MICROECONOMICS EXAM STUDY GUIDE

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Module 1: Basic Economic Concepts
1.01 Scarcity
*Ceteris Paribus: Assume that nothing else happens
3 Basic Economic Questions:
- What will be produced, how will it be produced, and for whom will it be produced?
Scarcity and Tradeoffs.
Land, labour, capital and entrepreneurship.
Economist defines all productive resources as scarce

Supply limited, wants unlimited

Resources used to produce goods are scarce

1.02 Production Possibilities Curve

PPC: Inefficient, efficient and unattainable.
Usually, the PPC curve is an increasing opportunity cost, y/x increases

Command Economy: Government decides

Market Economy: Let the market do its thing, only step in to prevent monopolies.
Mixed Economy: There is economic freedom but the government can protect rights and
intervene if needed.
1.03 Resource Allocation and Economic Systems
Resource Allocation
Allocative efficiency: Producing at the point that society desires (Equilibrium)
Productive efficiency: Producing at a combination that minimizes costs/maximizes profits
(Equilibrium)
Opportunity Cost: The loss of other alternatives when one alternative is chosen.
Calculating opportunity cost:

1.04 Comparative Advantage and Trade

Absolute advantage: Ability to produce more with the same resources (comparing 2
companies)
Comparative advantage: Ability to produce at a lower opportunity cost than another
company.
Terms of Trade: Determined by looking at the two opportunity costs and choosing a number
that falls between the opportunity costs in order for it to be beneficial to both
1.05 Cost-Benefit Analysis
Implicit vs Explicit Cost:
Implicit is the traditional cost, direct, while explicit cost is the cost that occurred because of a
choice. (opportunity cost)
Utility= Utils per dollar, trying to get the most utils per dollar, utils/cost,
● Best one= utility maximizing choice
Utility Maximizing Rule: Consumer’s money should be spent so that the marginal utility per
dollar of each goods equal each other. (Marginal Utility per Dollar)
Example-
If the budget given to Sam at the
local county fair for food is $18,
what would be the combination of
hamburgers and soft pretzels that
would maximize his utility?

Answer: He would first buy ONE soft pretzel because the MU/P of 1 soft pretzel is 8 and the
MU/P of one hamburger is 6. He will be left over with $15.Next, he will buy a SECOND soft
pretzel (MU/P = 6) and a FIRST hamburger (MU/P = 6). He will have $10 at this point.
Then, he will buy a SECOND hamburger (MU/P = 4) and a THIRD soft pretzel (MU/P = 4).
He will end up with $5 after this. Finally, to use the last of his budget, he would buy his
THIRD hamburger (MU/P = 3) and the FOURTH soft pretzel (MU/P = 3)
The ideal combination would be 3 hamburgers and 4 soft pretzels. MU/P of 3 hamburgers =
MU/P of 4 soft pretzels (3 = 3), while still staying in budget.
* You consume until your Marginal Benefit= Marginal Cost.
01.06 Marginal Analysis and Consumer Choice
Law of Diminishing Marginal Utility: As more and more input is used in short-run
production, the marginal product declines.
Total utility: Sum of all marginal utilities
Marginal Utility: Benefit from consuming another unit of a good or service, usually decreases
as you consume more and more.
Marginal cost: cost of consuming an additional unit of a good or service, usually increasing
as you consume more and more.
Consumers always choose the good with the best MU/P, last unit of buying should be when
both goods/services have the same MU/P
Module 2: Supply & Demand
2.01 Demand
Quantity demanded is one point on the curve and Demand is the entire line with all of the
points that make it up. The only thing that changes the quantity demanded is the price of the
good or service. To shift demand, you need a non-price incentive.
Changes in the prices of related products (either substitutes or complements) can affect the
demand curve for a particular product.
Law of Demand: The relationship between the price level and the quantity demanded of a
good or service is inverse.
Law of Demand causes the demand curve to be downward-sloping for 3 reasons:
● Substitution Effect: Whenever the price of a good increases, a consumer will buy less
of that good and more of a substitute good (and vice versa).
● Income Effect: Whenever the price of a good increases, consumers have less
purchasing power, which means they can buy less of that good with their income (and
vice versa).
● Law of Diminishing Marginal Utility: As you consume a good more and more, the
additional satisfaction you get from it decreases more and more.
Several Determinants of Demand that can cause demand to shift left or right
● A change in income
● A change in the number of consumers/buyers
● A change in the price of substitute goods
● A change in the expectations of future prices
● A change in the price of complementary/substitute goods
● A change in tastes/preferences
Market demand schedule: Sum of all individual demand curves
2.02 Supply
Law of Supply: the relationship between price level and quantity supplied of a good or
service is positive. As price increases, supply can also increase and vice versa.
Quantity supplied is one point on the curve and supply is the entire line.
Determinants of Supply that can cause supply to shift left or right
● A change in resource costs and availability
● A change in the price of other goods
● Technology/Productivity
● Taxes, subsidies and other gov actions
● Expectations for the future
● Number of sellers/producers
2.03 Price elasticity of demand
Price elasticity of demand: How sensitive consumer demand is to a change in price. It shows
us just how much consumers will alter their consumption when the price of a product
changes.
Five types of Elasticity:
Perfectly inelastic (Infinity, horizontal on graph),
Inelastic
Unit elastic (inversely proportional)
Elastic
Perfectly inelastic (0, vertical on graph).
Elasticity of Demand Formula: % change in quantity demanded / % change in price.
*Take out all Negatives
Elastic Demand: EoD>1, Inelastic EoD<1, Unit Elastic=1
Elastic: P↑,TR↓ ; P↓,TR↑
Inelastic: P↑,TR↑ ; P↓,TR↓
Unit Elastic: P↑ or ↓, TR doesn’t change
*Elasticity of demand is not the slope, it varies on the demand curve
Total Revenue Test can also determine Price elasticity of Demand: Price x Quantity (apply
the above rules) OR
How to know Elasticity:

