Market Failure 1

Market Failure - Externalities - Spill Over 

Market Failure: When market forces (demand and supply) alone fail to allocate scarce resources efficiently, either that to much or not enough of a good is produced or consumed.

Externality - When an economic activity creates benefits or imposes costs for third parties for which these do not pay for, or do not get compensated for, respectively.

4 Types:

• Externalities - Positive & Negative Production, Positive & Negative Consumption
• Public Goods
• Monopoly Power - (more when get to monopoly, proper)
• Asymmetric Information

Externalities

mjmfoodie: Market Failure

mjmfoodie: Externalities

Externalities - When is a Potato chip not just a potato chip - Video

An externality leads to a market failure as either more or less than the socially optimal amount is produced or consumed. Market forces alone fail to lead to an efficient resource allocation.

Externalities may arise in the production process, where they are known as production externalities, or in the consumption process, in which they are known as consumption externalities. If the impose costs on third parties they are considered negative externalities. In contrast, if they create benefits they are considered positive externalities.

Production = Costs = Supply = MPC & MSC  (Remember this)

MPC - Marginal Private Costs: defined as the costs of producing an extra unit of output. Include, wages costs of raw materials and other costs that the firm takes into consideration in its decision making process to produce. It follows that the supply curve reflects the MPC of a competitive firm.

MSC - Marginal Social Costs: defined as the costs of producing an extra unit of output that are borne by society. They reflect the value of all resources that are sacrificed in the specific production process. This means that they include not just the labour and other resources that are sacrificed, the costs of which are taken into consideration by the firm, but also include any (External Costs) that are not considered by the the firms, like pollution.

Consumption  = Benefits = Demand = MPB & MSB (Remember this)

MPB - Marginal Private Benefits: defined as the benefits the individual enjoys from the consumption of an extra unit of the good. The willingness of consumers to pay for an extra unit is determined by the extra benefit he enjoys from consuming that extra unit. The demand curve reflects the MPB enjoyed from consuming extra units of a good.

MSB - Marginal Social Benefits: benefits that society enjoys from each extra unit consumed. MSB includes the private benefits enjoyed by the individual but in addition any benefits others may enjoy as a result (External Benefits).

Reffonomics - Great website - Reffonomics
http://www.reffonomics.com/TRB/INPROGRESS/Microeconomicsindex1Externalities.html

Elasticity 3 - YED , Income elasticity of demand

Elasticity 3 - YED

YED - responsiveness of demand when consumers income changes.

Formula -

pajholden on YED

Ok, YED, after you have calculated your answer using the formula above, then you must interpret your answer.

Start with the sign:

• if it's positive, it's a normal good
• if it's negative, it's an inferior good

The absolute value shows the level of income elasticity of demand.

• if the YED is 0 < YED < 1  = income inelastic
• if YED > 1 = income elastic

2008 AP Microeconomics Exam

Answer (D) X is an inferior good and is a complement to Y.

Elasticity Cheat Sheet

Elasticity 2 - XED, Cross Price Elasticity of Demand

Elasticity - XED

XED - (Cross Price Elasticity of Demand) - measures the responsiveness of the demand of one good to a change in the price of another.

Formula -

The sign (+ or - ) determines how we interpret XED for a product:

XED > 0, the two goods are substitutes, if one becomes more expensive then consumers switch to                       the other.

XED < 0, the two goods are compliments, or jointly demanded: if one becomes more expensive and                    people buy less, they will also buy less of the other one.

XED = 0, the two goods are unrelated

XED is positive, or XED >  0 

Notice, this is not a demand curve,,, this is a representation using a graph to show the relationship between two competitive goods. As coffee (P to P1) becomes more expensive consumers switch to drinking tea. (Q to Q1), apply the same to the Coke and Pepsi graph.

XED < 0, or XED is negative

Notice, this is not a demand curve,,,, The price of sugar rises and the quantity of tea demanded will fall. 

