional labourers
-Rule for maximum profits for business: Hire additional hours of about (or any input)
as long as marginal revenue product is greater than wage (or price of input)
Present value tells you what money earned in the future are work today. Present value
compares the price you pay for today’s investment against the investments future
earnings. For a smart choice, the present value of the investments future earnings
should be greater than the investment price today.
Present value: of a future amount of money is the amount that, if invested today,
will grow as large as the future amount, taking into account earned interest.
Present value = Amount of money available in (n) years
(1 + Interest rate) to the power of (n)
-Revenues available in future not work as much as revenues today because today’s
revenues earn interest
Discount: reduction of future revenues for forgone interest
Present value gives you a method to simply future steam of revenues from and
investment to a single number today. Converts flow of future revenues into stock
concept, a value at a moment in time—today—you can compare with cost today to
make a smart choice.
For a smart choice, the present value of investments stream of future revenues
should be greater than the price of investment today.
Income for any input in inelastic supply, for example land or superstar talent, is
economic rent, which is determined by demand alone.
Economic rent: Income paid to any input in relatively inelastic supply.
-For inputs like land in inelastic supply, prices effectively determined by demand
-For most products/services, high input prices cause high output prices -For inputs in inelastic supply, high output prices cause high input prices—high
Government polices to address the markets unequal distributions of income and
wealth involve trade-offs between efficiency and equality.
-“What are you worth?” is a positive question; depends on quantities of inputs you
on and prices markets place on those inputs
-“What should you, or any person, be worth?” is a normative question you must
answer as a citizen.
-Poverty result from no owning labour skills or assets the market values, or from
not getting a high enough price for what you do own.
-Policy options to reduce inequality and poverty: education, training, progressive
tax and transfer system.
-Improving human capital through education and training addresses underlying
cause of poverty: lack of inputs the market values.
Human Capital: Increased earning potential from work experience, on-the-job
training, and education.
-Federal and provincial tax systems use progressive taxes—tax rate increases as
Regressive taxes: tax rate decreases as income increases
Proportional (flat rate) taxes: tax rate same regardless of income.
Marginal tax rate: rate on additional dollar of income
Transfer payments: payments by government to household
-Due to incentive effects, “A more equally shared pie may be a smaller pie”
-Efficient market outcome not necessarily fair or equitable. May include (poor)
people unable to pay for basic necessities like shelter, food, and medical care.
-Governments can directly reduce poverty and inequality using tax and transfer
system to take from rich and give to poor (Robin Hood Principle). -Costs and benefits policies to help the poor apply to different people. How you feel
about Robin Hood’s mottos depends on whether you are being taken from or given
Macro Chapter 1: Are your smart choices smart for all?
(Macroeconomics and Microeconomics)
Smart microeconomic choice by individuals may or may not add up to
smart macroeconomic outcomes for the economy as a whole. The key
question about the relationship between microeconomic and
macroeconomics is, “if left alone, do markets quickly self-adjust?”
-The great recession of 2008-09 and the great depression of 1929-33
involved financial bubbles that burst, high unemployment, failing living
standards, bankruptcies, as well as government policy mistakes.
Macroeconomics: analyzes the performance of the whole Canadian
economy and global economy—the combined outcomes of all individual
Microeconomics: analyzes choice that individuals in households,
individual businesses, and governments make and how those choices
interact in markets.
Fallacy of composition: what is true for one is not true of all; whole is
greater than the sum of the parts
Paradox of thrift: attempts to increase savings cause aggregate savings
decrease because of galling employment and incomes.
-The circular flow diagram reduces the complexity of the Canadian
economy to three sets of players—households, businesses, and
-Input markets determine incomes; households are the sellers
businesses are the buyers -Output markets determine the value of all products/services sold;
households are buyers and businesses are sellers
Business cycles: ups and downs of overall economic activity.
-The fundamental macroeconomic question “if left aone by government,
does the price mechanisms of market economies adjust quickly to
maintain steady growth in living standards, full employment and stable
-“Yes” answer based on Say’s Law—supply creates its own demand.
-“No” answer from John Maynard Keynes, founder of macroeconomics
“If left alone, do markets quickly self-adjust?” The “yes” and “no” camps
differ on the fallacy of composition, cuases of business cycles, risk of
government failure versus market failure, role of government, and the
Market failure—market outcomes fial to serve in public interest
Government failure: government policy fails to serve the public
-“government policy fails to serve the public interest.
-“Yes”—left alone markets will quickly self-adjust” camp believes
Macroeconomic and microeconomic outcomes are the same
External events or government policy causes business cycles
Government failure is worse than market failure
Government should be hands-off
-“No”—Left alone, markets fail to quickly self-adjust” camp belives Fallacy of composition—macroeconomic and microeconomic
Markets cause business cycles through coordination failures, roles
of money banking, and expectations.
Market failure is worse than government failure.
Government should be hands off.
-Politicians on the right tend to be “Yes” camp, government as hands-off
-Politicians on left tend to be in “No” camp, government as hands on.
The most important outcomes measures the performance of the Canadian
economy are living standards (related to GDP per person), unemployment,
-Gross domestic product (GDP)—Value of al final products and services
produced annually in Canada
-You are unemployed if not employed and actively seeking work.
Inflation: rising average prices and falling value of money.
The five groups of macroeconomic players are consumers, businesses,
governments, Bank of Canada and the banking system, and the rest of the
world. Each group has different choices.
-Spend income or save.
-Buy Canadian products/services or imports. Business choices: