ECON 201 Exam 2 Study Guide PDF

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Everything you need to know for Professor Snow's second exam....

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ECON 201 Exam 2 Study Guide Elasticity of Supply  Measures how responsive a change of quantity supplied is to a change in price o ***The fundamental determinant of elasticity of supply is how quickly per-unit costs increase with an increase in production. If increased production requires much higher per-unit costs, then supply will be less elastic – or inelastic. If production can increase without much increasing per-unit costs, then supply will be elastic Less Elastic More Elastic Difficult to increase production at constant Easy to increase production at constant unit unit cost (e.g. some raw materials) cost (e.g. some manufactured goods) Large share of market for inputs Small share of market for inputs Global Supply Local Supply Short run Long run o Formula: 

Elasticity of supply = % change Q / % change P

Qa− Qb (Qa+Qb)/ 2 Pa− Pb (Pa+ Pb)/2

o Gun Buyback Program: Police buy back guns in D.C., no questions asked in 2000.  The Theory: gun buybacks reduce the number of guns in circulation, and reductions in the number of guns circulating reduces the amount of crime  Part 2 is correct, but part 1 is incorrect. Gun buybacks in a city like D.C. are very unlikely to reduce the number of guns in circulation.  The supply of low-quality guns in D.C. is very elastic. This program increases the demand for used guns, shifting the demand curve outward, and the increase in demand pushes up the quantity of guns supplied in D.C. to 6000 units from 1000. There is no net change in the number of guns on the streets of D.C. with this program  A shoe buyback program is unlikely to make people go shoeless, just as a gun buyback program is unlikely to make gun owners gunless.  The point is that if the police can’t drive up the price of guns, then they can’t reduce the quantity of guns demanded on the streets. And the price of guns is not determined in D.C., but in the national market for guns where millions of guns are bought and sold so a police buyback of 5000 is too small to influence the price.  A buyback makes new guns more valuable; now they come with an insurance policy protecting against declines in value, which increases the demand for new guns.

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Taxes and Subsidies Assume that the government is considering a tax on apples. It can tax apple sellers $1 for every basket supplied, or they can tax apple buyers $1 for every basket bought. o They both have the same effect  Who ultimately pays a tax is determined not by the laws of Congress, but by the laws of supply and demand

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The Tax = Price paid by buyers – Price received by sellers

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Who ultimately pays the tax depends on the relative elasticities of supply and demand o When demand is more elastic than supply, demanders pay less of the tax than sellers o When supply is more elastic than demand, suppliers pay less of the tax than buyers Elasticity = escape  So long as the industry is not taxed out of existence, someone must pay the tax, so whether buyers or sellers pay more depends on who can escape the best – that is, which curve is relatively more elastic.

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A tax generates revenues for the government but also results creates a deadweight loss (i.e. reduces the gains from trade) Some of the consumer and producer surplus is transferred to the government in the form of tax revenues, but notice that consumer and producer surplus reduce by more than government revenue increases – this difference is the deadweight loss. Broad-based taxes will tend to create less DWL than more narrowly based tax. Subsidy  Reverse tax  Instead of taking money away from consumers (or producers), the government gives money to consumers (or producers). o Who gets the subsidy does not depend on who gets the check from the government o Who benefits from a subsidy does depend on the relative elasticities of demand and supply o Subsidies must be paid for by taxpayers and they create inefficient increases in trade (DWL) The Subsidy = Price received by sellers – price paid by buyers A subsidy creates DWL because with the subsidy, nonbeneficial trades occur o The resources used to produce the extra baskets of goods have an opportunity cost, and they could produce more value in some other part of the economy. ***Whoever bears the burden of the tax gets the benefit of the subsidy

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The Price System: Signals, Speculation, and Prediction The Great Economic Problem  To arrange our limited resources to satisfy as many of our wants as possible

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A price is a signal wrapped up in an incentive o Prices are incentives, prices are signals, prices are predictions

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Speculation  The attempt to profit from future price changes

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Prediction Market  A speculative market designed so that prices can be interpreted as probabilities and used to make predictions

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No market is an island. Markets are linked geographically, through time and across different goods. The price of gasoline at your local gas station is linked to the market for oil in China. The price of oil today is linked to the expectations about the market for oil in the future and, through investment, to the market for oil in the past.