2009B - AP Microeconomics Exam FRQ, #2 

Answer - if XED is > 1 or positive, then the goods are substitutes, and therefore if the price of  bananas increases (due to crop failure), then the demand for peanuts will increase. Also the equilibrium price and quantity of peanuts will both increase.

Elasticity Cheat Sheet

Elasticity 1 - PED, Price Elasticity of Demand

Elasticity 1

Ok,, elasticities,, What's the purpose of elasticity?

It's (as a business owner) nice to know that raising the price of your product won't/ or will destroy your income and thus your business. (How much will your revenue change with a price change).

4 sections under this topic:

• PED or price elasticity of demand 
• XED or cross price elasticity of demand
• YED or income elasticity of demand

• PES or Price Elasticity of Supply

PED - Price Elasticity of Demand

Good Video to watch to get introduced to the concept of PED.

PED - measures the responsiveness of quantity demanded to a change in price along a given demand            curve. 

Formula - 

Yes, this above is the formula but almost never are we given the % change in Qd or Price.

Usually we are given a table of old and new prices and quantities and asked to derive the % change in Qd and price.   

more useful formula - 

This is known as the midpoint formula.

Example 1:

Example 2:

2008 AP Microeconomics Exam

Answer (B) elastic - use the formula above. Do the math.

PED varies along a demand Curve.

On a linear negatively sloped demand curve price elasticity varies continuously as one travels up or down the curve. 

This makes total sense, responsiveness t a price change (PED) will be higher, the higher the initial price of the good, the more expensive it is.

• PED > 1, demand is price elastic =  % change in Qd is larger than the change in price.

Notice in the graph above, a 25% reduction in price leads to a much larger % change in Qd.

Also notice the demand curve is almost horizontal.

• 0 < PED < 1, demand is price inelastic = % change in Qd is smaller  than the change in price.

Notice the demand curve is almost vertical.

• PED = 1 or Unit Elasticity, % change in Qd is equal to the % change in price.

• PED – ∞, Demand is infinitely or perfectly elastic, a small change in price leads to an infinite change in Qd.

Usually, perfectly elastic demand describes a perfectly competitive firm,,, It can sell any amount at the going price.

2005 AP Microeconomics Exam

Answer (E) It will not be able to sell any output - I added this, even though you probably haven't had any perfect competition instructions. The fact is that given a graph like the one above showing a perfectly elastic curve could also be given... The perfect elastic curve above shows that at that price (market price) all can be sold,,, Qd is infinite at that price,,, all that they want to sell they can. But any raising of price,, and they will sell nothing/0/nada/zip. 

Why? If it increases its price,, consumers will buy elsewhere at the lower price given by competitors.

2000 AP Microeconomics Exam

• PED = 0, Demand is perfectly inelastic, change in price leads to no change in Qd.

Perfectly inelastic demand curve (PED = 0) is often used to describe the case of highly addictive goods such as drugs, or pharmaceutical products of which there are no substitutes, (insulin)

You must for the AP exam know how to draw the graphs above and explain them. The AP exam asks very (interesting) questions about elasticity.

Determinants of PED

• Substitutes: the number and closeness of available substitutes affect PED. The more substitutes there are for a good, and the closer these are, the more easily people will switch to these alternatives when the price of the good rises: the greater therefore will be the PED.
• Income: the proportion of income spent on the good. The higher the proportion of income spent on a good, the more consumers will be forced to lower consumption when its price rises(the bigger the income effect) and the more price elastic the demand will be. If a small proportion of income is spent on a good (it is insignificant) then a price change will not effect our spending behavior, demand will be price inelastic.
• Time: if someone is pressed for time (gas light comes on in car) the availability of substitutes are limited. It follows that the longer the time period after a price change, the more price elastic the demand is likely to be.
• Necessity: whether consumers consider the good or service a necessity. If it is considered a necessity a price change will tend to affect it less than a price change affects another product (luxury).
• Addictive: substances that are addictive are relatively price inelastic.

Elasticity & Total Revenue

Total Revenue: is the money received by a firm from the sale of a particular quantity of output and is equal to price times quantity sold.

