Microeconomics Study Notes: Trade, Externalities, Factor Markets, Monopoly, and Market Structures

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Ch. 8 Trade

Production Possibilities

The Production Possibilities Curve (PPC) illustrates the maximum combinations of two goods that an economy can produce given its resources and technology.

Attainable but Inefficient: Points inside the PPC; resources are underutilized.
Attainable and Efficient: Points on the PPC; resources are fully and efficiently used.
Unattainable: Points outside the PPC; not possible with current resources.
Slope of the PPC: Represents the opportunity cost of producing one more unit of a good (how much of the other good must be given up).
Shifts or Pivots: Caused by changes in resources, technology, or economic growth.

Example: If producing more cars means producing fewer computers, the slope of the PPC shows the opportunity cost of cars in terms of computers.

Trade

Trade allows economic agents to specialize and exchange goods, increasing overall efficiency and welfare.

Absolute Advantage: An agent can produce more of a good with the same resources than another agent.
Comparative Advantage: An agent can produce a good at a lower opportunity cost than another agent.
Determining Comparative Advantage: Compare opportunity costs between agents for each good.
Absolute vs. Comparative Advantage: Having an absolute advantage does not guarantee a comparative advantage.
Specialization: Agents specialize in goods for which they have a comparative advantage.
Terms of Trade: The price at which goods are exchanged must lie between the opportunity costs of the two agents for mutual benefit.

Example: If Country A can produce wheat at a lower opportunity cost than Country B, A should specialize in wheat and trade for other goods.

International Trade

International trade is determined by world prices and comparative advantage, affecting domestic markets and welfare.

World Price: The prevailing price of a good on the global market, determined by international supply and demand.
Open Economy: Domestic buyers and sellers face the world price, not the domestic price.
Importing vs. Exporting: If the world price is lower than the domestic price, a country imports; if higher, it exports.
Winners and Losers: Exporters and consumers may benefit or lose depending on price changes.
Arguments for Trade: Increases efficiency, variety, and lowers costs.
Arguments Against Trade: Can harm domestic industries and lead to job losses.
Tariffs: Taxes on imports create winners (domestic producers, government) and losers (consumers, foreign producers).

Example: Imposing a tariff raises domestic prices, benefiting producers but harming consumers.

Ch. 9 Externalities, Public Goods, and Common Pool Resources

Externalities

An externality is a cost or benefit from an economic activity experienced by third parties not directly involved in the transaction.

Negative Externality: Imposes costs (e.g., pollution).
Positive Externality: Confers benefits (e.g., education).
Pecuniary Externality: Occurs when market transactions affect others through prices rather than direct costs or benefits.
Market Inefficiency: Not all externalities cause inefficiency, but many do by creating a divergence between private and social costs/benefits.
Identifying Externalities: Analyze who is affected and how.
Key Relationships:

Efficient vs. Market Outcomes: Markets with externalities often fail to achieve efficiency without intervention.
Restoring Efficiency:
- Private Solutions: Bargaining (Coase Theorem), provided property rights are clear, transaction costs are low, and parties can negotiate.
- Government Solutions: Command-and-control policies, market-based incentives (Pigouvian taxes/subsidies).
Pigouvian Tax/Subsidy: Set equal to the external cost/benefit to internalize the externality.

Example: A factory pays a tax equal to the cost of pollution it causes, aligning private and social costs.

Public Goods and Common Pool Resources

Goods are classified by rivalry (one person's use reduces availability for others) and excludability (people can be prevented from using).

Private Goods: Rival and excludable (e.g., food).
Club Goods: Non-rival but excludable (e.g., subscription TV).
Public Goods: Non-rival and non-excludable (e.g., national defense).
Common Pool Resources: Rival but non-excludable (e.g., fisheries).
Free Rider Problem: People benefit from public goods without paying, leading to under-provision.
Market Demand for Public Goods: Sum individual willingness to pay at each quantity.
Tragedy of the Commons: Overuse of common resources due to lack of exclusion.
Solutions: Regulation, assigning property rights, or collective management.

