Perfect Competition 2 - Lump Sum, Tax & Subsidy

Perfect Competition 2 - Lump-Sum, Tax & Subsidy

I have been tutoring some lately and have noticed that many students seem to have a bit of trouble with Lump-Sum & PerUnit taxes and subsidies within a perfect competitive market structure. While I have only seen this in one FRQ,, I believe 2008, Question, 1, I want to try and explain it and then we will do the 2008 FRQ and see if our graphs help us understand and answer the question...

Lump Sum Tax --A lump sum tax is a tax of a fixed amount that has to be paid by everyone (every firm in the industry) regardless of the level of his or her (its) income (production). (So no matter how much you produce or don't produce, you still have to pay this tax).

Lump Sum Subsidy - A lump sum subsidy of a fixed amount that is given to everyone (every firm in the industry).  Think of a subsidy like a gift or grant from the government for producing in the specified industry.

Subsidy humor

Lump-Sum Subsidy 

So, Short-run is on the left and Long-run is on the right.

Marginal Cost curves intentionally left off (as not effected) to show effects clearly,, feel free to add as Profit Max is where MR=MC.

Lets start with the short-run. The market graph is drawn showing supply and demand in equilibrium. Firms look at lump-sum subsidies as if they are monies added, decreasing the firms fixed costs. Additional decreases in fixed costs will not effect the variable costs and therefore won't effect marginal costs. Fixed cost increases will effect the ATC or (Average total costs curve) not the AVC or MC curves.

• A lump sum subsidy will shift the ATC downward, in the short-run the firm will earn positive (super/abnormal) economic profits due to the subsidy. Remember - that in the short run other firms cannot enter the market. 
• In the long-run firms are attracted to this industry's abnormal profits and will enter the market. As more producing firms enter the market, supply increases,  pushing down the market price and increasing the quantity produced. In the long run the the price will decrease to the point that the firm is only making normal profit/zero economic profit.

Lump-Sum Tax

So, Short-run is on the left and Long-run is on the right.

Lets start with the short-run. The market graph is drawn showing supply and demand in equilibrium. Firms look at lump-sum taxes as if they are extra costs added to the firms fixed costs. Increases in fixed costs will not effect the variable costs and therefore will not shift the marginal cost curve. 

• A lump sum tax will shift the ATC upward, in the short-run the firm will have a loss due to the tax. Remember - that in the short run other firms cannot enter the market. 
• In the long-run firms exit this industry. As more producing firms exit the market, supply decreases,  pushing up the market price and decreasing the quantity produced. In the long run the the price will increase to the point that the firm is only making normal profit/zero economic profit.

AP Microeconomics 2008, FRQ, question 1

So, (a) is asking for the short run market graph in equilibrium,, and the long run firm graph,, labelled appropriately, of course. This question is starting with everything in equilibrium.

(b) Notice, the underlined in the short-run. 

(i) Callahan's quantity of output? (Callahan's output/quantity doesn't change in the short-run as lump-sum subsidies are considered as an increase in fixed costs and therefore don't effect output/quantity produced.) (Variable costs are not effected therefore marginal cost is not effected.)

(ii) Callahan's Profit? (Callahan's profit definitely increases in the short-run)

(iii) The number of firms in the industry? (Tricky bastards) (The number of firms in the short-run never changes, look at the market graph in the short-run,,, firms only enter and exit in the long run.)

(c) Notice, the underlined in the long run.

(i) The number of firms in the industry. Explain (In the long-run the number of firms enter the market attracted to Callahan's abnormal profits) (Look at the long-run market graph.)

(ii) Price? (The price decreases as new firms increase supply, pushing down the price.)

(iii) Industry Output? (Industry output will increase.) (Look at the long-run firm graph and notice that the quantity is now at Q2, this makes since in that at the new lower price more quantity will be demanded and supplied by the firms in the industry.)

AP 2008 FRQ, Question 1 - Scoring Guideline

Both graphs in one,, for your learning pleasure.

