Microeconomics Study Notes: Trade, Externalities, Taxation, Factor Markets, Monopoly, and Oligopoly

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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 not fully utilized.
Attainable and Efficient: Points on the PPC; resources are fully and efficiently used.
Unattainable: Points outside the PPC; not possible with current resources and technology.
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: Each agent should specialize in the good 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 1 car or 2 computers, and Country B can produce 1 car or 4 computers, Country B has a comparative advantage in computers, and Country A in cars.

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: 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; producers benefit from exports, consumers from imports.
Arguments for Trade: Efficiency, increased variety, lower prices, and innovation.
Arguments against Trade: Job losses in certain sectors, national security, and infant industry protection.
Tariffs: Taxes on imports create winners (domestic producers, government) and losers (consumers, foreign producers), and generate deadweight loss.

Example: A tariff on imported steel raises domestic steel prices, benefiting domestic producers but harming consumers and foreign exporters.

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: Arises when market prices are affected, not direct costs or benefits.
Market Inefficiency: Not all externalities cause inefficiency, but many do by creating a wedge between private and social costs/benefits.
Identifying Externalities: Analyze whether third parties are affected by the market activity.
Key Relationships:

Efficient vs. Market Outcomes: Markets with externalities often fail to achieve efficiency; the market outcome differs from the socially optimal outcome.
Restoring Efficiency:
- Private Solutions: Private bargaining (Coase Theorem) can resolve externalities if property rights are clear, transaction costs are low, and parties can negotiate.
- Government Solutions: Command-and-control policies, Pigouvian taxes/subsidies (set equal to the external cost/benefit), and market-based incentives.

Example: A factory polluting a river imposes a negative externality on fishermen. A Pigouvian tax equal to the marginal external cost can restore efficiency.

Public Goods and Common Pool Resources

Goods are classified by their excludability and rivalry in consumption.

Private Goods: Excludable and rival (e.g., food).
Club Goods: Excludable but non-rival (e.g., subscription TV).
Public Goods: Non-excludable and non-rival (e.g., national defense).
Common Pool Resources: Non-excludable but rival (e.g., fisheries).
Rival in Consumption: One person's use reduces availability for others.
Excludable: Possible to prevent non-payers from using the good.
Free Rider Problem: People benefit from a good without paying, leading to under-provision (especially for public goods).
Market Demand for Public Goods: Derived by vertically summing individual willingness to pay.
Tragedy of the Commons: Overuse of common resources due to lack of property rights.
Solutions: Regulation, assigning property rights, or collective management.

Example: Overfishing in international waters is a classic tragedy of the commons.

Ch. 10 Taxation and Regulation

Taxes and Tax Incidence

A tax is a compulsory payment to the government. Statutory incidence refers to who is legally responsible for paying the tax, while economic incidence refers to who actually bears the burden.

Per-unit Tax on Sellers: Shifts supply curve upward by the amount of the tax.
Tax on Buyers: Shifts demand curve downward by the amount of the tax.
Effects: Reduces equilibrium quantity, increases price paid by buyers, decreases price received by sellers.
Tax Burden: The less elastic side of the market bears more of the tax burden.

Example: If demand is inelastic and supply is elastic, consumers bear most of the tax.

Surplus, Tax Revenue, and Efficiency

Consumer Surplus: Area between demand curve and price paid.
Producer Surplus: Area between supply curve and price received.
Tax Revenue:
Deadweight Loss (DWL): Loss of total surplus due to reduced quantity traded.
Elasticity: Greater elasticity leads to larger DWL.

Subsidies

Subsidy: Government payment to buyers or sellers.
Effect on Supply/Demand: Subsidy to sellers shifts supply right; to buyers, shifts demand right.
Effects: Increases equilibrium quantity, lowers price for buyers, raises amount received by sellers.
Total Subsidy Spending:
DWL: Subsidies can create DWL if they encourage overproduction.

Tax Equity

Progressive Tax: Tax rate increases with income.
Regressive Tax: Tax rate decreases with income.
Proportional Tax: Tax rate is constant regardless of income.
Ability-to-Pay Principle: Taxes should be levied according to ability to pay.
Benefits Principle: Taxes should be levied according to benefits received.
Horizontal Equity: Equal treatment for equals.
Vertical Equity: Higher-income individuals pay more.

Price Controls and Black Markets

Price Ceiling: Legal maximum price. Binding if set below equilibrium, causing shortages.
Price Floor: Legal minimum price. Binding if set above equilibrium, causing surpluses.
Shortage/Surplus: at the controlled price.
Deadweight Loss: Price controls reduce total surplus.
Black Markets: May arise when price controls make legal trade unprofitable.

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): (Marginal Product times Price of output).
Demand for a Factor: Equal to its VMP.
Profit Maximization Rule: Employ input until .
Downward Sloping Demand: Due to diminishing marginal returns.
Shifters: Changes in output price, productivity, or supply of other factors.

Labor-Leisure Trade-off

Labor Supply: Workers choose between labor and leisure to maximize utility.
Substitution Effect: Higher wages make work more attractive relative to leisure.
Income Effect: Higher wages increase income, possibly leading to more leisure.

Wage Inequality

Human Capital: Skills, education, and experience.
Discrimination: Statistical (based on group averages) or preference-based.
Compensating Differentials: Wage differences due to job characteristics.
Skill-Biased Technological Change: Increases demand for skilled workers.

Ch. 12 Monopoly

Monopoly Characteristics

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 (downward sloping).
Marginal Revenue (MR): For a monopolist, due to the downward sloping demand.
Profit Maximization: Set to find optimal quantity.
Market Power: Ability to set price above marginal cost.
Inefficiency: Monopoly creates deadweight loss.

Restoring Efficiency

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

Ch. 14 Oligopoly and Monopolistic Competition

Oligopoly

Few Sellers: Market dominated by a small number of firms.
Product Differentiation: Products may be homogeneous or differentiated.
Residual Demand Curve: Demand remaining for a firm after rivals' output is considered.
Duopoly: Oligopoly with two firms.
Strategic Interaction: Firms consider rivals' actions (game theory).
Bertrand Competition: Firms compete on price; with identical products, price may fall to marginal cost.
Nash Equilibrium: Each firm's strategy is optimal given rivals' strategies.
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: Due to product differentiation.
Short-Run: Firms may earn profits or losses; production decision based on price and average variable cost.
Long-Run: Entry and exit drive profits to zero; residual demand shifts as firms enter/exit.
Efficiency: Not fully efficient; deadweight loss exists due to excess capacity and markup over marginal cost.

Market Structure Comparison Table

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

Market Structure	Number of Firms	Type of Product	Barriers to Entry	Price Taker/Maker	Demand Curve	Surplus	Long-Run Profits
Perfect Competition	Many	Homogeneous	None	Taker	Horizontal	Maximized	Zero
Monopolistic Competition	Many	Differentiated	None	Maker	Downward	Not Maximized	Zero
Oligopoly	Few	Homogeneous or Differentiated	Some	Maker	Downward	Not Maximized	Zero or Positive
Monopoly	One	Single good	High	Maker	Downward	Not Maximized	Positive