AP Micro Economics Review Session 4 Review Session

A/P Micro Economics Review Session #4

Review Session Dates • 5/5 (Factor Markets & Externalities) • 5/13 This is next Wednesday (Wrap UP Loose Ends) • 6: 30 – 8: 30

Reminders • Time to really start applying yourself. 1 ½ weeks!!!! • Form study groups. • Set a study schedule for A/P Micro.

Some Resources • reffonomics. com • econclassroom. com • You. Tube lessons from AC/DC Leadership – Click on Micro channel • Review Book(s) – Various Publishers

5/5 Review Session • • Please: BE ON TASK! Clean up your garbage Externalities Factor Market/ Resource Market

Government and Market Failures

What is a Market Failure? • A situation in which the free-market syste fails to satisfy society’s wants. • Private markets do not efficiently bring about the allocation of resources. The government must step in to satisfy society’s wants. 7

The Four Market Failures We will focus on four different market failures: 1. Public Goods 2. Externalities (third person side effects) 3. Monopolies 4. Unfair distribution of income In each of the above situations, the government step in to allocate resources efficiently. 8

Public Goods • Public Goods: No rival products. Nobody excluded from consuming this good. Provided by Government. (Highway, Education, Section 8 Housing). • Free Riders: a person who receives the benefit of a good and does not pay for it.

Definition of Public Goods To be considered a true public good, it must meet two criteria: 1. Nonexclusion • Everyone can use the good. • Cannot exclude people from enjoying the benefits (even if they don’t pay). • Ex: National Defense/Public Schools 2. Shared Consumption (Nonrivalry) • One person’s consumption of a good does not reduce the usefulness to others. • Ex: Swallow Cliff 10

Private Goods • Private Goods: Produced by private firms. Individually consumed. Non Payers are excluded. UNDER Allocated P=MC does not happen in imperfect markets

Negative Externalities 12

Externalities • Externality is a side effect. • Negative Externality: Spillover cost on a third party. – Air, Noise, Water Pollution. Traffic Congestion, Litter

Private Benefit/Cost Simple S and D is for an individual. D = MSB What about the externality? S = MPC Socially Optimal $ Q

Negative Externality S = MSC Optimal Allocation D = MSB S = MPC $ $ Overallocation

Market for Cigarettes The marginal private cost doesn’t include the costs to society. P Supply = Marginal Private Cost D=MSB QFree Market Q 16

Market for Cigarettes What will the MC/Supply look like when EXTERNAL cost are factor in? Supply = P Marginal Social Cost Supply = Marginal Private Cost D=MSB QOptimal QFree Market Q 17

Market for Cigarettes If the market produces QFM why is it a market failure? P S =MSC S=MPC At QFM the MSC is greater than the MSB. Too much is being produced Overallocation D=MSB QOptimal QFree Market Q 18

Market for Cigarettes What should the government do to fix a negative externality? P S =MSC S=MPC Solution: Tax the amount of the externality (Per Unit Tax) D=MSB QOptimal QFree Market Q 19

Market for Cigarettes What should the government do to fix a negative externality? P S =MSC =MPC MSB = MSC S=MPC Solution: Tax the amount of the externality (Per Unit Tax) D=MSB QOptimal QFree Market Q 20

Methods to Deal With Negative Externalities • Remember: there is an overallocation of resources. – 1. Tax on Producers – 2. Direct Government Controls (EPA)

Positive Externalities 22

Externalities • Positive Externality: Spillover benefit on a third party. – Historical Preservation, Lake/Pond Regeneration, Education, Property Improvement

Positive Externality Simple S and D D = MPB is for an individual. What about the externality? S = MPC Socially Optimal $ Q

Positive Externality (Spillover Benefit) Optimal Allocation S = MPC $ $ D = MSB D = MPB Q Under Production Q

Market for Flu Shots The marginal private benefit doesn’t include the additional benefits to society. P S = MSC QFree Market D=Marginal Private Benefit Q 26

Market for Flu Shots What will the MB/D look like when EXTERNAL benefits are factor in? P S = MSC D=Marginal Social Benefit QFM QOptimal D=Marginal Private Benefit Q 27

