EC120 TEST #2 EXAM-AID

1. EC120 TEST #2 EXAM-AID Tutors: Fisnik “Fiz” Lokku “Princess Leila” Bautista Coordinator: “Action Jackson” Hounsell Some images used from course and textbook slides.

2. What is SOS? • Before we begin, a quick blurb about what we do. • SOS runs outreach programs in less developed countries • We assist in building schools for the less fortunate. And if you get involved, you could be on one of these trips!

3. Costa Rica

4. Costa Rica

5. Costa Rica

6. AGENDA Alright folks, put on your thinking caps Chapters 7,8,10,13, and 14 • Go through them all • Answer any questions • A few examples • Leave you with the package

7. Chapter 7 Consumers, Producers, and the Efficiency of Markets

8. WTP & Consumer Surplus • Willingness to pay (WTP) is the maximum amount a buyer is willing to pay for a good. • Demand curve • measures the willingness to pay for an additional unit of a good (quite possibly the WTP of the marginal buyer – the price needed to get one more buyer). • Consumer surplus is the difference between what buyer’s are WTP and what they actually pay. • A measure of how happy you are because you would have been willing to pay more for those Lady Gaga tickets. CS = Total Value – Total Spending CS = WTP – Price Paid

9. Consumer Surplus = consumer surplus (happiness or “welfare”) CS is the difference between the price the consumer is willing to pay and the price they actually have to pay. If you can’t remember that just remember, it is the area above the price line and below the demand curve. Happy face image from: http://neoavatara.files.wordpress.com/2009/01/happy-face_happyface_smiley_2400x2400.jpg.

10. Consumer Surplus Changes • As price increases, CS falls. • This is due to the fall in happiness from people no longer buying, and the fall in happiness from those who continue to buy. • Vice versa occurs when price falls.

11. EXAMPLE 16 4 Answer – (d) Before the fall, Ann’s consumer surplus was the area between the $4 price line and the demand curve. Now that the price has fallen to 3, and the question is asking us the increase in CS, its basically the area of the rectangleand the triangle shown in the diagram.

12. WTS and Producer Surplus • Willingness to sell (WTS) represents the price at which producers are willing to sell a particular good. • Since a producer will rationally never sell below cost, we use cost to measure WTS (opportunity cost, that is). • At each quantity, the supply curve represents the marginal cost (cost to produce one more unit). • Producer surplus is the difference between what seller’s receive (price) and their WTS. • A measure of how happy you are because you were willing to sell your gangsta hand-knitted mittens for $10 and your buddy bought them off you for $30. PS = Total Spending – Total Cost PS = Price Received - WTS

13. Producer Surplus PS is the difference between the price the seller receives and the costs they incur. If you can’t remember that just remember, it is the area below the price line and above the supply curve.

14. Producer Surplus Changes • As P decreases, PS decreases. • This is due to the decrease in happiness to the suppliers who leave the market and the decrease in happiness to the remaining suppliers who now receive a lower price per unit. • Vice versa occurs for a price increase.

15. Allocative Efficiency • Total Surplus = CS + PS • Total Surplus = Value to Buyers – Cost to Sellers • Allocative Efficiency occurs when TS is maximized. • As well, the buyers who value the good the most receive the good, and the sellers with the lowest costs produce the good. • Equity is a measure of how fair this allocation is, but is very hard to judge. • The free market eq’m maximizes TS and is efficient.

16. Laissez Faire – Oui ou Non? • Since the free market eq’m efficiently allocates resources, any sort of government distortion of the market is seen to have a negative effect on overall surplus. • A “laissez faire” approach to economics is one which say the government should not interfere with market interactions (as they will distort the market and decrease TS). • However, this is all assuming that markets are indeed perfectly competitive. In the real world, there are market failures caused by market power imbalances and externalities.

17. Chapter 8 The Costs of Taxation

18. Tax Effects • We know from previous chapters that taxes reduce the quantity exchanged, increase the price to buyers, and decrease the price received by sellers. • For the sake of analyzing its effect on TS, we include tax revenue as part of TS because it can lead to good things (taxes pay for roads, national defense, etc.). • The effect, as shown in the next slide, is a decrease in CS (buyers now pay more), decrease in PS (sellers receive less), and an increase in tax revenue. • Overall, the TS goes down. The loss in TS is known as deadweight loss (DWL).

19. Tax Effects • BEFORE Tax: • CS = A + B + C • PS = D + E + F • Tax Revenue (TR) = 0 • TS = A + B + C + D + E + F • AFTER Tax: • Quantity exchanged = 40, Price paid by buyers = $1.10, Price rec’d by sellers = $0.90. • CS = A • PS = F • TR = B + D • TS = A + B + D +F • Therefore, loss in TS = C + E • DWL = C + E • DWL = [(1.10 – 0.90)*(50 – 40)]/2 = $1 Image from: http://cwx.prenhall.com/bookbind/pubbooks/osullivan12/chapter16/medialib/ch16_m3_1-4.gif

20. Minimizing Surplus Loss • As taxes are necessary to a society, governmentstry to tax goods that lead to the least happiness (surplus) loss –> which goods will have the lowest DWL. • This relates back to elasticity. • The more responsive (elastic) buyers or suppliers are to a good’s price, the greater the distortion will be when a tax is imposed -> leading to a larger DWL. • Therefore, to minimize DWL in society, taxes on inelastic goods (in demand and supply) should be pursued.

21. Elasticity Effects Elastic Demand Inelastic Demand • In the graph with an elastic demand curve (flatter), the red area (DWL) is notably larger, given the fact that consumers react more to price changes (therefore creating a greater market distortion than when the curve is steeper and more inelastic) • The same applies to the elasticity of supply (the flatter and more elastic it is, the greater the distortion -> bigger DWL). Image from: http://cwx.prenhall.com/bookbind/pubbooks/osullivan12/chapter16/medialib/ch16_m3_1-4.gif

22. Government Size & Labour Market • Bigger government = More services provided = More taxes required = Greater DWL • Much debate in labour market, which represents a large portion of tax revenue (with marginal tax rate close to 50%) • If the supply of labour is inelastic -> DWL is small and it’s no biggie. • Yet, some argue it is elastic and therefore taxes greatly distort the labour market. • It is elastic by: choice of overtime hours, discretion over work in combined income houses, retirement options, and under-the-table motivations.

23. Changing Tax Size • When taxes are low, increasing them or decreasing them doesn’t have a huge DWL effect. • When taxes are higher, increasing them or decreasing them has a huge effect on DWL. • GRAPH THIS OUT TO SEE THE CHANGE. • As well, when increasing taxes, they may originally lead to an increase in TR. But this only happens to a certain point. • At some point TR starts to go down. This relationship is shown in the Laffer Curve. Image from: http://3.bp.blogspot.com/_Ytw3f14YpgE/THVKTp75WOI/AAAAAAAAACI/avvBbVLtTgQ/s1600/Laffer_Curve.png

24. Chapter 10 Externalities

25. Positive and Negative Externalities • An externality occurs whenever actions taken by firms or consumers directly impose costs or confer benefits on others. • When you smoke a cigarette in a restaurant, you might impose costs on others present; when you renovate your home you might confer benefits on your neighbours. • A negative externalityoccurs when external costs exist (i.e. social cost exceeds private cost) • Examples: smoking, pollution, congestion • A positive externalityoccurs when external benefits exist (i.e. social benefits exceed private benefits) • Examples: Education, innovation, flu shots, Old Spice

26. Private + External = Social • Private Cost - cost to the seller • External Cost - cost to a 3rd party • Social Cost = private cost + external cost • Private Benefit – benefit to the buyer • External Benefit – benefit to a 3rd party • Social Benefit = private benefit + external benefit • Marginal social cost: MCS = MCP + MCE • Marginal social benefit: MBS = MBP + MBE

27. Negative Externality • The efficient level of output is where D = Social Cost (S). • In this diagram, that point is represented by QS. This is where the total surplus is maximized. • Externalities can be eliminated by “internalizing” them (altering incentives to make people account for them) • To eliminate a negative externality, the government usually uses taxes. These taxes are known as Pigovian taxes. • An effective internalizing tax is one that is equal to the externality cost (= Social Cost – Private Cost).

28. Negative Externality Deadweight Loss

29. Positive Externality • The efficient level of output is where S = Social Benefit (D). • In this diagram, that point is represented by QS. This is where the total surplus is maximized. • To internalize a positive externality, the government usually uses subsidies. • An effective subsidy equals the External Benefit ( = Social Benefit – Private Benefit). • - In this case, the private market yields underproduction. P S Ext. Benefit Social Benefit Private Benefit QP QS

30. Positive Externality EXAMPLE FIND the total surplus at each level of production (i.e. QS and QP). Recall the TS Formula TS = TV(area under demand) – VC(area under supply) TS at QP TS = (A+F) – (F) = A (allocative inefficient) TS at QS TS = (A+B+C+D+E+F) – (E+F+D) = A+B+C (allocative efficient) The change in TS from QP to QS? (A+B+C)-(A) = B + C Therefore, after the subsidy has been imposed to cover the positive externality, the TS risesby B + C B represents benefits 3rd parties were already experiencing. C represents DWL when at QP.

31. Coase Theorem • Private solutions to externalities include: the moral code and social sanctions (Golden rule), charities, self-interest of relevant parties, and contracts b/w relevant parties. • Coase Theorem: Assuming no costs, private parties can bargain amongst themselves to allocate resources at a socially optimal level (they can fix externalities). • In any externality scenario, the benefits and costs of the good in question are measured. • If benefit > cost -> socially optimal (efficient) to keep good. • If cost > benefit -> socially optimal (efficient) to get rid of good • The private outcome of each scenario depends on the costs, benefits, and rights surrounding them. • Coase theorem states that the private outcome = efficient outcome every time, regardless of initial distribution of rights. • This can fail if assumptions do not hold true.

32. Public Policy Approaches • Policies towards solving externalities can be: • Command-and-Control – direct regulation • I.e. absolute limit on pollution, mandatory business process implementations, etc. • Market-based policies – incentives are used to lead parties to the solution. • Pigovian taxes -> ideal when set equal to externality cost. Leaves no limit to savings or costs. • These taxes increase economic efficiency and raise tax revenue. • Subsidies -> ideal when set equal to externality benefits. • Tradeable pollution permits (see next slide).

33. Pollution Control Policies • Tradable pollution permitsgive each firm an allocation of permits that allows them to buy/sell permits between other firms, if they wish to increase/decrease pollution. • Pollution permits are the right to pollute a certain amount. To reduce pollution, gov’ts can hand out permits totaling less than what the current pollution is. • If it costs Fiz’s Gun Factory $100 to reduce pollution emitted by 1 tonne, and only $20 for Leila’s Play-Doh Factory to have the same reduction: • Fiz will seek to buy pollution permits (because he has high pollution reduction costs) • Leila will seek to sell pollution permits (because reducing pollution doesn’t cost her too much) • Pollution permit price will fall somewhere in b/w their costs ($20 - $100) • Most of pollution reduction will fall on Leila, as she can do it the best (at the least cost) -> both Leila and Fiz are happier.

34. Pigovian Taxes vs. Pollution Permits • Demand for ability to pollute is negatively sloped in comparison to the price to pollute (higher pollution prices = less pollution). • Pigovian taxes seek increase the price of pollution to decrease overall quantity. • Pollution permits seek to limit the supply of pollution to decrease overall quantity. • They both have similar effects, but in practice pollution permits are much more precise.

35. Pigovian Taxes vs. Pollution Permits • In the Pigovian market, the price is set by the tax and the quantity of pollution is then determined. • In the Permit market, the quantity of pollution is determined first (= amount of pollution permits) and then the price of pollution is determined.

36. Chapter 13 Costs of Production

37. Economic vs. Accounting Profit • Accounting Profit = Revenues – Explicit Costs • Economic Profit = Revenues – Explicit Costs – Implicit Costs • The difference in calculating economic profits is that we also subtract out implicit costs (Revenue – OC). • Therefore: • economic profits < accounting profits • If economic profit is positive, the owner’s capital is earning more than it could in its next best alternative use • Zero economic profit does not mean zero accounting profit. • 0 accounting profit means revenues are equal to expenses. • 0 economic profit means that firm is in a stable condition to stay in the market.

38. Production & Marginal Product • A production function shows the relationship between inputs and their resulting outputs. • How much material/labour (x-axis) I need to make 1 morph suit, 2 morph suits, 3 morph suits, etc. (y-axis) • Marginal product (MP) is the change in the total product resulting from the use of one more (or one less) unit of the variable factor. • This also represents the slope of the production function. • The marginal product (of labour) is:

39. Diminishing MP • The law of diminishing returnsstates that if increasing amounts of a variable factor are applied to a given quantity of the fixed factor, eventually the marginal product of the variable factor declines. • Consider a worker who does all the tasks required to manufacture a product. As subsequent workers are added, each can specialize on one task, and marginal product rises. • But if there is a fixed amount of physical capital, eventually the marginal product begins to decline (could become negative). • I.e. – one cook running a kitchen is hard. You throw another chef in there and they can each specialize in certain tasks and MP is large. Once you get the 100th cook in their, it’s too crowded and they suck. • I.e. – you can only give so many hammers to a construction crew of 6, before the 10th hammer you give them has any effect at all (diminished MP of the hammer compared to the first one).

40. Diminishing MP Marginal Product Curve is derived from the Total Product Curve. When TP is rising at an increasing rate (curving up), MP is positive and rising. When TP is rising at a decreasing rate (curving down), MP is positive and falling. When TP is falling,MP is negative (below Q Labour axis). Image from: http://www.s-cool.co.uk/assets/learn_its/alevel/economics/costs-and-revenues/the-law-of-diminishing-marginal-returns/2007-11-26_162359.gif

41. Marginal Cost • Marginal cost (MC) is the CHANGE in total cost associated with a CHANGE in the level of output. (NOTE—This is NOT the change in cost associated with a change in the use of an INPUT) TC MC = Q Because fixed costs do not vary with output, the only part of TC that changes is the variable cost.

42. Marginal Cost and MP

43. Costs in the Short Run • Total cost (TC) is the full cost of producing any given level of output. Total cost is divided into two parts: fixed cost and variable cost. Total fixed cost (TFC) does not vary with the level of output. Total variable cost (TVC) varies directly with output. TC = TFC + TVC Average total cost (ATC) is TC divided by the level of output. Average total cost can be separated into average fixed cost (AFC) and average variable cost (AVC). ATC = AFC + AVC

44. Example! The answer is c)! ATC = TC/Q TC = TFC + TVC TFC = $30 TVC = 0.15*200 + 10*(200/100) = $50 TC = $80 ATC = $80/200 = $0.40

45. Example! Using the following information in the production schedule, fill in the blanks.

46. Example! Answer:

47. Short Run Cost Curves • The AFC curve declines steadily as output rises. The decline reflects spreading the overhead over more units of output. Cost Cost TFC AFC Output Output

48. Short Run Cost Curves Total Cost is the sum of TVC and TFC. It is derived by adding the constant fixed cost to the TVC curve. TC looks like TVC, but shifted vertically upward by the amount of TFC. The height of the ATC curve is the vertical sum of AFC and AVC. Because AFC is everywhere falling, the difference between AVC and ATC gets smaller as output rises.

49. Important graph to remember! Minimum of AVC= shut down point! If the firm cannot afford to pay for variable costs like labour it is better off for them to shut down. That way, they will only be paying the fixed costs (minimizing loss). The minimum of ATC occurs at a larger quantity than the minimum of AVC. • ATC is U-shaped because originally the declining AFC brings it down. But eventually, the increases in AVC outweigh the decrease in AFC and ATC begins to rise. • MC intersects ATC at its minimum because: • When MC < ATC, ATC is falling • When MC > ATC, ATC is rising

50. Short Run and Long Run • The short runis a length of time over which some of the firm’s factors of production are fixed. • Typically, physical capital (the size of the plant) is the fixed factor -- labour and material inputs are typically variable. • The long runis the length of time over which all of the firm’s factors of production can be varied, but its technology is fixed.