Perfect Competition 1

Perfect Competition

Mjmfoodie - Perfect Comp. - Video

I wanted to post some new graphs that I created to push me to do some new blog posts.
Comments always welcome. :)

Obviously this is a perfect competition graph,,,

Firms in a perfectly competitive market are consider price-takers meaning that in this industry they can't manipulate the price of their goods. They can't do this because the market is saturated with firms all selling identical products. (Hint - perfect competition doesn't really exist) The closest markets are agricultural markets and they are often subsidized by their governments for various reasons: security (America & corn), patriotic bromides (Japan & rice), environmental (America and corn/ethanol) or tradition (America and sugar).

Profit - often students of economics don't quite get the references to a firm earning profits.

• @ P1 the market is in short-run and long-run equilibrium, this means that the firm is earning a normal profit and all of its explicit and implicit costs are being covered. (Implicit in that the entrepreneur is earning enough profit to allow him to stay in this industry,,, more than his next best alternative) The AP exam uses normal profit and zero economic profit interchangeably.  They mean the same thing, (zero economic profit = normal profit)Notice that at P1 the firm is at a break even, meaning that all revenues are covering all costs. 
• @P3 the price has risen above the firms ATC's (Average Total Costs). This price rise allows the firm to make Abnormal/Super/Positive Economic Profit, you must know that all of these terms when used,,, imply that the price has risen above where MC intersects with the ATC curve. When firms are makingAbnormal/Super/Positive Economic Profit, then we can expect other entrepreneurs/firms to rush into the industry to try and capture these profits. As more and more of these firms rush into this industry,,, the increase in supply causes prices to fall,,, falling prices causes inefficient firms to leave the market until we return to the previous level of equilibrium at P1, where P=minATC or Long-Run Equilibrium.

Lets look at it on a graph.

Notice that at P3 firms are making super/abnormal/positive economic profits. 

• As more firms enter the market and increase supply, P3 to P1 (right shift) the price drops and inefficient firms exit the market.
• Know that a perfectly competitive firm always produces to Maximize Profit, where MR = MC.

Why you ask?,,,, well.

MC = MR -  the firm’s total profits are maximized or losses are minimized - there is no reason to change the level of output, if it does it will be decreasing profits or increasing losses.

MR>MC - revenues are rising faster than costs so it pays the firm to increase output as in this way it will increase profits or decrease losses. There is money on the table. If the marginal unit is sold then more revenue will be collected. If more profit can be collected then the firm has not maxed profit. ** Ok, to often, this is very confusing to students,,, why? don't we want MR to be more than MC. NO,,, you want your revenues to be more than costs, but not your Marginal Revenues to be greater than your Marginal Costs... Explain,, you say,,

First, recognize that the word marginal here means either to sell or not sell one more unit. Would it increase our profit if we sold one more unit or would it decrease our profits. MR>MC, simply means that by selling that (one more unit)  or (more units) profits will be increased. {Lets use as an example the selling of a 3 million dollar plane. If your costs are 2 million and you sell the plane for 3 million, you have just increased the firms profits by 1 million dollars. If you had not sold the plane you would have cost the firm a million dollars in unrealized profit. If you can make one penny on a marginal sell,,(by selling one more) then you aren't at max profit until you make the sell}. Simple,, yes..

MC>MR - costs are rising faster than revenues, so it pays to decrease output as in this way the firm will increase profits or decrease losses.

Mjmfoodie - Profit Max - Video

What if the Price drops to P2?

• @P2, the firm is now suffering some losses. At this price the firm will produce a quantity equal to Q2. Still at (MR = MC) to profit maximize. They are making losses but they are still covering some of their fixed cost. Why shouldn't they exit the market if they are making losses. Well, if they did exit the market they would still have to pay for all of their fixed costs. By staying in the market they can at least pay for some of their fixed costs. 
• Remember that fixed costs are = to ATC - AVC. That rectangle that that includes LOSS & Area of fixed costs being Paid,,, is equal to all of the fixed costs. (ATC-AVC= AFC.)

What if the Price drops to P4?

• Shut-Down is when price drops below the AVC. Once the price drops below P4, then the firm is not able to even pay its VC (workers) and to stay in business would be costing it money. Exit the Industry.

What if Demand Shifts lowering or raising price. If you understand the right sided graph it's easy to plug in the Demand Shift.

