Final Exam Review Sheet - Introduction to Microeconomics | EC 201, Study notes of Microeconomics

Download Final Exam Review Sheet - Introduction to Microeconomics | EC 201 and more Study notes Microeconomics in PDF only on Docsity! Professor C.L. Ballard Fall Semester, 2011 ECONOMICS 201 KEY CONCEPTS FROM THE FINAL PART OF THE COURSE I. Regulation and Antitrust A. An industry is a natural monopoly if a single firm can produce all of the relevant output at a lower average total cost than could any combination of two or more firms. This will occur where average total cost is declining throughout the relevant range. It was once thought that electric-power utilities are natural monopolies, although there is evidence that this may not be the case. In fact, there are probably few natural monopolies, if any. B. If a natural monopoly does exist, marginal-cost pricing is problematic, since the firm would suffer economic losses if it were to charge a price that is equal to marginal cost. However, monopoly profit maximization is also unattractive. As a result of these problems, governments have sometimes responded by regulating the monopolies. Often, there is an attempt to guarantee a “normal” rate of return. This would mean that the firm would be required to charge a price that is equal to average total cost. The problem with this is that it may reduce the incentives to control costs. If a regulated industry is in fact not a natural monopoly, the best strategy is probably to allow new firms to enter the industry, so that competition can take hold. C. Much of the regulation in the United States has not dealt with natural monopolies, but rather with industries that could be very competitive. Here, the regulation has come about as a result of the political power of the industries themselves. In many cases, regulation has stifled competition and led to higher prices. Starting in the late 1970s, deregulation succeeded in getting lower prices in trucking, airlines, and other industries. D. The antitrust laws began with the Sherman Act in 1890, and were expanded by the Clayton Act in 1914. The antitrust laws prohibit monopoly, price fixing, certain types of price discrimination, tied sales, predatory pricing, and interlocking directorates. The most spectacular uses of these laws have been the breakups of large companies, such as Standard Oil and American Tobacco in 1911, ALCOA in 1945, and AT&T in 1984. E. Other important antitrust cases include the electrical-equipment conspiracy, in which General Electric, Westinghouse, and other firms were found guilty of having fixed prices in the late 1950s. More recently, Archer, Daniels, Midland was fined for price fixing in the market for lysine in 1998. F. The antitrust laws can also be used to prohibit mergers, in cases where the mergers will reduce competition substantially. A conglomerate merger is one between two firms in unrelated industries. Conglomerate mergers do not pose much of a problem for competition, and they are usually not the subject of antitrust actions. A vertical merger is one between a firm and one of its input suppliers. Vertical mergers may present more problems than conglomerate mergers, but vertical mergers still are not a major concern for antitrust officials. The main concern of the antitrust authorities is with horizontal mergers, which are mergers between firms in the same industry. Even with horizontal mergers, it is not always true that the mergers are a problem from the perspective of competition. If 1 the merger is between two small firms in a very competitive industry, the resulting combined firm is unlikely to wield much market power. On the other hand, if two large firms merge, it is possible that the degree of competitiveness of the industry will be reduced substantially. In spite of this, the antitrust authorities have allowed many very large horizontal mergers. II. Labor Markets A. The benefit that a firm gets from hiring an extra unit of labor is the marginal revenue product (MRP). The MRP is equal to the marginal product multiplied by the marginal revenue: MRP = (MR) (MP). Marginal product is decreasing. Marginal revenue is constant for a perfectly competitive firm, and marginal revenue is decreasing for a firm that is not perfectly competitive. Therefore, the marginal-revenue-product curve is downward sloping. If the firm is a perfect competitor in its input market, the cost to the firm of hiring an extra unit of labor is the wage rate. Thus, the firm's optimal input choice will involve hiring the number of workers at which the marginal revenue product is equal to the wage rate. As a result, the marginal-revenue-product curve is the firm's demand curve for labor. The labor-demand curves of the individual firms are summed horizontally to get the market labor- demand curve. More generally, for any input, if the firm is a perfect competitor in the input market, the firm’s optimal input choice will involve using the amount of the input at which the marginal revenue product is equal to the price of the input. As a result, the marginal-revenue-product curve is the firm’s demand curve for the input. B. The worker's labor-supply curve comes from the choice between consumption and leisure. Leisure is a normal good, so that increases in non-labor income lead to increases in leisure, and thus to a reduction in labor supply. If the wage rate rises, the substitution effect leads to an increase in labor supply (“I can’t pass up that kind of money”), but the income effect works in the opposite direction (“I can work less and still pay my bills”). If the wage rate falls, the substitution effect leads to a decrease in labor supply (“If that’s all I get paid, why should I bother to work?”), but the income effect leads to an increase in labor supply (“I have to work harder just to keep food on the table”). Thus, it is not possible to tell, from theoretical considerations alone, whether labor supply will increase or decrease as the wage rises. The empirical evidence is that married men have very inelastic labor-supply curves (elasticity close to zero), whereas married women probably have somewhat more elastic labor supply (elasticity positive, but probably not extremely large, possibly 0.2 or 0.3 or 0.4 or 0.5). If we combine these, the weighted average of the labor-supply elasticities is probably fairly small—probably something like 0.1 or 0.2. C. Market wages are determined by the interaction of labor supply and labor demand. Market wages tend to be high when the demand curve is far to the right, either because the price of the product is high or because the workers are very productive at the margin. On the supply side, wages will be high when the supply curve is farther to the left. This can occur for positions that require special skills (i.e., skills that are costly and/or difficult to acquire), or where the unpleasant nature of the job means that workers need an extra financial incentive to take the job. The differences in wages between unpleasant jobs and pleasant jobs (holding constant other influences) are called compensating wage-rate differentials. D. Human-capital differences are one of the most important sources of wage differentials. Those with 2 B. Zero pollution is not a reasonable goal. At the socially optimal quantity, the amount of pollution will be positive. The social optimum involves the correct balance between the social marginal benefits and social marginal costs, taking all of the relevant costs into consideration. But since most industrial processes involve at least some pollution, it will usually not be possible to push pollution to zero. C. In some circumstances, an externality may be solved by private negotiation. This idea was popularized by Ronald Coase. However, the Coase solution may not work well for many externality problems, because they tend to affect a very large number of people. When large numbers of people are involved, the transactions costs of private negotiation can be very large. D. Economists have often advocated taxes (called Pigouvian taxes after A.C. Pigou) to control externalities. A Pigouvian tax will give firms the incentive to use pollution-control devices. A related method of controlling pollution is to use marketable licenses. E. In the United States, regulations have been used more widely than Pigouvian, market-oriented mechanisms. There will be inefficiency if the regulations require all firms to meet the same pollution standard, or to use the same pollution-reduction technology. This is because different firms usually will have different technologies of cleaning up. It will be most efficient if pollution abatement is undertaken in such a way that all firms have the same marginal cost of pollution abatement. This will only occur by accident when we use regulations. However, Pigouvian, market-oriented mechanisms will correct this inefficiency. In the presence of a Pigouvian tax, all firms will want to clean up until the marginal cost of pollution abatement is equal to the tax rate. Thus, the Pigouvian tax will lead to a situation in which the marginal cost of pollution abatement is the same for all firms. This is the condition for efficiency. F. A potential advantage of Pigouvian mechanisms is that they can raise revenue for the government. This revenue can be used to reduce our reliance on other taxes. Most taxes generate deadweight loss, or excess burden. If we use Pigouvian taxes (which actually improve the allocation of resources in the economy) to replace other taxes that generate excess burden, there will be a gain to society. G. The “Tragedy of the Commons” is a phrase that is used to refer to common-property-resource problems. These problems occur in situations where the property rights to a resource are either poorly defined or poorly enforced. For example, in international waters, no one has clearly established ownership of the fish. Thus, it is in everyone’s interest to deplete the resource as rapidly as possible. After all, if a fisherman leaves fish in the sea, they will not be preserved for future generations; they will only be caught by another fisherman. One possible response to common-property-resource problems is for a government to auction off the rights to the resource. V. Public Goods Most of the commodities studied in this course are private goods. However, some commodities or 5 activities can be characterized as public goods. One characteristic of public goods is that they are nonrival in consumption. That is, it is possible for many people to enjoy the activity or commodity simultaneously, without interfering with each other's enjoyment. The other characteristic is that public goods are nonexcludable. That is, it is difficult or impossible to exclude those who don't pay from receiving the service. Consequently, it is likely that public goods will be associated with market failure. The private market may not be able to provide public goods at all. In order to derive a "social demand curve", or "social willingness-to-pay curve", we sum the individual curves vertically. The optimal amount of a public good would be given by the intersection of the social willingness-to-pay curve and the relevant supply curve. However, unlike the case of private markets, there is no mechanism that will push strongly toward this outcome. Instead of relying on market forces, as we do for private goods, we rely on political and bureaucratic processes for public goods. VI. Taxation A. The first characteristic of any good tax system is that it must raise revenue. Another desirable characteristic is that the tax system should have low costs of administration and compliance. A third desirable characteristic is that the tax system should not generate a lot of inefficiency in the workings of the private economy. Also, it would be good for the tax system to be “fair”, although different people define fairness in different ways. These desirable