Chapter 4: Extensions of Supply & Demand

Taxes

This section explores how taxes affect market outcomes, focusing on the concepts of tax incidence and graphical analysis.

• Statutory Incidence: The legal assignment of who is responsible for paying a tax (e.g., buyers or sellers).

• Actual (Economic) Incidence: The true burden of a tax, determined by the relative elasticities of supply and demand. The side of the market that is less elastic bears more of the tax burden.

• Graphing Taxes: Taxes create a wedge between the price buyers pay and the price sellers receive. The vertical distance between the supply and demand curves equals the tax per unit.

Example: If a $1 tax is imposed on sellers, the supply curve shifts vertically upward by $1. The new equilibrium shows how the tax is split between buyers and sellers.

Chapter 5: Externalities and Public Goods

Market Functioning and Market Failures

Markets can fail to allocate resources efficiently due to several reasons, including lack of competition, imperfect information, and externalities.

• Lack of Competition: Monopolies or oligopolies can lead to higher prices and lower output than competitive markets.

• Imperfect Information: When buyers or sellers lack full information, markets may not reach efficient outcomes.

• Externalities: Costs or benefits that affect third parties not directly involved in a transaction.

Defining Externalities

• Positive Externalities: Benefits received by third parties (e.g., education, vaccinations).

• Negative Externalities: Costs imposed on third parties (e.g., pollution, secondhand smoke).

• Which Curve Shifts: Negative externalities shift the supply curve left (higher cost), while positive externalities shift the demand curve right (higher benefit).

• Socially Optimal vs. Market Outcome: The market equilibrium does not account for externalities, leading to overproduction (negative) or underproduction (positive) compared to the socially optimal level.

• Social vs. Private Benefits/Costs: Social benefit/cost includes both private and external effects. Private benefit/cost only considers the direct participants.

Example: A factory emits pollution (negative externality). The social cost of production exceeds the private cost, so the market produces more than the socially optimal quantity.

Correcting for Externalities

• Positive Externalities: Subsidies or government provision can increase production to the socially optimal level.

• Negative Externalities: Taxes, regulations, or tradable permits can reduce production to the socially optimal level.

• Potential Problems: Difficulty in measuring externalities, unintended consequences, and administrative costs.

Public Goods

• Characteristics: Non-excludable (cannot prevent non-payers from using) and non-rivalrous (one person's use does not reduce availability to others).

• Not All 'Public' Goods Are Public Goods: The term 'public' in a good's name or government provision does not guarantee it is a public good.

• Correcting for Public Goods: Government provision or funding is often necessary due to the free rider problem.

• Free Riders: Individuals who benefit from a good without paying for it, leading to under-provision in private markets.

Other Key Concepts

• Property Rights: Clearly defined and enforceable property rights can help internalize externalities.

• Optimal Level of Pollution: Achieved when the marginal benefit of pollution reduction equals the marginal cost.

• Rebound Effect: When increased efficiency leads to increased consumption, offsetting some of the expected gains.

Chapter 6: Elasticity

Types of Elasticity

Elasticity measures the responsiveness of one variable to changes in another. Key types include:

• Price Elasticity of Demand: Measures how much quantity demanded changes in response to a price change.

• Price Elasticity of Supply: Measures how much quantity supplied changes in response to a price change.

• Income Elasticity of Demand: Measures how quantity demanded changes as consumer income changes.

• Cross-Price Elasticity of Demand: Measures how quantity demanded of one good changes in response to a price change of another good.

Midpoint Formula

• The midpoint formula is used to calculate elasticity between two points:

Interpreting Elasticity Values

• Elastic: Elasticity > 1 (quantity responds strongly to price changes)

• Inelastic: Elasticity < 1 (quantity responds weakly to price changes)

• Unit Elastic: Elasticity = 1

• Perfectly Elastic: Elasticity = ∞ (horizontal demand curve)

• Perfectly Inelastic: Elasticity = 0 (vertical demand curve)

Applications and Effects

• Revenue and Price Changes: If demand is elastic, lowering price increases total revenue; if inelastic, raising price increases total revenue.

• Elasticity Along Demand Curves: Elasticity varies along a straight-line demand curve—more elastic at higher prices, less elastic at lower prices.

• Reasons for Elasticity Differences: Availability of substitutes, necessity vs. luxury, time horizon, and proportion of income spent.

Classification Table (Described)

The table classifies goods based on elasticity values:

• Substitutes: Positive cross-price elasticity

• Complements: Negative cross-price elasticity

• Normal Goods: Positive income elasticity

• Inferior Goods: Negative income elasticity

Chapter 10: Consumer Choice & Behavioral Economics

Total vs. Marginal Utility

Utility is the satisfaction or pleasure derived from consuming goods and services.

• Total Utility: The total satisfaction received from consuming a certain quantity of a good.

• Marginal Utility: The additional satisfaction from consuming one more unit of a good.

• Water-Diamond Paradox: Explains why water (essential but abundant) is cheap, while diamonds (less useful but scarce) are expensive—marginal utility, not total utility, determines price.

• Calculating Marginal Utility:

• Graphical Representation: Marginal utility typically decreases as more of a good is consumed (diminishing marginal utility).

• Diminishing Marginal Utility: Each additional unit of a good provides less additional satisfaction. If this did not exist, consumers would consume only one good.

Consumer Choice Fundamentals

• Consumer Optimum: The combination of goods that maximizes utility given a budget constraint.

• Two Goods: The consumer allocates spending so that the marginal utility per dollar is equal for both goods:

• Many Goods: The principle extends to all goods in the consumer's basket.

• "Bang for Your Buck": Consumers adjust consumption to equalize marginal utility per dollar across all goods.

Effects of Price Changes

• Income Effect: A price change affects the consumer's real purchasing power.

• Substitution Effect: A price change makes a good relatively more or less expensive compared to others, leading to substitution.

• Overall Effect: The total change in quantity demanded is the sum of the income and substitution effects.

Why the Demand Curve Slopes Downward

• Due to diminishing marginal utility, substitution effect, and income effect, as price falls, quantity demanded increases.