*(Q2-Q1 & P2-P1) are just the increase/decrease in price. (Change in quantity over change in
price)
2.04 Price Elasticity of Supply
Elasticity of Supply Formula: (% change in quantity supplied/ % change in price)
*drop all negatives when calculating formula
Law of Supply: As the price increases, so will the quantity that producers are willing to
provide.
Elastic: Responsive, Unit Elastic: Proportionally elastic, Inelastic: Not responsive
Input availability and time are the only determinants that affect price elasticity of supply.
2.05 Other Elasticities
Income Elasticity of Demand: Measurement of how sensitive the market is to a change in
consumers' disposable income.

*Formula: (% change in quantity demanded

for a good/ % change in income level)
Shows if its normal: a good we buy when
income increases OR inferior: good we buy if
income decreases
2 neg or pos %= normal good, 1 pos 1 neg
%= inferior good

Normal necessity if the elasticity of demand is less than 1 but greater than 0.
Normal Luxury if the elasticity of demand is greater than 1.
Cross-Price Elasticity of Demand: Measurement of how responsive the market is when a
change in the price of one good affects the demand for either a substitute or complementary
good.

Formula: (% change in demand for a good/ %

change in price for other good)
If pos= substitute, neg= complementary
*If the cross price elasticity of demand = 0,
then the goods aren’t related because a
change in price of one good doesn’t effect the
demand of the other good.

2.06 Market Equilibrium and Consumer/Producer Surplus

Market equilibrium: A market where the quantity supplied equals the quantity demanded at
an optimal price level.
Quantity shortage & surplus= Disequilibrium in the short run

Consumer surplus: Difference between the total

amount that consumers are willing to pay for a
good or service and the total amount that they
actually pay.
*When both supply and demand shift, either the
price or the quantity will be indeterminate.
Producer Surplus
2 types: Individual and total producer surplus

2.07 Market Disequilibrium and Changes in Equilibrium

If supply decreases (shifts left), consumer surplus will also decrease. If supply increases
(shifts right), it will increase as well. However, producer surplus is more ambiguous.
If demand decreases, price and quantity both decrease, and so consumer and producer surplus
will also decrease. If demand increases, they will increase as well.
2.08 Effects of Government Intervention in Markets
Whenever the government intervenes in a market in perfect competition, it will always
decrease the market's allocative efficiency.
Deadweight Loss: the total amount of consumer and producer surplus lost due to market
inefficiency. It's a visual account of the cost of market inefficiency.
Price Ceiling: Maximum legal price that can be charged for a good or service in a market or
industry.
Could be binding, which means it’s lower than the equilibrium price, or non-binding which
means it isn’t lower than the equilibrium price.