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Price Ceilings and Floors Price Ceiling  A maximum price allowed by law Price ceilings create 5 important effects: o Shortages  When prices are held below the market price, Qd>Qs o Reductions in product quality  At the controlled price, demanders find that there is a shortage of goods – they cannot buy as much of the good as they would like. Equivalently, at the controlled price, sellers find that there is an excess of demand, seller have more customers than they have goods. In this case, quality declines so more goods can be produced  Additionally, quality can fall with reductions in service. When prices are lower than market levels, businesses don’t have the same incentive to please their customers o Wasteful lines and other search costs  Instead of competing by paying bribes, buyers competed by their willingness to wait in line. Buyers will compete to avoid being left with nothing.  Paying in time is much more wasteful than paying in bribes. o A loss of gains from trade (DWL)  The total of lost consumer and producer surplus when not all mutually profitable gains from trade are exploited. Price ceilings create a DWL o A misallocation of resources

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Price controls misallocate resources because without prices (signal wrapped in an incentive), there is no signal as to where goods need to go, and no incentive to get them there Price controls cause resources to be misallocated not just geographically, but also across different uses for those resources. Without market prices we have no guarantee that oil will flow to its highest valued uses. Under price controls, oil suppliers would have no incentive to supply oil to just the highest-valued uses. Instead, oil suppliers will give the oil to any user who is willing to pay the controlled price.

Rent Control  A price ceiling on rental housing, such as apartments, so everything we have learned about price ceilings also applies to rent controls. Rent controls create shortages, reduce quality, create wasteful lines and increase the costs of search, cause a loss of gains from trade, and misallocate resources o Shortages  In the short-run, landlords have no option but to absorb the lower price. But in the long-run, fewer new apartment units are built and older units are turned into condominiums or torn down to make way for parking garages or other higher-paying ventures  Although old apartment buildings can’t disappear overnight, future apartment buildings can o Reduction in Quality  When the price of apartments is forced down, owners attempt to stave off losses by cutting their costs. With rent controls, for example, owners mow the lawn less often, replace lightbulbs more slowly, and don’t fix the elevators so quickly.  When controls are strong, cheap but serviceable apartment buildings turn into slums and then slums turn into abandoned and hollowed-out apartment blocks o Wasteful lines and increased search costs  Search costs can be especially high for people who landlords think are not “ideal renters”. At the controlled price, landlords have more customers than they have apartments, so they can pick and choose among prospective renter. Price controls lead landlords to discriminate, as well. Rent controls reduce the price of discrimination, so remember the law of demand: when the price of discrimination falls, the quantity of discrimination demanded will increase o Loss of gains from trade  At the quantity supplied under rent control, demanders are willing to pay more for an apartment than sellers would require to rent the apartment. If buyers and sellers were free to trade, they could both be better off, but under rent control, these mutually profitable trades are illegal and the benefits do not occur. o Misallocation of resources

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As with gasoline, apartments under rent control are allocated haphazardly – some people with a high willingness to pay can’t buy as much housing as they want, even as others with a low willingness to pay consume more housing than they would purchase at the market rate.

Price Floors o A price floor is a minimum price allowed by law… they create four important effects  Surpluses  This surplus comes in the form of a surplus from labor, aka unemployment.  A minimum wage will decrease unemployment among low-skilled workers, because the more employers have to pay for low-skilled workers, the fewer low-skilled workers they will hire.  Lost Gains from Trade (DWL)  If employers and workers could bargain freely, the wage would fall and the quantity of labor traded would increase to the level of market unemployment. At the market employment level, the gains from trade increase with consumer and producer surpluses.  Small increases in the minimum wage won’t change much, but big increases will cause serious unemployment.  Wasteful increases in quality  A price floor means that prices are held above market levels, so firms want more customers. The price floor, however, makes it illegal to compete for more customers by lowering prices. Price floors cause firms to compete by offering customers higher quality.  When airlines were regulated, for example, they competed by offering their customers fancy meals, wide seats, and frequent flights. That increase in quality came at a price, however. If consumers were willing to pay for fine meals on an airplane, airlines would offer that service. But customers today prefer to pay a lower price for their plane ticket, and save their money for when they arrive at their destination. An increase in quality that consumers are not willing to pay for is a wasteful increase in quality.  A misallocation of resources  When airline regulations were in effect, the CAB prevented new airlines from entering the industry, as they knew that this would push prices down. Restrictions on entry misallocated resources because low-cost airlines were kept out of the industry. Southwest Airlines was only able to enter the industry after deregulation occurred.

