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Example 1C: Assume the same facts as Example 1A, except that now the market generates an external cost of $20 for each unit produced. The table below indicates marginal private benefit (MPB), marginal private cost (MPC), marginal external cost, and marginal social cost (MSC) for different quantities. Marginal social cost is the sum of marginal private cost and marginal external cost. The graph below illustrates that private market equilibrium (where MPB = MPC) occurs at a quantity of 4 units and a price of $45. The optimal quantity (where MSB = MSC) occurs at 3 units, which corresponds to a price of $55. Quantity MPB MPC Marginal External Cost MSC 1 $75 $15 $20 $35 2 65 25 20 45 3 55 35 20 55 4 45 45 20 65 5 35 55 20 75 6 25 65 20 85 7 15 75 20 95 $ $95 - 85 - 75 - 65 - 55 - 45 - 35 - 25 - 15 - Z 0 0 1 2 3 4 5 6 7 OPT P.M.E. Quantity S MSC S MPC D MPB With an external cost, the private market equilibrium (where MPB = MPC) will be greater than the optimal quantity (where MSB = MSC). Controlling Externalities There are four methods for controlling externalities. Three of these methods involve internalizing the externality (changing the external benefit or cost into a private benefit or cost to the person generating it). Internalizing Externalities: FOR REVIEW ONLY - NOT FOR DISTRIBUTION 1. Persuasion. Generally, a person generating an external benefit or cost does not take it into account in his or her consumption or production decision. Persuasion may cause the person to consider the external effect of his or her actions. Market Failure 27 - 4
Example 2: To encourage the consumption of flu shots, the local health department produces public service announcements stating, “Remember to buy your flu shot. The life you save may be your grandmother’s.” To discourage littering, the Texas Department of Transportation produces public service announcements admonishing, “Don’t mess with Texas.” 2. Establishing private property rights and reaching voluntary agreements. Externalities often occur where property rights are not clearly established. For example, public property (owned by everybody) is much more likely to be littered on than private property (owned by a specific person). Example 3: Nguyen produces widgets. The widget production generates an external cost that falls on Vu, imposing a cost on Vu of $500 per month. If Vu has the property right to not have the cost imposed on him, Vu can sue Nguyen and recover the $500 per month in damages caused by Nguyen’s production. This internalizes the cost to Nguyen. It will cost Nguyen $500 per month in damages to Vu to continue generating the external cost. If Nguyen has the property right to impose this cost on Vu, Vu can offer to pay Nguyen $500 per month to not generate the external cost. This also internalizes the cost to Nguyen. It will cost Nguyen $500 per month in foregone payment from Vu to continue generating the external cost. If Nguyen’s benefit from generating the external cost is greater than Vu’s benefit from avoiding it ($500 per month), Nguyen will go ahead and generate the cost (paying the damages or turning down the offered payment). If Vu’s benefit from avoiding the external cost ($500 per month) exceeds Nguyen’s benefit from generating it, Nguyen will not generate the cost. Whichever party is assigned the property rights, a more efficient solution can be worked out. This is the Coase Theorem (developed by economist Ronald Coase). 3. Taxes and subsidies. To internalize an external benefit, a subsidy equal to the marginal external benefit could be offered to the consumers. To internalize an external cost, a tax equal to the marginal external cost could be imposed on the producers. To achieve the optimal quantity of output, the tax (or subsidy) needs to be equal to the external cost (or benefit). Example 4: In Example 1B, a $20 subsidy to consumers would shift the private market demand curve to the right, making it the same as the demand curve based on MSB. In Example 1C, a $20 tax on producers would shift the private market supply curve to the left, making it the same as the supply curve based on MSC. Government Regulation of Externalities Externalities can also be controlled through government regulation of the externality producing activity. If production of a good generates an external cost (e.g. pollution), the government can mandate certain types of producer behavior (e.g. pollution control devices must be used). If consumption of a good generates an external benefit (e.g. a flu shot), the government can mandate certain types of consumer behavior (e.g. everyone must get a flu shot). Unfortunately, government regulation of externalities may result in costs that exceed benefits, because: 1. Regulations are generally imposed on a blanket basis (or “one size fits all”). Example 5: Government regulations require all new cars to be equipped with catalytic converters. A catalytic converter converts harmful compounds in automobile exhaust (e.g. carbon monoxide) into less harmful compounds (e.g. carbon dioxide). Catalytic converters, which add to the cost of each new car, may benefit more than they cost for cars driven in heavily populated areas, but almost certainly cost more than they benefit for cars driven in rural areas. FOR REVIEW ONLY - NOT FOR DISTRIBUTION 2. Regulations are sometimes imposed without careful comparison of costs and benefits. 27 - 5 Market Failure
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PRINCIPLES OF ECONOMICS JEFF HOLT S
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Principles of Economics, 6th Editio
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16. Study Guide for Chapter 7 17. C
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11. Appendix: Book Review - “The
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20. Appendix: The NCAA Cartel 21. S
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Introduction: A Brief History of U.