Price Floor: Minimum legal price that

should be charged for a good or service in a market or industry.
Subsidy: A government grant to producers aimed at increasing the production of integral
goods and services.
Excise Tax: A per unit tax levied on specific products that are aimed at decreasing the
production of a good or service.
Tax Incidence: Used to understand the division of tax burden between buyers and sellers.
Inelastic: Consumers pay tax, elastic: producers pay tax
2.09 International Trade and Public Policy
Public policies include quotas and tariffs.
Quota: Government-imposed limit on production levels. This means that it limits the amount
of a particular good that can come into a country from somewhere else. Quotas are used as a
trade barrier in an effort to protect the domestic industries that produce similar goods.
Tariffs: Taxing imports or foreign goods coming into the country.
Why?: Easier than taxing domestic trade, national security, and protecting domestic industries
Tariff just increases the price of the imported goods.

Import quotas have all the same effects as import tariffs except that the government does not
gain any tax revenue.
Module 03: Production, Cost, and the Perfect Competition Model
03.01 The Production Function
The Production Function- Maximum amount of output for a given input, technical efficiency
Theory of the Firm- Understanding producers; the purpose of a business is to make decisions
that maximize profits
Factors of Production: Process by which a firm takes inputs and creates outputs.
● Ex: Tomatoes, yeast, and flour are FoP used to make pizza

Fixed Costs: Costs that don’t scale with output

Variable Costs: Vice versa
Total Cost= Fixed cost+ variable costs
Total Revenue: Price * Quantity
Profit= TR-TC
Accounting Profit: Amount of money a business
makes; normal one
Economic Profit: Accounting profit plus
accounting opportunity cost, what it could’ve
made
● (Same goes with accounting and economic costs)
Total Product: Firm's total product
Average Product: Total product/ Number of units
Marginal Product: Additional output from adding one more unit of product
Law of Diminishing Marginal product: As we add more inputs, the additional product we
receive from each input eventually diminishes
Increasing Marginal Returns: Increasing MP
Negative MR: MP is negative
03.02 Short-Run Production Costs
Two states of production: Short run and Long run.
Short Run: There is at least one fixed cost.
Long run: No fixed costs.
Per Unit Cost Curves:
Average Total Cost (ATC) = TC / Q
Average Variable Cost (AVC) = VC / Q
Average Fixed Cost (AFC) = FC / Q
ATC= AFC+AVC
Marginal Cost: Change in TC/Change in Q
Because of diminishing marginal returns, we eventually see an increase in marginal cost.

Marginal Product graph is the opposite of the marginal cost curve.

Marginal product: How much output each additional unit of input produces
03.03 Long-Run Production Costs

LRATC: Lowest cost per unit at each level of output when all factors of production are
available.
Economies of scale refer to the reduction in total cost per unit as a firm increases its
production. In this phase, the firm can reduce its total cost-per-unit by boosting its
plant capacity and output.
Diseconomies of scale refer to the rise in total cost-per-unit as the firm increases its
production. In this phase, the firm would be better off reducing its plant capacity and
output in order to lower its per-unit costs.
Constant returns to scale are when the firm increases production but the costs stay the
same. The ATC is at its lowest here.
Maximum Efficient Scale: Point where the constant returns to scale and diseconomies
of scale meet.
Minimum Efficient Scale: Point where the economics of scale and the constant returns
to scale meet.

*The LRATC is just made up of SRATC curves.

03.04 Types of Profit
3 Types of Profit
❖ Accounting profit: Total revenue minus the firm's explicit costs. (or ATC < price)
❖ Economic profit: Accounting profits minus the firm's opportunity/implicit costs.
(ATC = price)
❖ Normal Profit: Zero economic profit (ATC > price)
Economic Losses: Costs > Revenue
Supernormal Profits: Profits in the long run
03.05 Profit Maximization
Profit-maximizing rule: Marginal Cost=Marginal Revenue
Profit: Revenue-cost
Normal Economic Profit: ATC=MC=Price
MC-ATC= Profit/Loss

03.06 Firms' Short-Run Decisions to Produce and Long-Run Decisions to Enter/Exit a

Market

Economic Profit
Produce with Profit: MR = MC = P > ATC
Short run: Firms obviously continue to produce.
Long run: Firms will enter the market and push the
market price down.

Zero Economic Profit

Break-Even: MR = MC = P = ATC
At this level, businesses will continue to operate in
the short run. They will stay in the market in the long
run.

Negative Economic Profit

Produce at a Loss: MR = MC = P < ATC
Businesses will continue to operate in the short run to
minimize their losses. However, they will leave the
market in the long run.
Why Produce with a Short-Run Loss?
Business will lose less, because at least some of the fixed costs are paid for by product
revenue. Shutting down, however, means zero revenue, and the entire fixed cost is counted as
a loss.
The Shut-Down Rule: When the price of the good or service drops below the average
variable cost; it means that the firm should continue to operate as long as the price is equal to
or above the AVC.
03.07 Perfect Competition
Characteristics of a Perfectly Competitive Market
Many, small firms in the industry.
Firms are "Price Takers": Must charge market price because it lacks market control.
Low barriers to entry: In perfect competition, there are very low barriers of entry so it
is very easy for firms to enter or exit as they see fit.
Firms break even in the long-run: Perfectly competitive firms cannot make an
economic profit and will only break even. In long-run equilibrium, price is equal to
marginal cost and the minimum ATC.
Products sold are identical: In perfect competition, the various products that are sold
are identical. No firm has a better/different product.
No non-price competition: Consumers and producers know they’re identical, no need
for advertising.
Firms are perfectly efficient in the long-run: Both allocatively and productively
efficient.
Difference between MC and ATC = Profit/Loss.
On a graph, allocative efficiency is P( or MR) = MC, and productive efficiency is P =
minimum ATC.
Perfectly elastic: Short-run profit/loss, long-run will always return to normal economic profit.
Long-run supply: The line that connects the old long-run equilibrium to the next long-run
equilibrium. Tells you whether your market is in an increasing, constant, or decreasing cost
industry.
Module 4: Imperfect Competition
04.01 Basics of Imperfectly Competitive Markets
Imperfect competition is a market structure where there are some restrictions on competition,
leading to the absence of perfect competition.
Imperfectly competitive markets include monopoly, oligopoly, and monopolistic competition.
Monopsony- Single buyer market
Characteristics of Imperfectly Competitive Firms
Fewer, large firms in the industry
Firms are "price makers"
Higher barriers to entry means firms cannot enter as easily
Firms earn long-run profits (except monopolistic competition, which break even in the
long-run)
Products that are sold are differentiated
Non-price competition is used
Firms are inefficient in the long-run
Demand is greater than marginal revenue
Price maker means that the firms have some or total control over the price at which they
choose to sell their goods in the market

In all of these imperfectly competitive

markets, the products are differentiated
which leads to non-price competition.
Non-price competition is when
companies use tools like advertising to
promote their products.
In imperfect competition, suppliers must
lower their price to sell additional units at
every level of output.
Want it where MR=MC.
Barriers to entry:
Legal Barriers
High Startup Costs
Brand Loyalty
Specialized knowledge & training
Trade Secrets, Patents
04.02 Monopoly
A monopoly is a market structure in which one supplier controls the market, the price-setter.
Natural monopoly occurs when an individual firm comes to dominate an industry by
producing goods and services at the lowest possible production cost. Ex- Electricity and
water utilities (Good for society)
You know if it’s a natural monopoly if its ATC is still declining when it intersects with
the demand curve.
Characteristics of Monopolies:
High barriers to entry: Makes it difficult or impossible for other firms to enter the
market. These barriers can be economic, legal, or related to access to resources.
Firms earn long-run profits: They do not face competition and can charge higher
prices. There is also no long-run adjustment like in perfect competition since a
monopoly is the entire market
Products sold are unique: Monopolies typically sell unique products or services that
are not offered by other firms in the market.
Non-price competition is used: Non-price competition, such as advertising or
improving product quality, may be used by a monopoly to differentiate itself from
potential competitors.
Firms are inefficient if they are left unregulated: If left unregulated, monopolies may
be inefficient due to lack of competition, which can lead to higher prices and reduced
innovation. Government regulation can help to promote competition and prevent
monopolies from becoming too powerful.

Profit/Loss is
determined by
where the
ATC curve is.
Profit-Maximizing output: Where MR=MC.
Socially optimal price and output: This is located where P = MC.
Fair-return price and output: This is where P = ATC. Earn normal profits because TC=TR
Monopolies are not allocatively and productively efficient because they overcharge and
underproduce.

Consumer Surplus- From profit maximizing point and up,

the difference between the price consumers pay for a
product or service and what they're willing to pay. (Positive)
Producer Surplus- From profit maximizing point and down,
the difference between the amount the producer is willing to
supply goods for and the actual amount received by him
when he makes the trade. (Positive)

Dead-Weight Loss (DWL): The cost of market inefficiency. See graph above for example.
Monopoly Elasticity:
❖ Elastic: Before MR=MC
❖ Unit-Elastic: When MR=MC
❖ Inelastic: After MR=MC
04.03 Price Discrimination (Monopoly)
Price discrimination: Charging different prices for the same good, where each consumer is
charged the highest price that they are willing and able to pay. (Most common example is
time: plane tickets price difference for early bird and last minute)

3 Conditions Make Price

Discrimination Possible:
1. Must have some market power
2. Be able to separate consumers:
Figuring out how much each
consumer is willing to pay
3. Prevent resale/ Make resale
difficult
Characteristics Pure Monopoly Price Discriminating Monopoly

Demand & MR D > MR D = MR

Efficiency Productively and allocatively Allocatively efficient, productively

inefficient inefficient

Economic Profits Smaller long-run economic profts Larger long-run economic profits

Consumer Some consumer surplus Zero consumer surplus

Surplus

04.04 Monopolistic Competition

Monopolistic Competition: Many firms selling slightly differentiated products with low
barriers of entry, dependent on ads, and an imperfect market structure.
Price Makers: Each firm has some market power
Firms break even in the long-run: Normal Profits
Firms are inefficient when left unregulated
Firms experience "excess capacity" in the long run - these markets are productively
inefficient! They do not produce where price = min ATC
When firms earn a profit in the short run, it compels firms to enter the market, and vice versa.

Excess Capacity: Optimum output (min.

ATC point)- firms inefficient level of
output (MR=MC).

04.05 Oligopoly and Game Theory

Oligopoly: Market with very few suppliers who each have significant market power.
2 types of Oligopolies:
- Colluding oligopolies- the firms communicate with each other and act as one unit to
maximize profits (illegal in most places)
- Non-colluding oligopolies/price leadership - the firms compete and do not work
together
Characteristics of Oligopolies:
- High barriers to entry
- Firms earn long-run profits
- Inefficient if left unregulated: Price does not always= MC
*Interdependent: Firms profit is dependent on the actions of the other firms in the market
Game Theory: Study of how people behave in strategic situations
Duopoly: Market with 2 producers (Almost always what you are going to use)

Prisoner’s Dilemma (Not necessary to know

on AP exam but helps you to understand the
logic behind this and why we’re learning this):
Since both of them have a dominant strategy
to confess, they’ll both confess and get 8 years
each. This shows why oligoplies are rarely
able to enjoy the benefits of full cooperation
because there is an incentive to cheat for personal gain.
Dominant Strategy: A player’s best action regardless of the actin of the other players.
Nash Equilibrium: No player can gain a greater payoff by changing strategy when the other
player doesn’t/cannot move.
Neither firm has a dominant strategy: 2 Nash equilibrium
Example-
(Table is called a payoff matrix)

Coke strategy:
If Pepsi chooses high, Coke would
choose low.
If Pepsi chooses low, Coke would
still choose low.
Coke Dominant Strategy: Low.