P*Q = TR, or price times quantity sold is total revenue,

Law of Demand states that as price rises, the quantity demanded decreases,, the change in total revenue depends on the price elasticity of demand, PED.

0 < PED < 1, When demand is inelastic, an increase in price from P1 to P2 will cause a lower % decrease in Qd (quantity demanded) from Q1 to Q2. The gain in total revenue from the price increase is larger than the loss in revenue from quantity decrease.

PED > 1, When demand is elastic, an increase in price from P1 to P2 will cause a higher % decrease in Qd from Q1 to Q2. The gain in total revenue from a price increase is lower than the loss in revenue from a quantity decrease.

PED = 1, When demand is unitary elastic,  price and quantity change in the same proportion.

1995 AP Microeconomics Exam

Answer (A) Inelastic - Price rises proportionately more than quantity, the change in price has a bigger effect  on TR (total revenue) than the change in quantity does

2000 AP Microeconomics Exam

Answer (C) A decrease in price will likely lead to an increase in total revenue. - This is an application of the total revenue test.  A good is elastic if total revenue increases when price decreases (arrows move in opposite directions). Remember, the demand curve becomes inelastic when marginal revenue is negative.  And, it’s unit elastic when MR = 0.

2005 AP Microeconomics Exam

Answer (A) inelastic - When demand is inelastic, an increase in price from P1 to P2 will cause a lower % decrease in Qd (quantity demanded) from Q1 to Q2. The gain in total revenue from the price increase is larger than the loss in revenue from quantity decrease.

Impact of price change on total revenue under different PED values.

Welker on PED and total revenue.

Elasticity Cheat Sheet



Welker playlist on elasticity

Government Intervention 7 - FRQ per-unit tax

Government Intervention 7 - FRQ, per-unit tax

Conversations welcome - 

Econowaugh's Facebook

2014 AP Microeconomics Exam - FRQ, question 3

(a) Draw a CLG (correctly labelled graph) of the gasoline market in which demand is relatively inelastic and the supply is relatively elastic.

You must know that inelastic demand is drawn more vertical (inelastic = I) and elastic is more like the the lines of the E, horizontal... So elastic (supply) is more horizontal and inelastic (demand) is drawn steeper.

(b) Suppose the Gov't imposes a $2 per unit tax on the producers of gasoline. On your graph from part (a), show each of the following after the tax imposed.

• The price paid by buyers, labeled Pb
• The after tax price received by sellers, labelled Ps
• The quantity, labeled Q

• So the price paid by buyers is simply the equilibrium price of the demand and new (s+tax) supply curve. Draw a dotted line over to the price axis and mark it Pb
• The after tax (net) price received by sellers is the amount of the tax. In essence the horizontal distance between the two parallel supply curves. But, to get the after tax price start at the new equilibrium (s+tax) and follow the dotted line down to the original supply curve, look left,, make a dotted line across to the price axis and mark it Ps.
• The quantity demanded at the new higher (higher prices mean less Qd) is less than at the original lower price. Draw a straight line down from the new (s+tax) equilibrium and label the new quantity as Qt.

(C) Using the labeling on your graph, explain how to calculate the total tax revenue collected by the government.

Since Pb is the market price paid by the consumer and the net amount kept by the seller we could write this as 

• Pb-Ps times the quantity sold, which is Qt, so (Pb-Ps*Qt)

or

• since we know the tax $2 and we know the quantity sold, then ($2 * Qt)

or

• (Pb * Qt) - (Ps * Qt) I'm not writing that out:)

(d) Will the tax burden fall entirely on the buyer, entirely on the seller, more on the buyer and less on the seller, more on the seller and less on the buyer, or equally on the buyer and seller. Explain.

Look at the graph,, its easy to see that the consumer (buyer) will pay more of the tax. When the demand curve is inelastic the buyers bear most of the tax incidence.

Hope this helps. 

