Microeconomics

Microeconomics
Define market:
Any arrangement where buyers and sellers of goods, services or resources are linked together to carry
out an exchange.
Define competition:
There are many buyers and sellers acting independently, so that no one has the ability to influence the
price at which a product is sold.
Define market power:

The control a seller may have over the price of the product it sells.
Define demand:
The demand of an individual consumer indicates the various quantities of a good/service the consumer is
willing and able to buy at different possible prices during a particular time period, ceteris paribus.
State the law of demand:

There is a negative relationship between the price of a good and its quantity demanded over a particular
time period, ceteris paribus: as the price of the good increases, the quantity demanded falls, as the price
falls, the quantity demanded increases, ceteris paribus.
Define market demand:

The sum of all individual demands for a good.
List the non-price determinants of demand:

1. Tastes and preferences
2. Income distribution
3. Population and geographics
4. Prices of Supplementary and Complementary goods
5. Expectations for future prices
Explain the law of diminishing marginal utility:

As consumption of a good increases, marginal utility, or the extra satisfaction the consumer receives,
decreases with each additional unit consumed. This underlies the law of demand, as it shows that a
consumer will be willing to buy an additional unit of a good only if its price falls.
Explain the income effect:

A fall in price means that the consumer's real income (or purchasing power) has increased. Therefore
quantity demanded increases.
Explain the substitution effect:

If the price of a good falls, the consumer substitutes (buys more) of the now less expensive good.
Therefore quantity demanded increases.
Define supply:
The supply of an individual firm indicates the various quantities of a good/service a firm is willing and able
to produce and supply to the market for sale at different possible prices, during a particular period of time,
ceteris paribus.
State the law of supply:

There is a positive relationship between the quantity of a good supplied over a particular time period and
its price, ceteris paribus: as the price of the good increases, the quantity of the good supplied also
increases, as the price falls, the quantity supplied also falls, ceteris paribus.
Define market supply:

The sum of all individual firms' supplies for a good.
List the non-price determinants of supply:

1. Number (#) of firms
2. Costs of factors of production
3. Prices of Related goods
4. Expectations of prices
5. Shocks
6. Technology
7. Subsidies and taxes
Define short run:

A time period during which at least one input is fixed and cannot be changed by the firm.
Define long run:

A time period when all inputs can be changed.
Explain the law of diminishing marginal returns:

As more and more units of a variable input are added to one or more fixed inputs, the marginal product of
the variable input at first increases, but there comes a point when it begins to decrease.
Define total product:

Total quantity of output produced by a firm.
Define marginal cost:

The additional output produced by one additional variable input.
Define total cost:

All costs of production incurred by a firm.

The additional cost of producing one more unit of output.
Explain increasing marginal returns:

When marginal product increases, marginal cost decreases; when marginal product is maximum,
marginal cost is minimum, and when marginal product falls, marginal cost increases. A firm's supply curve
is a portion of its marginal cost curve that shows the price-quantity combination where the extra cost of
producing one more unit of output is equal to the price of that unit.
Define competitive market equilibrium:

When quantity demanded is equal to quantity supplied. The forces of demand and supply are in balance
and there is no tendency for price to change.
Define market disequilibrium:

There is excess demand (shortage) or excess supply (surplus) and the forces of demand and supply
cause the price to change until the market reaches equilibrium.
What causes a change in the market equilibrium?

A change in the non-price determinants of demand or supply.
Draw an increase in demand for chocolates due to change in tastes and preferences:
Explain the diagram above:

Initially D1 intersects with S1 at point A, resulting in an equilibrium price and quantity of P1 and Q1. Due to
an increase in the taste and preference for chocolate bars, the demand for chocolate shifted from D1 to
D2. Given D2 at the initial price P1, there is a movement to point B, which results in an excess demand
equal to the horizontal distance between points A and B. Point B represents a disequilibrium, where
quantity demanded is larger than quantity supplied, thus exerting an upward pressure on price. The price
therefore begins to increase, causing a movement up D2 to point C, where excess demand is eliminated
and a new equilibrium is reached. At C, there is a higher equilibrium price P2, and a greater equilibrium
quantity Q2, given by the intersection of D2 with S.
Draw a decrease in demand for chocolates due to a change in tastes and preferences:
Initially D1 intersects with S1 at point A, resulting in an equilibrium price and quantity of P1 and Q1. A
decrease in demand, due to a decrease in tastes and preferences for chocolate bars, leads to a leftward
shift in the demand curve from D1 to D3. Given D3, at price P1, there is a shift from the initial equilibrium,
point A, to point B, where quantity demanded is less than quantity supplied, and there is excess supply
equal to the horizontal difference between A and B. This exerts a downward pressure on price, which
falls, causing a movement down D3 to point C, where excess supply is eliminated, and a new equilibrium
is reached. At C, there is a lower equilibrium price, P3, and a lower equilibrium quantity Q3, given by the
intersection of D3, with S.
Draw an increase in supply due to a change in technology:

The initial equilibrium is at point a where D intersects S1, and where equilibrium price and quantity are P1
and Q1. An increase in supply (say, due to an improvement in technology) shifts the supply curve to S2.
With S2 and initial price P1, there is a move from point a to b, where there is disequilibrium due to excess
supply (by the amount equal to the horizontal distance between a and b). Therefore, price begins to fall,
and there results a movement down S2 to point c where a new equilibrium is reached. At c, excess supply
has been eliminated, and there is a lower equilibrium price, P2, but a higher equilibrium quantity, Q2.
Draw an decrease in supply due to a change in number of firms:

The initial equilibrium is at point a where D intersects S1, and where equilibrium price and quantity are P1
and Q1. A decrease in supply (say, due to a fall in the number of firms), shifts the curve from S1 to S3.
With the new supply curve S3, at the initial price P1, there has been a move from initial equilibrium a to
disequilibrium point b, where there is excess demand (equal to the distance between a and b). This
causes an upward pressure on price, which begins to increase, causing a move up S3 until a final
equilibrium is reached at point c, where the excess demand has been eliminated, and there is a higher
equilibrium price P3 and lower quantity Q3.
Define price mechanism:

Prices are determined by the forces of supply and demand in competitive market.
Define signaling:
Prices provide information to producers and consumers about where resources are wanted (markets with
increasing prices) and where they are not (markets with decreasing prices)
Define incentive:
When prices for a good/service rise, it incentivises producers to reallocate resources from a less
profitable market to this market in order to maximize their profits. Falling prices incentivise the reallocation
of resources to new markets.
Define rationing:
A method of apportioning or parceling out goods and services among consumers or households.
Define price rationing:

Involves the use of prices freely determined in markets. Price, and price alone is the deciding factor.
Define allocative efficiency:

Refers to producing the quantity of goods and services mostly wanted by society. Achieved when the
economy allocates its resources so that the society gets more benefits from consumption.
Define marginal benefit:
The extra benefit that you get from each additional unit of something you buy.
Explain the relationship between marginal benefit and demand:

Since marginal benefit decreases as the quantity of a good consumed increases, consumers will be
willing to buy an extra unit of the good only if its price falls. The demand curve can therefore also be
called a marginal benefit curve.

The extra cost of producing one more unit of output.
Explain the relationship between marginal cost and supply:

Since marginal cost increases as the quantity of a good produced increases, producers will be willing to
produce and sell an extra unit of the good only if its price increases. The supply curve can therefore also
be called a marginal cost (MC) curve.
Define consumer surplus:

The highest price consumers are willing to pay for a good minus the price actually paid .
Identify where consumer surplus can be found in a diagram:

The area under the demand curve and below the price paid by the consumer up to the quantity
purchased.
Define producer surplus:

The price received by firms for selling their goods minus the lowest price that they are willing to accept to
produce the good.
Identify where consumer surplus can be found in a diagram:

The area above the firms' supply curve and below the price received by the firm, up to the quantity
produced.
Define social surplus:

The sum of consumer and producer surplus.
When is social surplus maximum?:

At the point of competitive market equilibrium.
Define welfare:
Refers to the amount of consumer and producer surplus. Welfare is maximum when social surplus is
maximum.
Outline the formula for calculating the following economic quantities:
Consumer surplus ((Pe - PConsumers) X Qe) /2
Producer Surplus ((Pproducers - Pe ) x Qe)/2
Social Surplus Producer Surplus + Consumer Surplus

Define welfare loss
Loss of a proportion of social surplus that arises when marginal social benefits are not equal to marginal
social costs, due to market failure.
Define elasticity
A measure of the responsiveness of a variable to changes in price or any of the variable's determinants.
Define price elasticity of demand

A measure of the responsiveness of the quantity of a good demanded to changes in its price.
Outline the formula for PED:

Percentage given: %∆Q/%∆P
Numerical data given: ((Qfinal value - Qinitial value)/Qinitial value) ÷ ((Pfinal value - Pinitial value )/Pintial value)
Fill in the blanks:

Value Classification Interpretation
0<PED<1 Price inelastic demand Quantity demanded is relatively

unresponsive to price
1<PED<∞ Price elastic Quantity demanded is relatively

responsive to price
Constant PED along the length of the demand curve
PED = 1 Unit elastic demand Percentage change in quantity

demanded equals percentage
change in price
PED = 0 Perfectly inelastic demand Quantity demanded is

completely unresponsive to
price
PED = ∞ Perfectly elastic demand Quantity demanded is infinitely

responsive to price
How is PED indicated along a demand curve?