Example: Overfishing in open seas is a classic tragedy of the commons.

Ch. 11 Markets for Factors of Production

Factors of Production

Factors of production are inputs used to produce goods and services: labor (L), capital (K), and land (T).

Demand for Factors of Production

Value Marginal Product (VMP): The additional revenue from employing one more unit of an input.
Demand for a Factor: Equal to its VMP.
Profit Maximization Rule: Employ inputs until .
Downward Sloping Demand: Due to diminishing marginal returns.
Shifts in Demand: Changes in output price, technology, or supply of other factors.

Example: A firm hires workers until the value of the last worker's output equals the wage.

Labor-Leisure Trade-off

Labor Supply: Workers choose between labor and leisure to maximize utility.
Utility Maximization: Occurs where the marginal benefit of leisure equals the wage (opportunity cost of leisure).
Substitution Effect: Higher wages make work more attractive relative to leisure.
Income Effect: Higher wages increase income, potentially increasing demand for leisure.

Wage Inequality in the Labor Market

Human Capital: Skills, education, and experience that affect productivity and wages.
Discrimination: Statistical (based on group averages) or preference-based (personal bias).
Compensating Wage Differentials: Higher wages for undesirable jobs.
Skill-Biased Technological Change: Increases demand for skilled workers, raising wage inequality.

Ch. 12 Monopoly

Characteristics of Monopoly

Single Seller: Only one firm supplies the market.
No Close Substitutes: The product is unique.
Barriers to Entry: Legal (patents, licenses) or natural (economies of scale).

Monopoly vs. Perfect Competition

Demand Curve: Monopolist faces the market demand curve (downward sloping).
Marginal Revenue (MR): Lies below the demand curve; for linear demand, has twice the slope.
Profit Maximization: Set to find optimal quantity; price is set from the demand curve.
Market Power: Ability to set price above marginal cost.
Efficiency: Monopoly is not efficient; creates deadweight loss.

Restoring Efficiency in Monopoly

Price Discrimination: Charging different prices to different consumers.
- 1st Degree: Perfect price discrimination; each consumer pays their maximum willingness to pay.
- 2nd Degree: Price varies by quantity purchased.
- 3rd Degree: Price varies by consumer group.
Government Regulation: Price controls (fair-return or efficient price).

Example: Utility companies are often regulated monopolies.

Ch. 14 Oligopoly and Monopolistic Competition

Oligopoly

Few Firms: Market dominated by a small number of firms.
Product Differentiation: Products may be homogeneous or differentiated.
Residual Demand Curve: The demand remaining for a firm after accounting for competitors' output.
Duopoly: Special case with two firms.
Strategic Interaction: Firms consider rivals' actions (game theory).
Bertrand Competition: Firms compete on price; can lead to prices equal to marginal cost.
Nash Equilibrium: Each firm's strategy is optimal given the other's strategy.
Collusion: Firms cooperate to set prices/quantities; illegal in the U.S.
Grim Trigger Strategy: Cooperate until a rival cheats, then revert to non-cooperation forever.

Monopolistic Competition

Many Firms: Each sells a differentiated product.
Downward Sloping Demand: Each firm faces its own demand curve.
Short-Run: Firms may earn profits or losses; decide whether to produce or shut down.
Long-Run: Entry and exit drive profits to zero; demand curve becomes tangent to average cost.
Efficiency: Not efficient; creates deadweight loss due to excess capacity and markup over marginal cost.

Comparison of Market Structures

The following table summarizes key features of the four main market structures:

Market Structure	Number of Firms	Type of Good	Barriers to Entry	Price Maker/Taker	Demand Curve	Surplus Maximized?	Long-Run Profits
Perfect Competition	Many	Homogeneous	None	Price Taker	Horizontal	Yes	Zero
Monopolistic Competition	Many	Differentiated	None	Price Maker	Downward	No	Zero
Oligopoly	Few	Homogeneous or Differentiated	Some	Price Maker	Downward	No	Zero or Positive
Monopoly	One	Single Good	High	Price Maker	Downward	No	Positive