characteristics are often in conflict with one another. Therefore, it is difficult to identify an overall tax system that is optimal in every way. B. A progressive tax is one for which average tax rates (tax divided by income) rise with income. For a regressive tax, the opposite is true. For a proportional tax, the average tax rate is constant. The vertical equity of a tax depends on its degree of progressivity or regressivity, although different people may reasonably desire different degrees of progressivity or regressivity. Horizontal equity means that taxpayers in similar circumstances should pay similar taxes. Marriage penalties and marriage bonuses are widely viewed as violations of horizontal equity. C. Most taxes generate inefficiency, which we call excess burden, or deadweight loss. The excess burden arises because the dollar value of the losses to the private economy will exceed the amount of tax revenue. (This does not mean that government spending is necessarily bad, because the social value of government programs can also be greater than the tax revenue. However, it does mean that, all else equal, we should look for sources of revenue that do not generate a lot of excess burden.) Excess burden will be relatively greater for taxes on commodities that are relatively more elastic in demand or supply. D. When we study tax incidence, we try to determine who really pays a tax. The ultimate incidence of any tax will depend on the shapes of the supply and demand curves in the markets that are affected by the tax. An example of this is that the payroll tax will be borne primarily by workers (because their labor supply is fairly inelastic), regardless of whether it is levied on employers or employees. In general, economic agents whose behavior is inelastic will tend to bear most of the burden of taxes. Those with elastic behavior will escape the burden of the tax by changing their consumption or production decisions. Consequently, it is important to remember that it is not economically meaningful to talk about taxes that are borne by businesses. All taxes must ultimately be borne by people. Taxes that are officially levied on businesses (such as corporate income taxes or some property taxes) must ultimately be borne by people. Business taxes may be borne by (1) owners of capital (because of decreases in stock prices, or profits, or dividends, or interest), and/or (2) workers 6 (because of decreases in wages), and/or (3) consumers (because of increases in prices). E. The federal individual income tax is progressive, for two reasons. First, the income tax has exemptions, which mean that a few thousand dollars of income are shielded from tax, for every member of a household. Second, the income tax has graduated marginal rates, which means that the tax rate on one additional dollar of income will be larger, when the income is larger. F. The payroll tax is levied as a flat percentage of labor earnings, up to a ceiling. Beyond the ceiling, the marginal tax rate on earnings is much lower. Thus, the payroll tax is somewhat progressive at very low incomes (because it does not apply to transfer payments), approximately proportional over most of the income range (because most households get most of their income from labor earnings, and most workers fall below the ceiling at which the tax rate falls), and somewhat regressive at high incomes. The regressivity of the payroll tax at high incomes is partly because the payroll tax does not apply to capital income, and partly because of the decrease in the tax rate on earnings above the ceiling. G. Sales taxes tend to be regressive. Sales taxes only apply to goods that are purchased; they do not apply to savings. Since higher-income people tend to have higher savings rates, and since savings are not taxed by the sales tax, the burden of sales taxes tends to be relatively higher for low-income people. H. Overall, the U.S. tax system is probably somewhat progressive, although it may not be very far from proportional. VII. The Personal Distribution of Income A. The personal distribution of income will depend primarily on the prices of factors (wage rates and capital prices) and on the distribution of endowments of factors (that is, who has the most labor skill and who owns the most capital assets). The personal distribution of income also depends on transfer payments. B. The Lorenz Curve summarizes information about the distribution of income. The Gini Coefficient, or Gini Index, or Gini Ratio, can be calculated from the Lorenz curve. The Gini coefficient varies from a value of zero (for a completely equal distribution) to one (for extreme inequality). C. During the 1930s and 1940s in the United States, the Gini coefficient decreased substantially, i.e., the distribution of income became more equal. This was due in part to a tremendous increase in the rate of high-school graduation, which increased the supply of more-skilled workers, and decreased the supply of less-skilled workers. Labor unions also helped to boost the incomes of workers at the lower end of the wage scale. Greater regulation of the financial-services sector meant that the earnings of those who worked for big banks and Wall Street firms were reduced. From about 1955 to 1975, the degree of inequality in the United States income distribution was remarkably constant. Since about 1975 in the United States, the Gini coefficient has risen, i.e., the distribution of income has become more unequal. This is due to several factors. One important factor is that technological change has increased the demand for more highly skilled workers relative to less-skilled workers. Other factors include the decline of unions, increases in manufacturing imports, immigration of low-skilled workers, the decrease in the real value of the minimum wage, the decline in certain kinds of transfer payments, and the rapid increase in earnings for Chief Executive Officers and others with very high incomes, 7