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Externalities: When the Price is Not Right Private Cost  a cost paid by the consumer or producer External Cost  a cost paid by people other than the consumer or the producer trading in the market Social Cost  the cost to everyone  Social Cost = Private Cost + External Cost Externalities  external costs or external benefits, that is, costs or benefits, respectively, that fall on bystanders. o External Costs = Negative Externalities o External Benefits = Positive Externalities When externalities are significant, markets work less well and government action can increase social surplus Social Surplus  consumer surplus + producer surplus + everyone else’s surplus o A market with externalities does not maximize social surplus o Efficient Equilibrium  the price and quantity that maximizes social surplus o Efficient Quantity  The quantity that maximizes social surplus A tax on an ordinary good increases deadweight loss, but a tax on a good with an external cost reduces DWL and raises revenue. For these reasons, there is a strong argument for taxing goods with external costs. Such taxes are often called Pigouvian taxes, after the economist Arthur C. Pigou. External Benefit  A benefit to people other than the consumers or the producers trading in the market. o Consider vaccines for an example. Vaccines benefit the person who is vaccinated but they also create an external benefit for other people because people who have been vaccinated are less likely to harbor and spread disease-causing viruses. Flu viruses spread from person to person when someone who already has the flu coughs or sneezes. As a result, when one person gets a flu shot, the expected number of people who get the flu falls by more than one. o When an individual compares the private costs and befits of getting a flu shot, it may be quite sensible not to get one. It takes time to get a shot, it costs money, and often a slight fever and ache are associated with the vaccine itself. The problem is that the person getting the flu shot bears all these costs but doesn’t receive all of the benefits. As a result, fewer people get flu shots than is efficient. o Vaccination reduces the probability that a disease spreads so there are external benefits from vaccination. The social value curve counts all benefits of vaccine use, the private value plus the external benefits, so the efficient quantity is found where the social value curve intersects the supply curve. o To maximize social surplus, output should increase to Qefficient, the unit for which social value just equals the cost of production.

o A subsidy on a good with external benefits is a Pigouvian Subsidy o ***A Pigouvian tax increases the price so that the after-tax price sends the correct signal. Similarly, if there are external benefits, the market price is too high, thus resulting in underconsumption. A Pigouvian subsidy reduces the price so that the after-subsidy price sends the correct signal. 

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Private Solutions to Externality Problems o Internalizing an externality  adjusting incentives so that decision makers take into account all the benefits and costs of their actions, private and social. o Transaction Costs  all the costs necessary to reach an agreement o When Alex boards a plane and has the flu, one cough might in turn get 1000 people sick. But if he receives a flu shot, all of these people are better off. In theory, if each of these people paid Alex a small amount for getting a flu shot, Alex would be more likely to get a flu shot. But the transaction costs of arranging a deal like this are enormous – simply to identify the beneficiaries is difficult and getting thousands of them to send a check to Alex is next to impossible. Coase Theorem  says that if transaction costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even when there are externalities. o In a free market, the quantity of goods sold will maximize social surplus, the sum of the consumer, producer, and everyone else’s surplus. o But, these conditions are unlikely to be met. Thus, markets alone will not solve all externality problems.

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Government Solutions to Externality Problems Two government solutions (besides taxes and subsidies) for control externality problems o Command and Control  This is when the government orders firms to use/make more or less resources/products.  The problem with this is that there are typically many methods to achieve a goal and the government may not have enough information to choose the least costly method.  The bottom line is that command and control can be useful if the best approach to a problem is well known and if success requires very strong compliance. If it’s important to control the externality at the least possible cost and if the government doesn’t have full information, then more flexible approaches such as taxes and subsidies are preferable o Tradeable Allowances  When trying to reduce pollution, tradable allowances require that firms reduce pollutants by a specific quantity

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Three government solutions to externality problems: Taxes and subsidies, command and control, and tradeable allowances

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Market prices do not correctly signal true costs and benefits when there are significant external costs or benefits. Taxes and subsidies can adjust prices so that they send the correct signals. When external costs are significant, the market price is too low, so an optimal tax raises the price. When external benefits are significant, the market price is too high, so an optimal subsidy lowers the price. Command and control solutions can work but are often too high-cost because they are inflexible and do not take advantage of differences in the costs and benefits of eliminating and producing the externality. The Coase theorem explains that the ultimate source of the externality problem is too few markets. If property rights can be clearly defined and transaction costs reduced, then markets in the externality will solve the problem and will do so at the lowest cost. In recent years, successful markets have been created in the right to emit sulfur dioxide, and new markets are being used to reduce the gases that contribute to global warming....