Pepsi Strategy:
If Coke chooses high, Pepsi would choose low. If Coke chooses low, Pepsi would choose
low.
Pepsi Dominant Strategy: Low.
Nash Equilibrium would be (1000, 1000) because both firms have a dominant strategy of low.
Module 5: Factor Markets
05.01 Introduction to Factor Markets
The factor market is where the factors of production are sold by households to businesses.
*Critical to Understand: In the factor markets, household consumers are the suppliers and
business firms are the demanders.
Derived demand: The idea that business demand for any factor of production comes from
consumer demand for what final product that factor will be used to make. Ex- Demand for
carpenters is derived from the demand for homes. If there was a spike in demand for new
houses, demand for carpenters will increase as well.

In this example, the consumers increased demand for cars has caused the increased demand
in steel.
Factors of production-
- Land- Corresponding Payments: Rent
- Labour- Corresponding Payments: Wages
- Capital- Corresponding Payments: Interest Payments/Dividends
- Entrepreneurship- Corresponding Payments: Profits/Dividends
Process
1. Consumers demand products and offer money to businesses for those products.
2. Businesses demand the factors needed to produce those products and offer money to
consumers for those factors of production.
Law of diminishing marginal returns: As variable resources are added to fixed resources, the
additional output produced from each new input will eventually fall. (Productivity will
eventually be maximized)

Law of Demand for Labour: Inverse relationship

between wage rate and demand for labour
(Without shifting, only movement on the
demand curve)
Law of Supply for Labour: Positive relationship
between wage rate and supply for labour
(Without shifting, only movement on the supply
curve)
Marginal Revenue (MR): How much revenue
each additional unit brings
Marginal Product (MP): Additional units of output from another unit of input (Can be neg.)
MR*MP=MRP
Marginal Revenue Product (MRP): Revenue gained by another unit of input
Marginal Resource Cost (MRC) = Supply: Cost of another unit of input
Perfectly Competitive Output Market where MR=P
- MP(labour)*P(q)= MRP(labour)
Profit Maximization
- Where MRP=MRC
- Ex: MRP > MRC, we should still hire and vice versa
05.02 Changes in Factor Demand and Factor Supply
Determinants of Factor/Resource Demand
Prices of Related Input: These include substitute and complementary resources that
are used in the production of goods and services. If the price of one resource becomes
more expensive, the firm will increase their demand for the substitute resource. In
looking at complementary resources, we can look at the production of soft drinks.
Ex: If the price of aluminium increases, then we would see the demand for
sugar decrease since both products are used to produce soft drinks.
Changes in Productivity: Let's take a situation where a new technique is developed
that cuts production time in half. Since labour productivity has increased, each worker
can make a greater quantity of goods than they used to. This leads to each worker
generating a greater marginal revenue product which increases their value to the firm
or business. As a result, this increases the demand for labour.
Product Demand: For example, if there is an increase in the demand for pizza, then
there will be greater demand for all the resources that are involved in the production
of pizza, including cheese, sauce, dough, and workers. Resource demand can also
change when the price of a product changes. For example, if the price of pizza
decreases, then the worker who is trained to make a pizza generates a smaller MRP
(because MRP = MP x price), so the demand for these workers will decrease.
Test Your Understanding:
Determinants of Factor/Resource Supply:
Number of Qualified Workers: immigration, education, and demographics can all
affect the number of qualified workers, increasing/decreasing the labour supply.
Government Regulations: Licenses, how strict they are
Personal/Cultural Values regarding leisure time and societal roles
Test Your Understanding

Shortages and Surpluses of Labor

Could be caused by minimum/maximum wage

Changes in the Labor Market Equilibrium: (Both demand and supply):

05.03 Perfectly Competitive Labour Markets

Two types of factor markets: 1st one is the perfectly competitive factor markets.
Left: Market
Right: Firm

Least-Cost Rule (for profit-maximization):