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In the twentieth century, per capit
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Appendix: The 35 Largest National E
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Multiple Choice: ___ 1. The Jamesto
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2. Describe the economic cost of th
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Chapter 1 Scarcity and Choices The
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Example 5B: At the end of 1982, the
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Example 11: When Cindy quits her jo
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consequences may result in failure
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An upward sloping curve (as in Exam
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In making decisions, humans tend to
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5. ______________________ _________
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___ 13. If the value of one variabl
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Y Point X Y A 0 1 B 3 3 C 6 5 D 9 7
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Chapter 2 Trade and Economic System
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Example 4B: The following quantitie
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1. An increase in the quantity of r
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3. For whom to produce? This is det
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The graph below illustrates the shi
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The two primary economic systems ar
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___ 12. The capitalist vision sees
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___ 25. According to the book “Ca
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Chapter 3 Demand, Supply, and Equil
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. For inferior goods, income and de
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The same information can be placed
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Not only does a free market elimina
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$7 - 6 - 5 - S 3 S1 S 2 Price 4 - 3
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Example 17: The graph below illustr
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Questions for Chapter 3 Fill-in-the
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___ 12. Assuming a market originall
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$8 - 7 - 6 - 5 - Price 4 - 3 - 2 -
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Chapter 4 Inflation and Unemploymen
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Computing the Rate of Inflation The
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Full Employment Though unemployment
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3. Cyclical unemployment - due to d
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During the Great Depression, the ec
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Appendix: Think Like an Economist -
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Answer questions 8. and 9. based on
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___ 25. The extension of unemployme
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Chapter 5 Measuring Total Output: G
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5. Leisure. Leisure time is by defi
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The U.S. is a high per capita GDP c
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Example 17: In “An International
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The simple circular flow diagram be
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___ 3. Which of the following would
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2. Explain what nonproduction trans
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Chapter 6 The Aggregate Market The
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Example 2C: Assume the same facts a
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Example 5B: The price of crude oil
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Price Level Real GDP SRAS AD 2 AD 1
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Appendix: Why the Aggregate Demand
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___ 3. DEF Company can invest in ne
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2. List and explain the two factors
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Chapter 7 Classical Economic Theory
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Notice that the investment demand c
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Long-Run Equilibrium If Real GDP is
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Example 6B: When the economy is in
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Laissez-faire If the economy is sel
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___ 5. According to Say’s Law: a.