2005 AP Microeconomics Exam - FRQ, question 2

2. The graph above shows the market for a good that is subject to a per-unit tax.    (a) Using the labeling on the graph, identify the following:

• equilibrium price and quantity before the tax.

easy, Yes? The equilibrium before the tax is where the supply curve crosses the demand curve. (NOT the supply curve that says, Supply + Tax)

The equilibrium price before the tax is (follow the dashed line across to the price axis) $12
The equilibrium quantity before the tax is (follow the dashed line down to the quantity axis) 100

• The area representing the Consumer surplus before the tax.

The consumer surplus before the tax is the areas, A,B,C and F.

• The area representing the Producer surplus before the tax.

The producer surplus before the tax is the areas, D,G,and E. or 100. Why 100 you ask?

Area of a triangle is 1/2 B*H    or (one-half, base times height.)  So the base is 100, the height of the producers surplus (up the price axis) is 2 (12-10=2)   so,   2 X 100 = 200 *1/2 = 100.

(b) Assume the tax is now imposed. Does the price paid by the buyers rise by the full amount of the tax? Explain!

Remember that the two supply curves are parallel so the tax is the vertical distance between them. In essence the tax shifted the supply curve leftward. Tax is a determinate of supply so a shift occurs.

Where the supply+tax curve crosses the demand curve is the new equilibrium, at that point follow the dotted line down until it touches the original supply curve ,, then look left. (follow the dotted line to the price axis) and you will see a price of $11.

Go back to the supply+tax curve where it crosses the demand curve, and look left. (follow the dotted line to the price axis) and you will see a price of $13.

• $13 minus $11 = $2 , two dollars is the tax. 

Consider that the former supply/demand equilibrium was at $12 and now the supply+tax/demand equilibrium is at $13. The equilibrium price has only moved from $12 to $13 so the price paid by the buyers has risen by $1. ($12 to $13 is 1 dollar) So the buyers have not paid the full amount of the tax.

Elasticity explanation - Supply is not perfectly elastic,, or demand is not perfectly inelastic or demand/supply have the same elasticities.

(C) Using the labeling on the graph, identify each of the following (after the imposition of the tax).

• The net price paid to the sellers.

Remember that net means (tax taken out) so the amount the seller receives minus the tax.

If the equilibrium price is $13 and the tax is (we now know) $2 then 13-2 is $11. So the seller receives $11 per unit.

• The amount of tax revenue.

Dollar amount of tax ($2) times, multiplied by, the quantity sold or (go to supply+tax equilibrium and follow the dotted line straight down to the quantity axis) 80.   $2 X 80 = $160

In essence the government tax is two dollars and the sellers sells 80 units,, the government gets $160 dollars in tax revenue.

• The area representing the consumer surplus (after the imposition of the tax).

The area representing the consumer surplus is the area A.

• The area representing the producer surplus (after the imposition of the tax).

The area representing the the producer surplus is the area B.

Now, On the graph above what if the questions had been worded differently,, such as 

• The area representing the change in consumer surplus.

The original consumer surplus was area A,B,C and F now, after the imposition of the tax, the area of consumer surplus is just A,,, so the change would be (B,C,F).

Discussions welcome - 
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2006 AP MIcro FRQ#2

2006 Price Ceiling - FRQ#2

Watch me do this FRQ on youtube https://youtu.be/Ux4F3PnCg4w

(A) Using a correctly labeled graph of supply and demand, show each of the following

We see the same pattern being used here. First questions are asked, usually, before any tax, tariff, subsidy happens.

• The equilibrium price and quantity, labeled as P* and Q*. Respectively  -- (Respectively is used when enumerating two or more items or facts that refer back to a previous statement). 

• area representing consumer surplus, labeled CS
• area representing the producer surplus, labeled PS

Simple enough, yes. but  1point is awarded for the CLG - Correctly Labeled Graph

                                         1point is awarded for the labeling of the CS (consumer surplus)

                                         1point is awarded for the labeling of the PS (producer surplus)

(B) The government imposes an effective(binding) price ceiling. Redraw your graph in       part (a), and label the ceiling price as P2. Completely shade the area representing       the sum of the consumer surplus and the producer surplus after the imposition of       the price ceiling.

We can see that with a binding (below equilibrium) price ceiling at P2,,, only Q1 of quantity will be supplied.

