AP Microeconomics Chapter 5 Outline

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1 I. Learning Objectives In this chapter students should learn: A. How to differentiate demand side market failures and supply side market failures. B. The origin of consumer surplus and producer surplus, and how properly functioning markets maximize their sum and total surplus, while optimally allocating resources. C. Why free riding occurs with public goods, and illustrate why private firms cannot normally produce public goods. D. How positive and negative externalities cause under and over allocations of resources. E. Why we normally won t want to pay what it would cost to eliminate every last bit of a negative externality such as air pollution. II. Market Failure A. Market failure occurs when the competitive market system produces the wrong amounts of certain goods or services or fails to provide any at all. B. Demand side market failures happen when demand curves do not reflect consumers full willingness to pay for a good or service. C. Supply side market failures occur when supply curves do not reflect the full cost of producing a good or service. III. Efficiently Functioning Markets A. Consumer Surplus 1. Definition the difference between the maximum price a consumer is willing to pay for a product and the actual price. 2. The surplus, measurable in dollar terms, reflects the extra utility gained from paying a lower price than what is required to obtain the good. 3. Consumer surplus can be measured by calculating the difference between the maximum willingness to pay and the actual price for each consumer, and then summing those differences. 4. Consumer surplus is measured and represented graphically by the area under the demand curve and above the equilibrium price (Figure 5.1).

2 Use the formula for calculating the area of a triangle (1/2 base times height) to find the area of consumer surplus. 5. Consumer surplus and price are inversely related all else equal, a higher price reduces consumer surplus. B. Producer Surplus 1. Definition the difference between the actual price a producer receives and the minimum acceptable price. 2. Producer surplus can be measured by calculating the difference between the minimum acceptable price and the actual price for each unit sold, and then summing those differences. 3. Producer surplus is measured and represented graphically by the area above the supply curve and below the equilibrium price (Figure 5.2). Use the formula for calculating a triangle (1/2 base times height) to find the area of producer surplus. 4. Producer surplus and price are directly related all else equal, a higher price increases producer surplus. IV. Efficiency Revisited and Efficiency (Deadweight) Losses A. Efficiency is attained at equilibrium, where the combined consumer and producer surplus is maximized (Figure 5.3).

3 1. Consumers receive utility up to their maximum willingness to pay, but only have to pay the equilibrium price. 2. Producers receive the equilibrium price for each unit, but it only costs the minimum acceptable price to produce. 3. Productive efficiency occurs at equilibrium, because competition forces firms to produce at the lowest cost per unit. 4. Allocative efficiency occurs at the quantity where three conditions exist: a. Marginal Benefit = Marginal Cost b. Maximum willingness to pay = minimum acceptable price c. Combined consumer and producer surplus is at a maximum B. Efficiency (Deadweight) Losses 1. Underproduction reduces both consumer and producer surplus, and efficiency is lost because both buyers and sellers would be willing to exchange a higher quantity (Figure 5.4a).

4 2. Overproduction causes inefficiency because at quantities greater than the equilibrium quantity, it costs society more to produce the good than it is worth to the consumer in terms of willingness to pay (Figure 5.4b). V. Public Goods A. Private goods are produced and sold in competitive markets and have two characteristics: 1. Rivalry in consumption when one person buys and consumes a good, it is not available to others. 2. Excludability sellers can keep people who do not pay for a product from obtaining its benefits. B. Market demand for private goods is found by horizontally summing the individual demand schedules. C. Private markets allocate goods and resources efficiently; those willing to pay to obtain goods get them. Sellers produce goods to satisfy consumer wants, and consumer behavior tells them whether to produce more or less of any particular good. D. Unlike private goods, public goods are those goods that are nonrival and nonexcludable. 1. National defense is a good example of a public good. Increased national security is there for all to enjoy whether or not they paid for it. 2. Other examples include flood control and public health. 3. Public goods suffer from the free rider problem, where a consumer can enjoy the benefit of the good without having to pay for it. As a result, firms cannot profitably provide public goods, and the market fails. E. The demand for public goods differs from the market demand for private goods. 1. It is a phantom demand, because consumers will not be making individual purchases.

5 3. To find the collective demand schedule for a public good, we add the prices people collectively are willing to pay for the last unit of the public good at each quantity demanded (Table 5.3). 4. Figure 5.5 is a graphical illustration of this table. A collective demand curve is the vertical sum of the individual demand curves for the public who want that good. (Recall that the market demand for a private good was a horizontal summation of the individual demand curves.)

6 F. The supply curve for any good is its marginal cost curve. As with private goods, the law of diminishing returns applies to the supply of public goods. G. The optimal quantity of a public good is at the intersection of the collective demand (marginal benefit) curve and the supply (marginal cost) curve. It can also be found where marginal benefit equals marginal cost on the supply and demand schedules. H. Cost benefit analysis is a technique for decision making in the public sector. 1. The concept involves comparing the benefit of providing incremental units of public goods with the costs of providing these additional units. Note that the comparison is a marginal one (i.e., the comparison is made between the costs and benefits of additional amounts of a public good or service). 2. Table 5.4 illustrates this concept in determining the scope of a national highway construction project. Four possible phases of projects are considered, with costs and benefits compared. By comparing the marginal costs and benefits as one moves from the least expensive phase to the most expensive phase, you see Plan C is the optimal choice. 3. The rule for this decision making technique is to use the marginal benefit = marginal cost rule; if the marginal cost exceeds the marginal benefit, that part of the project should not be included. 4. The problem with this technique is the difficulty in measuring costs and benefits. Benefits are particularly difficult to estimate, because there are many related aspects that are not easily calculated. Nevertheless, the method is widely used. 5. Government provides public goods and quasi public goods and services. a. Private producers are not able to find enough paying buyers for public goods because of the free rider problem. Therefore, public goods are not produced voluntarily through the market, but must be provided by the public sector and financed by compulsory taxes. b. Quasi public goods are those that have large positive externalities, so government sponsors their provision. Otherwise, they would be underproduced. Medical care, education, and public housing are examples. c. Resources are reallocated from private to public use by levying taxes on households and businesses, thus reducing their purchasing power and using the proceeds to purchase public and quasi public goods. This can bring about a significant change in the composition of the economy s total output.

