Exam Midterm 2 Prep Sheet

Foreign Exchange Market (What happens in a domestic market when there is international trade?)

Foreign exchange market (forex, or FX, market), institution for the exchange of one country's currency with that of another country. Foreign exchange markets are actually made up of many different markets, because the trade between individual currencies—say, the euro and the U.S. dollar—each constitutes a market. The foreign exchange markets are the original and oldest financial markets and remain the basis upon which the rest of the financial structure exists and is traded: foreign exchange markets provide international liquidity, preferably with relative stability. A foreign exchange market is a 24-hour over-the-counter (OTC) and dealers' market, meaning that transactions are completed between two participants via telecommunications technology. The currency markets are also further divided into spot markets—which are for two-day settlements—and the forward, swap, interbank futures, and options markets. London, New York, and Tokyo dominate foreign exchange trading. The currency markets are the largest and most liquid of all the financial markets; the triennial figures from the Bank for International Settlements (BIS) put daily global turnover in the foreign exchange markets in trillions of dollars. It is sobering to consider that in the early 21st century an annual world trade's foreign exchange is traded in just less than every five days on the currency markets, although the widespread use of hedging and exchanges into and out of vehicle currencies—as a more liquid medium of exchange—means that such measures of financial activity can be exaggerated. The original demand for foreign exchange arose from merchants' requirements for foreign currency to settle trades. However, now, as well as trade and investment requirements, foreign exchange is also bought and sold for risk management (hedging), arbitrage, and speculative gain. Therefore, financial, rather than trade, flows act as the key determinant of exchange rates; for example, interest rate differentials act as a magnet for yield-driven capital. Thus, the currency markets are often held to be a permanent and ongoing referendum on government policy decisions and the health of the economy; if the markets disapprove, they will vote with their feet and exit a currency. However, debates about the actual versus potential mobility of capital remain contested, as do those about whether exchange rate movements can best be characterized as rational, "overshooting," or speculatively irrational. The increasingly asymmetric relationship between the currency markets and national governments represents a classic autonomy problem. The "trilemma" of economic policy options available to governments are laid out by the Mundell-Fleming model. The model shows that governments have to choose two of the following three policy aims: (1) domestic monetary autonomy (the ability to control the money supply and set interest rates and thus control growth); (2) exchange rate stability (the ability to reduce uncertainty through a fixed, pegged, or managed regime); and (3) capital mobility (allowing investment to move in and out of the country). Historically, different international monetary systems have emphasized different policy mixes. For instance, the Bretton Woods system emphasized the first two at the expense of free capital movement. The collapse of the system destroyed the stability and predictability of the currency markets. The resultant large fluctuations meant a rise in exchange rate risk (as well as in profit opportunities). Governments now face numerous challenges that are often captured under the term globalization or capital mobility: the move to floating exchange rates, the political liberalization of capital controls, and technological and financial innovation. In the contemporary international monetary system, floating exchange rates are the norm. However, different governments pursue a variety of alternative policy mixes or attempt to minimize exchange rate fluctuations through different strategies. For example, the United States displayed a preference for ad hoc international coordination, such as the Plaza Agreement in 1985 and the Louvre Accord in 1987, to intervene and manage the price of the dollar. Europe responded by forging ahead with a regional monetary union based on the desire to eliminate exchange rate risk, whereas many developing governments with smaller economies chose the route of "dollarization"—that is, either fixing to or choosing to have the dollar as their currency. The international governance regime is a complex and multilayered bricolage of institutions, with private institutions playing an important role; witness the large role for private institutions, such as credit rating agencies, in guiding the markets. Also, banks remain the major players in the market and are supervised by the national monetary authorities. These national monetary authorities follow the international guidelines promulgated by the Basel Committee on Banking Supervision, which is part of the BIS. Capital adequacy requirements are to protect principals against credit risk, market risk, and settlement risk. Crucially, the risk management, certainly within the leading international banks, has become to a large extent a matter for internal setting and monitoring. The series of contagious currency crises in the 1990s—in Mexico, Brazil, East Asia, and Argentina—again focused policy makers' minds on the problems of the international monetary system. Moves, albeit limited, were made toward a new international financial architecture. Most importantly, these crises led to the establishment of the Financial Stability Forum (since 2009 the Financial Stability Board), which investigated the problems of offshore, capital flows, and hedge funds; and the G20, which attempted to broaden the international regime's membership and thus deepen its legitimacy. In addition, there were calls for a currency transaction tax, named after Nobel Laureate James Tobin's proposal, from many civil society nongovernmental organizations as well as some governments. The success of international monetary reform is a crucial issue for governments and their autonomy, firms and the stability of their investments, and citizens who ultimately are those who absorb these effects as they are transmitted into everyday life.

Price Floors ("Too much" output MC > MWTP)

A price floor is the lowest legal price a commodity can be sold at. Price floors are used by the government to prevent prices from being too low. The most common price floor is the minimum wage--the minimum price that can be payed for labor. Price floors are also used often in agriculture to try to protect farmers. For a price floor to be effective, it must be set above the equilibrium price. If it's not above equilibrium, then the market won't sell below equilibrium and the price floor will be irrelevant. Price Floor Drawing a price floor is simple. Simply draw a straight, horizontal line at the price floor level. This graph shows a price floor at $3.00. You'll notice that the price floor is above the equilibrium price, which is $2.00 in this example. A few crazy things start to happen when a price floor is set. First of all, the price floor has raised the price above what it was at equilibrium, so the demanders (consumers) aren't willing to buy as much quantity. The demanders will purchase the quantity where the quantity demanded is equal to the price floor, or where the demand curve intersects the price floor line. On the other hand, since the price is higher than what it would be at equilibrium, the suppliers (producers) are willing to supply more than the equilibrium quantity. They will supply where their marginal cost is equal to the price floor, or where the supply curve intersects the price floor line. As you might have guessed, this creates a problem. There is less quantity demanded (consumed) than quantity supplied (produced). This is called a surplus. If the surplus is allowed to be in the market then the price would actually drop below the equilibrium. In order to prevent this the government must step in. The government has a few options: 1. They can buy up all the surplus. For a while the US government bought grain surpluses in the US and then gave all the grain to Africa. This might have been nice for African consumers, but it destroyed African farmers. 2. They can strictly enforce the price floor and let the surplus go to waste. This means that the suppliers that are able to sell their goods are better off while those who can't sell theirs (because of lack of demand) will be worse off. Minimum wage laws, for example, mean that some workers who are willing to work at a lower wage don't get to work at all. Such workers make up a portion of the unemployed (this is called "structural unemployment"). 3. The government can control how much is produced. To prevent too many suppliers from producing, the government can give out production rights or pay people not to produce. Giving out production rights will lead to lobbying for the lucrative rights or even bribery. If the government pays people not to produce, then suddenly more producers will show up and ask to be payed. 4. They can also subsidize consumption. To get demanders to purchase more of the surplus, the government can pay part of the costs. This would obviously get expensive really fast. Although some of those ideas may sound stupid, the US government has done them. In the end, a price floor hurts society more than it helps. It may help farmers or the few workers that get to work for minimum wage, but it only helps those people by hurting everyone else. Price floors cause a deadweight welfare loss. A price floor with deadweight welfare loss shown A deadweight welfare loss occurs whenever there is a difference between the price the marginal demander is willing to pay and the equilibrium price. The deadweight welfare loss is the loss of consumer and producer surplus. In other words, any time a regulation is put into place that moves the market away from equilibrium, beneficial transactions that would have occured can no longer take place. In the case of a price floor, the deadweight welfare loss is shown by a triangle on the left side of the equilibrium point, like in the graph. The area of the triangle is the amount of money that society loses.

Actual Price (The effect of each failure compared with the outcome in a competitive market--public good--the possibilities of market failure)

(The effect of each failure compared with the outcome in a competitive market--public good--the possibilities of market failure)

Disposal Problem (Price Floors--"Too Much" Output MC > MWTP)

A few crazy things start to happen when a price floor is set. First of all, the price floor has raised the price above what it was at equilibrium, so the demanders (consumers) aren't willing to buy as much quantity. The demanders will purchase the quantity where the quantity demanded is equal to the price floor, or where the demand curve intersects the price floor line. On the other hand, since the price is higher than what it would be at equilibrium, the suppliers (producers) are willing to supply more than the equilibrium quantity. They will supply where their marginal cost is equal to the price floor, or where the supply curve intersects the price floor line. As you might have guessed, this creates a problem. There is less quantity demanded (consumed) than quantity supplied (produced). This is called a surplus. If the surplus is allowed to be in the market then the price would actually drop below the equilibrium. In order to prevent this the government must step in. The government has a few options: 1. They can buy up all the surplus. For a while the US government bought grain surpluses in the US and then gave all the grain to Africa. This might have been nice for African consumers, but it destroyed African farmers. 2. They can strictly enforce the price floor and let the surplus go to waste. This means that the suppliers that are able to sell their goods are better off while those who can't sell theirs (because of lack of demand) will be worse off. Minimum wage laws, for example, mean that some workers who are willing to work at a lower wage don't get to work at all. Such workers make up a portion of the unemployed (this is called "structural unemployment"). 3. The government can control how much is produced. To prevent too many suppliers from producing, the government can give out production rights or pay people not to produce. Giving out production rights will lead to lobbying for the lucrative rights or even bribery. If the government pays people not to produce, then suddenly more producers will show up and ask to be payed. 4. They can also subsidize consumption. To get demanders to purchase more of the surplus, the government can pay part of the costs. This would obviously get expensive really fast. Although some of those ideas may sound stupid, the US government has done them. In the end, a price floor hurts society more than it helps. It may help farmers or the few workers that get to work for minimum wage, but it only helps those people by hurting everyone else. Price floors cause a deadweight welfare loss.

Amount bought and sold (The effect of each failure compared with the outcome in a competitive market--public good--the possibilities of market failure)

A market failure occurs whenever the individuals in a group end up worse off than if they had not acted in perfectly rational self-interest. Such a group either incurs too many costs or receives too few benefits. Even though the concept seems simple, it can be misleading and easy to misidentify. Contrary to what the name implies, market failure does not describe inherent imperfections in the market economy — there can be market failures in government activity, too. One noteworthy example is rent seeking by special interest groups. Special interest groups can gain a large benefit by lobbying for small costs on everyone else, such as through a tariff. When each small group imposes its costs, the whole group is worse off than if no lobbying had taken place. Additionally, not every bad outcome from market activity counts as a market failure. Nor does a market failure imply that private market actors cannot solve the problem. On the flip side, not all market failures have a potential solution, even with prudent regulation or extra public awareness.

Monopoly ("too little" output MC<MWTP-- Possibilities of Market Failure)

A monopoly is a kind of structure that exists when one company or supplier produces and sells a product. If there is a monopoly in a single market with no other substitutes, it becomes a "pure monopoly." When there are multiple sellers in an industry and there are many similar substitutes for the goods being produced, and companies keep some power in the market, then it is called monopolistic competition. High or no barriers to entry: Other competitors are not able to enter the market Single seller: There is only one seller in the market. In this instance, the company becomes the same as the industry it serves. Price maker: The company that operates the monopoly decides the price of the product that it will sell. Price discrimination: The firm can change the price or quantity of the product at any time. A monopoly is characterized by the absence of competition, which can lead to high costs for consumers, inferior products and services, and corrupt behavior. A company that dominates a business sector or industry can use that dominance to its advantage, and at the expense of others. It can create artificial scarcities, fix prices and otherwise circumvent natural laws of supply and demand. It can impede new entrants into the field, discriminate and inhibit experimentation or new product development, while the public — robbed of the recourse of using a competitor — is at its mercy. A monopolized market often becomes an unequal, and even inefficient, one. Mergers and acquisitions among companies in the same business are highly regulated and researched for this reason. Firms are typically forced to divest assets if federal authorities think a proposed merger or takeover will violate anti-monopoly laws.

Negative Externality ("Too much" output--True or social MC>MWTP-- Possibility of market failure)

A negative externality is a cost that is suffered by a third party as a result of an economic transaction. In a transaction, the producer and consumer are the first and second parties, and third parties include any individual, organisation, property owner, or resource that is indirectly affected. Externalities are also referred to as spill over effects, and a negative externality is also referred to as an external cost. Some externalities, like waste, arise from consumption while other externalities, like carbon emissions from factories, arise from production. Externalities commonly occur in situations where property rights over assets or resources have not been allocated, or are uncertain. For example, no one owns the oceans and they are not the private property of anyone, so ships may pollute the sea without fear of being taken to court. The importance of establishing property rights is central to the ideas of influential Peruvian economist, Hernando De Soto, who has widely argued that successful market economies need a widespread allocation of property rights to enable economies to fully develop.

Positive Externality ("too little" output MC< true or social marginal benefits-- Possibilities of Market Failure)

A positive externality is a benefit that is enjoyed by a third-party as a result of an economic transaction. Third-parties include any individual, organisation, property owner, or resource that is indirectly affected. While individuals who benefit from positive externalities without paying are considered to be free-riders, it may be in the interests of society to encourage free-riders to consume goods which generate substantial external benefits. Most merit goods generate positive consumption externalities, which beneficiaries do not pay for. For example, with healthcare, private treatment for contagious diseases provides a considerable benefit to others, for which they do not pay. Similarly, with education, the skills acquired and knowledge learnt at university can benefit the wider community in many ways. Unlike the case of negative externalities, which should be discouraged to achieve a socially efficient allocation of scarce resources, positive externalities should be encouraged.

Rationing Problem (Price Ceilings---"too little" output MC < MWTP)

A price ceiling is a government-imposed limit on the price charged for a product. If the price ceiling is set below the market equilibrium price, a shortage will occur. This leads to a rationing problem. A rationing mechanism is a system for choosing who gets how many goods during a shortage. There have been many cases throughout history in which governments have been unwilling to let markets adjust to market-clearing prices. Instead, they have established either price ceilings, which are prices above which it is illegal to buy or sell, or price floors, which are prices below which it is illegal to buy or sell. If a price ceiling is placed below the market-clearing price, as Pc is in the picture below, the market-clearing price of Pe becomes illegal. At the ceiling price, buyers want to buy more than sellers will make available. In the graph, buyers would like to buy amount Q4 at price Pc, but sellers will sell only Q1. Because they cannot buy as much as they would like at the legal price, buyers will be out of equilibrium. The normal adjustment that this disequilibrium would set into motion in a free market, an increase in price, is illegal; and buyers or sellers or both will be penalized if transactions take place above Pc. Buyers are faced with the problem that they want to buy more than is available. This is a rationing problem. Price ceilings are not the only sort of price controls governments have imposed. There have also been many laws that establish minimum prices, or price floors. The graph below illustrates a price floor with price Pf. At this price, buyers are in equilibrium, but sellers are not. They would like to sell quantity Q2, but buyers are only willing to take Q3. To prevent the adjustment process from causing price to fall, government may buy the surplus, as the U.S. government has done in agriculture and in precious metals. If it does not buy the surplus, government must penalize either buyers or sellers or both who transact below the price floor, or else price will fall. Because there is no one else to absorb the surplus, sellers will. Rationing is necessary to deal with scarcity.1 When an item is scarce, people must sacrifice something in order to get as much of the item as they would like to have. There are some goods that are not scarce. Air is an example--it is free to all who want to breathe it. Ice is not scarce in Greenland. But almost all other goods are scarce. Price is a way to ration goods. It deprives those who do not have enough income or desire for a product. The function of price as a rationer is most clearly seen when price is prohibited from acting as a rationer, so that some other method of rationing (such as queuing or coupon rationing) must emerge or be developed.

Price Ceilings ("too little" output (MC < MWTP)

A price ceiling is the maximum price a seller is allowed to charge for a product or service. Price ceilings are usually set by law and limit the seller pricing system to ensure fair and reasonable business practices. Price ceilings are often set for essential expenses; for example, some areas have rent ceilings to protect renters from climbing rent prices. Price ceilings are regulations designed to protect low-income individuals from not being able to afford important resources. However, many economists question their effectiveness for several reasons. For example, price ceilings have no effect if the equilibrium price of the good is below the ceiling. In contrast, if the ceiling is set below the equilibrium level, a dead-weight loss is created. Price ceilings, while advantageous for many reasons, can also carry disadvantages. For example, in the 1970s, when the government imposed a price ceiling on gasoline prices, the price of gas was relatively low. To take advantage of those low prices, consumers waited in long lines to buy gas. In addition to the inconvenience of having to spend a lot of time getting gas, this caused a shortage. Arguably, if the government had simply let prices increase, consumers would have been forced to conserve, lines would have stayed short and a shortage may not have ensued. Another risk of price ceilings is retailers may attempt to get around these regulations with fees. For example, a business may sell an item below the price ceiling but may assess fees for related products or services to indirectly drive up the price past the ceiling. Both price ceilings and floors are forms of price controls. While a price ceiling dictates the maximum price of a good or service, a price floor refers to the lowest price for which a good or service may be sold. Both of these concepts are based on the idea of protecting the consumer or the market. However, price ceilings can be linked with shortages. Namely, if too many consumers can afford a good, they may all buy it, and supplies may fall short. Conversely, price floors can correlate with surpluses. If the floor makes the product or service unaffordable, few people are likely to buy it, creating a surplus. To understand how price ceilings cause shortages, imagine an area has been devastated by a tornado. As the community rebuilds, there is high demand for plywood, and to boost profits, businesses increase the price of plywood. However, the community protests this increase and demands a price ceiling. The city complies and forbids retailers from charging over a certain amount for plywood. In turn, as prices fall, suppliers become less willing to sell plywood to the stores in the area due to their diminishing profit margin, and a shortage ensues.

Quotas ("too little" specialization-- The effects of market distortions)

A quota is a government-imposed trade restriction that limits the number, or monetary value, of goods that can be imported or exported during a particular period. Quotas are used in international trade to help regulate the volume of trade between countries. They are sometimes imposed on specific goods to reduce imports and increase domestic production. In theory, quotas boost domestic production by restricting foreign competition. Quotas are different than tariffs or customs, which place a tax on imports or exports in and out of a country. Both quotas and tariffs are protective measures imposed by governments to try to control trade between countries, but quotas focus on limiting the quantities of a particular good that will be accepted while tariffs impose a specific fee on those goods destined for entry into a country. The fees associated with tariffs are designed to raise the overall cost to the producer or supplier seeking to sell goods within a country. Tariff fees increase the price of goods. Highly restrictive quotas coupled with high tariffs can lead to trade disputes between nations and problems within nations. For example, in January 2018, President Trump imposed tariffs of 30 percent on imported solar panels from China. This move signaled a more aggressive approach toward China's political and economic stance, but it also was a blow for the $28 billion solar industry in the United States, which relies on imports for 80% of its solar panel products.

Subsidies ("Too much" output MC > MWTP in terms of "true" benefit)

A subsidy shifts either the demand or supply curve to the right, depending upon whether the buyer or seller receives the subsidy. If it is the buyer receiving the subsidy, the demand curve shifts right, leading to an increase in the quantity demanded and the equilibrium price. If the seller receives the subsidy, the supply curve shifts right and the quantity demanded will increase, while the equilibrium price decreases.

Tariffs (and Quotas :What happens in a domestic market when there is international trade?)

A tariff is a tax on imported goods, usually assessed to protect domestic suppliers. Tariffs are only effective, however, if the domestic suppliers cannot produce their product for less than the world price; otherwise, buyers would buy the domestic product rather than the import, so no tariffs would be collected. Tariffs raise the prices of imports, reducing their quantity, and moving the market for that good or service closer to what the domestic market equilibrium would be without international trade. Domestic buyers must pay a higher price, which benefits both sellers and the government. Sellers benefit because they can charge a higher price for their product and, thus, enjoy increased producer surplus. The government benefits by collecting the revenue which a tariff generates when people buy the imported products. However, as with most taxes, there is a deadweight loss that results from assessing a tariff. This deadweight loss lowers the total surplus of the domestic economy by reducing the consumer surplus that buyers enjoy by paying lower prices. The deadweight loss of a tariff equals the total loss of consumer surplus that is not compensated by an increase in the producer surplus of those domestic producers who can now sell at the higher price or by the tax revenue generated by the tariff. When a tariff is imposed, the quantity demanded decreases from the quantity demanded at the world price to the quantity demanded at the world price plus the tariff. At the same time, the quantity produced by domestic suppliers increases from the quantity supplied at the world price to the quantity supplied at the higher price. People who buy a product either increase producer surplus by buying from domestic producers or increase government revenues by buying the imported product and paying the tariff. The deadweight losses that result from a tariff arise entirely from people who do not buy the product because of its higher price. Note that when the government imposes a tariff, it has decided to reward a few producers at the expense of the many buyers.

