Midterm 2 Study Guide: Externalities, Elasticity, Consumer Choice, and Production

CHAPTER 5 - EXTERNALITIES, ENVIRONMENTAL POLICY, AND PUBLIC GOODS

Externalities and Social Costs

Externalities occur when the actions of individuals or firms have effects on third parties that are not reflected in market prices. Understanding externalities is crucial for analyzing market failures and the role of government intervention.

• Externality: A cost or benefit imposed on a third party not directly involved in a transaction. Can be negative (e.g., pollution) or positive (e.g., education).

• Private cost / private benefit: Costs or benefits borne by the individuals directly involved in an economic activity.

• Social cost / social benefit: The total cost or benefit to society, including both private and external effects.

• Example: A factory emits pollution (negative externality), causing health costs to nearby residents (external cost not paid by the factory).

Property Rights and the Coase Theorem

Property rights and transaction costs are central to understanding how externalities can be resolved without government intervention.

• Property rights: Legal rights to use and control resources.

• Transaction costs: Costs incurred in making an economic exchange, such as negotiating and enforcing agreements.

• The Coase Theorem: If property rights are well-defined and transaction costs are low, private parties can negotiate to solve externality problems efficiently, regardless of the initial allocation of rights.

• Example: A beekeeper and an apple orchard owner can negotiate compensation for pollination services if property rights are clear.

Government Policies for Externalities

When private negotiation is not feasible, government intervention can address externalities through taxes, subsidies, or regulation.

• Pigovian taxes and subsidies: Taxes imposed to correct negative externalities or subsidies to encourage positive externalities.

• Cap-and-trade policy: A system where the government sets a cap on total emissions and issues permits that can be traded among firms.

• Emission allowances: Permits that allow firms to emit a certain amount of pollution; can be bought and sold in a market.

• Example: A carbon tax on fossil fuels internalizes the external cost of carbon emissions.

Types of Goods: Rivalry and Excludability

Goods are classified based on whether they are rival (one person's use reduces availability for others) and excludable (people can be prevented from using them).

• Rival goods: Consumption by one person reduces the amount available for others.

• Excludable goods: It is possible to prevent someone from using the good.

• Private goods: Both rival and excludable (e.g., food).

• Common resources: Rival but not excludable (e.g., fish in the ocean).

• Quasi-public goods: Non-rival but excludable (e.g., cable TV).

• Public goods: Non-rival and non-excludable (e.g., national defense).

	Excludable	Non-Excludable
Rival	Private goods	Common resources
Non-Rival	Quasi-public goods	Public goods

• Free riding: Occurs when people benefit from a good without paying for it, common with public goods.

• Tragedy of the commons: Overuse of common resources due to lack of excludability.

CHAPTER 6 - ELASTICITY

Price Elasticity of Demand

Elasticity measures how much quantity demanded or supplied responds to changes in price or other factors.

• Price elasticity of demand: The percentage change in quantity demanded divided by the percentage change in price.

$\text{Price Elasticity of Demand} = \frac{\%\ \text{Change in Quantity Demanded}}{\%\ \text{Change in Price}}$

• Perfectly inelastic: $E_d = 0$ (vertical demand curve)

• Inelastic: $0 < E_d < 1$

• Unit-elastic: $E_d = 1$

• Elastic: $E_d > 1$

• Perfectly elastic: $E_d = \infty$ (horizontal demand curve)

Other Elasticities

• Cross-price elasticity of demand: Measures how the quantity demanded of one good responds to a change in the price of another good. $\text{Cross-Price Elasticity} = \frac{\%\ \text{Change in Quantity Demanded of Good A}}{\%\ \text{Change in Price of Good B}}$

• Income elasticity of demand: Measures how quantity demanded changes as consumer income changes. $\text{Income Elasticity} = \frac{\%\ \text{Change in Quantity Demanded}}{\%\ \text{Change in Income}}$

• Price elasticity of supply: Measures how much quantity supplied responds to a change in price. $\text{Price Elasticity of Supply} = \frac{\%\ \text{Change in Quantity Supplied}}{\%\ \text{Change in Price}}$

Determinants and Applications of Elasticity

• Determinants: Availability of close substitutes, passage of time, whether the good is a necessity or luxury, definition of the market, and share of the good in the consumer's budget.

