Microeconomics Study Guide: Supply & Demand Extensions, Externalities, Elasticity, and Consumer Choice

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 per-unit tax.

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:

$\text{Tax Burden on Buyers} = \frac{E_s}{E_s + |E_d|} \times \text{Tax}$

$\text{Tax Burden on Sellers} = \frac{|E_d|}{E_s + |E_d|} \times \text{Tax}$

Where $E_s$ is the price elasticity of supply and $E_d$ is the price elasticity of demand.

Chapter 5: Externalities and Public Goods

Market Efficiency and Market Failure

Markets are efficient when resources are allocated to maximize total surplus. However, certain conditions can lead to market failures.

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

• 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.

Externalities

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

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

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

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

• Social vs. Private Benefits/Costs: Social benefit/cost includes both private and external effects.

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

Example: A factory emitting pollution imposes a negative externality on nearby residents. The social cost of production exceeds the private cost, so the market produces more than the socially optimal quantity.

Formulas:

$\text{Social Cost} = \text{Private Cost} + \text{External Cost}$

$\text{Social Benefit} = \text{Private Benefit} + \text{External Benefit}$

Correcting Externalities

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

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

• Potential Problems: Difficulties in measuring external costs/benefits, enforcement issues, and unintended consequences.

Public Goods

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

• Examples: National defense, clean air, public radio (if non-excludable and non-rival).

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

• Free Rider Problem: Individuals may benefit without paying, leading to under-provision by the market.

• Correcting for Public Goods: Government provision or funding through taxation.

Property Rights

• Definition: Clearly defined and enforceable property rights can help internalize externalities and improve market outcomes.

Optimal Level of Pollution

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

Rebound Effect

• Definition: When improvements in efficiency lower the cost of consumption, leading to increased use and partially offsetting the gains.

Chapter 6: Elasticity

Types of Elasticity

• Price Elasticity of Demand ($E_d$): Measures responsiveness of quantity demanded to price changes.

• Price Elasticity of Supply ($E_s$): Measures responsiveness of quantity supplied to price changes.

• Income Elasticity of Demand: Measures responsiveness of demand to changes in income.

• Cross-Price Elasticity: Measures responsiveness of demand for one good to price changes of another good.

Midpoint Formula

The midpoint formula calculates elasticity between two points to avoid issues with directionality.

$E_d = \frac{\frac{Q_2 - Q_1}{(Q_2 + Q_1)/2}}{\frac{P_2 - P_1}{(P_2 + P_1)/2}}$

Interpreting Elasticity Values

• Elastic ($|E_d| > 1$): Quantity demanded changes more than price.

• Inelastic ($|E_d| < 1$): Quantity demanded changes less than price.

• Unit Elastic ($|E_d| = 1$): Proportional change.

• Perfectly Elastic ($|E_d| = \infty$): Horizontal demand curve.

• Perfectly Inelastic ($|E_d| = 0$): Vertical demand curve.

Applications and Implications

• Revenue: If demand is elastic, a price increase reduces total revenue; if inelastic, a price increase raises total revenue.

• Elasticity Along Demand Curve: Elasticity varies along a straight-line demand curve—more elastic at higher prices and lower quantities.

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

Table: Types of Elasticity and Interpretation

Elasticity Type	Formula	Interpretation
Price Elasticity of Demand	$E_d = \frac{\% \Delta Q_d}{\% \Delta P}$	How much quantity demanded changes with price
Price Elasticity of Supply	$E_s = \frac{\% \Delta Q_s}{\% \Delta P}$	How much quantity supplied changes with price
Income Elasticity	$E_I = \frac{\% \Delta Q_d}{\% \Delta I}$	Normal ($E_I > 0$) vs. Inferior ($E_I < 0$) goods
Cross-Price Elasticity	$E_{xy} = \frac{\% \Delta Q_{dx}}{\% \Delta P_y}$	Substitutes ($E_{xy} > 0$), Complements ($E_{xy} < 0$)

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 are cheap and non-necessities like diamonds are expensive—marginal utility, not total utility, determines price.

• Calculating Marginal Utility: $MU = \frac{\Delta TU}{\Delta Q}$

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

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

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

Consumer Optimum

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

• Many Goods: The principle extends to all goods: $\frac{MU_1}{P_1} = \frac{MU_2}{P_2} = ... = \frac{MU_n}{P_n}$

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

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 attractive compared to alternatives.

• 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.

Example: If the price of pizza falls, the substitution effect leads consumers to buy more pizza instead of burgers, and the income effect allows them to buy more pizza (or other goods) because their real income has increased.

Additional info: Behavioral economics explores how real-world consumer behavior sometimes deviates from the rational model due to biases, heuristics, and framing effects.