Effect (of each failure compared with the outcome in a competitive market, public good, the possibilities of market failure)

Because many individuals who benefit from public goods will not pay for them, private firms will produce a smaller quantity of public goods than is efficient, if they produce them at all. In such cases, it may be desirable for government agencies to step in. Government can supply a greater quantity of the good by direct provision, by purchasing the public good from a private agency, or by subsidizing consumption. In any case, the cost is financed through taxation and thus avoids the free-rider problem. Most public goods are provided directly by government agencies. Governments produce national defense and law enforcement, for example. Private firms under contract with government agencies produce some public goods. Park maintenance and fire services are public goods that are sometimes produced by private firms. In other cases, the government promotes the private consumption or production of public goods by subsidizing them. Private charitable contributions often support activities that are public goods; federal and state governments subsidize these by allowing taxpayers to reduce their tax payments by a fraction of the amount they contribute. While the market will produce some level of public goods in the absence of government intervention, we do not expect that it will produce the quantity that maximizes net benefit. Figure 6.15 "Public Goods and Market Failure" illustrates the problem. Suppose that provision of a public good such as national defense is left entirely to private firms. It is likely that some defense services would be produced; suppose that equals Q1 units per period. This level of national defense might be achieved through individual contributions. But it is very unlikely that contributions would achieve the correct level of defense services. The efficient quantity occurs where the demand, or marginal benefit, curve intersects the marginal cost curve, at Q*. The deadweight loss is the shaded area ABC; we can think of this as the net benefit of government intervention to increase the production of national defense from Q1 up to the efficient quantity, Q*.

Amount demanded (Effect of this distortion on an otherwise competitive market--Prohibited Markets)

Black market sales will skew the numbers a company will use to calculate its supply output. ... Additionally, the goods sold by a company may have less value than black market goods, resulting in lower consumer demand.

Amount supplied (The effect of each failure compared with the outcome in a competitive market--public good-the possibilities of market failure)

Central to your revision will be to understand why public goods may not be provided by the market. You can work this out by distinguishing between public and private goods and focusing on the ideas of rivalry and excludability in consumption. Students should understand the free rider and valuation problems - there are big debates in economics about the optimum size of the state. Rapid changes in technology are also changing the nature of what is and what is not a public good. What are the main characteristics of pure public goods? The characteristics of pure public goods are the opposite of private goods: Non-excludability: The benefits derived from pure public goods cannot be confined solely to those who have paid for it. Indeed non-payers can enjoy the benefits of consumption at no financial cost - economists call this the 'free-rider' problem. With private goods, consumption ultimately depends on the ability to pay Non-rival consumption: Consumption by one consumer does not restrict consumption by other consumers - in other words the marginal cost of supplying a public good to an extra person is zero. If it is supplied to one person, it is available to all. Non-rejectable: The collective supply of a public good for all means that it cannot be rejected by people, a good example is a nuclear defence system or flood defence projects. There are relatively few examples of pure public goods. Examples include flood control systems, some of the broadcasting services provided by the BBC, public water supplies, street lighting for roads and motorways, lighthouse protection for ships and also national defence services.

Role of Price (How does a competitive market work?)

Competition among buyers increases prices and allocates goods and services to those people who are willing and able to pay the most for them. Competition among sellers results in lower costs and prices, higher product quality, and better customer service. Competition among buyers increases prices and allocates goods and services to those people who are willing and able to pay the most for them. Competition among sellers results in lower costs and prices, higher product quality, and better customer service.

Efficiency (What does efficiency mean?)

Economic efficiency implies an economic state in which every resource is optimally allocated to serve each individual or entity in the best way while minimizing waste and inefficiency. When an economy is economically efficient, any changes made to assist one entity would harm another. Marginal willingness to pay is equal to marginal cost.

Efficiency (Why should efficiency matter?)

Economic efficiency implies an economic state in which every resource is optimally allocated to serve each individual or entity in the best way while minimizing waste and inefficiency. When an economy is economically efficient, any changes made to assist one entity would harm another. In terms of production, goods are produced at their lowest possible cost, as are the variable inputs of production. Economic efficiency occurs when the cost of producing a given output is as low as possible. Technological efficiency is an engineering matter. ... Economic efficiency depends on the prices of the factors of production. Something that is technologically efficient may not be economically efficient.

Prices (Provide incentives and prices convey information-- reasons for market distortions and market failures)

Equilibrium Consumers and producers react differently to price changes. Higher prices tend to reduce demand while encouraging supply, and lower prices increase demand while discouraging supply. Economic theory suggests that, in a free market there will be a single price which brings demand and supply into balance, called equilibrium price. Both parties require the scarce resource that the other has and hence there is a considerable incentive to engage in an exchange. Price discovery In its simplest form, the constant interaction of buyers and sellers enables a price to emerge over time. It is often difficult to appreciate this process because the retail prices of most manufactured goods are set by the seller. The buyer either accepts the price. or does not make the purchase. While an individual consumer in a shopping mall might haggle over the price, this is unlikely to work, and they will believe they have no influence over price. However, if all potential buyers haggled, and none accepted the set price, then the seller would be quick to reduce price. In this way, collectively, buyers have influence over market price. Eventually a price is found which enables an exchange to take place. A rational seller would take this a step further, and gather as much market information as possible in an attempt to set a price which achieves a given number of sales at the outset. For markets to work, an effective flow of information between buyer and seller is essential. Market clearing Equilibrium price is also called market clearing price because at this price the exact quantity that

Actual Price (Effect of this distortion on an otherwise competitive market--Prohibited Markets)

Goods and services acquired illegally and/or transacted for in an illegal manner may exchange above or below the price of legal market transactions: They may be cheaper than legal market prices. The supplier does not have to pay for production costs and/or taxes. This is usually the case in the underground economy. Criminals steal goods and sell them below the legal market price, but there is no receipt, guarantee, and so forth. When someone is hired to perform work and the client is unable to write off the expense (particularly common for work such as home renovations or cosmetological services), the client may be inclined to request a lower price (usually paid in cash) in exchange for foregoing a receipt, which enables the service provider to avoid reporting the income on his or her tax return. They may be more expensive than legal market prices. For example, the product is difficult to acquire or produce, dangerous to handle, is strictly rationed, or not easily available legally if at all. If exchange of goods are made illegal by some sort of state sanction, such as is often seen with certain pharmaceutical drugs, their prices will tend to rise as a result of that sanction. The price of black market goods and services can fall above or below legal market prices. Prices are higher where the goods or service are difficult to acquire or produce, dangerous to handle or transport, or otherwise challenging to obtain in a legal manner. Prices are lower where the supplier does not have to pay for manufacturing costs or taxes. Examples include illegally obtained goods that are turned around and sold for less than the fair market price, such as stolen art or pirated software.

International Trade (What happens in a domestic market when there is international trade?)