Market for Flu Shots If the market produces QFM why is it a market failure? P S = MSC D=Marginal Social Benefit D=MSB QFM QOptimal Q 28

Market for Flu Shots P At QFM the MSC is less than the MSB. Too little is being produced S = MSC D=Marginal Social Benefit Underallocation QFM QOptimal Q 29

Market for Flu Shots What should the government do to fix a negative externality? P Subsidize the amount of the externality (Per Unit Subsidy) S = MSC D=MSB =MPB D=MPB QFM QOptimal Q 30

Methods to Deal With Positive Externalities • Remember: there is an underallocation of resources. – 1. Subsidy to Consumers – 2. Subsidy to Producers – 3. Government Provisions (“Free Flu Shots”)

Resource/Product Market • How are wages set?

Use supply and demand analysis to explain why surgeons earn an average salary of $137, 050 and chefs earn $13, 560. Supply and Demand For Surgeons Supply and Demand For Chefs SL Wage Rate DL Quantity of Workers SL DL Quantity of Workers

Resource/Product Market • Product Market: Consumer goods. • Resource Market: Market for Resources necessary to produce consumer goods. – AKA Factor Market

Market Demand for Resources • Product Demand curve is sum of individual’s D for a product. • Resource Demand is derived the same way. (The sum of individual firms MRP Marginal Revenue Product or Demand for a resource)

Market Demand for Resources • Perfect Competition for resources implies that no single firm affects the price for that resource (Labor/Wage). • Imperfect Competition (Monopsony) for resources means that a firm can affect the price for that resource (Labor/Wage).

Determinates of Resource Demand • Change in product demand. Derived Demand • Change in productivity. • Change in price of other resources. – Substitutes – Complements

Marginal Product Theory • Marginal Revenue Product: Change in a firm’s total revenue when it employs 1 additional unit of a resource. Change in Total Revenue ___________ = MRP Change in resource qty

Marginal Product Theory • Marginal Resource Cost: The amount that each additional unit of a resource adds to a firm’s total resource cost. Change in Total Resource Cost ______________ = MRC Change in resource qty Wages

Marginal Product Theory • Rule for Hiring Resources: It will be profitable for a firm to hire additional units of a resource up to the point at which that resource’s Marginal Revenue Product=Marginal Resource Cost. • MRP=MRC • Refers to input of resources not output. • Similar to MR=MC.

You’re the Boss • You and your partner own a business. • Assume the you are selling the goods in a perfectly competitive PRODUCT market so the price is constant at $10. • Assume that you are hiring workers in a perfectly competitive RESOURCE market so the wage is constant at $20. • Also assume the wage is the ONLY cost. To maximize profit how many workers should you hire? 41

Use the following data: Workers Total Product (Output) 0 1 2 3 4 5 6 7 0 7 17 24 27 29 30 27 Price = $10 Wage = $20 *Hint* How much is each worker worth? 42

Use the following data: Units of Labor Total Product (Output) 0 1 2 3 4 5 6 7 0 7 17 24 27 29 30 27 Price = $10 Wage = $20 1. What is happening to Total Product? 2. Why does this occur? 3. Where are three stages? 43

Use the following data: Units of Labor Total Product (Output) Marginal Product (MP) 0 1 2 3 4 5 6 7 0 7 17 24 27 29 30 27 7 10 7 3 2 1 -3 Price = $10 Wage = $20 This shows the PRODUCTIVITY of each worker. Why does productivity decrease? 44

Price = $10 Wage = $20 Use the following data: Units of Labor Total Product (Output) 0 1 2 3 4 5 6 7 0 7 17 24 27 29 30 27 Marginal Product Price (MP) 7 10 7 3 2 1 -3 0 10 10 Price is constant because we are in a perfectly competitive market. 45

Price = $10 Wage = $20 Use the following data: Units of Labor Total Product (Output) 0 1 2 3 4 5 6 7 0 7 17 24 27 29 30 27 Marginal Product Price (MP) 7 10 7 3 2 1 -3 0 10 10 Marginal Revenue Product 0 70 100 70 30 20 10 -30 This shows how much each worker is worth 46