The relative steepness of demand curves are used as an indication of PED. The flatter the demand curve,
the more elastic the demand (higher PED); the steeper the demand curve, the more inelastic the demand
(lower PED).
Diagram a price inelastic demand:

Diagram a price elastic demand:
Diagram a unit elastic demand:
Diagram a perfectly inelastic demand:

Diagram a perfectly elastic demand:
Why does PED vary along a demand curve?

The reason behind the changing PED along a straight-line demand curve has to do with how PED is
calculated. At high prices and low quantities, the percentage change in Q is relatively large, while the
percentage change in P is relatively small. Therefore, the value of PED, given by a large percentage
change in Q divided by a small percentage change in P, results in a large PED. At low prices and high
quantities the opposite holds. The value of PED is given by a low percentage in Q divided by a high
percentage change in P, resulting in a low PED.
List the determinants of PED:

1. Number and closeness of Substitutes
2. Proportion of income spent on a good
3. Necessities versus Luxuries
4. Addictiveness
5. Length of Time
Define total revenue:

The amount of money received by firms when they sell a good or service
Outline the formula for calculating total revenue:

TR = P x Q
Fill in the blanks:

PED Effect on total revenue
Elastic demand (PED>1) An increase in price causes a fall in total revenue,

while a decrease in price causes a rise in total
revenue.
Inelastic demand (PED<1) An increase in price causes an increase in total

revenue, while an decrease in price causes a fall
in total revenue.
Unit elastic demand (PED = 1) A change in price does not cause any change in
total revenue
What is the relationship between a good's PED and the government revenue received from the
imposition of a tax?
The lower the price elasticity of demand for the taxed good, the greater the government tax revenue.
What is the relationship between PED and primary commodities VS. manufactured goods?
Many primary commodities have a relatively low PED because they are necessities and have no
substitutes. The PED of manufactured products is relatively high because they usually have substitutes.
What are the consequences of a low PED for primary commodities?

Due to a low PED, price fluctuations are larger for primary commodities. Large price fluctuations over
short periods of time are referred to as price volatility. As the price of commodities are highly volatile,
producers' incomes suffer, as their revenue depends upon the output sold.
Define income elasticity of demand (YED):

A measure of the responsiveness of demand to changes in income.
Outline the formula for YED:

Percentage given: %∆Q/%∆Y
Numerical data given: ((Qfinal value - Qinitial value)/Qinitial value) ÷ ((Yfinal value - Yinitial value )/Yintial value)
Define normal good:

A good the demand for which varies positively (directly) with income; this means that as income
increases, the demand for the good increases.
Define inferior good:

A good the demand for which varies negatively(indirectly) with income; this means that as income
increases, the demand for the good decreases.
Define income inelastic demand:

A percentage increase in income produces a smaller percentage increase in quantity demanded.
Define income elastic demand:

A percentage increase in income produces a larger percentage income in quantity demanded.
Fill in the blanks:
Sign of YED Interpretation
YED>0 A positive income elasticity of demand indicates

that the good in question is normal.
YED<0 A negative income elasticity of demand indicates

that the good is inferior.
Fill in the blanks:

Quantity of YED Interpretation
YED<1 If a good has a YED that is positive but less than

one, it has income inelastic demand, and is
considered a necessity.
YED<0 If a good has a YED that is positive and greater

than one it has income elastic demand, ans is
considered a luxury
Define price elasticity of demand:
A measure of the responsiveness of the quantity of a good supplied to changes in its prices.
Outline the formula for PES:

Percentage given: %∆Q/%∆P
Numerical value given: ((Qfinal value - Qinitial value)/Qinitial value) ÷ ((Pfinal value - Pinitial value )/Pintial value)
Fill in the blanks:

Value Classification Interpretation
0<PES<1 Inelastic supply Quantity supplied is relatively

1<PES<∞ Elastic supply Quantity supplied is relatively

responsive to price
Special Cases
PES = 1 Unit elastic supply Percentage change in quantity

supplied equals percentage
change in price
PES = 0 Perfectly inelastic supply Quantity supplied is completely

PES = ∞ Perfectly elastic supply Quantity supplied is infinitely

responsive to price
Diagram a price inelastic supply:

Diagram a price elastic supply:
Diagram a unit elastic supply:
Diagram a perfectly inelastic supply:

Diagram a perfectly elastic supply:
List the determinants of PES:

1. Length of time
2. Mobility of factors of production
3. Spare (unused) capacity of firms
4. Ability to store stocks
5. Rate at which costs increase
Explain the relationship between PES and primary commodities VS. manufactured products.
In general primary commodities usually have lower PES than manufactured goods. The main reason
relies on the time needed for quantity supplied to respond to price changes. The inelastic supply of
primary commodities, hence, contributes to price and income instability for primary product producers.
Outline the reasons governments intervene in markets:

1. Earn revenue for the government
2. Provide support to low income households
3. Influence the levels of production of firms
4. Influence levels of consumption of consumption of households/consumers
5. Correct market failure
6. Promote equity
Outline the forms of government intervention undertaken at microeconomic levels:
1. Price controls
a. Price ceilings
b. Price floors
2. Indirect taxation
3. Subsidies
4. Direct provision of goods and services
5. Command and control regulation and legislation
6. Consumer nudges
Define price control:

Refer to the setting of minimum or maximum prices by the government (or private organizations) so that
prices are unable to adjust to their equilibrium level determined by supply and demand. Price controls
result in disequilibrium, and therefore in shortages or surpluses.
Define price ceiling:

A maximum price set below the equilibrium price, in order to make goods more affordable to people on
low incomes.
Diagram a price ceiling:

The equilibrium price is Pe, determined by the forces of demand and supply. The price ceiling, Pc, is set by
the government at a level below the equilibrium price, leading to a shortage (excess demand), since
quantity demanded, Qd, is greater than quantity supplied, Qs. If the market were free, the forces of
demand and supply would force prices up to Pe. However, now this cannot happen, because the price hits
the legally set price ceiling.
Fill in the table below:

Consequence Explanation
Shortages At Pc, set below the equilibrium price, not all
interested buyers who are willing and able to buy
the good are able to do so because there is not
enough of the good being supplied
Non-price rationing As a shortage arises as a consequence of the

price ceiling, the price mechanism no longer
achieves its rationing function. The producers
have to establish non-price rationing systems to
determine how the goods will be distributed.
Underground markets Involve buying a good at the maximum legal price

and then illegally reselling the good at a price
above the legal maximum. Underground markets
arise due to dissatisfied consumers who have not
succeeded in buying the goods because of a
decreased supply. The consumers are willing and
able to pay more than the legal maximum, and do
so through the underground markets.
Underallocation resulting in allocative inefficiency The price ceiling results in a smaller quantity
supplied. Not enough resources are allocated
towards the production of the good, resulting in
underproduction relative to the social optimum.
Society is worst off due to the underallocation of
resources and allocative inefficiency.
Negative welfare impacts A price ceiling creates a welfare loss, indicating

that the price ceiling introduces allocative
inefficiency due to an underallocation of
resources.
Define underground markets:

Involve buying/selling transactions that are unrecorded, and are usually illegal.
What are the methods for non-price rationing?