7 I. Consider This Street Entertainers 1. Street entertainers regularly appear in popular tourist areas in major cities. Even though some people pay when the hat is passed, many benefit from the shows without contributing to pay for the cost (free riding). 2. Some street entertainers involve audience members or use pay for performance in an attempt to reduce the free rider problem, but the problem continues to exist. VI. Externalities Figure 5.6 A. Externalities occur when some of the benefits or costs of production are not fully reflected in market demand or supply schedules. Some of the benefits or costs of a good may spill over to third parties. B. Negative externalities are supply side market failures, which occur when producers do not take into account the costs that their negative externalities impose on others. 1. An example of a negative externality (or external cost) is pollution, which allows polluters to enjoy lower production costs because the firm is passing along the cost of pollution damage or cleanup to society. Because the firm does not bear the entire cost, it will overallocate resources to the production of goods (Figure 5.7a).

8 2. Correcting for negative externalities requires that government get producers to internalize these costs (Figure 5.7b). a. Direct controls place limits on the amount of the offensive activity that can occur. Clean air and water legislation are examples. The effect is to force the offenders to incur costs associated with pollution control. This should shift the product supply curve leftward and reduce the equilibrium quantity. Therefore, it should reduce the resource allocation in a socially optimal way. b. Specific taxes can be levied on polluters. The tax payment will increase costs to the producer, shifting the product supply curve leftward, and reducing resource allocation to this type of production.

9 C. Positive externalities are demand side market failures, which occur when market demand fails to include the willingness to pay of third parties who receive benefits caused by the positive externality. 1. Examples of positive externalities include public health vaccinations and education. Because some of the benefits accrue to others, individuals will demand too little for themselves, and resources will be underallocated by the market (Figure 5.8a). 2. Correcting for positive externalities requires that the government somehow increase demand or supply to increase benefits to socially desirable amounts. a. Buyers can be subsidized. This increases the demand and the quantity produced, eliminating the underallocation of resources (Figure 5.8b). b. Producers can be subsidized. This reduces the producers costs of production, increasing the supply and eliminating the underallocation of resources (Figure 5.8c). c. The government could provide the product as a public good where spillover benefits are extremely large. An example would be administering free vaccines to all children in India to end smallpox. D. Table 5.5 reviews the methods for correcting externalities.

10 E. Society s optimal amount of externality reduction is not necessarily total elimination. 1. The cost of reducing spillover costs increases with each additional unit of reduction. The benefit received from each additional unit of reduction decreases due to diminishing marginal utility. 2. In general, the marginal benefit of reducing the next unit of pollution should equal the marginal cost of reducing that unit of pollution. At this point, society has found its optimal amount of pollution abatement (Figure 5.9). 3. In reality, it is difficult to measure benefits as well as costs, but this analysis demonstrates that some degree of pollution may be socially efficient. F. Another approach to reducing the externality or misallocation problem is the market approach of individual bargaining. 1. The Coase theorem, named after Nobel prize winning economist Ronald Coase, suggests that government may not be needed to remedy external costs and benefits when property rights are clearly defined, few people are involved, and bargaining costs are negligible. 2. The Coase theorem has limitations, because many externalities affect large numbers of people and bargaining is too costly and inefficient to find solutions effectively. G. Another corrective approach is the development of markets for externality rights, known as cap and trade systems. This is the latest policy innovation for dealing with pollution abatement. 1. A pollution control agency decides the acceptable amount of pollution in a particular region and creates permits that firms can purchase to allow them to pollute. Each permit allows a certain amount of pollution. The total supply of permits is perfectly inelastic.

11 2. The demand for permits should be downward sloping. At high prices, polluters will either stop polluting or pollute less by acquiring pollution abatement equipment, which is more attractive when the permits are more expensive. 3. With the given supply and demand for permits, an equilibrium price will be established for each permit to pollute. 4. The advantage to a cap and trade system is that it reduces society s costs because pollution rights can be bought and sold. Some firms will find it cheaper to buy the rights than to acquire abatement equipment; other firms can sell their rights because they may be able to reduce pollution at a lower cost. In both situations, the firms reduce their cost below what the cost would have been under direct controls. 5. The disadvantages are the costs of monitoring all firms, the level of cheating that has occurred in existing programs, and the ability of politically connected polluters to gain exemptions and free permits. As a result, many economists have concluded that a cap and trade system would not be the most effective system for reducing CO2 emissions in the United States. VII. Government s Role in the Economy A. Government carries out its economic functions within a political context (and the constraints on activity that come with that). B. In attempting to balance and satisfy both political and economic objectives, government may end up over or under regulating, or over or under providing public goods.

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