Economics Unit Six
What are the two key questions that drive policy decisions from the government?
1) Which problems/market failures should the government get involved with trying to solve? 2) To what extent should the government get involved?
Alcoa case
A 1945 case in which the courts ruled that the possession of monopoly power, no matter how reasonably that power had been used, was a violation of the antitrust laws; temporarily overturned the rule of reason applied in the U.S. Steel case.
Microsoft case
A 2002 antitrust case in which Microsoft was found guilty of violating the Sherman Act by engaging in a series of unlawful activities designed to maintain its monopoly in operating systems for personal computers; as a remedy the company was prohibited from engaging in a set of specific anticompetitive business practices.
Wheeler-Lea Act
A federal law that prevents businesses from deceiving customers through pricing strategies
Public good
A good or service that benefits lots of people, but for which it's difficult/impossible to get individuals to actually pay for.
Quasi-public goods
A good or service that can be priced and provided by private firms through the market system, but since the benefit of these goods flow well beyond the benefit of individual buyers (positive externality), the government provides them to prevent underproduction of these goods.
Unfunded liability
A government creates an unfunded liability when it commits to making a series of future expenditures without simultaneously committing to collect enough tax revenues to pay for those expenditures.
Regulatory capture
A government is said to suffer from regulatory capture if its regulations and enforcement activities come to be heavily influenced by the industry that it is supposed to be regulating. Otherwise expressed as when regulations favor the interests of regulated firms.
price ceiling
A legal maximum on the price at which a good can be sold
price floor
A legal minimum on the price at which a good can be sold
effective price floor
A legal minimum price set above the equilibrium price. This results in the quantity supplied exceeding the quantity demanded at the floor price. Hence a surplus exists in the market.
Deadweight loss
A measure of the inefficiency of a market (the extent of a market failure or the inefficiency).
Gini ratio
A numerical measure of the overall dispersion of income among households, families, or individuals; found graphically by dividing the area between the diagonal line and the Lorenz curve by the entire area below the diagonal line.
effective price ceiling
A price ceiling is a legal maximum price set below the equilibrium price. This results in the quantity demanded exceeding the quantity supplied at the ceiling price. Hence a shortage exists in the market.
per se violation
A restraint of trade that is so anticompetitive that it is deemed inherently (per se) illegal.
Unemployment Compensation
A system of government payments to people who are out of work and looking for a job.
Regressive tax
A tax for which the percentage of income paid in taxes decreases as income increases
Progressive tax
A tax for which the percentage of income paid in taxes increases as income increases
Proportional tax
A tax in which the average tax rate is the same at all income levels.
Loan guarantees
A type of investment subsidy in which the government agrees to guarantee (pay off) the money borrowed by a private company to fund investment projects if the private company itself fails to repay the loan.
What is the consequence of negative externalities?
An overallocation of society's resources (Quantity in the market > socially optimal quantity)
Special-interest effect
Any political outcome in which a small group ("special interest") gains substantially at the expense of a much larger number of persons who each individually suffers a small loss.
Principal-agent problems (politics)
Arise when tasks are delegated by one group of people (principals) to another group of people (agents) who have different interests. In politics, politics may have goals such as reelection that are inconsistent with the best interests of their constituents.
marginal-cost-marginal-benefit rule
As it applies to cost-benefit analysis, the tenet that a government project or program should be expanded to the point where the marginal cost and marginal benefit of additional expenditures are equal.
Transfer payments
Benefits given by the government directly to individuals. Transfer payments may be either cash transfers, such as Social Security payments and retirement payments to former government employees, or in-kind transfers, such as food stamps and low-interest loans for college education.
What causes positive externality (buyer side)?
Buyers do not want to pay for benefits they will get anyway. Quantity market < socially optimal quantity.
What is the effect of a tax on perfect competition?
Creates deadweight loss, shifts supply left, raising price but decreasing quantity
What is the effect of a subsidy on perfect competition?
Creates deadweight loss, shifts supply right, lowers price but increases quantity
Deadweight loss in negative externality
Deadweight loss is represented as a triangle on a graph depicting negative externalities. The vertex of the triangle is on the socially optimal price and quantity, while the "base" is the distance between the marginal social cost and the marginal private cost curves at the quantity where the marginal private benefit equals the marginal private costs.
Deadweight loss in a positive externality (buyer side)
Deadweight loss is represented as a triangle on a graph depicting positive externalities. The vertex is the socially optimal price, while the base is the distance between the marginal social benefit and marginal private benefit curves at the quantity where marginal social cost equals marginal private benefit.
Deadweight loss in a positive externality (seller side)
Deadweight loss is represented as a triangle on a graph depicting positive externalities. The vertex of the triangle is the socially optimal price, while the base is the distance between the marginal private benefit and marginal social cost at the quantity where marginal private benefit intersects marginal social benefit.
What causes inequalities in income?
Differences in ability, differences in education and training, disutility assumptions (discrimination), differences in age, geographic misalignment
What are the challenges caused by chronic deficits?
Economic inefficiency (deficits may allow the government to control and inefficiency large fraction of the economy's resources, so that it is underallocated in the public sector and overallocated in the government sector) and debt crisis (the government is unable to borrow more money due to investors lack of faith).
What is the problem with antitrust laws?
Economies of scale may only support one firm. If broken up, the monopoly will experience higher costs since it will produce in economies of scale rather than at the output where average total cost is minimized.
U.S. Steel case
Established rule of reason, under which not every monopoly is illegal. As long as monopolies do not resort to illegal acts against competitors to obtain its monopoly power, it is a "good trust."
Supplemental Nutrition Assistance program
Federal program that permits eligible low-income persons to obtain vouchers that can be used to buy food.
Why do economists consider perfect competition to be the ideal market structure?
Firms are forced to be allocatively efficient in the long run (price = MC). Firms are forced to be productively efficient in the long run (price = minimum ATC).
Entitlement programs
Government benefits that certain qualified individuals are entitled to by law, regardless of need.
Government in Circular Flow
Government buys products from the product market and employs resources from the resource market to provide goods and services to households and businesses. Government finances its expenditures through the net taxes (taxes minus transfer payments) it receives from households and businesses.
Fair-return pricing and where to find it
Government imposes a price ceiling that forces firms to sell at price where demand = ATC. Firm will then produce at quantity set by demand = ATC.
Socially optimal pricing and where to find it
Government imposes a price ceiling that forces firms to sell at the price where demand = MC. Firm will then produce the quantity set by demand = MC.
Fiscal policy
Government policy that attempts to manage the economy by controlling taxing and spending.
Monetary policy
Government policy that attempts to manage the economy by controlling the money supply and thus interest rates.
Mixed Economy
Government, acting as an agent of the people, gets involved in "fixing" market failures.
Lorenz Curve
Graph showing how much the actual distribution of income differs from an equal distribution
What causes deadweight loss?
Imperfect competition, externalities, or taxes and subsidies when there are no externalities
Why do perfect competitions lack positive or negative externalities?
In a perfect competition, Marginal Private Cost = Marginal Social Cost = Supply, while Marginal Private Benefit = Marginal Social Benefit = Demand.
Income vs wealth
Income comes from wages, rents, interest, and profits, while wealth is the value of assets such as property, stocks, and bonds.
How can the government alleviate market failures?
Looking out for either buyers or sellers in less-than-perfect competition markets, forcing buyers and sellers in a market to bear the full cost of their choices, providing things that free markets really can't take care of, dealing with social welfare and wealth inequality issues
Sherman Act of 1890
Makes monopolizing a market, cartels, and other collusive arrangements illegal
Characteristics of perfect competition
Many buyers and many sellers, every participant has full access to info, everyone is free to enter/exit, standardized product, consumer and producer surplus are maximized.
Allocative efficiency occurs at the market equilibrium market when three conditions are met:
Marginal benefit = marginal cost, maximum willingness to pay = maximum acceptable price, total surplus (=sum of consumer and producer surplus) is at a maximum
How does a pure free market economy answer the three economic questions?
Markets answer the three questions (intersection of supply and demand).
Why do governments feel the need to regulate monopoly markets?
Monopolies are not productively or allocatively efficient. Productive efficiency means that the quantity should be where ATC is lowest, but in monopolies, MC = MR isn't at that point. Allocative efficiency means that the price/MB = MC, but in a monopoly, quantity is at MR = MC.
Does socially optimal pricing lead to deadweight loss? If so, where would it be located?
No, it does not lead to deadweight loss, because the firm is producing at the socially optimal quantity (where demand = MC).
Optimal reduction of an externality
Occurs when society's marginal cost and marginal benefit of reducing that externality are equal (MC = MB).
Free-rider problem
Once a producer has provided a public good, everyone, including non-payers, can obtain the benefit.
How does economies of scale act as a barrier to entry?
Only a few large firms, or a single large firm, can satisfy demand at lowest average total cost.
Clayton Act of 1914
Outlawed price discrimination, tying contracts that force consumer to purchase another product, prohibits acquisition of stocks of competing corporations, prohibits formation of interlocking directorates (where director of one firm is a board member of competing firm)
Supply-side market failures
Over-allocations of resources that occur when private supply curves do not reflect the full cost of producing a good or service.
statistical discrimination
People are judged on the basis of the average characteristics of the group to which they belong rather than their personal characteristics or productivity.
Negative externalities (spillover cost)
People outside the market are being harmed by the decisions made within a market (bearing a cost they shouldn't have to).
Positive externality (spillover benefit)
People outside the market are benefiting by the decisions made within a market (getting a benefit they haven't really paid for)
Discrimination
Practice of according people inferior treatment in hiring, wage rate, occupational access, promotion, on the basis of a factor such as race, gender, or ethnicity.
What is the effect of a price ceiling on consumer surplus, producer surplus, and deadweight loss in a perfect competition?
Price ceilings create deadweight loss, which describes a loss to society of producer and consumer surplus. Deadweight loss on a price ceiling has its point at the socially optimal price and quantity and its base is the distance between the supply and demand curve at the point producers are willing to accept (where the price intersects the supply curve).
What is the effect of a price floor on consumer surplus, producer surplus, and deadweight loss in a perfect competition?
Price floors create deadweight loss, which describes a loss to society of producer and consumer surplus. Deadweight loss on a price floor has its point at the socially optimal price and quantity and its base is the distance between the supply and demand curves at the point consumers are willing to accept (where the price intersects the demand curve).
social insurance programs
Programs to help the elderly, ill, and unemployed if the claimant has paid into them
What are the alternative means government can use to control market forces?
Regulatory agencies and antitrust laws
Regulations
Rules set and enforced by the government relating to economic and business activity.
Characteristics of monopolies
Single seller, no close substitutes, price maker, blocked entry, nonprice competition
collective action problem (and reasons why it exists)
Smaller groups can sometimes achieve political victories against larger groups because of the collective action problem, in which larger groups are more difficult to organize and motivate than smaller groups. This is because the larger the group, the smaller each member's share of the benefits. Additionally, the larger the group, the higher its organizing costs.
What are the two types of prices that government can set to "correct" monopolies?
Socially optimal pricing and fair-return pricing
What is the effect of socially optimal pricing on firms?
Socially optimal pricing causes the firms to experience an economic loss because the price ceiling leads to a price below the ATC curve.
Earmarks
Special spending projects that are set aside on behalf of individual members of Congress for their constituents. They may reallocate some of society's scarce resources from highly-valued uses to lower-valued uses.
What are the three options the government has to correct the underallocation of resources resulting from a positive externality?
Subsidizing the buyers to purchase the product, subsidizing the firms to produce the product (reduces production costs), or government provisions (the government may provide the product free to everyone).
Payroll taxes
Taxes based on wages and salaries used to finance compulsory federal programs for retired workers: Social Security and Medicare.
Property taxes
Taxes paid by anyone who owns property such as land, a home or commercial real estate.
Pigovian taxes
Taxes that are used as an incentive for producers to cut back on an activity that creates an external cost. Used to make marginal social cost equal to marginal private cost.
DuPont cellophane case
The antitrust case brought against DuPont in which the U.S. Supreme Court ruled (in 1956) that while DuPont had a monopoly in the narrowly defined market for cellophane, it did not monopolize the more broadly defined market for flexible packaging materials. It was thus not guilty of violating the Sherman Act.
Rent-seeking
The appeal to government for special benefits at taxpayers' or someone else's expense. Those engaged in rent seeking behavior are attempting to use government influence to get paid more for providing a good or service than the minimum amount you would actually have to pay for that food or service.
marginal private benefit
The benefit from an additional unit of a good or service that the consumer of that good or service receives.
equality-efficiency trade-off
The decrease in economic efficiency that may accompany a decrease in income inequality; the presumption that some income inequality is required to achieve economic efficiency.
Positive Externality Graph (seller side)
The demand is a downward sloping marginal social benefit curve. There are two supply curves, one that represents the marginal private benefit and another that represents the marginal social cost. The marginal private benefit curve is greater than the marginal social cost curve, representing how the benefits experienced by society are more significant than the costs in a positive externality.
Negative Externality graph
The demand is the downward sloping marginal private benefit curve. There are two parallel lines intersecting the demand curve, the marginal social cost and the marginal private cost curve. The marginal social cost curve is higher than the marginal private cost curve, representing how the marginal social cost is greater than marginal private costs in a negative externality.
Marginal Social Benefit
The extra benefit or utility to society of consuming an additional unit of output, including both the private benefit and the external benefits.
Marginal Social Cost
The extra cost to society of producing an additional unit of output, including both the private cost and the external costs.
How does the federal tax system vary with the state and local tax system?
The federal tax system is progressive (higher-income groups pay more taxes), while the state and local tax system is regressive (as income rises, property taxes and sales taxes fall).
When demand is perfectly inelastic
The incidence of the tax falls entirely on consumers
What is the market price and quantity in a positive externality? (seller side)
The intersection between the marginal private benefit and marginal social benefit.
What is the market price and quantity in negative externality?
The intersection between the marginal private cost and marginal private benefit curves.
What is the socially optimal price and quantity in a positive externality? (seller side)
The intersection between the marginal social cost and marginal social benefit.
What is the socially optimal price and quantity in a negative externality?
The intersection between the marginal social cost and the marginal private benefit curves.
What is the market price and quantity in a positive externality? (buyer side)
The intersection of the marginal social cost and marginal private benefit curves.
What is the socially optimal price and quantity in a positive externality? (buyer side)
The intersection of the marginal social cost and marginal social benefit curves.
The more inelastic demand for the product
The larger the portion of the tax that is shifted to consumers
Deregulation
The lifting of government restrictions on business, industry, and professional activities. It solves the problem of regularly capture but only works if the deregulated industry becomes competitive and is automatically guided towards productive and allocative industry.
Efficiency loss of the tax
The loss of net benefits to society because a tax reduces the production and consumption of a taxed good below the level of allocative efficiency, where marginal benefit (demand) and marginal cost are equal. Also called the deadweight loss of the tax.
Describe where producer surplus, consumer surplus, and deadweight loss are on a monopoly graph
The point of the deadweight loss triangle is the socially optimal price (where demand = ATC), while the base is the distance from the demand and the marginal revenue curves at the quantity where MR = MC. Producer surplus is to the left of the distance between the marginal revenue and demand curves where MR = MC and under the price set by demand at MR = MC. Consumer surplus is above the price at demand where MR = MC and below the demand curve.
What is the effect on price when the government puts a subsidy on the seller to fix a positive externality?
The price decreases
What is the effect on price when the government puts a subsidy on the buyer to fix a positive externality?
The price increases
dilemma of regulation
The regulated socially optimal price imposed upon by a monopoly (Price = MC) that achieves allocative efficiency is likely to result in a loss in the monopoly.
In a perfect competition, the market price and quantity is equal to
The socially optimal price and quantity.
Political corruption
The unlawful misdirection of governmental resources or actions that occurs when government officials abuse their entrusted powers for personal gain. For instance, when a government official must be bribed to do what he should be doing as part of his job, or being bribed to do something they are not legally entitled to do.
Positive externality Graph (buyer side)
There is a single supply curve, the upward sloping marginal social cost. There are two demand curves, the downward sloping marginal social benefit and the marginal private benefit. The marginal social benefit is greater than the marginal private benefit, representing how society experiences greater benefits than the consumer alone.
What is the effect of fair-return pricing on firms?
They are able to produce normal profits because the revenue covers the costs.
What are the two options government has for regulating monopolies?
They can either regulate price/output or create antitrust laws to break up monopolies.
How does the government deal with "spillover" benefits in a positive externality? (buyer side)
They put a subsidy on consumers, shifting the marginal private benefit demand curve right so that the new equilibrium is at the socially optimal quantity.
How does the government deal with "spillover" benefits in a positive externality? (seller side)
They put a subsidy on suppliers, which will shift the supply curve right so that the new equilibrium is at the socially optimal quantity.
How does the government deal with "spillover" costs in a negative externality?
They put a tax on suppliers, which will shift the supply curve left so that the marginal private cost becomes the marginal social cost.
Demand-side market failures
Under-allocations of resources that occur when private demand curves do not reflect consumer's full willingness to pay for a good or service.
What is the consequence of positive externalities?
Underallocation of society's resources (Quantity in the market < socially optimal quantity)
Allocative efficiency
Value from the goods (price) is equal to the cost of producing the goods (marginal cost)
How do you find the per-unit tax?
Vertical distance between supply curves (supply and supply+tax or supply and supply+subsidy)
Taste-for-discrimination factor
Views discrimination as resulting from a preference or taste for which the discriminator is willing to buy.
Three economic questions
What to produce? How to produce? For whom to produce?
Budget deficit
When tax revenues are less than government spending during a particular year, which leads the government to borrow.
Taxes and Subsidies
When the government takes money away from (taxes) or gives money (subsidies) to private individuals or firms.
What is the optimal quantity of a public good?
Where marginal benefit = marginal cost
Does fair-return pricing lead to deadweight loss? If so, where would it be located?
Yes, because the firm is not producing at the socially optimal quantity (where demand = MC). The point of the deadweight loss triangle is the socially optimal quantity (where demand=MC), while the base is the distance between the demand and MC curves at the price where demand = ATC.
Earned Income Tax Credit
a "negative income tax" that provides income to very poor individuals in lieu of charging them federal income taxes
Standard Oil Case
a 1911 antitrust case in which Standard Oil was found guilty of violating the Sherman Act by illegally monopolizing the petroleum industry
Federal Trade Commission
a federal agency established in 1914 to investigate and stop unfair business practices
noncash transfers
a government transfer payment in the form of goods and services rather than money, for example, food stamps, housing assistance, and job training; also called in-kind transfers
Discrimination coefficient
a measure of the cost or disutility of prejudice; the monetary amount an employer is willing to pay to hire a preferred worker rather than a non-preferred worker.
Productive efficiency
a situation in which a good or service is produced at the lowest possible cost (price = minimum ATC)
Personal income tax
a tax levied on the taxable income of individuals, households, and unincorporated firms
lump-sum tax (and its impact)
a tax of a fixed amount paid by all taxpayers. Affects fixed costs, but not MC.
Per-unit tax
a tax of a specific amount on each unit of a product sold. Affects MC, which will shift left.
corporate income tax
a tax on the value of a company's profits (the difference between its total revenue and total costs).
Sales taxes
added to the price of goods and services at the time of purchase (fall on a wide range of products)
Barriers to entry (examples)
business practices or conditions that make it difficult for new firms to enter the market, such as licenses, patents, economies of scale, ownership of essential resources, or advertising/slashing prices.
Government failure
economically inefficient outcomes caused by shortcomings in the public sector.
private goods
excludable (sellers can keep people who do not pay for a product from obtaining its benefits) and rival (when one person buys and consumes, it is not available for another) goods
Celler-Kefauver Act
extended the government's authority to control mergers
Supplemental Security Income
federal programs that include food stamps and payments to the disabled and aged
public assistance programs
government programs that pay benefits to those who are unable to earn income (because of permanent disabilities or because they have very low income and dependent children); financed by general tax revenues and viewed as public charity (rather than earned rights)
Temporary Assistance for Needy Families
income taxes from workers fund payments to poor families
Medicaid
income taxes fund health care costs for poor families
public goods
non-excludable (no way of excluding individuals from the benefit of the good) and non-rival (one person's consumption of a good or service does not prevent consumption of the good by others)
Medicare
payroll taxes from current workers fund healthcare costs for retired people
Social Security
payroll taxes from current workers fund pension payments to retired people
What are the four sources of federal tax revenues?
personal income tax, payroll tax, corporate income tax, excise tax
Efficiency losses
reductions of combined consumer and producer surplus tha result from both underproduction and overproduction
cease and desist order
ruling requiring a company to stop an unfair business practice that reduces or limits competition
Market failures
situations in which markets do not provide what society wants or needs, or when the answers to the three economic questions do not align with society's interests
Government purchases
spending on goods and services by local, state, and federal governments
total tax revenue
tax times quantity sold
Excise taxes
taxes charged on the purchase of specific goods and services (usually applied to select commodies)
Consumer surplus and where to find it
the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. Consumer surplus is above the price and below the demand curve.
horizontal merger
the combination of two or more firms competing in the same market with the same good or service
vertical merger
the combination of two or more firms involved in different stages of producing the same good or service
marginal private cost
the cost of producing an additional unit of a good or service that is borne by the producer of that good or service
Producer surplus and where to find it
the difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives. Producer surplus is below the price and above the supply curve.
Income mobility
the extent to which income receivers move from one part of the income distribution to another over some period of time
Legal cartel theory of regulation
the hypothesis that some industries seek regulation or want to maintain regulation so that they may form or maintain a legal cartel
ability-to-pay principle
the idea that taxes should be levied on a person according to their income and wealth; thus, those who have larger incomes pay more in taxes.
When demand is perfectly elastic
the incidence of the tax falls entirely on sellers
conglomerate merger
the joining of firms in completely unrelated industries
tax incidence
the manner in which the burden of a tax is shared among participants in a market
Poverty rate
the percentage of people who live in households with income below the official poverty line
Public interest theory of regulation
the presumption that the purpose of the regulation of an industry is to protect the public (consumers) from abuse of the power possessed by natural monopolies
marginal tax rate
the rate at which the tax is paid on each additional unit of taxable income; for example, a household with an income of 80,000 pays a certain tax for the money between 1-18,000, 18,000-50,000, and 50,000-80,000.
Benefits-received principle
those who benefit most from government-supplied goods or services should pay the taxes necessary to supply them.
average tax rate
total taxes paid divided by total income