1. Waiting in line and the first come first served principle
2. The distribution of coupons to all interested buyers so that they can purchase a fixed amount of
the good in a given time period
3. Favoritism
Fill in the blanks:

Stakeholder Winners VS. Losers Reasoning
Consumer Partially winners and partially Consumers who are able to

losers purchase the good at a lower
price are better off; however,
some consumers remain
unsatisfied due to their inability
to purchase the good.
Producers Losers Produce at a lower price and

smaller quantity, decreasing the
revenue of the firm.
Workers Losers The fall in output leads to the

firing of workers, resulting in
unemployment.
Government Neutral No gain nor losses as there is

no change in the government
budget.
Fill in the blanks

Quantity Calculation Formula
Shortage Qd - Qs
Change in consumer expenditure (Pe x Qe) - (Pc x Qs)
Change in producer revenue (Pe x Qe) - (Pc x Qs)
Change in consumer surplus Initial producer surplus = ((Pe - Pconsumers) x Qe))/2
Final producer surplus = ((Pc - Pconsumers) x Qs))/2
∆Consumer surplus = Final consumer surplus -

initial consumer surplus
Change in producer surplus Initial consumer surplus = ((Pproducers - Pe) x Qe))/2
Final consumer surplus = ((Pproducers- Pc) x Qs))/2
∆Producer surplus = Final producer surplus -

initial producer surplus
Welfare loss ((Qs - Qe) x 2(Pe - Pc))/2
Define price floor:

A minimum price set below the equilibrium price in order to provide support to farmers or to increase the
wages of low skilled workers.
Diagram a price floor:

A price floor, Pf, is set above the equilibrium price, Pe. At Pe, consumers are willing and able to buy Qd of
the good, but firms are willing and able to supply Qs of the good. Therefore, a surplus, or excess supply,
equal to the difference between Qs and Qd, arises. If the market were free, the forces of demand and
supply would force the price down to Pe. However, now this cannot happen.
Fill in the blanks:

Consequence Explanation
Surplus The price floor results in a larger quantity

supplied, and a smaller quantity demanded and
purchased. Hence, creating a disequilibrium
where there is excess supply.
Government measures to dispose of surpluses The government purchases the excess supply,
causing the demand curve for the product to shift
to the right.
Firm inefficiency Higher than the equilibrium product prices can

lead to inefficient production; inefficient firms with
high costs of production do not face incentives to
cut costs due to the protection offered by the high
prices.
Overallocation of resources to the production of Too many resources are allocated to the
the good and allocative inefficiency production of the good, resulting in a larger than
optimum quantity produced.
Negative welfare impacts A price floor created welfare loss, indicating that
the price floor introduces allocative inefficiency
due to the overallocation of resources to the
production of the good.
Fill in the blanks:
Consumer Losers Worse off, as they must now pay

a higher price for the good while
buying a smaller quantity.
Producers Winners Gain as they receive a greater

revenue due to a greater
quantity produced at a higher
price.
Workers Winners As output increases, the job

market expands, increasing
employment.
Government Losers As governments tend to buy the

excess surplus, the expenditure
creates a burden on their
budget, resulting in less
government funds to spend on
other desirable activities.
(Opportunity cost)
Stakeholder in other countries Winners As surpluses are sometimes

exported, the world price lowers
due to the extra supply made
available in world markets.
Fill in the blanks

Surplus Qs - Qd
Change in consumer expenditure (Pe x Qe) - (Pf x Qd)
Change in producer revenue (Pe x Qe) - (Pf x Qs)
Government Expenditure Pf x (Qs - Qd)
Change in consumer surplus Initial producer surplus = ((Pconsumers - Pe) x Qe))/2
Final producer surplus = ((Pconsumers- Pc) x Qd))/2

Change in producer surplus Initial consumer surplus = ((Pe - Pproducers) x Qe))/2
Final consumer surplus = ((Pc - Pproducers) x Qs))/2

Welfare loss ((Qs - Qd) x Pf) - (Pf x (Qs - Qd))
Define indirect tax

Imposed on spending to buy goods and services. Are paid partially by consumers, but are paid to the
government by producers.
Define excise taxes

Imposed on particular particular goods and services
Outline the reasons for imposing indirect taxes:

1. A source of government revenue
2. Method to discourage consumption of goods that are harmful to the individual
3. Used to redistribute income when focused on luxury goods
4. Method to improve the allocation of resources by correcting market externalities
Define specific taxes:

A fixed amount of tax per unit of the good or service sold
Define ad valorem taxes:

A fixed percentage of the price of the good or service
Diagram an indirect tax:

The pre-tax equilibrium is determined by the intersection of the demand curve D and the supply curve S1,
so the price paid by consumers and received by producers is P* and quantity demanded and supplied is
Q*. If the government imposes a specific tax on a good, the supply curve shifts upwards to S2 = S1 + tax.
The demand curve remains constant at D since demand is not affected. The new market equilibrium is
determined by the demand curve D and the new supply curve S2, so the price paid by consumers
increases to Pc and the quantity purchased falls to Qt. The amount of tax per unit of output is shown on
the vertical axis by Pc - Pp or the vertical difference between the two supply curves. Whereas producers
receive from consumers Pp per unit, they must pay the government Pc - Pp per unit (tax per unit).
Therefore, Pp is the final price received by producers after payment of the tax.
The tax is said to 'drive a wedge' between the price Pc paid by consumers and the price Pp received by
producers. The market outcomes due to the tax are the following: equilibrium quantity produced and
consumed falls from Q* to Qt, equilibrium price increases from P* to Pc which is the price paid by
consumers, consumer expenditure on the good is given by the price of the good per unit times the
quantity of units bought.
Fill in the blanks:

Consumer Losers Worse off, as they must now pay

a higher price for the good while
buying a smaller quantity.
Producers Losers The price received by the

government decreases, as well
as the quantity sold, reducing
the revenue of the firm.
Workers Losers As output decreases, the job

market contracts, increasing
unemployment.
Government Winners Receives revenue from taxation,

increasing government budget.
Society Losers The imposition of an indirect tax

results in reduced consumer and
producer surplus, part of which
is transformed into government
revenue and part of which is due
to welfare loss. The welfare loss
arises as a result of the
underallocation of resources.
The quantity of the good
produced and consumed is little
relative to the social optimum.
Fill in the blanks

Surplus Qs - Qd
Consumer expenditure P* x Q*
Pc x Pt
Producer Revenue P* x Q*
Pp x Pt
Government Expenditure Pf x (Qs - Qd)
Change in consumer surplus Initial producer surplus = ((Pconsumers - P*) x Q*))/2
Final producer surplus = ((Pconsumers- Pc) x Qt))/2

Change in producer surplus Initial consumer surplus = ((Pe - Pproducers) x Qe))/2
Final consumer surplus = ((Pp- Pproducers) x Qt))/2

Government Revenue (Pc - Pp)xQt
Welfare loss ((Pc - Pp)(Q*-Qt))/2
Define subsidy
The assistance by the government to individuals or groups of individuals. May take the form of direct cash
payments or other firms of assistance such as low-interest or interest-free loans, the provision of goods
and services below market prices, tax relief among others.
Outline the reasons for imposing subsidies:

1. Can be used to increase producer revenue
2. Can be used to make certain goods(necessities) affordable to low-income consumers
3. Can be used to encourage production and consumption of particular goods and services that are
believed to be desirable for consumers
4. Can be used to support the growth of particular industries in an economy
5. Can be used to encourage exports of particular goods
6. Method to improve the allocation of resources by correcting positive externalities
Diagram a subsidy:

The initial, pre-subsidy equilibrium is determined by the intersection of the demand curve D and the
supply curve S1, giving rise to equilibrium price P* paid by consumers and received by producers, and
equilibrium quantity Q*. Now the government grants a subsidy consisting of a payment to the firm of a
fixed amount for each unit of output sold. This means that for each unit of output the firm is willing and
able to produce, it receives a lower price than the original by the amount of the subsidy; this produces a
downward, parallel shift of the supply curve by the S2 = S1 - subsidy. The demand curve remains constant
at D since demand is not affected. The demand curve and new supply curve S2 determine a new
equilibrium, where price is Pc (the price paid by consumers) and the quantity produced and sold increases
to Qsb. Since the vertical difference between the two supply curves represents the subsidy per unit of
output, the firm receives price Pp which is equal to the price paid by the consumer, Pc, plus the subsidy
per unit of output.
Fill in the blanks:

Consumer Winners Better off, as they must now pay

a lower price for the good while
buying a larger quantity.
Producers Winners The price received by the

government increases, as well
as the quantity sold, increases
the revenue of the firm.
Workers Losers As output increases, the job

market expands, increasing
employment.
Government Losers Has to pay the subsidy, which is

a burden to its budget.
(opportunity cost).
Society Losers Society as a whole is worse off

because there is an
overallocation of resources to
the production of the good. In
addition, society is worse off
because the higher price
received by producers protects
relatively inefficient firms,
allowing them to continue to
produce.
Foreign producers Losers Subsidies lowers prices and

increases quantities of exports.
Foreign producers become
worse off as they may be unable
to compete with the low prices
provided by the subsidized
goods.
Consequences of the imposition of a subsidy for society:

The granting of a subsidy results in a greater consumer and producer surplus; however, society loses due
to government spending on the subsidy. Since the loss from government spending is greater than the
gain in producer and consumer surplus, welfare loss results, reflecting allocative inefficiency, which in this
case is due to overallocation of resources to the production of the good. Too much of the good is being
produced and consumed relative to the social optimum.
Fill in the blanks

Consumer expenditure P* x Q*
Pc x Qsb
Producer Revenue P* x Q*
Pp x Psb
Government Expenditure (Pp-Pc) x Qsb
Change in consumer surplus Initial producer surplus = ((Pconsumers - P*) x Q*))/2
Final producer surplus = ((Pconsumers- Pc) x Qsb))/2

Change in producer surplus Initial consumer surplus = ((P* - Pproducers) x Q*))/2
Final consumer surplus = ((Pp- Pproducers) x Qsb))/2

Government Expenditure (Pp - Pc)xQsb
Welfare loss ((Pp - Pc)(Q*-Qsb))/2
Define public goods

A good that is non-rivalrous and non-excludable (only provided by government)
Define rivalry:
Consumption by one person reduces its availability for someone else
Define excludability:
It is possible to exclude people from using the good; exclusion is usually achieved by charging a price for
the good.
Define non-excludable goods

A characteristic of some goods where it is not possible to exclude someone from using a good, because it
is not possible to charge a price
Define non-rivalrous goods

A characteristic of some goods where the consumption of the good by one person does not reduce
consumption by someone else
Define common pool resources

Resources with the following characteristics: rivalrous and non-excludable.
How does the lack of public goods indicate market failure?

The free rider problem consists of when people can enjoy the use of a good without paying for it; in other
words, the product suffers from non-excludability. Public goods are a part of market failure because, due
to the free rider problem, firms will never produce these goods (b/c they can't make profit). So the market
fails to allocate resources efficiently, and creates a divergence between the marginal social cost and
marginal private cost.
How does non-excludability lead to overallocation?

The lack of a pricing mechanism for common access resources means that these goods may be
overused/depleted/degraded as a result of activities of producers and consumers who do not pay for the
resources that they use, and that this poses a threat to sustainability.
Define market failure:

Market failure refers to the failure of the market to allocate resources efficiently. Market failure results in
allocative inefficiency, where too much or too little goods or services are produced and consumed from
the point of what is socially desirable.
Define externality:
An externality occurs when the actions of consumers or producers give rise to negative or positive
side-effects on other people who are not part of these actions, and whose interests are not taken into
consideration.
Define marginal private costs:

Refers to costs of producers of producing one more unit of a good.
Define marginal social costs:

Refers to the costs to society of producing one more unit of a good.
Define marginal private benefits:

Refers to the benefit to consumers from consuming one more unit of a good.
Define marginal social benefits:
Refers to benefits to society from consuming one more unit of a good.
Describe the market at equilibrium:

When MSC = MSB, there is allocative efficiency and socially optimal output is produced. When there is no
externality, the competitive free market ;eads to an outcome where MPC = MSC = MPB = MSB, indicating
allocative efficiency.
Describe the market when suffering an externality:

An externality creates a divergence between MPC and MSC or between MPB and MSB. When there is an
externality, the free market leads to an outcome where MPB=MPC, but where MSB is not equal to MSC,
indicating allocative inefficiency. Either too much or too little is produced relative to the social optimum.
Define negative production externalities:

Refers to the external costs created by producers. When there is a negative production externality the
free market overallocates resources to the production of the good and too much of it is produced relative
to the socially optimum. This is shown by Qm>Qopt and MSC>MSB at the point of production, Qm.
Diagram a negative externality of production:

In the figure above, the supply curve, S = MPC, reflects the firm’s private costs of production, and the
marginal social cost curve given by MSC represents the full cost to society of producing cement. For each
level of output, Q, the social costs of producing cement given by MSC are greater than the firm’s private
costs. The vertical difference between MSC and MPC represents the external costs. Since the externality
involves only production (the supply curve), the demand curve represents both marginal private benefits
and marginal social benefits. The free market outcome is determined by the intersection of MPB and
MPC, resulting in quantity Qm and price Pm. The socially optimum (or ‘best’) outcome is given by the
intersection of MSB with MSC, which determines quantity Qopt and price Popt. The shaded area
represents the welfare loss arising from the negative production externality. For all units of output greater
than Q_opt, MSC > MSB, meaning that society would be better off if less were produced. The welfare loss
is equal to the difference between MSC and MSB for the amount of output that is overproduced (Q_m -
Q_opt). It is a loss of social benefits due to overproduction of the good caused by the externality. If the
externality were corrected, so that the economy reaches the social optimum, the loss of benefits would
disappear.
Outline the government interventions for negative externalities of production:

1. Pigouvian tax
2. Carbon tax
3. Tradable permits
4. Government regulation and legislation
Define pigouvian taxes:

Indirect taxes designed to correct negative externalities of production or consumption.
Diagram a pigouvian tax:

The tax results in an upward shift of the supply curve, from S = MPC to MSC (=MPC + tax). The optimal
(or best) tax policy is to impose a tax that is exactly equal to the external cost, so the MPC curve shifts
upward until it overlaps with MSC. The new, after-tax equilibrium is given by the intersection of MSC and
the demand curve, D = MPB = MSB, resulting in the lower, optimal quantity of the good produced, Q_opt,
and higher, optimal price, P_opt.
Define a carbon tax:

A carbon tax is a per unit tax of carbon emissions of fossil fuels.
Diagram a carbon tax:

Following the imposition of the tax, firms must pay the higher price to buy the fossil fuel. This appears in
the figure above, as the upward shift in S = MPC toward MSC because of the firm’s higher costs of
production. Since there are other substitute energy sources with lower carbon emissions (thus taxed at a
lower rate), or that do not emit carbon (if they are not fossil fuels, thus not taxed at all), the increase in the
price of the high-carbon fuel creates incentives for firms to switch to other, less polluting or non-polluting
energy sources. The result is that if the firm switches to alternative, less polluting resources, Qopt, will
increase, because the external costs of producing the output will become smaller. The MSC curve shifts
from MSC1 to MSC2, indicating that the external costs are lower due to the use of the less polluting
resources. With the fall in external costs, the optimum quantity of output increases from Qopt1 to Qopt2.
(Note that this also involves a lower tax on pollutants, shown by the smaller distance between the
demand curve and MSC2.)
Define tradable permits:

Policy involving permits to pollute issued to firms by a government or an international body. These permits
can be used to pollute or can be traded in a market.
Diagram the imposition on tradable permits:

The supply of permits is perfectly inelastic (i.e. the supply curve is vertical), as it is fixed at a particular
level by the government (or an international authority if several countries are participating). For this policy
to effectively reduce the level of pollution, the total pollution that is permitted based on the pollution
permits must be less than the amount of pollution created with no permits. The fixed supply of permits is
distributed to firms. The position of the demand-for-permits curve determines the equilibrium price. As an
economy grows and the firms increase their output levels, the demand for permits is likely to increase, as
shown by the rightward shift of the demand curve from D1 to D2. With supply fixed, the price of permits
increases from P1 to P2.
Diagram government legislation and regulation:

The impact is to lower the quantity of the good produced and bring it closer to Q_opt in the figure above,
by shifting the MPC curve upward towards the MSC curve. Pollutant and output restrictions achieve this
by forcing the firm to produce less. Requirements to install technologies reducing emissions achieve this
by imposing higher costs of production due to the purchase of non-polluting technologies. Ideally, the
higher costs of production would be equal to the value of the negative externality. The government’s
policy objective is to make the MPC curve shift upwards until it coincides with the MSC curve, in which
case Q_opt is produced, price increases from P_m to P_opt, and the problem of overall allocation of
resources to the production of goods is corrected. If polluting firms do not comply with the regulations,
they would have to pay fines.
Negative externality of production
Policy Advantages Disadvantages
Pigouvian Tax ● Economists prefer ● Do not provide

market based solutions incentives to reduce the
as long as the situation amount of pollution they
permits the use of create or to switch to
market-based policies. less polluting resources
● Internalize the ● Face serious practical
externality: the costs difficulties that involve
that were previously designing a tax equal in
external are made value to the amount of
internal, because they pollution
are now paid for by ● Usually set too low to
producers and make a significant
consumers who are impact.
parties to the ● Risk that even if taxes
transaction. are imposed some firms
● Provide incentives to may not lower their
producers to reduce the pollution levels,
quantity of output continuing to pollute
produced with a given even though they pay a
technology and given tax.
polluting resources ● Unlikely to achieve
socially optimal results.
● If taxes are raised too
much, consumers might
look for other illegal
sources of supply,
causing black markets
to appear.
Carbon Tax ● Economists prefer ● Face serious practical