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3. On the graph below, draw an aggr
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Chapter 8 Keynesian Economic Theory
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Example 2B: The graph below illustr
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Example 5: Assume that the table be
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Notice on the graph on the previous
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According to Keynesian theory, a ch
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“The General Theory” also inclu
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___ 8. If the consumption function
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3. If the MPC is .667, and investme
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Chapter 9 Fiscal Policy The basic e
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Keynesian Fiscal Policy Theory and
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Example 5A: The federal government
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The Laffer Curve What will happen t
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Appendix: The Importance of Incenti
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___ 4. A decrease in government exp
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2. Explain what automatic stabilize
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Chapter 10 Money, Money Creation, a
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Example 4B: The castaways on Gillig
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Looking at the balance sheet below,
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Demand-side One-shot Inflation Exam
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4. Inflation increases uncertainty
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life; it came into existence not by
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calculated by using the potential d
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___ 12. If the required-reserve rat
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4. Referring to the balance sheet f
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Chapter 11 The Federal Reserve Syst
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5. After Bank X sells the $300,000
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Low Mortgage Interest Rates Mortgag
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Relaxed Standards for Mortgage Loan
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The Bursting of the Housing Bubble
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On February 17, 2009, the federal g
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Fed policies caused short-term inte
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___ 10. The Fed’s most important
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___ 25. In response to the recessio
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Chapter 12 Monetary Policy The basi
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2. A change in aggregate demand (AD
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Monetarist Transmission Mechanism C
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3. Borrowers do not have to seek ou
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Appendix: Book Review - “The Age
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Questions for Chapter 12 Fill-in-th
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___ 16. The primary source of incom
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7. According to Alan Greenspan, wha
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Chapter 13 Taxes, Deficits, and the
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Example 5: In 2015, Taxpayer A had
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of $5 and a quantity of 10 units. T
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The complexity of the tax law also
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the current government spending and
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cut of 1964. The top rate was lower
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___ 6. Federal excise taxes: a. are
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3. How would eliminating the loopho
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Chapter 14 Economic Growth The basi
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2. Labor. Labor can contribute to e
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estricting international trade (e.g
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An improvement in technology (e.g.
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The table below shows the economic
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will increase both Real GDP and per
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___ 8. Which of the following is co
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___ 26. The opinion that economic g
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Chapter 15 Less Developed Countries
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Example 8: Countries A, B, C, and D
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Obstacles to Economic Development f
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c. Restrictions on international tr
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Appendix: Book Review - “The Powe
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Example 25: In Brazil, about half t
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Study Guide for Chapter 15 Chapter
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___ 13. Among the counterproductive
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4. List four ways that governments
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Chapter 16 International Trade The
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Other Benefits of Free Internationa
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Example 6: The graph below illustra
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competitive disadvantage. But dumpi
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is only 25% as productive as before
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Smith was skeptical of government a
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___ 4. For Country X, what is the o
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___ 18. Frédéric Bastiat’s “P
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4. On the graph below: (1) What is
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Chapter 17 Elasticity We are often
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Example 4A: What is price elasticit
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Example 5A: Gertie’s Gas and Go i
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Example 10A: When the price of Good
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Example 13B: On the graph below, su
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$7 - 6 - 5 - Price 4 - 3 - 2 - 1 -
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In the long run, would the deadweig
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___ 7. The factors that determine w
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3. a. Which price (or prices) from
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Chapter 18 Utility The basic econom
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Nonetheless, society generally assu
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Example 9: Capital City operates a
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Marginal rate of substitution - the
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The diamond-water paradox is the ob
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Complete the table below to answer