If a market is connected to international markets the prices of goods will quickly move to equalise across markets. This happens as there is an arbitrage opportunity - a person can make an assured profit by exploiting the difference between markets by buying in one and selling in the other. Any divergence in prices between markets is usually due to govt regulations, taxes or the cost of transporting goods. In terms of impact on manufacturers, any manufacturer that is producing goods that provide better value than existing goods in international markets would see a jump in profits as it can sell more goods. At the other end, non competitive manufacturers will go out of business or have to shape up. Although there are some cogent arguments restricting for trade, the advantages of international trade are that a greater variety of goods and services can be provided to the world market at lower prices because of differences in people's knowledge and skills, differences in available resources and their costs, and simply because many more people compete to create products for the market. Moreover, a larger market provides more possibilities through economies of scale, which may not be realized by selling only to a domestic market. Increased world competition may also limit monopolies or oligopolies. Moreover, world peace will be easier to maintain when the world's economies are intertwined, where each economy will be dependent on all of the others.

Partially informed (why might it me optimal--information: as a public good)

Ignorance about an issue is said to be "rational" when the cost of educating oneself about the issue sufficiently to make an informed decision can outweigh any potential benefit one could reasonably expect to gain from that decision, and so it would be irrational to waste time doing so. Rational ignorance is refraining from acquiring knowledge when the cost of educating oneself on an issue exceeds the potential benefit that the knowledge would provide. Ignorance about an issue is said to be "rational" when the cost of educating oneself about the issue sufficiently to make an informed decision can outweigh any potential benefit one could reasonably expect to gain from that decision, and so it would be irrational to waste time doing so. This has consequences for the quality of decisions made by large numbers of people, such as general elections, where the probability of any one vote changing the outcome is very small. The term is most often found in economics, particularly public choice theory, but also used in other disciplines which study rationality and choice, including philosophy (epistemology) and game theory.

Competitive Market (How does a competitive market work?)

In a competitive market no single producer, or group of producers, and no single consumer, or group of consumers, can dictate how the market operates. Nor can they individually determine the price of goods and services, and how much will be exchanged. Competitive markets will form under certain conditions.

Dependent Risk (What is the problem--Information- as a public good)

In economics, a public good is a good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.[1] Gravelle and Rees: "The defining characteristic of a public good is that consumption of it by one individual does not actually or potentially reduce the amount available to be consumed by another individual." In a non-economic sense, the term is often used to describe something that is useful for the public generally, such as education and infrastructure, although these are not "public goods" in the economic sense. This is in contrast to a common good which is non-excludable but is rivalrous to a certain degree. Public goods include knowledge, official statistics, national security, common language(s), flood control systems, lighthouses, street lighting, and Wikipedia itself. Public goods that are available everywhere are sometimes referred to as global public goods.[2] There is an important conceptual difference between the sense of "a" public good, or public "goods" in economics, and the more generalized idea of "the public good" (or common good, or public interest), "a shorthand signal for shared benefit at a societal level".[3][4][5] Many public goods may at times be subject to excessive use resulting in negative externalities affecting all users; for example air pollution and traffic congestion. Public goods problems are often closely related to the "free-rider" problem, in which people not paying for the good may continue to access it. Thus, the good may be under-produced, overused or degraded.[6] Public goods may also become subject to restrictions on access and may then be considered to be club goods or private goods; exclusion mechanisms include copyright, patents, congestion pricing, and pay television. There is a good deal of debate and literature on how to measure the significance of public goods problems in an economy, and to identify the best remedies.

Distortion (Why is there distortion in each case-- Prohibited markets)

In neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for an item that is substantially different from the price that a market would achieve while operating under conditions of perfect competition and state enforcement of legal contracts and the ownership of private property. In this context, "perfect competition" means: all participants have complete information, there are no entry or exit barriers to the market, there are no transaction costs or subsidies affecting the market, all firms have constant returns to scale, and all market participants are independent rational actors. Many different kinds of events, actions, policies, or beliefs can bring about a market distortion. For example: almost all types of taxes and subsidies, but especially excise or ad valorem taxes/subsidies, asymmetric information or uncertainty among market participants, any policy or action that restricts information critical to the market, monopoly, oligopoly, or monopsony powers of market participants, criminal coercion or subversion of legal contracts, illiquidity of the market (lack of buyers, sellers, product, or money), collusion among market participants, mass non-rational behavior by market participants, price supports or subsidies, failure of government to provide a stable currency, failure of government to enforce the Rule of Law, failure of government to protect property rights, failure of government to regulate non-competitive market behavior, stifling or corrupt government regulation. nonconvex consumer preference sets market externalities natural factors that impede competition between firms, such as occurs in land markets

Barriers to entry (MC = MWTP but "too little" produced because capital cannot move to markets with economic profits so there is no long-run supply response)

In theories of competition in economics, a barrier to entry, or an economic barrier to entry, is a cost that must be incurred by a new entrant into a market that incumbents do not have or have not had to incur.[1][2] Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices and are therefore most important when discussing antitrust policy. Barriers to entry often cause or aid the existence of monopolies or give companies market power. Various conflicting definitions of "barrier to entry" have been put forth since the 1950s, and there has been no clear consensus on which definition should be used. This has caused considerable confusion and likely flawed policy.[1][3][4] McAfee, Mialon, and Williams list 7 common definitions in economic literature in chronological order including:[1][5] In 1956, Joe S. Bain used the definition "an advantage of established sellers in an industry over potential entrant sellers, which is reflected in the extent to which established sellers can persistently raise their prices above competitive levels without attracting new firms to enter the industry." McAfee et al. criticized this as being tautological by putting the "consequences of the definition into the definition itself." In 1968, George Stigler defined an entry barrier as "A cost of producing that must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry." McAfee et al. criticized the phrase "is not borne" as being confusing and incomplete by implying that only current costs need be considered. In 1979, Franklin M. Fisher gave the definition "anything that prevents entry when entry is socially beneficial." McAfee et al. criticized this along the same lines as Bain's definition. In 1994, Dennis Carlton and Jeffrey Perloff gave the definition, "anything that prevents an entrepreneur from instantaneously creating a new firm in a market." Carlton and Perloff then dismiss their own definition as impractical and instead use their own definition of a "long-term barrier to entry" which is defined very closely to the definition in the introduction. A primary barrier to entry is a cost that constitutes an economic barrier to entry on its own. An ancillary barrier to entry is a cost that does not constitute a barrier to entry by itself, but reinforces other barriers to entry if they are present.[1][6] Antitrust barriers to entry An antitrust barrier to entry is "a cost that delays entry and thereby reduces social welfare relative to immediate but equally costly entry".[1] This contrasts with the concept of economic barrier to entry defined above, as it can delay entry into a market but does not result in any cost-advantage to incumbents in the market. All economic barriers to entry are antitrust barriers to entry, but the converse is not true.

Information (as a public good)

Knowledge or information is an extreme public good. Knowledge are extremely good candidates to be collaborative goods because Knowledge is "an extreme nonrival good" and an "unusually" non-exclusive good. As Risha Aiyer Ghosh has put it: Information is not just an extreme nonrival good, in that many people can enjoy its benefits at the same time; information is also unusual in that ownership over it cannot be expressed through a public act of possession. You can possess information if you keep it to yourself - in which case it remains private, and nobody knows what it is that you possess. As soon as you make public the information you claim to own, it is public information that everyone can access since you no longer have natural control over it.... With information goods, your "property" can be secret and only possessed by you. However, if published - if distributed even to one other person - that information is no longer within your control. Summary : When you keep knowledge secret, it will not be a public good, However, if published or distributed even to one person, it will become a public good.

Examples (of each failure--Public good--Possibilities of Market Failure)

Market Failures As productive and as efficient as our modern economy is we cannot meet all of our needs and all of our wants. This being the case, an certainly no one would expect perfection, there is clearly some failure on the part of the market to provide these goods and services. While the term failure may be a tad harsh, it is the essence of what has occurred... a market failure. Market failure - The situation that exists when the market fails to function properly. Market failure occurs when the following condition exist: When adequate competition does not exist. In an age where mergers are all too common, the result has been an increase in larger and fewer firms in many industries. In extreme cases, this results in a monopoly. The greatest threat that a monopoly poses is that it denies consumers the benefit of choice and competition. Because a monopoly occupies the top spot in its market, it can use its position to impede competition and restrict production. Thus in the end there are artificial shortages and higher prices. Inadequate competition may also enable a firm to influence politics by means of economic strength. In the past there have been executives who furthered the political careers of those closest to them. Though it is not necessary for a business to be a monopoly in order to influence politics, it certainly helps. A large corporation may simply want tax brakes on a state or local level. If the government refuses, then the plant may threaten to moves its facilities elsewhere. Because the government does not want an economic loss to its area, it may acquiesce to the demands of the corporation. In order to efficiently allocate resources, consumers, business people, and government officials must have adequate information about market conditions. Some of which is easy to obtain like sales prices or want ads. Yet there is a little more difficulty in ascertaining information about a companies earnings and dividends. Buyers and sellers are not well informed. Without information uneducated decision are made. This leads to mistakes and thus, market failure. Resources are not free to move from one industry to another. This is known as resource immobility. Resource immobility is a difficult problem in any economy. The efficient allocation of resources requires that land, labor, entrepreneurs, and capital be free to move to markets where returns are the highest. But there are times when a business that is located in a certain community decides to up and leave, leaving hundreds unemployed. The consequence of the move is a reason that may hamper the corporation from taking its business elsewhere. Resource mobility is considered ideal in the competitive market economy, but is actually much more difficult to accomplish. When resources are immobile, markets don't function, as they should. Prices do not reasonably reflect the costs of production. This represents a problem because then wealth is being redistributed unfairly and prices are too high. Externalities Externality - an economic side effect that affects an uninvolved third party. These are also examples of market failures. There are two types of externalities: Negative externality- harmful side effect that affects an uninvolved third party. In most events, it constitutes external cost. Positive externality- beneficial side effect that affects an uninvolved third party. An externality, by definition, is an economic side effect that either benefits or harms a party not directly involved in the activity. A negative externality is an action that harms a third party resulting in external cost. An example of this would be the construction going on on the LIE. Because the roadway is being widened, trees along side have been taken down, thus exposing the once secluded service road and the homes that are alongside it. This construction has annoyed drivers, who have to put up with the mess and homeowners as well. A positive externality is if the economic action benefits a third party. Such an example can be drawn from the previously mentioned one. The construction on the LIE may cause traffic tie-ups, but local businesses may benefit from the traffic, which detours by their shops, and the workers who may require services from one of the businesses. Public Goods Public goods are those goods and services provided by the government because a market failure has occurred and the market has not provided them. Sometimes it is in our benefit to not allow for a market provision. In the case of police, national defense and public education it can be argued that private provision of these services would be less desirable for a variety of reasons. Public goods are economic products that are consumed collectively, like highways, sanitation, schools, national defense, police and fire protection. All members of society should theoretically benefit from the provision of public goods but the reality is that some need them more then others. For example the wealthy do not need welfare and the elderly still pay for school taxes. This leads to the inevitable argument about paying for public goods.... taxes!

Reasons (For Market Distortion and Market Failures)

Market Failures. ... This distortion creates an inefficiency in the market. There are four probable causes of market failures; power abuse (a monopoly or monopsony, sole buyer of a factor of production), improper or incomplete distribution of information, externalities and public good

Effect (of each distortion on an otherwise competitive market--Prohibited Markets)

Market distortion is an economic scenario that occurs when there is an intervention in a given market by a governing body. The intervention may take the form of price ceilings, price floors or tax subsidies. arket distortions create market failures, which is not an economically ideal situation. Market distortions are often a byproduct of government policies that aim to protect and raise the general well-being of all market participants. Regulators must make a tradeoff when deciding to intervene in any given marketplace. For this reason, analysts and lawmakers try to seek a balance between the general well-being of all market participants and market efficiency in the formulation of economic policy. Although an intervention may create market failures, it is also intended to enhance a society's welfare. For example, many governments subsidize farming activities, which makes farming economically feasible for many farmers. The subsidies paid to farmers create artificially high supply levels, which will eventually lead to price declines if the goods are not subsequently purchased by the government or sold to another nation. Although this type of intervention is not economically efficient, it does help ensure that a nation will have enough food to eat. Other Causes of Market Distortions Government actions aren't solely responsible for all market distortions. Several types of events, actions, policies or beliefs can bring about a market distortion. For example, a market may become distorted when a single business holds a monopoly or when other factors prevent free and open competition. This distortion causes problems for consumers as well as for private sector businesses following standard procurement procedures. A lack of competition typically means higher prices. A monopoly may exist because of a lack of competition or not enough strong competitors. For example, almost all types of taxes and subsidies, but especially excise or ad valorem taxes/subsidies, can cause a market distortion. In addition, asymmetric information, uncertainty among market participants or any policy or action that restricts information critical to the market can cause a market distortion. Inaction on the part of governments may also result in a market distortion. For instance, government failure to provide a stable currency, enforce the rule of law, protect property rights or regulate non-competitive or anti-competitive market behavior can also cause market distortion. Other Possible Causes of Market Distortions Criminal coercion or subversion of legal contracts, Lack of liquidity in the market (lack of buyers, sellers, product, or money), Collusion among market participants, Mass non-rational behavior by market participants, Price supports or subsidies, Stifling or corrupt government regulation. Nonconvex consumer preference sets Market externalities Natural factors that impede competition between firms, such as occurs in land markets

Market Failure (Possibilities of)

Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market. Furthermore, the individual incentives for rational behavior do not lead to rational outcomes for the group. Put another way, each individual makes the correct decision for him/herself, but those prove to be the wrong decisions for the group. In traditional microeconomics, this is shown as a steady state disequilibrium in which the quantity supplied does not equal the quantity demanded. A market failure occurs whenever the individuals in a group end up worse off than if they had not acted in perfectly rational self-interest. Such a group either incurs too many costs or receives too few benefits. Even though the concept seems simple, it can be misleading and easy to misidentify. Contrary to what the name implies, market failure does not describe inherent imperfections in the market economy — there can be market failures in government activity, too. One noteworthy example is rent seeking by special interest groups. Special interest groups can gain a large benefit by lobbying for small costs on everyone else, such as through a tariff. When each small group imposes its costs, the whole group is worse off than if no lobbying had taken place. Additionally, not every bad outcome from market activity counts as a market failure. Nor does a market failure imply that private market actors cannot solve the problem. On the flip side, not all market failures have a potential solution, even with prudent regulation or extra public awareness.

Moral Hazard (What is the moral hazard problem- Information--as a public good)

Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other. ... This economic concept is known as moral hazard.

Why is a competitive market efficient?

Productive efficiency and allocative efficiency are two concepts achieved in the long run in a perfectly competitive market. ... Perfect competition is considered to be perfect because both allocative and productive efficiency are met at the same time in a long-run equilibrium.

Amount demanded (The effect of each failure compared with the outcome in a competitive market--public good--the possibilities of market failure)

Public goods are non-excludable and non-rival. Individuals cannot be effectively excluded from using them, and use by one individual does not reduce the good's availability to others. Examples of public goods include the air we breathe, public parks, and street lights. Public goods may give rise to the "free rider problem. " A free-rider is a person who receives the benefit of a good without paying for it. This may lead to the under-provision of certain goods or services. Private Goods

Failure (Why is there a failure in each case--Public Good-- Possibilities of Market Failure)

Reasons for market failure include: Positive and negative externalities: an externality is an effect on a third party that is caused by the consumption or production of a good or service. ... Lack of public goods: public goods are goods where the total cost of production does not increase with the number of consumers. The four types of market failures are public goods, market control, externalities, and imperfect information. Public goods causes inefficiency because nonpayers cannot be excluded from consumption, which then prevents voluntary market exchanges. Public goods provide an example of market failure resulting from missing markets. Which goods and services are best left to the market? And which are more efficiently and fairly provided as collective consumption goods by the state? This is at the heart of your revision of public goods. What are the main characteristics of pure public goods? The characteristics of pure public goods are the opposite of private goods: Non-excludability: The benefits derived from pure public goods cannot be confined solely to those who have paid for it. Indeed non-payers can enjoy the benefits of consumption at no financial cost - economists call this the 'free-rider' problem. With private goods, consumption ultimately depends on the ability to pay Non-rival consumption: Consumption by one consumer does not restrict consumption by other consumers - in other words the marginal cost of supplying a public good to an extra person is zero. If it is supplied to one person, it is available to all. Non-rejectable: The collective supply of a public good for all means that it cannot be rejected by people, a good example is a nuclear defence system or flood defence projects. There are relatively few examples of pure public goods. Examples include flood control systems, some of the broadcasting services provided by the BBC, public water supplies, street lighting for roads and motorways, lighthouse protection for ships and also national defense services.

Quotas (and Tariffs :What happens in a domestic market when there is international trade?)

Sometimes the government will impose an import quota rather than levy a tariff. Governments generally set import quotas by selling licenses to specific importers, allowing them to import a specified quantity. The license fee has the same economic effect as a tariff, lowering consumer surplus for the buyers and causing a deadweight loss by eliminating some buyers from the market.

Tariffs ("too little" specialization--The effects of market distortions)

Tariffs are used to restrict imports by increasing the price of goods and services purchased from overseas and making them less attractive to consumers. A specific tariff is levied as a fixed fee based on the type of item, for example, $1,000 on any car. An ad-valorem tariff is levied based on the item's value, for example, 10% of the car's value. Governments may impose tariffs to raise revenue or to protect domestic industries - particularly nascent ones - from foreign competition. By making foreign-produced goods more expensive, tariffs can make domestic-produced ones more attractive. By protecting these industries, governments can also protect jobs. Tariffs can also be used as an extension of foreign policy: imposing tariffs on a trading partner's main exports is a way to exert economic leverage. Tariffs can have unintended side-effects, however. They can make domestic industries less efficient by reducing competition. They can hurt domestic consumers, since a lack of competition tends to push up prices. They can generate tensions by favoring certain industries over others, as well as certain regions over others: tariffs designed to benefit manufacturers in cities may hurt consumers in rural areas, who do not benefit from the policy and are likely to pay more for manufactured goods. Finally, an attempt to pressure a rival country using tariffs can devolve into an unproductive cycle of retaliation, known as a trade war.

Taxes ("Too little" output MC [in terms of scarce resources] < MWTP)

Taxes reduce both demand and supply, and drive market equilibrium to a price that is higher than without the tax and a quantity that is lower than without the tax. ... After imposition of the tax, the supply curves shift up and to the left. Consumers pay $2.60 per gallon. Taxes reduce both demand and supply, and drive market equilibrium to a price that is higher than without the tax and a quantity that is lower than without the tax. If buyers have many alternatives to a good with a new tax, they will tend to respond to a rise in price by buying other things and will, therefore, not accept a much higher price. If sellers easily can switch to producing other goods, or if they will respond to even a small reduction in payments by going out of business, then they will not accept a much lower price. The incidence of the tax will tend to fall on the side of the market that has the least attractive alternatives and, therefore, has a lower elasticity. Cigarettes are one example where buyers have relatively few options; we would therefore expect the primary burden of cigarette taxes to fall upon the buyers.

Free Riding Problem (Public good-- "too little" output MC< true marginal benefit--Possibilities of Market Failure)

The free rider problem is a situation where some individuals consume more than their fair share or pay less than their fair share of the cost of a shared resource. It is a market failure that occurs when people take advantage of being able to use a common resource, or collective good, without paying for it, as is the case when citizens of a country utilize public goods without paying their fair share in taxes. The free rider problem only arises in a market in which supply is not diminished by the number of people consuming it and consumption cannot be restricted. Goods and services such as national defense, metropolitan police presence, flood control systems, access to clean water, sanitation infrastructure, libraries and public broadcasting services can be obtained through free riding Free riding depletes from a tax base, can be the cause of natural resource exploitation and can even lead to the disappearance of a good's supply if enough people jump on board with the mentality. For some people, a free ride means there is little incentive to expend money or time toward the production of a collective good when they stand to enjoy its benefits even if they expend none at all. Free rider problems occur for two reasons. First, because there is non-excludability, which means that when providing something that's supposed to be for everyone, there's no way to stop anyone from using it. Secondly, if the use of a good doesn't reduce its availability for others, people won't stop using it. Because the free rider problem occurs with public goods, governments are usually the ones left to enforce as much regulation as possible to deter people from engaging in the practice. In the United States, the Internal Revenue Service (IRS) is the agency in charge of collecting taxes and upholding tax laws. The crime of attempting to evade or defeat tax carries a maximum penalty of five years in prison and a $250,000 fine, which is $500,000 for corporations. Free riding also occurs in a workplace that is partly unionized, because all of the company's employees experience wage hikes and a better working environment, regardless of whether they belong to the labor union.

Long Run Effects (The effect of each failure compared with the outcome in a competitive market--public good--the possibilities of market failure)

Theoretically, markets should strive for equilibrium, but there are many forces that pull them away from this point. Many markets do not operate freely; instead, they face external forces, such as government rules and regulations that influence how much of a product suppliers have to provide. Another factor to consider is the elasticity of supply and demand. When supply and demand are elastic, they easily adjust in response to changes in prices. When they are inelastic, they do not. Inelastic goods are not always produced and consumed in equilibrium. Read more: Quantity Supplied https://www.investopedia.com/terms/q/quantitysupplied.asp#ixzz5Dq8OOHkZ Follow us: Investopedia on Facebook

Suppliers and Demanders (response to incentives and rely on information conveyed--reasons for market distortions and market failures)

Therefore if prices are "wrong" Because of distortion or market failure, decisions will be "wrong" (relative to efficient outcome)

Amount Supplied (Effect of this distortion on an otherwise competitive market--Prohibited Markets)

Typically the supply side effects dominate the demand side ones when the government creates a black market. ... Now look at the new point at which the new supply and demand curves intersect. The shift in supply and demand causes the quantity consumed of the black market good to decrease, while the price rises.

Public Good ("too little" output MC< true marginal benefit-- Possibilities of Market Failure)

Unlike the case of negative externalities, which should be discouraged to achieve a socially efficient allocation of scarce resources, positive externalities should be encouraged. A public good is a product that one individual can consume without reducing its availability to another individual, and from which no one is excluded. Economists refer to public goods as "nonrivalrous" and "nonexcludable." National defense, sewer systems, public parks and other basic societal goods can all be considered public goods. A public good is an item consumed by society as a whole and not necessarily by an individual consumer. Public goods are financed by tax revenues. All public goods must be consumed without reducing the availability of the good to others, and cannot be withheld from people who do not directly pay for them. Law enforcement is also an example of a public good. While public goods are important for a functioning society, there is an issue that arises when these goods are provided, called the free-rider problem. This problem says a rational person will not contribute to the provision of a public good because he does not need to contribute to benefit. For example, if a person does not pay his taxes, he still benefits from the government's provision of national defense by free riding on the tax payments of his fellow citizens. Almost all public goods are considered to be nonrivalrous and nonexcludable goods. Nonrivalry denotes any product or service that does not reduce in availability as people consume it. Nonexcludability refers to any product or service that is impossible to provide without it being available for many people to enjoy. Therefore, a public good must be available for everyone and not be limited in quantity. A dam is another example of a public good. It is nonrivalrous and nonexcludable in that all people within a society benefit from its use without reducing the availability of its intended function. However, in some cases, a public good can be excludable and a private good can be nonexcludable. A public good is considered excludable when it has a nominal cost that creates a low barrier to consuming the good. The post office, for example, is an excludable public good because even though the service is provided for the public, there are low costs such as stamp expenses that prevent people who have not paid from using it. Private goods such as a basic AM radio show are considered nonexcludable since anyone with a radio can consume them.

Adverse Selection (What is the adverse selection problem--Information-as a public good)

What is 'Adverse Selection' Adverse selection refers generally to a situation where sellers have information that buyers do not have, or vice versa, about some aspect of product quality. In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to get life insurance. To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.

Amount bought and sold (Effect of this distortion on an otherwise competitive market--Prohibited Markets)

When a product is made illegal by the government, often times a black market will emerge for said product. But how does supply and demand change when goods shift from a legal to a black market? A simple supply and demand graph can prove helpful in visualizing this scenario. Let's see how the black market affects a typical supply and demand graph, and what that means for consumers. A drop in supply means the upward sloping supply curve will shift to the left. Similarly, a drop in demand means the downward sloping demand curve will shift to the left. Typically the supply side effects dominate the demand side ones when the government creates a black market. Meaning, the shift in the supply curve is larger than the shift in the demand curve. This is shown with the new dark blue demand curve and the new dark red supply curve in this graph. Now look at the new point at which the new supply and demand curves intersect. The shift in supply and demand causes the quantity consumed of the black market good to decrease, while the price rises. If the demand side effects dominate, there will be a drop in quantity consumed, but there will also see a corresponding drop in price. However, this does not typically happen in a black market. Instead, there is normally a rise in price. The amount of the price change and the change in quantity consumed will depend on the magnitude of the shifts of the curve, as well as the price elasticity of demand and the price elasticity of supply.

Prohibited Markets (enforcement problem-- against suppliers and/or demanders)

When a product is made illegal by the government, often times a black market will emerge for said product. But how does supply and demand change when goods shift from a legal to a black market? A simple supply and demand graph can prove helpful in visualizing this scenario. Let's see how the black market affects a typical supply and demand graph, and what that means for consumers. To understand what changes happen when a good is made illegal, it is important to first illustrate what the supply and demand for the good looked like in the pre-black market days. To do so, arbitrarily draw a downward sloping demand curve (shown in blue) and an upward sloping supply curve (shown in red), as illustrated in this graph. Note that price is on the X-axis and quantity is on the Y-axis. The point of intersection between the 2 curves is the natural market price when a good is legal. When the government makes the product illegal, a black market is subsequently created. When a government makes a product illegal, such as marijuana, 2 things tend to happen. First, there is a sharp drop in supply as the penalties for selling the good cause people to shift into other industries. Second, a drop in demand is observed as a prohibition of possessing the good deters some consumers from wanting to buy it. A drop in supply means the upward sloping supply curve will shift to the left. Similarly, a drop in demand means the downward sloping demand curve will shift to the left. Typically the supply side effects dominate the demand side ones when the government creates a black market. Meaning, the shift in the supply curve is larger than the shift in the demand curve. This is shown with the new dark blue demand curve and the new dark red supply curve in this graph. Now look at the new point at which the new supply and demand curves intersect. The shift in supply and demand causes the quantity consumed of the black market good to decrease, while the price rises. If the demand side effects dominate, there will be a drop in quantity consumed, but there will also see a corresponding drop in price. However, this does not typically happen in a black market. Instead, there is normally a rise in price. The amount of the price change and the change in quantity consumed will depend on the magnitude of the shifts of the curve, as well as the price elasticity of demand and the price elasticity of supply.

Exports (What happens in a domestic market when there is international trade?)

f the domestic suppliers can supply the product for less than the world price then they will be able to sell their product worldwide at the world price. The domestic supply increases until equilibrium is reached with the world price. Since the world price is higher than the domestic price, producers will continue to sell in the worldwide market rather than the domestic market until the domestic price increases to the world price; thus, domestic demand will decline. However, the country benefits because the producer surplus is increased by the higher price which compensates for the loss of consumer surplus to the domestic buyers. There is an additional gain of producer surplus that is not offset by a loss of consumer surplus by selling on the world market. Hence, total surplus is maximized by exporting in the world market.

Imports (What happens in a domestic market when there is international trade?)

n theory, trade is good. In practice, considerable debate exists on whether importing foreign goods has an adverse effect on the domestic economy (and on the labor market in particular). The impact of this effect depends on whether foreign goods compete with or complement local production. For example, if imported computers can easily substitute for domestically produced computers, then the domestic production of computers and employment in the computer and electronics industries will most likely fall with an increase in imports. On the other hand, if computers are used as inputs to produce other domestic goods, like bank services, local production costs of banking services will be lower with cheaper computers, and, all else equal, domestic production and employment will likely rise in the banking industry.