(fix the price of the pollutant in market based solutions difficulties that involve
the form of a tax on carbon and as long as the situation designing a tax equal in
allow for the quantity of carbon permits the use of value to the amount of
emitted tio vary, depending on market-based policies. pollution
the firms' response to the tax) ● Internalize the ● Usually set too low to
externality: the costs make a significant
that were previously impact.
external are made ● Risk that even if taxes
internal, because they are imposed some firms
are now paid for by may not lower their
producers and pollution levels,
consumers who are continuing to pollute
parties to the even though they pay a
transaction. tax.
● Provide incentives to ● Unlikely to achieve
firms to economize on socially optimal results.
the use of polluting ● More effect on the poor
resources and use because it raises
production methods that household energy prices
pollute less. ● Face political pressures
● Firms do not all face the to be set too low
same costs of reducing ● Cannot target a
pollution particular level of carbon
● Taxation leads to lower reduction.
pollution levels and ● Are regressive. The tax
overall costs to society as a fraction of income
● Make energy prices is higher for low-income
more predictable earners and goes
compared to tradable against the principle of
permits. equity. Consumers are
● Easier to design and affected as taxes are
implement than tradable partially paid by
permits. consumers with an
● Can be applied to all increase in price.
users of fossil fuels ● If taxes are raised too
instead of one particular much, consumers might
industry. look for other illegal
● Do not offer sources of supply,
opportunities for causing black markets
manipulation by the to appear.
government.
● Do not require as much
monitoring for
enforcement.
Tradable Permits ● Economists prefer ● Require the government

(fix the quantity of the market based solutions to set a maximum
permissible pollutant, and allow as long as the situation acceptable level for
for its price to vary, based on permits the use of each type of pollutant.
supply and demand). market-based policies. Demands having
● Internalize the technical information
externality: the costs that are often not
that were previously available.
external are made ● If maximum level is set
internal, because they too high it will not have
are now paid for by the desired effects on
producers and cutting pollution
consumers who are ● If set too low, permits
parties to the become too costly,
transaction. causing hardships for
● System creates firms that need to buy
incentives for firms to them
cut back on their ● Tradable permits have
pollution if they can do been set for just a few
so at relatively low cost. pollutants
● Firms that cannot ● Must be found to
reduce pollution at high distribute permits to
costs will be forced to polluting firms in a fair
buy additional permits. way. Issues with political
favoritism may take
place.
● Unlikely to achieve
socially optimal results.
● Usually target one
particular industry
● Hard to design and
implement
● Prices of energy are too
volatile to be predicted.
● Require monitoring of
emissions.
● Face political pressures
to set cap too high
Government Legislation and ● Simple to put into effect ● Do not offer incentives
Regulation and oversee. to reduce emissions by
● Easier to implement using less polluting
compared to market resources, to increase
based policies and avoid energy efficiency and to
the technical difficulties switch to alternative
that arise in the use of fuels.
market based solutions ● Cannot distinguish
● Can be quite effective. between firms that have
● Regulations force firms lower or higher costs of
to comply and reduce reducing pollution, which
their harmful activities. would limit the overall
● Commonly used. cost of reducing
pollution. Reduced at a
higher overall cost.
● Suffer from lack of
sufficient information on
types and amounts of
pollution
● Can only be partially
effective in reducing
pollution.
● Costs of monitoring and
supervision to detect
possible violations,
leading to opportunity
costs
● Problems with
enforcement
International Agreements ● Helps solve international ● Do not offer incentives
issues to reduce emissions by
● Simple to put into effect using less polluting
and oversee. resources, to increase
● Easier to implement energy efficiency and to
compared to market switch to alternative
based policies and avoid fuels.
the technical difficulties ● Cannot distinguish
that arise in the use of between firms that have
market based solutions lower or higher costs of
● Can be quite effective. reducing pollution, which
● Regulations force firms would limit the overall
to comply and reduce cost of reducing
their harmful activities. pollution. Reduced at a
● Commonly used. higher overall cost.
● Suffer from lack of
sufficient information on
types and amounts of
pollution
● Can only be partially
effective in reducing
pollution.
● Costs of monitoring and
supervision to detect
possible violations,
leading to opportunity
costs
● Problems with
enforcement
● This would have a large
effect on the
corresponding industry
in terms of shareholders
and employment.
● It might have a big effect
on the government's
revenue as it would
receive fewer or no
taxes from this market.
● Banning the good might
cause a negative
reaction from
consumers if they
perceive the banning of
the good as restrictions
on their liberties and
rights. This could have a
negative effect on the
government's future
election prospects, as
consumers are also
voters, which makes it
unlikely that
governments will choose
this option.
● Regulations will need to
be enforced and this
may impose an
additional cost on the
government.
Education and awareness ● Firms are very much ● Can only make a small
influenced by the difference in terms of
opinions of their solving the problem of
customers and want to production externalities
keep them happy, and sustainability.
otherwise they will suffer
from drops in sales.
Define negative externality of consumption:

Refers to external costs created by consumers. When there is a negative consumption externality, the
free market overallocated resources to the production of the good, and too much of it is produced relative
to what is socially optimum.
Diagram negative externality of consumption:

The buyers of cigarettes have a demand curve, MPB, but when smoking, create external costs to society.
These costs can be thought of as 'negative benefits', which therefore cause the MSB curve to lie below
the MPB curve. The vertical difference between MPB and MSB represents the external costs. Note that
since the externality involves consumption (i.e. the demand curve), the supply curve represents both
marginal private costs and marginal social costs. The market determines an equilibrium quantity, Q_m,
and price P_m, given by the intersection of the MPB and MPC curves, but the social optimum is Q_opt
and P_opts, determined by the intersection of the MSB and MSC curves. The welfare loss resulting from
negative consumption externalities is the shaded area in the figure above and represents the reduction in
benefits for society due to the overallocation of resources to the production of the good. For all units of
output greater than Q_opt, MSC > MSB, indicating that too much of the good is produced. The welfare
loss is equal to the difference between the MSC and MSB curves for the amount of output that is
overproduced relative to the social optimum (Q_m - Q_opt). It represents the loss of social benefits from
overproduction due to the externality. If this externality were corrected, society would gain the benefits
represented by the shaded area.
Outline the government interventions for negative externalities of consumption:

1. Indirect taxes
2. Government regulation/legislation
3. Education/Negative advertising
4. Nudges
Diagram an indirect tax on the good:

The effects of an indirect tax are shown in the figure above. When such a tax is imposed on the good
whose consumption creates the external cost, the result is a decrease in supply and an upward shift of
the supply curve from MPC to MPC + tax. If the tax equals the external cost, the MPC + tax curve
intersects MPB at the Q_opt level of output, and quantity produced and consumed drops to Q_opt. (The
demand curve does not shift but remains at D = MPB.) Q_opt is the socially optimum quantity, and price
increases from P_m to P_c. The tax therefore permits allocative efficiency to be achieved.
Diagram government regulations and advertising:

If negative consumption externalities were corrected, Q_opt quantity of the good would be produced,
reflecting allocative efficiency. Regulations can be used to prevent or limit consumer activities that impose
costs on third parties, such as legal restrictions on activities like smoking in public places or age
restrictions forcing sellers to do business only with adults. This has the effect of shifting the D_1 = MPB
curve towards the MSB curve in Figure 5.11(b), until D_2 overlaps with MSB. This would eliminate the
externality, with production and consumption occurring at Q_opt and price falling to P_opt.
Fill in the blanks
Negative externality of consumption
Indirect Tax ● Economists prefer ● Difficulty in measuring

market based solutions the value of the external
as long as the situation costs
permits the use of ● Many technical
market-based policies. difficulties in trying to
● Internalize the asses who and what is
externality: the costs affected
that were previously ● Technical difficulties in
external are made trying to determine the
internal, because they value of the external
are now paid for by costs, on the basis of
producers and which a tax can be
consumers who are designed.
parties to the ● Some goods whose
transaction. consumption leads to
● By changing relative negative consumption
prices, indirect taxes externalities have an
create incentives for inelastic demand.
consumers to change Therefore it is possible
their consumption that imposing taxes on
patterns; the goods that such goods works to
are taxed become increase government
relatively more revenue while not
expensive and significantly decreasing
consumption is reduced. quantity demanded. This
● Creates government could mean that to
revenue that can be achieve allocative
reinvested into society. efficiency a very high tax
would have to be
imposed, which would
very likely be politically
unacceptable.
Government Legislation and ● Can be very effective in ● Cannot be used with