Price = $10 Wage = $20 Use the following data: Units of Labor Total Product (Output) 0 1 2 3 4 5 6 7 0 7 17 24 27 29 30 27 Marginal Product Price (MP) 7 10 7 3 2 1 -3 0 10 10 Marginal Revenue Product 0 70 100 70 30 20 10 -30 Marginal Resource Cost 0 20 20 How many workers should you hire? 47

Perfectly Competitive Labor Market and Firm SL Wage ? $20 QE Industry DL Q Q Firm

Side-by-side graph showing Market and Firm SL Wage SL=MRC $20 QE Industry DL Q DL=MRP 5 e Firm Q

Use the following data: Units of Labor Total Product (Output) Price = $10 Wage = $20 Additional Marginal Product Revenue Product Price per worker (MP) Additional Cost per worker 0 0 0 7 10 1 7 70 20 10 10 2 17 100 20 7 10 3 24 70 20 3 10 4 27 30 20 2 10 if the 20 5 would 29 this change How demand 20 for 1 10 significantly? 6 the 30 10 20 good increased -3 would 10 increase. 71. Price 27 of the good -30 20 2. Value of each worker would increase. 50

Use the following data: Units of Labor Total Product (Output) 0 1 2 3 4 5 6 7 0 7 17 24 27 29 30 27 Price = $100 Wage = $20 Marginal Product Price (MP) 7 10 7 3 2 1 -3 Additional Revenue per worker 0 100 100 51

Use the following data: Units of Labor Total Product (Output) 0 1 2 3 4 5 6 7 0 7 17 24 27 29 30 27 Price = $100 Wage = $20 Marginal Product Price (MP) 7 10 7 3 2 1 -3 0 100 100 Additional Revenue per worker 0 700 1000 700 300 200 100 -300 Each worker is worth more!! THIS IS DERIVED DEMAND. 52

Use the following data: Units of Labor Total Product (Output) Price = $10 Wage = $20 Additional Marginal Product Revenue Product Price per worker (MP) Additional Cost per worker 0 0 0 7 10 1 7 70 20 10 10 2 17 100 20 7 10 3 24 70 20 3 10 4 27 30 20 2 10 5 would 29 this change 20 20 How if the productivity 1 10 increased? 6 30 each worker 10 20 -3 would 10 increase. 27 Product -30 20 1. 7 Marginal of 2. Value of each worker would increase. 53

Price = $10 Wage = $20 Use the following data: Units of Labor 0 1 2 3 4 5 6 7 Total Product (Output) 0 70 170 240 270 290 300 270 Marginal Product Price (MP) 70 100 70 30 20 10 -30 0 10 10 Additional Revenue per worker 0 700 1000 700 300 200 100 -300 Each worker is worth more! More demand for the resource. 54

Terms • Lorenz Curve: Is the actual curve of distribution of wealth compared to equal distribution of wealth.

Marginal Product Theory • MRP=MRC • Refers to input of resources not output. • Similar to MR=MC. Labor 0 1 2 3 4 5 6 Total Product 0 12 22 30 36 40 42 Price $3 $3

Marginal Product Theory • MRP=MRC • Refers to input of resources not output. • Similar to MR=MC. Labor 0 1 2 3 4 5 6 Total Product 0 12 22 30 36 40 42 Price $3 $3 TR 0 $36 $66 $90 $108 $120 $126

Marginal Product Theory • MRP=MRC • Refers to input of resources not output. • Similar to MR=MC. Labor 0 1 2 3 4 5 6 Total Product 0 12 22 30 36 40 42 Price $3 $3 TR MRP 0 $36 36 $66 30 $90 24 $108 18 $120 12 $126 6

Marginal Product Theory • MRP=MRC • Refers to input of resources not output. • Similar to MR=MC. Labor 0 1 2 3 4 5 6 Total Product 0 12 22 30 36 40 42 Price $3 $3 TR 0 $36 $66 $90 $108 $120 $126 Wage MRP MRC 36 30 24 18 12 6 12 12 12

Marginal Product Theory • MRP=MRC • Refers to input of resources not output. • Similar to MR=MC. Labor 0 1 2 3 4 5 6 Total Product 0 12 22 30 36 40 42 Price $3 $3 TR MRP 0 36 $36 30 $66 24 $90 $108 18 $120 12 $126 6 Wage MRC 12 12 12