Chapter 4: Extensions of Supply & Demand

Taxes

Taxes are a key government intervention in markets, affecting both buyers and sellers. Understanding how taxes impact market outcomes is essential in microeconomics.

• Statutory Incidence: Refers to who is legally responsible for paying the tax to the government (e.g., buyers or sellers).

• Actual (Economic) Incidence: Refers to who actually bears the economic burden of the tax, which depends on the relative elasticities of demand and supply.

• 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 the division of the tax burden between buyers and sellers.

Formula:

where is the price buyers pay, is the price sellers receive, and is the original equilibrium price.

Chapter 5: Externalities and Public Goods

Market Efficiency and Market Failure

Markets are efficient when resources are allocated to maximize total surplus. However, market failures can occur due to several reasons:

• Lack of Competition: Monopolies or oligopolies can restrict output and raise prices.

• Imperfect Information: When buyers or sellers lack full information, markets may not allocate resources efficiently.

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

Externalities

• Definition: An externality is a side effect of an economic activity that affects other parties without being reflected in market prices.

• Types:

  • Positive Externality: Benefits third parties (e.g., vaccination).

  • Negative Externality: Imposes costs on third parties (e.g., pollution).

• Which Curve Shifts: For negative externalities, the supply curve shifts left (upward) to reflect higher social costs. For positive externalities, the demand curve shifts right (upward) to reflect higher social benefits.

• Social vs. Private Costs & Benefits:

  • Private Cost: Cost borne by the producer or consumer directly involved.

  • Social Cost: Total cost to society (private cost + external cost).

  • Private Benefit: Benefit received by the consumer or producer.

  • Social Benefit: Total benefit to society (private benefit + external benefit).

• Comparing Outcomes: The market outcome does not account for externalities, leading to overproduction (negative externality) or underproduction (positive externality) compared to the socially optimal outcome.

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.

Formula:

Correcting Externalities

• Positive Externalities: Government can subsidize the good or service to increase consumption to the socially optimal level.

• Negative Externalities: Government can tax or regulate the activity to reduce production to the socially optimal level.

• Potential Problems: Difficulty in measuring external costs/benefits, unintended consequences, enforcement challenges.

Public Goods

• Definition: A public good is non-excludable (cannot prevent non-payers from using it) and non-rivalrous (one person's use does not reduce availability to others).

• Examples: National defense, clean air, public radio.

• Clarification: Not all goods with "public" in the name are public goods, and not all government-provided goods are public goods.

• Free Rider Problem: Individuals have an incentive to consume without paying, leading to under-provision by the market.

• Correcting for Public Goods: Government provision and taxation are common solutions.

Property Rights

• Importance: Clearly defined property rights help internalize externalities and improve market outcomes.

Optimal Level of Pollution

• Concept: The optimal level of pollution is not zero; it is where the marginal benefit of pollution reduction equals the marginal cost.

Rebound Effect

• Definition: When improvements in efficiency lower the cost of using a good, leading to increased consumption that partially offsets the efficiency gains.

Chapter 6: Elasticity

Types of Elasticity

• Price Elasticity of Demand (): Measures responsiveness of quantity demanded to a change in price.

• Price Elasticity of Supply (): Measures responsiveness of quantity supplied to a change in price.

• Income Elasticity of Demand (): Measures responsiveness of quantity demanded to a change in income.

• Cross-Price Elasticity of Demand (): Measures responsiveness of demand for one good to a change in the price of another good.

Midpoint Formula

The midpoint formula is used to calculate elasticity between two points on a demand or supply curve:

Interpreting Elasticity Values

• Elastic (): Quantity is very responsive to price changes.

• Inelastic (): Quantity is not very responsive to price changes.

• Unit Elastic (): Proportional response.

• Perfectly Elastic (): Horizontal demand curve.

• Perfectly Inelastic (): Vertical demand curve.

Applications and Examples

• Substitutes: Positive cross-price elasticity.

• Complements: Negative cross-price elasticity.

• Necessities: Inelastic demand.

• Luxuries: Elastic demand.

Elasticity and Total Revenue

• If demand is elastic: Price increase lowers total revenue.

• If demand is inelastic: Price increase raises total revenue.

Formula:

Elasticity Along Demand Curves

• Elasticity varies along a straight-line demand curve: more elastic at higher prices and lower quantities, more inelastic at lower prices and higher quantities.

Reasons for Elasticity Differences

• Availability of substitutes, necessity vs. luxury, time horizon, share of income spent on the good.

Chapter 10: Consumer Choice & Behavioral Economics

Total vs. Marginal Utility

• 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 necessities like water have low prices while non-essentials like diamonds have high prices—marginal utility, not total utility, determines price.

• Calculating Marginal Utility:

• Graphical Representation: Marginal utility typically decreases as quantity consumed increases (diminishing marginal utility).

• Diminishing Marginal Utility: Each additional unit consumed adds less to total utility than the previous unit.

• If Diminishing Marginal Utility Did Not Exist: Consumption would increase without bound; if marginal utility increased, consumers would want infinite quantities.

Fundamentals of Consumer Choice

• Consumers allocate their income to maximize total utility, subject to their budget constraint.

Consumer Optimum

• Two Goods: The consumer optimum is where the marginal utility per dollar spent is equal for both goods.

• Formula:

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

• "Bang for Your Buck": Consumers get the most utility per dollar when the above condition holds.

Effects of Price Changes

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

• Substitution Effect: A price change makes the good more or less attractive relative to substitutes.

• 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, consumers buy more as price falls.

Additional info: These notes expand on the exam topics by providing definitions, formulas, and examples for each concept, ensuring a comprehensive review for students preparing for a microeconomics midterm covering chapters 4, 5, 6, and 10.