The quantity demanded is Q2 but the amount from Q1 to Q2 will never be supplied at this price.

At the low price of P2 consumer surplus has increased and gained the lower square.

Producer surplus has shrank to the small lower shaded triangle.

I want to point out that the white triangle (unshaded) to the left of the old equilibrium price is now considered DWL or dead weight loss. It represents the consumers and producers who would have liked to buy or sell at a higher price but can't now due to government intervention. 

(C) Suppose the demand for home security systems decreases and the price ceiling remains binding. Indicate what will happen to consumer and producer surplus.

So if Demand decreases, the demand curve shifts left. But, because they say in the problem (the price ceiling remains binding) we know that the demand curve has NOT shifted below the P2 price ceiling. Shifting the demand curve will decrease the consumer surplus but the producer surplus will remain unchanged. The producer surplus will only be effected if the supply curve shifts,, or the demand curve shifts far enough to cause the equilibrium price to go lower than P2.

Government Intervention 5 - World Price/ Tariffs FRQ's

Government Intervention - World Price/Tariffs

What exactly do I mean when I write (World Price) as a heading for a government intervention post. 

Since a picture or graph is worth a thousand words:

2004 AP Microeconomics Exam - FRQ,  Question 2

Watch me answer it 

https://youtu.be/ODPKsAEjyHk

These type of FRQ's (Free Response Questions) tend to have a predictive pattern of questioning.

The graph above shows the demand for oil by US residents, the supply of oil by US producers, and the world price of oil. Use the labeling of the graph to answer the following questions:

(A) Identify the following before trade occurs.

• Price of oil in the US market
• Quantity of oil produced in the US

Simple right! The price and quantity before trade occurs is the demand and supply curve at equilibrium. Start at (G) and follow the dotted line to P(2) which is equilibrium price, and then follow the dotted line down from (G) to the equilibrium quantity or Q(2).

• Price of oil in the US market - P(2)
• Quantity of oil produced in the US - Q(2)

(B) Now assume the US begins to import oil at the world market price of Pw. 

      Identify the quantity imported by the US.

At the world market price (low price) the US quantity demand for oil will be at point H, or Q3.

At the world market price (low price) domestic suppliers will only supply up to point J and the quantity domestically supplied is from 0 to Q1.

So the quantity imported is the total amount (internationally) supplied minus the amount domestically supplied. Since we know that the domestically supplied amount is from 0 to Q1 and the total amount supplied is Q3, then the difference is Q3 minus Q1 (Q3-Q1).

(C) Identify the consumer surplus in the US market for each of the following cases.

• Before international trade.
• After international trade.

Before international trade is easy, right? Consumer surplus is simply (K,G,P2),, that triangle is the consumer surplus before world market price is considered.

After international trade is fairly easy also. Consumer surplus after trade is (K,H, Pw).

Mind blown,, did you miss it?

With the lowering of the price the Consumer surplus expands to include what is blow the demand curve and above the world price.

(D) Identify the producer surplus in the US market for each of the following cases.

• Before international trade
• After international trade

Before international trade, easy right? Producer surplus is simply (P2,G,P1). 

After international trade, (Pw,J,P1).

(E) Identify the net gain in total surplus from trade.

Net gain would be the area under the curve that we didn't have before world price was introduced.

Net gain in total surplus is the area that has been gained by having a world price. The addition of a world price increased consumer surplus and reduced producer surplus, but the only new area under the curve is (J,G,H), the triangle represents the net gain in total surplus.

2012 AP Microeconomics Exam, FRQ, question 3

Watch me answer it here

https://youtu.be/POk4t7enQZ8

(a) at the world price of $2 per pound, how much sugar is Loriland importing?

at the $2 world price, domestic suppliers of sugar will only supply 2 million pounds (found where the Pw crosses the domestic Supply curve).

the total amount of sugar supplied is 14 million pounds of sugar, (found where the Pw crosses the Domestic Demand curve), at the low price 14 million pounds is demanded.