• Revenue and elasticity: Total revenue changes with price depending on elasticity. If demand is elastic, lowering price increases revenue; if inelastic, raising price increases revenue.

• Midpoint formula: Used to calculate elasticity between two points: $\text{Elasticity} = \frac{(Q_2 - Q_1)/[(Q_2 + Q_1)/2]}{(P_2 - P_1)/[(P_2 + P_1)/2]}$

CHAPTER 10 - CONSUMER CHOICE AND BEHAVIORAL ECONOMICS

Utility and Marginal Utility

Consumer choice theory explains how individuals allocate their income to maximize satisfaction (utility).

• Utility: The satisfaction or pleasure derived from consuming goods and services.

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

• Law of diminishing marginal utility: As more of a good is consumed, the additional utility from each extra unit decreases.

• Budget constraint: The limited amount of income available to spend on goods and services.

• Marginal utility per dollar spent: $\frac{MU}{P}$, where $MU$ is marginal utility and $P$ is price.

• Conditions for maximizing utility: Consumers maximize utility when the marginal utility per dollar is equal across all goods and the budget is exhausted. $\frac{MU_A}{P_A} = \frac{MU_B}{P_B}$

Income and Substitution Effects

• Income effect: The change in quantity demanded resulting from a change in real income due to a price change.

• Substitution effect: The change in quantity demanded resulting from a change in the relative price of goods.

• Sunk cost: A cost that has already been incurred and cannot be recovered; should not affect current decisions.

• Price anchoring: The tendency to rely heavily on the first piece of information (the "anchor") when making decisions.

Behavioral Economics and Deviations from Rationality

• Behavioral economics: Studies how psychological factors and social influences affect economic decision-making.

• Common deviations: Ignoring opportunity costs, reasoning based on sunk costs, and unrealistic expectations.

• Social influences: Demand can be affected by comparison to others, network effects, and concerns for fairness.

CHAPTER 11 - TECHNOLOGY, PRODUCTION, AND COSTS

Production and Costs

Firms transform inputs into outputs using technology, facing various costs in the process.

• Technology and technological change: The processes a firm uses to turn inputs into outputs; technological change refers to improvements in these processes.

• Production function: The relationship between inputs and the maximum output that can be produced.

• Short run and long run: In the short run, at least one input is fixed; in the long run, all inputs can be varied.

• Explicit costs: Direct, out-of-pocket payments for inputs.

• Implicit costs: Opportunity costs of using resources owned by the firm.

• Total cost (TC): The sum of fixed and variable costs. $TC = FC + VC$

• Average cost (AC): Cost per unit of output. $AC = \frac{TC}{Q}$

• Marginal cost (MC): The additional cost of producing one more unit. $MC = \frac{\Delta TC}{\Delta Q}$

• Marginal product of labor (MPL): The additional output from hiring one more worker. $MPL = \frac{\Delta Q}{\Delta L}$

Division of Labor and Returns

• Division of labor and specialization: Breaking production into tasks increases efficiency.

• Law of diminishing marginal returns: As more of a variable input is added to a fixed input, the additional output eventually decreases (holds only when other inputs are fixed).

Economies and Diseconomies of Scale

• Economies of scale: Long-run average costs decrease as output increases due to factors like specialization and bulk buying.

• Diseconomies of scale: Long-run average costs increase as output increases, often due to management inefficiencies.

• Minimum efficient scale: The lowest level of output at which long-run average cost is minimized.

Graphical Analysis and Skills

• Be able to compute and graph average (total, fixed, variable) and marginal cost curves. Marginal cost curve crosses average cost curves at their minimum points.

• Explain why short-run average cost curves are U-shaped due to specialization and diminishing marginal returns.

• Graph marginal product of labor curves and determine the long-run cost curve graphically.

Additional info: This guide covers key concepts and skills for midterm preparation in microeconomics, focusing on externalities, elasticity, consumer choice, and production theory.