Regulation reducing external costs certain consumption
of certain consumption activities such as the
activities use of petrol.
● If taxes are raised too
much, consumers might
look for other illegal
sources of supply,
causing black markets
to appear.
effect on the
and employment.
on the government's
revenue as it would
receive fewer or no
cause a negative
reaction from
consumers if they
government's future
consumers are also
unlikely that
this option.
may impose an
government.
Education and awareness ● Simpler than other ● High costs for

methods government campaigns.
The campaigns are
funded by tax funds,
which raises opportunity
costs for society.
● Such methods may not
be effective as
consumers may simply
not care about the
negative externalities.
Define positive production externalities

Refer to the external benefits created by producers. The free market underallocated resources to the
production of the good: too few is produced.
Diagram a positive externality of production:

In the figure above, the MSC curve lies below the MPC curve, and the difference between the two curves
is the value of the external benefits (these can be thought of as 'negative costs'). The demand curve
represents both MPB and MSB since the externality involves only production. The market gives rise to
equilibrium quantity Q_m and price P_m, determined by the intersection of the MPB and MPC curves,
while the social optimum is given by Q_opt and P_opt, determined by the intersection of the MSB with
MSC curves. Since Q_m < Q_opt, the market underallocates resources to research and development
activities that lead to new technologies, and not enough of them are undertaken.The underallocation of
resources to the production of a good with a positive production externality leads to a welfare loss, shown
as the shaded area. This loss is equal to the difference between the MSB and MSC curves for the amount
of output that is underproduced relative to the social optimum (Q_opt - Q_m). It involves external benefits
for society that are lost because not enough of the good is produced. If the externality were corrected,
society would gain the benefits represented by the shaded area.
Outline government interventions to correct positive externalities of production:

1. Direct government provision
2. Subsidies
Diagram direct government provision

The figure above shows that when the government intervenes by providing goods and services itself, this
has the effect of shifting the supply curve (MPC curve) downward (or to the right), toward the MSC curve
so that the optimum quantity of the good, Q_opt, will be produced, with price falling from P_m to P_opt.
Diagram subsidies

If the government provides a subsidy to a firm per unit of the good produced that is equal to the external
benefit, then the marginal private cost (MPC = supply) curve shifts downward (or rightward) until it
coincides with the MSC curve, as shown above. The result is to increase quantity produced to Q_opt and
to lower the price from P_m to P_opt. The problem of underallocation of resources and underprovision of
the good is corrected, and allocative efficiency is achieved.
Fill in the blanks:

Positive externality of production
Direct government provision ● Very effective in ● Involve the use of

increasing quantity of government funds that
the good produced and rely on tax revenues
consumed (opportunity cost)
● Added advantage of ● Governments cannot
lowering the price for directly provide or
consumers subsidies all goods with
positive externalities,
choices must be made
on which goods should
be supported and how
much they should be
supported
● Very difficult to measure
the size of the external
benefits and therefore
calculate precisely
which good should be
supported and the level
of support they should
receive
● Often highly political in
nature. Governments
are often susceptible to
political pressures and
sometimes make choice
based on political rather
than economic criteria
Subsidies ● Very effective in ● Involve the use of

much they should be
supported
calculate precisely
receive
nature. Governments
Define positive consumption externalities:

External benefits are created by consumers. The free market underallocates resources to the production
of the good, and too little is consumed relative to the social optimum.
Diagram a positive consumption externality:

In the figure above the marginal social benefit (MSB) curve lies above the marginal private benefit (MPB)
curve, and the difference between the two consists of the external benefits to society. The socially
optimum quantity, Q_opt, is given by the point where MSB = MSC, and the quantity produced by the
market is given by the point where MPB = MPC. Since Q_opt > Q_m, the market underallocates
resources to the good or service, and too little of it is produced. The welfare loss arising from a positive
consumption externality is the shaded area, and is the difference between the MSB and MSC curves for
the amount of output that is underproduced relative to the social optimum (Q_opt - Q_m). It represents
the loss of social benefits due to underproduction of the good. If this externality were corrected, society
would gain the benefits represented by the shaded area.
Outline the reasons for underprovision of merit goods:

1. Too little is provided by the market
2. Low levels of income and poverty
3. Consumer ignorance/indifference
Outline the government interventions to correct positive externalities of production:

1. Government legislation and regulation
2. Education and awareness creation
3. Nudges
4. Direct government provision
5. Subsidies
Diagram legislation/advertising
Explain the diagram above
Legislation can be used to promote greater consumption of goods with positive externalities. For example,
most countries have legislation that makes education compulsory up to a certain age (note that education
is a merit good). In this case, demand for education increases, and the demand curve D_1 = MPB shifts
to the right (or upward). Ideally, it will shift until it reaches the MSB curve, where D_2 = MSB, and Q_opt is
produced and consumed.
Diagram direct government provision

Direct government provision is shown in the figure above, and has the effect of increasing supply and
therefore shifting the supply curve S rightward (or downward) to S + government provision. To achieve the
social optimum Q_opt, the new supply curve must intersect MPB at the level of output Q_opt, as seen in
the figure. At the new equilibrium, price falls to P_c, Q_opt is produced and allocative efficiency is
achieved.
Diagram a subsidy
A subsidy to the producer of the good with the positive externality has the same effects as direct
government provision. It results in increasing supply and shifting the supply curve rightward (or
downward), as shown above. If the subsidy is equal to the external benefit, the new supply curve is MPC
– subsidy^2, and it intersects MPB at the Q_opt level of output. Again, price falls from P_m to P_c, Q_opt
is produced and allocative efficiency is achieved.
Fill in the blanks

Positive externality of consumption
Government Legislation and ● Can have very positive ● Only sometimes can be
Regulation effects in certain cases effective
● Can be more effective ● Can only help shift the
when implemented MPB curve in the right
together with other direction
policies ● In certain cases are
ineffective
● Have effect of raising
the price of the good to
consumers, which may
make the good
unaffordable to certain
consumer groups
effect on the
and employment.
on the government's
revenue as it would
receive fewer or no
cause a negative
reaction from
consumers if they
government's future
consumers are also
unlikely that
this option.
may impose an
government.
Education and awareness ● Can have very positive ● Only sometimes can be
effects in certain cases effective
● Can be more effective ● Can only help shift the
when implemented MPB curve in the right
together with other direction
policies ● In certain cases are
ineffective
● Have effect of raising
the price of the good to
consumers, which may
make the good
unaffordable to certain
consumer groups
Direct government provision ● Very effective in ● Involve the use of

much they should be
supported
calculate precisely
receive
nature. Governments
Subsidies ● Very effective in ● Involve the use of

much they should be
supported
calculate precisely
receive
nature. Governments
Define asymmetric information:

When one party in an economic transaction possesses more information about the product/service
involved than the other party
Define adverse selection:

Adverse selection occurs when asymmetric information is exploited, and occurs before the transaction
between parties takes place.
Define moral hazard:

Moral hazard is a situation where an individual alters his/her behavior after the transaction between
parties occurs knowing that their actions are unobserved.
Define signaling:
Method used by the party that has more information by convincing the buyers that the product being sold
is of good quality
Define screening:
Method used by party with limited information to try to get more information: screen product, producer or
seller of the product
Fill in the blanks:

Policies in response to asymmetric information
Regulation Definition Evaluation

(Governmental)
Cons Pros
Ensuring quality
standards and safety Costly (debt/deficit + Provides more
features through laws opportunity cost) information for
and regulations to be Hard to enforce consumers
maintained by Time consuming Provides more choice
producers TIme Lags Hard to enforce
May not protect all Inefficient
consumers
Legally binding
Provision of Information Definition Evaluation
Policy involving the Cons Pros

government directly
supplying information to Not possible to Helps add
consumers or forcing completely eliminate transparency to the
producers to provide information asymmetry. transaction.
information Sellers with technical
information can
selectively reveal
information.
Lead to dishonest
reports.
Inefficient.
Decreases demand.
Licensing Definition Evaluation
Cons Pros
Laws requiring a
license, only obtained Market will be reduced, Provides the consumer
upon proof of with fewer providers with comfort.
competence, which and diversification Higher wages for
ensures qualification. leading to less choice providers
for consumers. Higher quality for
Higher prices. products and services.
Legal barriers.
Leads to unethical
practices.
Difficulty in
enforcement.
Time lags.
Inequality; unequal
access to education.
Screening Definition Evaluation
Cons Pros
Method used by party
with limited information Time consuming No costs for
to try to get more Is the research government
information: screen reliable? No enforcement
product, producer or Higher costs for firms needed
seller of the product through branding; an More information
(ask friends, search the opportunity cost for the Cheap/free
internet, legal service firm, leads to a Could be time efficient
providers) decrease in spending Could provide jobs for
on quality, quantity, and reviewers
research in
development.
Signaling Definition Evaluation
Cons Pros
Method used by the
party that has more Unlikely to provide full No government costs
information by information to buyers No enforcement
convincing the buyers and may provide needed
that the product being inaccurate or No time lags
sold is of good quality misleading information More information
(brand names, Rooted in adverts Incentivizes firms to
warranties) Inefficient increase the quality of
Higher costs for firms their goods, which
through Branding: an incentivizes competition
opportunity cost for the and increases choices
firm, leads to a for consumers.
decrease in spending
on quality, quantity, and
research in
development.
Smaller firms will suffer.
Define firm:
Organization that employs factors of production to produce and sell a good and service.
Define industry:
A group of one or more firms producing identical or similar goods or services.
Define market structure:

Describe characteristics of a market organization that determine the behavior of firms.
Define market power:
The extent to which each individual firm in the industry is able to control the price at which it sells its
products.
Define perfect competiton:

Firms have no ability to control the price of their products, such that firms have zero market power.
Define monopoly:
There is a single firm in the market; this firm has the greatest ability to control the price of it's product, and
therefore the greatest amoung of market power
What is the relationship between market power and allocative inefficiency?

Firms in perfect competition, which have zero market power, do not result in market failure, and are the
only market structure where firms achieve allocative efficiency. Firms in the other three market structures
result in market failure to varying degrees, with monopoly resulting in the greatest degree of allocative
inefficiency. Hence, the greater the market, the greater the allocative inefficiency.
What are market structures defined by?

1. Number of firms in the industry
2. Product differentiation
3. Barriers to entry
Define product differentiation:

How similar or different are the goods or services being produced.
Define barriers to entry:

How easy or difficult it is for new firms to enter the industry and begin producing.
Outline characteristics of perfect competition

1. Very large number of firms in the industry
2. Sell homogenous (undifferentiated) products
3. No barriers ro entry/free entry
Outline characteristics of monopoly

1. A single seller or dominant firm in the industry
2. There is product differentitation
3. High barriers to entry
Outline characteristics of monopolistic competition

1. Fairly large number of small firms
2. Few barriers to entry
3. There is some product differentiation
Outline the characteristics of oligopoly

1. Small number if large firms
2. Interdependence among firms
3. Products may be either differentiated or undifferentiated
4. High barriers to entry
Explain the relationship between market power and competition
Competition occurs when there are many buyers and sellers acting interdependently, so that no one has
the ability to influence the price of a product. Therefore, by definition, market power is the opposite of
competition.
Define revenue
Payments firms receive when they sell the goods and services they produce.
Define total revenue and outline the formula for its calculation
Obtained by multiplying the price at which a good is sold by the number of units of the goods sold.
TR = P x Q
Define average revenue and outline the formula for its calculation
Obtained by multiplying the price at which a good is sold by the number of units of the good sold
AR = TR/Q = P
Define marginal revenue and outline the formula for its calculation
The additional revenue arising from the sale of an additional unit of output.
MR = ∆TR/∆Q
Define explicit cost

Payments made by a firm to outsiders to acquire resources for use in production.
Define implicit cost

The sacrificed income arising from the use of self-owned resources
Define economic costs

The sum of explicit and implicit costs incurred by a firm for its use of resources, whether purchased or self
owned.
Define total cost

All costs of production incurred by a firm.
Define marginal costs and outline the formula for its calculation
The additional cost arising from the production of an additional unit of output.
MC = ∆TC/∆Q
Define average costs and outline the formula for its calculation
The cost per unit of output produced.
AC = TC/Q
Define short run

The period of time when at least one factor of production is fixed.
Define long run
The period of time when all factors of production are variable.
Define economies of scale:

Decreases in average costs of production over the long run as a firm increases all its factors of
production. Explain the downward-sloping portion of the long run average costs curve.
Reasons why economies of scale occur:

1. Specialization of labor: as the scale of production increases, more workers must be employed,
allowing for greater labor specialization. Each worker specializes in performing tasks that makes
use of skills, interest, and talents, thus increasing efficiency and allowing output to be produced at
a lower average cost.
2. Specialization of management: larger scales of production allow for more managers to be
employed, each of whom can be specialized in a particular area, again resulting in greater
efficiency and lower average costs.
3. Bulk buying of inputs: As quantities of inputs purchased increases, the price per unit drops.
4. Financing economics: Larger firms may have lower interest rates, thus contributing to lower costs
per unit output.
5. Spreading of certain costs, such as marketing, over larger volumes of output
Define diseconomies of scale

Increases in the average costs of production in the long run as a firm increases its output by increasing all
its inputs. Explain the upward-sloping portion of the long run average costs curve.
Reasons why diseconomies of scale occur:

1. Coordination and monitoring difficulties: as a firm grows larger, its management may run into
difficulties of coordination, organizing, co-opert monitoring. The result involves growing
inefficiencies.
2. Communication difficulties: A larger firm size may lead to difficulties in communication between
various component parts of the firm, resulting in inefficiencies and higher average costs.
3. Poor worker motivation: If workers begin to lose their motivation, to feel bored and to care little
about their work
Outline the formula for profit:

Profit = revenues - costs of production = TR - TC
Profit = total revenue - (explicit + implicit costs)
Define profit maximization

Involves determining the level of output that the firm should produce to make profit as large as possible
Fill in the blanks:
+/- Formula Profit
Positive profit TR>TC Abnormal
Zero profit TR=TC Normal

Negative profit TC>TR Loss
Outline the point of profit maximization based on the marginal revenue and marginal cost
approach:
Firms maximize their profits or minimize losses when they produce a quantity where MC = MR.
Define normal profit:

The minimum amount of revenue that the firm must receive so that it will keep the business running.
The amount of revenue that covers all explicit and implicit costs.
Diagram a perfectly competitive market making normal profit:
Diagram a perfectly competitive market making abnormal profit:
Diagram a perfectly competitive market making economic loss:

Outline the profit made at the following points:
1. If AR>AC: the firm makes abnormal profit
2. If AR = AC the firm makes normal profit
3. If AR<AC the firm makes a loss
Can a perfectly competitive market make abnormal profit/loss in the long run?
In perfectly competitive long-run equilibrium, firms' profits and losses are eliminated, and revenues are
just enough to cover all costs so that every firm earns normal profits.
Indicate where allocative efficiency occurs in a perfectly competitive market:

Allocative efficiency occurs when firms produce the particular combination of goods and services that
consumers mostly prefer. The condition is achieved when P = MC, or when MB = MC. In the long run
equilibrium under perfect competition, the firm achieves allocative efficiency.
Fill in the blanks:

Perfect competition
Insights provided by model Limitations of model
Allocative efficiency Unrealistic assumption
Low prices for consumers Cannot take advantage of economies of scale
Market responds to consumer tastes Lack of product variety
Competition leads to the closing down of Limited ability to engage in new product
inefficient producers development due to lack of abnormal profit
Outline the barriers to entry of monopoly:

1. Economies of scale
2. Natural monopolies
3. Branding
4. Legal barriers
a. Patents
b. Licenses
c. Copyrights
d. Tariffs, quotas and other trade restrictions
5. Control of essential resources
6. Aggressive tactics
Diagram a monopoly making normal profit

Diagram a monopoly making abnormal profit
Diagram a monopoly making loss
Can a monopoly make abnormal profit/loss in the long run?