So, if 14 million pounds is demanded total,,, and 2 million pounds is supplied domestically, Loriland must be importing 12 million pounds of sugar. (14 - 2 = 12)

(b) Suppose that Loriland imposes a per-unit tariff on sugar imports and the new      domestic price including tariff is $4.

• identify the new level of domestic production
• Calculate the domestic consumer surplus for Loriland. (show work)
• Calculate the total tariff revenue collected by the government. (show work)

to identify the new level of domestic production (be careful, the directions are that the new domestic price is $4 not that the tariff is $4)

So to identify the new level of domestic production travel up the price axis until $4 is reached and then travel across until reaching the domestic supply curve. At a price of $4 the domestic supply is 6 million pounds of sugar.

Calculate the domestic consumer surplus for Loriland. (Remember that the area of a triangle is 1/2 (b x h)

So the consumer surplus at a price of $4 is found by following the dotted line across from the $4 price axis to the demand curve. Where it intersects the demand curve, we travel straight down and find a quantity of 10 million pounds.

On the price axis, from $4 to $9 is 5 (lets call it the height) 

From the $4 price straight across to the demand curve, and then down is 10 (lets call it the base)

-Domestic consumer surplus,, is the area of the consumer surplus triangle-

so, 1/2 (5x10) = 25.. (25 is the consumer surplus)

• Calculate the total tariff revenue collected by the government. (show work)

1. understand that if world price was $2 and the price after tariff was $4, then the tariff is $2pds.
2. the new domestic demand after the tariff, that raises the price up to $4 is for 6 million pds.
3. at a $4 price 10 million pds is demanded.
4. 10 million pds minus the 6 million pds produced domestically = 4 million pds imported
5. 4 million pds times the $2 tariff = $8 million
6. the total tariff revenue is $8 million pds.

(C) Given the world price of $2, what per unit tariff maximizes the sum of Loriland's domestic consumer and producer surplus?

(Bit of a trick question) - as the per unit tariff that maximizes consumer and producer surplus is ($0 tariff,, nada, zip, no tariff at all)

2004 B AP Microeconomics Exam, FRQ question 3

(A) If the current world price of good X is Pw, does Palconia exports or import good X. Explain.

Placonia, produces locally 50 units of good X but imports units from J to N.
or, they can get unit JN cheaper on the world market, they import mostly.
(The opportunity cost of producing it locally is higher than the world price, so they import.)

(B) Given your answer in part (a), indicate the quantity of good X that Placonia exports or imports.

Placonia, imports 350(N) minus 50(J) = (300 units)

(C) A tariff on good X, increasing the price from Pw to Pt. Indicate the change in each of the following.

• Consumer Surplus from H,N,Pw to H,M,Pt
• Producer Surplus from (that itty bitty triangle above supply and below PwJ) to Pt,K,J,Pw

(D) Indicate how employment in the domestic industry that produces good X is affected by the tariff.

Employment in the domestic market will increase.

But why??

If you are supplying dolls to the market and then someone opens a shop across the street and is selling a like good cheaper, you will of course loose business. So you go to your local government and get them to tax(tariff) the dolls of your competitor. That way, you don't really have to compete in the capitalistic sense, you can get the government to protect your profits. The consumer looses by having to pay more for the dolls. You win, not by being smarter, or more efficient, or innovative. You have won simply by the pull of your political connections. Thousands, perhaps millions of consumers have to pay more for the dolls but your profits have increased and the demand for your dolls has increased to the point that you have to hire more workers. 

The argument tends to always be the same:

yes, these reasons are all simplified.

• Jobs, more domestic jobs (yet, what is not thought about is the cost of those jobs to the consumers of X country) it's argued that steel jobs in America cost the country (taxpayers) upwards of $800,000 per job.
• Security - if we don't provide it then we really on others and in a time of war, etc they might not sell it to us. Yet, there are thousands of types of goods that we would need to protect to have security for a war. They aren't protected.
• New industry  - the new industry needs to be protected until they get on their feet. (steel) really?

There are a few more but I'm looking for a discussion.

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Thanks,

Charles