Points to Remember:

• Break-Even - P=minATC
• Profit Max - MR=MC
• Shut-Down - P<AVC
• A firm's MC curve above the AVC is its Supply Curve
• Price will equal MC (Allocative Efficiency) - Allocative Efficiency exists when just the right amount, from society's point of view, is being produced. It requires that for the last unit produced, price is equal to its marginal cost (MC) or, more generally, that MSB=MSC.
• Price will equal minimum ATC (Productive Efficiency) - When production takes place with a minimum average costs, implying that production takes place with minimal resource waste.
• Perfectly Competitive industries are the most efficient type of Market Structure

Market Failure - 7 Tragedy of the Commons & Asymmetric Information

Tragedy of the Commons - Resources

Tragedy of the Commons - Garrett Hardin, 1968

- a term introduced by Garrett Hardin that refers to users of a commons ( a common pool, for example a pasture) where in his original analysis the process inevitably leads to the destruction of the resource (for example, overgrazing of the pasture) on which users depends.

Garrett Hardin video

Common-access resources (common pool resources) share two characteristics

• It is difficult to exclude individuals from deriving benefits from the good or the resource.
• There is rivalry in the consumption of common-access resources (one individuals consumption subtracts from the benefits available to others using the resource).

The effects of the Tragedy of the Commons behavior may be illustrated using a negative externality diagram. Where MSC > MPC.

Tragedy of the Commons, examples

Tragedy of the Commons and the Pilgrims

Solutions to Tragedy of the Commons

Private property rights - Government Taxes - Regulation

Library of Liberty, Property Rights

Stossel on Tragedy of the Commons - Video

Learn Liberty - Tragedy of the Commons - Video

Negative Externalities and the Coase Theorem - Video

Learn Liberty - Tragedy of the Commons - reading

Reffonomics - The Lighthouse Story - slide show

Coase Theorem  - "The Problem of Social Cost" (1960), which suggests that well-defined property rights could overcome the problems of externalities.

• Coase theorem in real life, example - reading
• Lincoln Center Renamed - Coase in action..

• Bees and Barbed Wire, example - reading

Technology increasing property rights - Barb Wire  - reading

How Fishing Communities Protect Their Future - reading

Of the four released AP exams and the last ten years of FRQ's I have found no questions on Tragedy of the Commons. If anyone knows anything different, please drop me a line. wcwaugh@aol.com.

Asymmetric Information

When either the buyer or the seller possess incomplete or inaccurate information.

Asymmetric Information leads to the following:

• Adverse Selection - often one party knows more about a good than another, often, the seller knows more about the good being sold than the buyer.

Implications of costly information - Morgan Rose
Adverse Selection - Reading at amos web - nice examples

• Moral Hazard -  people will take risks, when others will assume the consequences of those actions.

video - by Texas Enterprise

Video, Fraser institute 2011 student contest

Again, no questions found but I would suspect some questions pertaining to concept, about Asymmetric Information.

Market Failure 6 - Public Goods

Market Failure - Public Goods

Public Goods - are non-excludable & non-rivalrous.

• non-excludable - it is not possible to prevent people who have not paid for a good from using                                 it. 
• non-rivalrous - consumption of the good by one person does not prevent others from also                                    consuming it. 

Free-riders are those who can use a good without paying for it.

Examples given: National Defense - it is not possible to exclude anyone within a country's borders while at the same time protecting those borders. Individuals are protected if they have paid or not. 

Public Goods by Tyler Cowen - Good Read

mjmfoodie on Public Goods- 

2005 AP Microeconomics Exam

Answer (B) an increase in the optimal quantity of the good. 

Market Failure 5 - Positive Consumption Externality

Positive Consumption Externality

Positive Consumption Externality: The type/name of the externality tells you what you need to do!

Positive = Positive (duh!) (we want more of it)
Consumption = Benefits = Demand (there will be two demand curves, MSB & MPB)

• Positive = we want more
• Consumption = benefits = demand
• Triangle = DWL (dead weight loss) (points to society) & is between the two demand curves
• SOQ = Socially Optimal Quantity or the quantity desired by society (Pos.= more quantity)
• Underproduction =  If we want more we must be underproducing the good. (duh!)
• MSB = MSC, obviously where social benefits and costs equal,  equilibrium quantity- Q*
• Subsidy shifts supply right, lowering price, increasing quantity consumed.
• CLG - always a correctly labelled graph

• Triangle - always points to society - to help you know which demand/cost curve is drawn above or below, know that the triangle always points to (MSB) society for a Positive Consumption Externality... Your going to say,, but Charles I could draw the curve pointing to the left and still have it between the curves,,, but then the triangles point would be pointing to an equilibrium of less production (we need more).
• Subsidy has been granted, shifting supply right, lowering price.
• Check your graph and make sure it is showing what you want,,, to get more consumption prices must go lower. (look above and you will see this is exactly what has happened, prices have decreased and quantity produced has risen.)

Market Failure 4 - Positive Production Externality

Positive Production Externality

pajholden - Positive Externalities - Video

Positive Production Externality: The type/name of the externality tells you what you need to do!

Positive = Positive (duh!) (we want more of it)
Production = Production = Costs = Supply (there will be two supply curves, MSC & MPC)

• Positive = we want more
• Production = costs = supply
• Triangle = DWL (dead weight loss) (points to society) & is between the two supply curves
• SOQ = Socially Optimal Quantity or the quantity desired by society (Pos.= more quantity)
• Underproduction =  If we want more we must be underproducing the good. (duh!)
• MSB = MSC, obviously where social benefits and costs equal,  equilibrium quantity- Q*
• CLG - always a correctly labelled graph

• Triangle - always points to society - to help you know which supply/cost curve is drawn above or below, know that the triangle always points to (MSC) society for a Positive Production Externality... Your going to say,, but Charles I could draw the curve pointing to the left and still have it between the curves,,, but then the triangles point would be pointing to an equilibrium of less production (we need more).

• Check your graph and make sure it is showing what you want,,, to get more production prices must go lower. (look above and you will see this is exactly what has happened, prices have increased and quantity produced has fallen.)

An example of a positive production externality would be a case of bee keepers producing honey next to an orchard. Bees help in the pollination of the orchard, causing a benefit (unpaid) to the orchard owner.

Demand in this instance, which always reflects the MPB of buyers of honey, and is identical to the MSB as no external effects of honey consumption are assumed. (D,MSB,MPB)

Supply of honey reflects the MPC of honey producers (costs paid, labour and bees). Since the honey producer's production process entails external benefits to apple growers in the form of pollination, it follows that the social costs of honey production are lower than the private costs that the beekeepers consider. The MSC of honey production are therefore lower than the MPC by the amount of the external benefit created. (Triangle points to Society = MSC)

There is an underproduction of this good, so prices need to be lowered. This is normally done through the use of a subsidy granted to the producer. This decreases the costs of production increasing output levels.

2008 AP Microeconomics Exam

Answer (B) Subsidizing flu shots will lead to the socially efficient level of output. 
                    (socially efficient level = socially optimal quantity)

Reffonomics, excellent website

Market Failure 3 - Negative Consumption Externalities

Negative Consumption Externalities

Negative Consumption Externality: The name of the externality tells you what you need to do!

Negative = Negative (duh!) (we want less of it)
Consumption  = Benefits = Demand (there will be two Demand curves, MSB & MPB)

• Negative = we want less
• Consumption = benefits = demand
• Triangle = DWL (dead weight loss) (points to society) & is between the two demand curves
• SOQ = Socially Optimal Quantity or the quantity desired by society (Neg.=less quantity)
• Overproduction =  If we want less we must be over producing the good (duh!)
• MSB = MSC, obviously where social benefits and costs equal,  equilibrium quantity- Q*
• Indirect tax pushes costs higher, shifting supply left, causing higher prices
• CLG - always a correctly labelled graph

• Triangle - always points to society - to help you know which demand/cost curve is drawn above or below, know that the triangle always points to (MSB) society for a Negative Consumption Externality... Your going to say,, but Charles, I could draw the curve pointing to the right and still have it between the curves,,, but then the triangles point will be pointing to an equilibrium of more production (we want less). 
• Indirect tax equal to the external costs of consumption is needed to decrease supply and to increase the price of the good. 
• Check your graph and make sure it is showing what you want,,, to get less production prices must go higher. (look above and you will see this is exactly what has happened, prices have increased (with the tax) and quantity produced has fallen.)

Examples: (drugs, alcohol, cigarettes) also known as demerit goods.