Under monopoly, high barriers to entry prevent potential competitor firms from entering a profit-making
industry and the monopolist can therefore continue making abnormal profit indefinitely in the long run due
to the lack of competition.
Define natural monopoly

A firm that has economies of scale so large that it is possible for the single firm alone to supply the entire
market at a lower average cost than two or more firms.
Outline the allocative inefficiency in monopolies:

The presence of welfare loss in a monopoly indicates market failure: there is allocative inefficiency shown
also by MB>MC at QM, meaning there is underallocation of resource: too little of the good is produced.
Fill in the blanks

Monopoly
Criticisms Economies of scale
Welfare loss, allocative inefficiency and market Natural monopolies

failure
Higher price and lower output Research and development for product
development and technological innovation
Loss of consumer surplus to the monopolist
Negative impacts on the distribution of income
Lack of competition may give rise to higher costs
Possibly less innovative
Outline forms of product differentiation in monopolistic competition:

Physical differences — differ in size, shape, texture, taste, packaging, etc
Quality differences
Location — locating themselves in areas that allow easy access for customers
Services — some offer special services to make products more attractive
Product image — firms attempt to create a favorable image
Explain how monopolistic competition combines elements of both monopoly and perfect
competition.
Resembles perfect competition: many firms in the industry, freedom of entry and of exit.
Resembles monopoly: each firm in the industry is a mini-monopoly in the specific version of the good.
Each product faces a downwards sloping demand curve. However because each of these products are
substitutes for each other, the demand curve is relatively elastic. Hence, in monopolistic competition if a
firm raises prices it will lose less consumers than in a perfectly competitive market but more consumers
than it will in a monopoly. This is due to product differentiation — there are available substitutes, however,
they are not perfect substitutes. The implication of this is that clients believe that some products are
superior to the others.
Outline the role of price competition and non-price competition in monopolistic competition:
Price competition — firm lowers its prices in order to attract customers from rival firms
Non-price competition — firms use other methods other than price reductions to attract consumers from
other firms. Most common form of non-price competition is product differentiation, advertising and
branding.
Firms that can attract more customers increase market power and market share hence increase their
ability to increase prices without losing customers.
The more differentiated the product is from its substitute and the more successful the branding and
advertising methods are the less elastic the demand curve is. Resulting in a greater market power,
increase in price, and greater short-run profit.
Diagram a monopolistic competition in normal profit:
Diagram a monopolistic competition in abnormal profit:
Diagram a monopolistic competition in loss:
Can a monopolistic competition make abnormal profit/loss in the long run?

In monopolistic competition, in the long run, profit-making industries attract new entrants; in loss-making
industries, some firms shut down and exit the industry. The process of entry and exit of firms in the
long-run ensures that economic profit or loss is zero and all firms earn normal profits.
Outline the allocative inefficiency in monopolistic competition:

In monopolistic competition P>MC or alternatively MB>MC, indicating there is market failure. The market
underallocated resources to the production of the good and too little of it is produced, generating a
welfare loss and resulting in allocative inefficiency.
Outline the implications of interdependence of oligopolistic firms:

1. Strategic behavior
2. Conflicting incentives
a. Incentive to collude
b. Incentive to compete or to cheat in a collusive agreement
Define collusion:
Agreement between firms to limit competition between them, usually by fixing a price and therefore
lowering quantity produced. By colluding to limit competition, form reduce uncertainties resulting from not
knowing how rivals will behave, and maximize profits for the industry as a whole.
Define game theory:

A mathematical technique analyzing behavior of decision-makers who are dependent on each other, and
who display strategic behavior.
Diagram a non-collusive oligopoly (pay-off matrix):
Explain how firms in an oligopoly are independent

What happens to the profits of one firm depends on the strategies adopted by the other firms; they
therefore try to predict the actions of their rivals in order to plan out their own strategy.
Define price war:

Competitive price-cutting by firms. As each one tries to capture market shares from rival firms; results in
lower profits for firms.
Outline the types of non-price competition:

● Product development
● Advertising
● Branding
● Numerous services such as quality customer service, warranties, provision of credit, discount on
upgrades and others
Explain why non-price competition is important for oligopolies:
1. Oligopolistic firms often have considerable financial resources that they can devote to both R&D
and advertising and branding.
2. The development of new products provides firms with a competitive edge; they increase their
market power, demand for the firm's products becomes less elastic, and successful products give
rise to opportunities for substantially increased sales and profit
3. Product differentiation can increase a firm's profit position without creating risks for immediate
retaliation by rivals.
Define collusive oligopoly:

Refers to situations where firms agree to collude, which means they form an agreement between
themselves to limit competition, increase market power and increase profits.
Define a cartel:
A formal agreement between firms in an industry to take actions to limit competition in order to increase
profits. The key objective of a cartel is to limit competition between the member firms and attempt to
maximize joint profits, hence, cartel members behave like a monopoly.
Diagram an oligopoly that has engaged in price-fixing by a cartel:
Outline what firms in a cartel have to gain:

1. Increased market power, hence, the ability to control price of the product
2. Increased profits due to higher prices
3. Elimination of competition between the firms, and therefore no more uncertainty or need to
outguess their rivals
Outline the reasons a cartel in not easy to maintain

1. The incentive to cheat
2. Cost differences between firms
3. Number of firms
4. The possibility of a price war
Define non collusive oligopoly

Oligopolistic firms that do not collude in any way in order to fix or coordinate prices and limit competition.
Each member behaves independently; however, they are still aware of each other in their pricing
decisions and display strategic behavior in that they take the possible actions of their rivals into
consideration.
Define concentration ratio:

A measure of how much an industry's production is concentrated among the industry's largest firms; it
measures the percentage of output produced by the largest firms in an industry, and is used to provide an
indication of the degree of competition or market power in an industry.
Fill in the blanks
Oligopoly
Criticisms Benefits
Welfare loss allocative inefficiency and market Economies of scale can be achieve due to the
failure large size of oligopolistic firms, leading to lower
production costs to the benefit of society and the
consumer
Higher prices and lower quantities of output than Product development and technological
under competitive conditions innovations can be pursued due to the high
abnormal profits from which research funds can
be drawn. This benefit of oligopoly is more
important than in the case of monopoly, since
non-price competition forces firms to be innovative
in order to increase their market share and profits.
Loss of consumer surplus to the oligopolists due Technological innovations that improve efficiency
to higher prices resulting in P>MC and lower costs of productions may be passed to
consumers in the form of lower prices.
Negative impacts on the distribution of income Product development leads to increased product
variety, thus providing consumers with greater
choice
There may be higher production costs due to lack

of price competition
Probably less innovative
Difficulty in detecting and proving collusion among

firms means that such firms may actually behave
like monopolies despite anti-monopoly legislation.
Define abuse of market power:

Also known as anti competitive practices, refers to situations where firms engage in activities that results
in reduced competition.
Outline the difference between legislation and regulation:

Legislation involves the creation of new laws by government, while regulation involves enforcing the laws
Outline and describe the forms of government intervention for anti competitive practices:

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Define market power:

State the law of demand:

Define market demand:

List the non-price determinants of demand:

Explain the law of diminishing marginal utility:

Explain the income effect:

Explain the substitution effect:

State the law of supply:

Define market supply:

List the non-price determinants of supply:

Define short run:

Define long run:

Explain the law of diminishing marginal returns:

Define total product:

Define marginal cost:

Define total cost:

Define marginal cost:

Explain increasing marginal returns:

Define competitive market equilibrium:

Define market disequilibrium:

What causes a change in the market equilibrium?

Explain the diagram above:

Draw an increase in supply due to a change in technology:

Explain the diagram above:

Draw an decrease in supply due to a change in number of firms:

Define price mechanism:

Define price rationing:

Define allocative efficiency:

Explain the relationship between marginal benefit and demand:

Define marginal cost:

Explain the relationship between marginal cost and supply:

Define consumer surplus:

Identify where consumer surplus can be found in a diagram:

Define producer surplus:

Identify where consumer surplus can be found in a diagram:

Define social surplus:

When is social surplus maximum?:

Outline the formula for calculating the following economic quantities:

Consumer surplus ((Pe - PConsumers) X Qe) /2

Producer Surplus ((Pproducers - Pe ) x Qe)/2

Social Surplus Producer Surplus + Consumer Surplus

Define price elasticity of demand

Outline the formula for PED:

Fill in the blanks:

0<PED<1 Price inelastic demand Quantity demanded is relatively

1<PED<∞ Price elastic Quantity demanded is relatively

Constant PED along the length of the demand curve

PED = 1 Unit elastic demand Percentage change in quantity

PED = 0 Perfectly inelastic demand Quantity demanded is

PED = ∞ Perfectly elastic demand Quantity demanded is infinitely

How is PED indicated along a demand curve?

Diagram a price inelastic demand:

Diagram a unit elastic demand:

Diagram a perfectly inelastic demand:

Why does PED vary along a demand curve?

List the determinants of PED:

Define total revenue:

Outline the formula for calculating total revenue:

Fill in the blanks: