Chapter 1: Introduction to Economics/Making and Using Graphs

• Scarcity is our inability to satisfy all our wants

• Microeconomics is the study of the choices that individuals and businesses make, the way these

choices interact in markets, and the influence of governments

• Macroeconomics is the study of the performance of the national economy and the global economy

• Choices made in economics determine what, how, and for whom goods and services are produced

- The what question is “What goods and services do we produce?”

- The how question is “How do we use the factors of production to produce these goods/services?”

- The for whom question is “Who consumes the goods and services that are produced?”

• You make choices that are in your self-interest – choices that you think are best for you

• Factors of production:

- Land earns rent; Labour earns wages; Capital earns interest; Entrepreneurship earns profit

• Choices that are the best for society as a whole are said to be in the social interest

• A tradeoff is an exchange – giving up one thing to get something else

• A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost

for the person making the choice

- Only the wants of the person making a choice are relevant to determine its rationality

• The opportunity cost of something is the highest-valued alternative that must be given up to get it

• Choices respond to incentives – a change in marginal benefit or a change in marginal cost

- If the marginal benefit of Option 1 is greater than its marginal cost then you will choose Option 1

- If the marginal cost of Option 2 is greater than its marginal benefit than you will not choose Option 2

• Positive statements are about what is

- A positive statement might be right or wrong but can be tested by checking it against facts

• Normative statements are about what ought to be

- These statements depend on values and cannot be tested

• An economic model describes some aspect of the economic world and includes only those features

needed for the purpose at hand

• To disentangle cause and effect, economists use economic models and look for natural experiments,

conduct statistical investigations, and perform economic experiments to test the predictions of those models

• A natural experiment is a situation that arises in the ordinary course of economic life in which one

factor of interest is different and other things are equal (or similar)

• A statistical investigation looks for correlations

• An economic experiment puts people in a decision-making situation and varies the influence of one

factor at a time to discover how they respond

Chapter 2: The Economic Problem

• The production possibilities frontier (PPF) shows the limits to production

- Points outside the frontier cannot be attained without technological change or capital accumulation

- Any point inside the PPF and on the PPF can be produced, so they are attainable

- The PPF illustrates scarcity by showing that that firm cannot produce at points outside the PPF, and as the firm moves along the PPF increasing production of Good A, it must decrease the quantity of Good B

• We achieve production efficiency if we produce goods and services at the lowest possible cost

- Achieved at all points on the PPF

• Opportunity cost equals the decrease in the quantity produce of one good divided by the increase in

the quantity produce of another good as we move along the PPF

- Opportunity cost increases because not all resources are equally productive in all activities as shown by the bowed-out shape of the PPF

- A ratio equal to the quantity of the good given up divided by the increase in quantity of the other good produced as we move along the PPF

• Marginal cost of a good is the opportunity cost of producing one more unit of the good

• The marginal cost is plotted at the x-value midway between the two values that generate it

• Marginal benefit from a good or service is the benefit received from consuming one more unit of it

- Measured by the most that people are willing to pay for an additional unit of said good or service

- The more we have of any good or service, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it

• Allocative efficiency is achieved when we cannot produce more of any good without giving up some

other good that we value more highly – the point on the PPF that we prefer above all other points

• Economic growth comes from technological change and capital accumulation

- Technological change is the development of new goods and of better ways of producing existing goods and services

- Capital accumulation is the growth of capital resources, which includes human capital

• The opportunity cost of economic growth is greater the faster we make our production grow

• In 1960, the production possibilities per person in Canada were more than 3x those in Hong Kong

• Canada devotes 1/5th of its resources to accumulating capital and the other 4/5th to consumption

• Hong Kong devotes 1/3rd of its resources to accumulating capital and 2/3rd to consumption

• Social institutions such as firms, markets, property rights, and money are necessary to make

decentralized coordination work and are required for society to enjoy the benefits of specialization and trade

• A market is any arrangement that enables buyers and sellers to get information and to do business

with each other

• Markets have evolved because they facilitate trade

• The flows from firms to households are the real flows of goods and services and the income flows of

wages, rent, interest and profit

• The flows from households to firms are the real flows of labour, land, capital, and entrepreneurship

and the flow of expenditure on goods and services

Chapter 3: Demand and Supply

• A relative price is the ratio of one price to another

• The opportunity cost of a good is the relative price of that good to another good

• The quantity demanded of a good or service is the amount that consumers plan to buy during a

given time period at a particular price

- Not necessarily the same as the quantity actually bought

• The law of demand states that, other things remaining the same, the higher the price of a good, the

smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded

• A demand curve is a willingness-and-ability-to-pay curve and the willingness and ability to pay is a

measure of marginal benefit

- Tells us the maximum that someone is willing to pay for an additional unit of a good or service

• A normal good is one for which demand increases as income increases

• An inferior good is one for which demand decreases as income increases

• The substitution effect displays that as the opportunity cost of a good rises, the incentive to

economize on its use and switch to a substitute becomes stronger

• The income effect displays that as the price of a good either increases or decreases consumers can

either afford to buy less or more of a good relative to their income

• A substitute is a good that can be used in place of another good

• A complement is a good that is used in conjunction with another good

• The quantity supplied of a good or service is the amount producers plan to sell during a given time

period at a particular price

- Not necessarily the same as the quantity actually sold

• The law of supply states that, other things remaining the same, the higher the price of a good, the

greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied

• A supply curve can be interpreted as a minimum-supply-price curve – a curve that shows the lowest

price at which someone is willing to sell and this lowest price is marginal cost

• The equilibrium quantity is the quantity at which the quantity demanded equals the quantity

supplied

• The equilibrium price is the price at which the quantity demanded equals the quantity supplied

• At any price below the equilibrium price, the quantity demanded exceeds the quantity supplied and a

shortage exists

• At any price above the equilibrium price, the quantity supplied exceeds the quantity demanded and a

surplus exists

Chapter 4: Elasticity

• The price elasticity of demand is a units-free measure of the responsiveness of the quantity

demanded of a good or service to a change in its price

• Price elasticity of demand = % change in the quantity demanded ÷ % change in the price

• The total revenue test is a method of estimating the price elasticity of demand by observing the

change in total revenue that results from a change in the price

• Demand is elastic (>1) if a price cut increases total revenue

• Demand is inelastic (<1) if a price rise increases total revenue

• Demand is unit-elastic (=1) if a price rise or cut leaves total revenue unchanged

• The fewer the substitutes for a good or service, the more inelastic is the demand for it

• The smaller the proportion of income spent on a good, the more inelastic is the demand for it

• The shorter the time that has elapsed since a price change, the more inelastic is demand

• Along a straight-line demand curve, demand is unit-elastic at the midpoint, elastic at all prices above

the midpoint, and inelastic at all prices below the midpoint

• The price elasticity of demand is a measure of the responsiveness of the demand for a good to a

change in the price of a substitute or complement

• Price elasticity of demand =

% change in quantity demanded ÷ % change in price of a substitute or complement

• Two goods are substitutes if the cross elasticity of demand between them is positive

• Two goods are complements if the cross elasticity of demand between them is negative

• The income elasticity of demand is a measure of the responsiveness of the demand for a good or

service to a change in income

• >1 (normal good, income elastic); +<1 (normal good, income inelastic); - (inferior good)

• The elasticity of supply is a units-free measure of the responsiveness of the quantity supplied of a

good or service to a change in its price

• Elasticity of supply = % change in quantity supplied ÷ % change in price

• Some goods and services can be produced by using unique or rare productive resources; these items

have a low, even perhaps a zero, elasticity of supply

• The greater the amount of time available after a price change, the greater is the quantity supplied

Chapter 5: Efficiency and Equity

• Markets need to possess the ability to allocate resources efficiently and fairly

• Resources might be allocated by:

- Market price; people who are willing and able to pay the price

- Command; by the order of someone in authority

- Majority rule; by what the majority of voters choose

- Contest; to a winner or group of winners

- First-come, first-served; by who’s first in line

- Lottery; to those who pick the winning number, luck

- Personal characteristics; people with the “right” characteristics get the resources

- Force; to the strongest

• Value is what we get and the price is what we pay

• The value of one more unit of a good or service is its marginal benefit

• Consumer surplus is the marginal benefit of a good minus the price paid for it, summed over the

quantity bought

• Producer surplus is calculated as the price received for a good minus its marginal cost summed over

the quantity sold

• Equilibrium in a competitive market occurs when marginal social benefit equals marginal social cost

and total surplus is maximized

• Deadweight loss arises when the quantity produced is greater than or less than the efficient quantity

- Equals the loss of the total surplus

• All ideas about fairness can be divided into two broad groups:

- It’s not fair if the result isn’t fair

- It’s not fair if the rules aren’t fair

• Utilitarianism is a principle that states that we should strive to achieve “the greatest happiness for the

greatest number”

- It ignores the cost of making income transfers

• Rawls said that, taking all costs of income transfers into account, the fair distribution of the economic

pie is the one that makes the poorest person as well off as possible

• The main idea of fairness is based on the following two rules:

- The state must enforce laws that establish and protect private property

- Private property may be transferred from one person to another only by voluntary exchange

• According to the fair results view, a fair outcome is one that benefits the less well off

• According to the fair rules view, all transactions are voluntary

Chapter 6: Government Actions in Markets

• A price ceiling is a government regulation that makes it illegal to charge a price higher than a

specified level

• When a price ceiling is applied to a housing market, it is called a rent ceiling

• With an effective rent ceiling, the rent is determined at the intersection of the rent ceiling and the

supply curve

• With an effective rent ceiling, some means for allocation of housing units other than by price

becomes necessary, the shortage of housing increases search activity, and a black market arises

• When a price ceiling is set below the market equilibrium price, some consumers are better off and all

producers are worse off

• A government imposed regulation that makes it illegal to charge a price lower than a specified level is

called a price floor

• When a price floor is applied to a labour market, it is called a minimum wage

• When a minimum wage is in place, scarce jobs are allocated by a method other than market price,

such as personal characteristics, first-come first-served, or discrimination

• Tax incidence is the division of the burden of a tax between buyers and sellers

• Perfectly inelastic demand – buyers pay

• Perfectly elastic demand – sellers pay

• Perfectly inelastic supply – sellers pay

• Perfectly elastic supply – buyers pay

• The greater the elasticity of demand, the smaller the tax revenue

• The smaller the elasticity of supply, the greater the tax revenue

• A tax is efficient when supply is perfectly inelastic or demand is perfectly inelastic so that the same

quantity is purchased because no tax falls on the buyers

• The benefits principle is the proposition that people should pay taxes equal to the benefits they

receive from the services provided by the government

• The ability-to-pay principle is the proposition that people should pay taxes according to how easily

they can bear the burden of the tax

• A production quota is an upper limit to the quantity of a good that may be produced in a specified

period

• It is difficult for production quotas to work when they are voluntary because each producer has an

incentive to cheat and produce a little bit more than the allotted quota

• A subsidy is a payment made by the government to a producer

• When a good is illegal, the cost of trading in the good increases

• When a penalty is imposed on sellers of illegal goods, the marginal cost of the good decreases

• When a penalty is imposed on buyers of illegal goods, the marginal cost of the good decreases

Chapter 8: Utility and Demand

• The budget line marks the boundary between those combinations of goods and services that a

household can afford to buy and those that it cannot afford

• A change in income shifts the budget line but leaves its slope unchanged

• A change in price changes the slope of the budget line

• Utility is the benefit or satisfaction that a person gets from the consumption of goods and services

• Total utility is the total benefit that a person gets from the consumption of all the different goods and

services

• Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a

good consumed

• The principle of diminishing marginal utility displays the tendency for marginal utility to decrease

as the consumption of a good increases

• In consumer equilibrium, a consumer maximizes his or her total utility and since more consumption

brings more utility only completely exhausting income can maximize utility

• Marginal utility per dollar is the marginal utility from a good that results from spending one more

dollar on it

- Calculated by dividing the marginal utility from the good by its price

• Total utility is maximized by making the marginal utility per dollar of both goods equal to one

another

• If the marginal utility per dollar from Good A exceeds that of Good B then buy more of Good A and

less of Good B

• When the price of a good rises, the marginal utility per dollar from this good decreases

• When the price of a good falls, the marginal utility per dollar from this good increases

• The paradox of value asks why the price of water is low and the price of diamond is high, but water is

essential to life while diamonds are not

• Utility is similar to temperature because both are abstract concepts which use arbitrary units of

measurement and neither can be observed

• Behavioural economics studies the ways in which limits on the human brain’s ability to compute and

implement rational decisions influences economic behaviour – both the decisions that people make and the consequences of those decisions for the way markets work

- There are three impediments that prevent rational choice:

- Bounded rationality is rationality that is limited by the computing power of the human brain

- Bounded will-power is the less than perfect will-power that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret

- Bounded self-interest is the limited self-interest that results in sometimes suppressing our own interests to help others

• Neuroeconomics is the study of the activity of the human brain when a person makes an economic

decision

• These sciences seek to explain why we do not always make rational economic decisions

Chapter 11: Output and Costs

• In the short-run, at least one factor of production is fixed. For most firms, capital, land, and

entrepreneurship are fixed factors of production and labour is the variable factor of production

- These are called the firm’s plant, in the short-run a firm’s plant is fixed

• In the long-run, the quantities of all factors of production can be varied, this is a period in which the

plant can be changed

• A sunk cost is the past expenditure on a plant that has no resale value and is irrelevant to the firm’s

current decisions

- The only costs that influence its current decisions are the short-run cost of changing its labour inputs and the long-run cost of changing its plant

• Total product is the maximum output that a given quantity of labour can produce

• Marginal product of labour is the increase in total product that results from a one-unit increase in

the quantity of labour employed

• Average product of labour is equal to total product divided by the quantity of labour employed

• The marginal product of labour and average product of labour both initially increase and then

decrease

• Diminishing marginal returns occur when the marginal product of an additional worker is less than

the marginal product of the previous worker

- The law states that as a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production , the marginal product of the variable factor eventually diminishes

• When marginal product exceeds average product, average product is increasing

• When average product exceeds marginal product, average product is decreasing

• All points that lie below the TP curve are attainable but they are inefficient

• The point at which MP intersects AP is the point at which AP begins decreasing

• A firm’s production function shows the relationship between the maximum output attainable and the

quantities of both labour and capital

• The marginal product of capital is the change in output resulting from a one-unit increase in the

quantity of capital

- Also, is the change in total product divided by the change in capital when the quantity of labour is constant

• Diminishing marginal product of capital occurs because as the quantity of capital increases and the

quantity of labour remains constant, the amount of additional output that can be produced by each successive quantity of capital will become smaller and smaller

• The LRAC is the relationship between the lowest attainable average total cost and output when both

the plant size and labour are varied – made up of the segments of individual average total cost curves

• Economies of scale are features of a firm’s technology that make average total cost fall as output

increases – the main source is a greater specialization of both labour and capital

• Diseconomies of scale are features of a firm’s technology that make average total cost rise as output

increases – the main source is the challenger or managing a large enterprise

• The smallest quantity of output at which long-run average cost reaches its lowest level is the firm’s

minimum efficient scale

Chapter 12: Perfect Competition

• Firms in perfect competition are price takers because as individuals they produce a tiny portion of the

total output of a particular good and buyers are well informed about the prices of other firms

• No single firm in this market can determine the price so the demand faced by the individual firm is

perfectly elastic and the curve is horizontal at the market price

• In a perfectly competitive market:

- Firms sell identical products to many buyers

- There are no restrictions on entry into the market

- Established firms have no advantage over new ones

- Sellers and buyers are well informed about price

• When marginal revenue equals marginal cost, economic profit is maximized

• The shutdown point is the price and quantity at which a firm is indifferent between producing and

shutting down

- Occurs when price equals minimum average variable cost (AVC) because this is the price at which the firm is only able to covers its variable costs and its fixed costs are the firm’s loss

- The firm can avoid losses that are greater than fixed costs by shutting down and not producing

• A firm’s supply curve is the marginal cost curve above minimum average variable cost

• The short-run market supply curve shows the quantity supplied by all the firms in the market at each

price when each firm’s plant and the number of firms remain the same

• When firms in a competitive market are making an economic profit, new firms enter the market,

which increases supply. The price falls in the long run until all the firms are making normal profit.

- The increase in supply increase the market output but the fall in price decreases the quantity produce by each firm

• When firms in a competitive market are incurring an economic loss, some firms exit the market,

which decreases supply. The price rises in the long run until all the firms are making normal profit

- The decrease in supply decreases the market output but the rise in price increases the quantity produced by each firm

• In the long run firms make a normal profit whereas in the short run they can make an economic profit

• When a new technology enters a competitive market, some firms adopt it and enter the market, some

that are already in the market adopt it, but firms who do not adopt it leave the market

• When a change in demand occurs and the price does not change in the long run, the supply curve is

horizontal and the industry is a constant-cost industry

Chapter 13: Monopoly

• A monopoly is a market with a single firm that produces a good or service for which no close

substitute exists and that is protected by a barrier that prevents other firms from selling that good or service

- A legal monopoly is a market in which competition and entry are restricted by the granting of a public franchise, government license, patent, or copyright

- A natural monopoly is an industry in which economies of scale enable one firm to supply the entire market at the lowest possible cost

- A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers

- A price-discriminating monopoly sells different units of a good or service for different prices

• A single-price monopoly maximizes profit by producing the quantity at which marginal cost equals

marginal revenue

- The profit-maximizing quantity is the quantity at the intersection of the marginal revenue curve and the marginal cost curve

- The price is taken from the demand curve at the profit-maximizing quantity – in a monopoly, price is greater than marginal revenue

• A monopoly can make positive economic profit in the short run and long run because barriers to entry

prevent the monopoly firm from facing competition and sharing the profit

• If a monopoly firm acts competitively, instead of producing where marginal revenue equals marginal

cost, the firm will produce where demand equals marginal cost (supply)

• When a monopoly is broken up into many small competitive firms, the monopoly’s marginal cost

curve becomes the competitive industry’s supply curve, and the competitive industry produces the quantity at which the market supply curve intersects the market demand curve

• When a monopoly firm takes over a perfectly competitive industry, the consumer surplus shrinks to

the triangular shape below the demand curve and above the new price where economic profit is maximized

- The part of the consumer surplus that is transferred to the monopoly is the area on the graph between the new monopoly price and the original perfectly competitive price, and between the y-axis and the new monopoly quantity

• A single-price monopoly is inefficient because marginal social benefit (demand curve) is greater than

marginal social cost at the quantity produced

• Any surplus – consumer surplus, producer surplus, or economic profit – is called economic rent and

rent seeking is the pursuit of wealth by capturing economic rent

• The cost of rent seeking is a fixed cost that must be added to a monopoly’s other costs

- Rent seeking and rent-seeking costs shifts the average total cost curve upward and until it touches the demand curve at which point economic profit becomes zero

- Consumer surplus is unaffected but the deadweight loss now includes the original deadweight loss triangle plus the lost producer surplus

• Price discrimination is selling a good or service at a number of different prices

- Price discrimination increases a monopoly’s economic profit by capturing consumer surplus

- For a perfect price-discriminating monopoly, the marginal revenue curve is the demand curve

• When a natural monopoly is regulated using a marginal cost pricing rule, price is set to marginal

cost

- But because price is less than long-run average cost, the monopoly incurs and economic loss

• An average cost pricing rule sets price equal to average total cost

- An average cost pricing rule is not an efficient way of regulating monopoly because at the quantity produced marginal benefit exceeds marginal cost

• A price cap is a price ceiling – a rule that specifies the highest price the firm is permitted to set

• Under a rate of return regulation, a firm must justify its price by showing that its return on capital

doesn’t exceed a specified target rate

- This gives the firm’s managers incentive to inflate costs by spending on luxury expenses

Chapter 14: Monopolistic Competition

• Monopolistic competition is a market structure in which a larger number of firms compete and each

firm produces a differentiated product

- Firms compete on product quality, price, and marketing, and are free to enter and exit

• The four-firm concentration ratio is the percentage of the value of sales accounted for by the four

largest firms in an industry (range is from almost 0 for perfect competition to 100 for monopoly)

• The Herfindahl-Hirschman Index (HHI) is the square of the percentage market share of each firm

summed over the largest 50 firms (range is from almost 0 for perfect competition to 10 000 for monopoly)

• In the short run, a firm in monopolistic competition produces the quantity at which marginal revenue

equals marginal cost

• When a firm in monopolistic competition is making an economic profit in the short run, other firms

enter the industry which decreases the demand for the good from each individual firm until each firm is making zero economic profit and the industry is in long-run equilibrium

• A firm has excess capacity if it produces below its efficient scale, which is the quantity at which

average total cost is a minimum (where MC = ATC)

- The loss that arises because the quantity produced is loss than the efficient quantity is offset by the gain that arises from having a greater degree of product variety

• When in long-run equilibrium, firms would not decrease their quantity because this would result in

ATC being greater than the market price thus creating an economic loss

• Advertising and packaging are the principal means firms use to achieve product differentiation if

actual differences are small

• A brand name provides information to consumers about the quality of a product, and is an incentive

to the producer to achieve a high and consistent quality standard

- Consumers also prefer to buy good from a firm with a brand name they know because they will know the quality they can expect

Chapter 15: Oligopoly

• Oligopoly is a market structure in which natural or legal barriers prevent the entry of new firms, and

a small number of firms compete

- Because barriers to entry exist, oligopoly consist of a small number of firms, each of which has a large share of the market

- Firms are interdependent because with a small number of firms, each firm’s actions influence the profits of all the other firms

• A duopoly is an oligopoly with two firms

• A cartel is a group of firms acting together – colluding – to limit output, raise price, and increase

economic profit

- Oligopoly firms can increase profits by forming a cartel

• The market is efficient if the firms within the oligopoly can combine quantities produced to meet

market demand at their efficient scale

• Game theory is a set of tools for studying strategic behaviour – behaviour that takes into account the

expected behaviour of others and the recognition of mutual interdependence

- All games share four common feature: rules, strategies, payoffs, and an outcome

• A collusive agreement is an agreement between two (or more) producers t firm a cartel to restrict

output, raise the price, and increase profits

• In a collusive agreement, all firms have the incentive to cheat because the payoff is better if they’re

the only ones to cheat than if all firms were to comply

• A dominant-strategy equilibrium is an equilibrium in which the best strategy of each player it to

cheat (confess) regardless of the strategy of the other player

• A cooperative equilibrium might occur if cheating is punished but is one in which making and

sharing the monopoly profit is possible

• A tit-for-tat strategy is one in which a player cooperates in the current period if the other player

cooperated in the previous period, but cheats in the current period if the other player cheated in the previous period

• A trigger strategy is one in which a player cooperates if the other player cooperates, but plays the

Nash equilibrium strategy forever thereafter if the other player cheats

• A contestable market is a market in which firms can enter and leave so easily that firms in the

market face competition from potential entrants

• Anti-combine law is the law that regulates oligopolies and prevents them from becoming monopolies

or behaving like monopolies

- Canada’s anti-combine law is defined in the Competition Act of 1986

• A merger is unlikely to be approve if the merger prevents competition or lessens competition

substantially

Chapter 16: Externalities

• An externality is a cost or a benefit that arises from production and falls on someone other than the

producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer

- We call an externality that imposes a cost a negative externality; and we call and externality that provides a benefit a positive externality

- We identify externalities as four types: negative production, negative consumption, positive production, and positive consumption

• A private cost of production is a cost that is borne by the producer of a good or service

• A social cost of production is a cost that is borne by the producer and by everyone else on whom the

cost falls

• An external cost is a cost of producing a good or service that is not borne by the producer but borne

by other people

• Marginal private cost (MC) is the cost of producing an additional unit of a good or service that is

borne by its producer

• Marginal external cost is the cost of producing an additional unit of a good or service that falls on

people other than the producer

• Marginal social cost (MSC) is the marginal cost incurred by the producer and by everyone else on

whom the cost falls – by society

• The Coase theorem is the proposition that if property rights exist, if only a small number of parties

are involved, and if transactions costs are low, then private transactions are efficient. There are no externalities because the transacting parties take all the costs and benefits into account. Furthermore, it doesn’t matter who has the property rights

• With marketable permits, firms that have a low marginal cost of reducing pollution sell their permits,

and firms that have a high marginal cost of reducing pollution buy permits

- Each firm buys or sells permits until its marginal cost of pollution equals the market price of a permit

- To find the price of a marketable permit take the total value of pollution an divide it by the number of permits given out

• A cap-and-trade scheme seeks an efficient outcome by assigning or selling pollution rights to

individual producers who are then free to trade permits with each other

- The price of a cap adjusts until it is equal to marginal external cost

• Marginal private benefit (MB) is the benefit that the consumer of a good or service receives from an

additional unit of it

• Marginal external benefit is the benefit from an additional unit of a good or service that people

other than its consumer enjoy

• Marginal social benefit (MSB) is the marginal benefit by society – by the consumer of a good or

service and by others

• Research and development creates an external benefit – with no intervention, we produce too little

research and development

Chapter 17: Public Goods and Common Resources

• A good is excludable if it is possible to prevent someone from enjoying its benefits

• A good is nonexcludable if it is impossible (or extremely costly) to prevent anyone from benefitting

from it

• A good is rival if one person’s use of it decreases the quantity available for someone else

• A good is nonrival if one person’s use if it does not decrease the quantity available for someone else

• A private good is both rival and excludable

• A public good is both nonrival and nonexcludable

• A common resource is rival and nonexcludable

• A natural monopoly good is nonrival and excludable

• The free-rider problem is that the market would provide an inefficiently small quantity of a public

good

• Rational ignorance is the decision not to acquire information because the cost of doing so exceeds

the expected benefit

• If voters are rationally ignorant, the bureaucrats will install more than the efficient capacity, because

the greater the capacity, the greater the budget

• Bureaucrats want to maximize their department’s budget because a bigger budget brings greater status

and more power

- Well-informed bureaucrats want to maximize their budget and rationally ignorant voters enable the bureaucrats to go some way towards achieving their goal

• The tragedy of the commons is the overuse of a common resource that arises when its users have no

incentive to conserve it and use it sustainably

• A common resource is used efficiently when the marginal social benefit equals the marginal social

cost

• Setting a production quota does not always achieve the efficient use of a common resource

- One reason is that marginal cost is not, in general, the same for every producer

- It is also in everyone’s self-interest to cheat and produce more than the quote

- Producers also have an incentive to lie to the government about their costs to get a bigger quota

• An individual transferable quota (ITQ) is a production limit that is assigned to an individual who is

then free to transfer (sell) the quote to someone else

- Equals the marginal social benefit minus the marginal cost

• The private property solution to the tragedy of the commons is available in some cases

- Property rights are sometimes difficult to assign and enforce

Chapter 18: Markets for Factors of Production

• The price of labour services is the wage rate

• The price in a capital services market is a rental rate

• The price of the services of land is a rental rate

• Entrepreneurs receive the profit or bear the loss that results from their business decisions

• The price of capital equipment is the price paid to acquire the piece of capital equipment which is

determined by supply and demand in the market for that piece of capital equipment

- The rental rate of capital is the price of capital services

• The value of marginal product of labour is the value to the firm of hiring one more unit of a factor of

production

- It equals the price of a unit of output multiplied by the marginal product of the factor of production

- Tells us what an additional worker is worth to a firm and the revenue that the firm earns by hiring one more worker

• A firm’s demand for labour curve is derived from its value of marginal product curve because the

value of marginal product diminishes as the quantity of labour employed increases, the demand for labour curve slopes downward

- To maximize profit, a firm hires the number of workers that sets the wage rate equal to the value of marginal product of labour

• A lower price for the firm’s output decreases the value of the marginal product of labour, which

decreases the demand for labour

• The reservation wage rate is the rate that – once exceeded – makes people willing to work

• A backward-bending labour supply curve is created by the substitution effect and the income

effect

- The substitution effect is the tendency for individuals to work longer hours at a higher wage rate

- The income effect induces individuals to increase demand for goods and services – leisure being one of those goods – once a certain wage rate has been met, individuals are more prone to trade longer working hours for more leisure time thus bending the labour supply curve backward

• A market supply curve shows the quantity of labour supplied by all households in a particular job

market

- Despite the fact that an individual’s labour supply curve eventually bends backward the market supply curve of labour slopes upward

• Unions try to influence wage rates by changing the demand for labour and the supply of labour, some

of the methods used by unions to increase the demand for labour of its members are to:

- Increase the value of marginal product of union members

- Encourage import restrictions

- Support minimum wage laws

- Support immigration restrictions

• A union can restrict supply by controlling entry into apprenticeship programs by influencing job

qualification standards

• A monopsony is a market in which there is a single buyer of labour

- The monopsony hires the quantity of labour at the point where the marginal cost of labour equals the value of marginal product

- In a monopsony, there is one employer and the wage rate is the lowest at which the firm can attract the labour it plans to hire

• Because a monopsony only demands the amount of labour where the MCL equals the VMP (D) then

it doesn’t want to produce at the equilibrium point

• In a monopsony, a minimum wage makes the supply of labour perfectly elastic and the marginal cost

of labour the same as the wage rate – the firm hires the quantity of labour at which the minimum wage line intersects the demand curve

• The demand for capital is derived from the value of marginal product of capital

- Profit-maximizing firms hire the quantity of capital services that makes the value of marginal product of capital equal to the rental rate of capital

• The demand for land is derived from the value of marginal product of land

- Profit-maximizing firms rent the quantity of land at which the value of marginal product of land is equal to the rental rate of land

- The supply of each particular block of land is perfectly inelastic because its quantity is fixed so the quantity supplied cannot be changed by people’s decisions

• The demand for a non-renewable natural resource is determined in part by the expected future price

of the resource and the value of marginal product of the resource

- The higher the expected future price of the resource, the greater is the present demand for the resource

• The supply of a non-renewable natural resource is determined by:

- The known reserves

- The scale of the current production facilities

- The expected future price

• The market fundamentals price and the equilibrium quantity are determined at the intersection of the

VMP curve and the MC curve

• If expectations about the future price of a non-renewable natural resource depart from what the

market fundamentals imply, speculation can drive a wedge between the equilibrium price and the market fundamentals price creating a new equilibrium price at the intersection of S and D

• The Hotelling Principle is the idea that the price of a non-renewable natural resource is expected to

rise at a rate equal to the interest rate

Chapter 19: Economic Inequality

• Market income equals the wages, interest, rent, and profit earned in factor markets before paying

income taxes

• Total income equals market income plus cash payments to households by governments

• After-tax income equals total income minus tax payments by households to governments

• Human capital is the knowledge and skill that people obtain from education, on-the-job training, adn

work experience

• Wealth is the value of the things that it owns at a point in time, while income is the amount that the

household receives over a given period of time

- Wealth is distributed more unequally than income because wealth data does not include the value of human capital, while the income data measures income from all wealth, including human capital

• Low-income cut-off is the income level below which a family normally spends 63.6% or more of its

income on food, shelter, and clothing

• The Gini ratio equals the ratio of the area between the line of equality and the Lorenz curve to the

entire area beneath the line of equality

- As the Gini ratio increases, the distribution of income becomes more unequal

• People who are most likely to earn large incomes have a post-graduate or professional degree, are

members of the labour force, and live in middle-aged households with a smaller number of children

• People who are most likely to earn small incomes have not completed high school, receive their

income in the form of a payment from the government, and live in a household with a single female parent

• The increase in the gap between the real average income of the richest and poorest Canadians tells us

what happened on average but it does not tell us what happened to the distribution of income

- Income inequality might have increased, decreased, or not changed

• A typical household’s income and wealth changes over its life cycle

- Income and wealth start out low, grow to a peak when the household’s workers reach retirement age, and then fall after retirement

• Technological change has decreased the value of marginal product of high-skilled workers and

decreased the value of marginal product of low-skilled workers

• Incomes can become more unequally distributed within countries when urban middle classes become

richer at a faster pace than rural farmers

• Incomes can become more unequally distributed within countries when average incomes in poorer

countries rise much faster than average incomes in rich countries

• Currently. The gap between the rich and the poor is widening within countries and narrowing across

countries

• The greater the human capital acquired, the smaller the supply of labour, the higher the wage rate

• If a group is discriminated against, their value of marginal product decreases and the value of

marginal product curve shifts leftward – the wage rate falls and employment decreases

• Individuals who are prejudiced have more incentive to buy from those of whom they are prejudiced

against due to their generally lower prices

• Winner-takes-all contests explain the trend toward greater inequality with an increasing share of total

income going to the super rich – the key is that globalization has increased the market reach of the winner and increased the spread between the winner and the runners-up

• If a generation has a high income and saves a large part of that income and leaves wealth to a

succeeding generation that has a lower income, this transfer decreases the degree of inequality

• A feature of intergenerational transfers of wealth that leads to increased inequality is wealth

concentration through marriage – people tend to marry within their own socioeconomic class (assortative marriage)

• The three main ways in which government in Canada redistribute income are through income taxes,

income maintenance programs, and subsidized services

• A progressive income tax is one that taxes income at an average rate that increases as income

increases

• A regressive income tax is one that taxes income at an average rate that decreases as income

increases

• A proportional income tax (flat-rate income tax) is one that taxes income at a constant average rate,

regardless of the level of income

• Income redistribution in Canada increases the share of total income received by the lowest 60% of

households and decreases the share of total income received by the highest 40% of households

• A major welfare challenge in Canada today is women who have not completed high school, have a

child (or children), and live without a partner

- Short-run solution is welfare, long-run solution is education and on-the-job training

• Social Security ensure a minimum level of income for senior citizens as well as cash payments t

retired or disabled workers or their surviving spouses

• Employment insurance provides an income to unemployed workers funded by employee and

employer contributions

• Welfare provides income maintenance for low-income families and persons