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4. The graph below shows indifferen
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Chapter 19 The Firm The basic econo
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than contributing to team productio
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1. Difficulty in raising large amou
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Corporations also use self-financin
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Example 24: A blacksmith who produc
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For financing needs, proprietorship
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___ 13. Corporations: a. are comple
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5. List two things that the absence
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Chapter 20 Production and Costs The
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In Example 5B, Birdwell finds that
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variable cost initially decreases,
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Quantity TC MC AFC AVC ATC 0 240 X
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If the scale of operation is increa
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average total cost. Average fixed c
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___ 11. Concerning the cost curves:
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5. Complete the following cost tabl
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Chapter 21 Perfect Competition The
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Even though a perfect competitor ca
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Example 6C: This example builds on
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At what price will there be neither
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Appendix: Perfect Competition in th
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Multiple Choice: ___ 1. A perfect c
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___ 17. Perfect competition: a. req
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Answers for Chapter 21 Fill-in-the-
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Chapter 22 Monopoly Of the four mar
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3. Exclusive ownership of an essent
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maximizing quantity (4 units) creat
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$22 - 20 - 18 - 16 - 14 - Deadweigh
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2. Negotiating, beginning at a high
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Legal barriers are created by gover
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___ 8. The slope of the demand curv
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Price Quantity 3. List some of the
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Chapter 23 Monopolistic Competition
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For Percomp (the perfect competitor
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Example 7A: The graph below represe
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Example 9: The Organization of the
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Example 12 illustrates the dilemma
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its current price and quantity. The
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___ 14. Game theory: a. is a method
Page 391 and 392: Answers for Chapter 23 Fill-in-the-
Page 393 and 394: Chapter 24 Factor Markets The basic
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Page 397 and 398: Since producers will attempt to equ
Page 399 and 400: 2. Differences in nonmoney aspects
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Page 409 and 410: Chapter 25 Labor Unions The primary
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Page 415 and 416: Notice from the graph in Example 6
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Page 423 and 424: 3. The graph below represents a lab
Page 425 and 426: Chapter 26 Interest, Present Value,
Page 427 and 428: An increase in expected rates of re
Page 429 and 430: An asset is valuable because we exp
Page 431 and 432: Example 13B: General Ordnance prove
Page 433 and 434: Appendix: Present Value Table One f
Page 435 and 436: ___ 4. An increase in expected rate
Page 437 and 438: Problems: 1. List and explain the t
Page 439 and 440: Chapter 27 Market Failure The basic
Page 441: External Benefit If a market genera
Page 445 and 446: $100 - 90 - 80 - MSC 70 - $ 60 - 50
Page 447 and 448: A common good is nonexcludable. Non
Page 449 and 450: Study Guide for Chapter 27 Chapter
Page 451 and 452: ___ 5. What government policy would
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Page 455 and 456: Chapter 28 Public Choice and Govern
Page 457 and 458: Candidates and the Median Voter Mod
Page 459 and 460: Example 8: According to State and F
Page 461 and 462: Example 10: When Elvis Presley was
Page 463 and 464: 4. Pessimistic bias. This is the te
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Page 467 and 468: 2. If a certain policy will yield s
Page 469 and 470: Chapter 29 Government Regulation of
Page 471 and 472: underproduction is the amount that
Page 473 and 474: micromanagement results in business
Page 475 and 476: market. They may agree with their c
Page 477 and 478: Questions for Chapter 29 Fill-in-th
Page 479 and 480: ___ 10. The public interest theory
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Page 483 and 484: Chapter 30 Agriculture and Health C
Page 485 and 486: weather may cause bumper crops. Bad
Page 487 and 488: Security and Rural Investment Act o
Page 489 and 490: Example 12: From 1960 to 2013, the
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d. Insurance providers are not allo
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Study Guide for Chapter 30 Chapter
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Answer questions 7. through 10. by
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___ 21. If there were no individual
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Chapter 31 Income Distribution and
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Income is more equally distributed
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over a typical career is the accumu
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Ideal Income Redistribution The ide
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Poverty - a family whose income fal
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Appendix: Income Inequality around
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How is this story an analogy for th
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___ 2. In 2013, the Lowest Income 6
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Problems: 1. Explain the two primar
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Absolute advantage - when one natio
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Fiat money - money by government de
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Nonrivalrous good - a good for whic
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Absolute advantage, 16-9 Absolute e
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“Company town”, 25-6 Comparativ
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Eli Lilly and Company, 22-1 Emergen
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Houston, Texas, 15-10 Human capital
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Market, 3-1, 3-8-9 Market basket, 4
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Political bias, 9-4, 12-7 Political
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Short run production, 20-2-3 Short-
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Upturns, 9-4 USDA, 27-9, 30-1-2, 30
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