Marginal Product/ Price of Labour =
Marginal Product/ Price of Capital
If MP/P of labour > MP/P of Capital, then you should increase labour and decrease capital.
Example:
​Sloth Emporium is a business that currently employs 4 workers, and the marginal product of
the last worker is 10 units of output. The firm is also using 25 units of capital, and the
marginal product of the last unit of capital is 2 units of output. The firm is currently using a
cost-minimizing combination of labour and capital, and the wage rate is $20 per hour.
Answer:
The last worker costs $20 to gain 10 units of output. 10 units / $20 = 0.5 units per dollar.
The last unit of capital costs $x to gain 2 units of output. 0.5 units per dollar = 2 units / x
dollars/
0.5 = 2/x (multiply by x on both sides to get x out of the denominator)
0.5x = 2 (2 divided by 0.5 to isolate x), x = 4
*To produce a certain amount of MP combined, add up the total for Labor and Capital to get
the closest number to the required amount.
05.04 Monopsony Markets
The second type of factor market.
Monopsony- An imperfectly competitive factor market where only a single firm buys
resources. More broadly, it is a market that has one buyer and many sellers.
More Characteristics:
- MRC > Supply (willingness to sell) - This is because when you hire an additional
worker, you must pay them a higher wage than the previous worker. However, you
cannot wage discriminate, so you not only have the additional cost of that worker but
also the cost of bringing all the earlier workers up to the current wage rate.
Ex- In this labour market,
the marginal resource
(wage) cost of $12
represents paying $9 to the
4th worker and then an extra
dollar to each of the first 3
workers, or another $3.
- Worker’s wage< MRP because of market power
D=MRP because of the law
of diminishing marginal
returns.
MRC>Supply because a firm
cannot wage discriminate.
Determine # of workers: find
MRP=MRC and look at the
x-axis.
Determine wage: MRP =
MRC and then go down to
the supply curve.
S intersects D=MRP: Where
the firm would be if it was
competitive.

Differences between a Monopoly and a Monopsony

Unit 6: Market Failure and the Role of Government
06.01 Socially Efficient and Inefficient Market Outcomes
Social Benefits: Total benefit in society due to the production of goods and services by a firm
Social Cost: Total cost paid for by the society due to the activities of a firm.

Socially Optimal Outcome

-When Marginal Social Benefit
(MSB) = Marginal Social Cost
(MSC)
MSB>MSC, underproducing and
vice versa
Marginal Social Benefit (MSB):
The additional benefit received by
all members of society due to the
consumption of an additional unit
of a good or service. (Can either be
direct or indirect) Decreases due to
the law of decreasing marginal
utility.
Marginal Social Cost (MSC): The additional cost incurred by all members of society due to
the consumption of an additional unit of a good or service. (Can either be direct or indirect)
Marginal Private Benefit (MPB): Change in the producer's total benefit brought about by the
production of an additional unit of a good or service.
Marginal Private Cost (MPC): Change in the producer's total cost brought about by the
production of an additional unit of a good or service.
06.02 Externalities
Externality is a third-person side effect of an economic decision that impacts someone other
than the original decision-maker.
Two types of Externalities:
- Positive: MSB>MPB
- Solution: Underproduction in the market, needs to encourage production with
a per-unit subsidy
- Negative: MSC>MPC (Overproduction in the market)
- Solution: Per-unit tax
Example (Graph):
This is a negative externality,
which could’ve been a factory
that produces cigarettes or a
factory causing pollution.
Besides their production costs,
there are many more costs to
society.
*Since you want to produce where MSB=MSC, you always move the MPB/MPC when using
the per-unit tax/subsidy.
Without intervention, the neg/pos externality will produce where MPB=MPC. The cost will
be where MPC intersects the MR.
Government Solutions
1. Tax or subsidize
2. Regulate
3. Publicly provide
4. Assign/Reassign property rights
06.03 Public and Private Goods
Public Good: An economic good that is provided by the government in the public sector
because the free market, or the private sector, has failed to produce them.
- Many can consume simultaneously & nonpayers can easily consume.
Private Good: The free market for goods and services where all economic decisions are made
by consumers who demand products and by firms that supply products.
- Nonpayers are excluded and only one can consume at a time.
Free Riders: A person who didn’t pay for a good/service but enjoys the benefit anyways.
Tragedy of the Commons: Consumers act in their own self-interest and over-consume.
Excludability: Producers prevent nonpayers from using the product/service.
Rivalry: Consumption by one prevents consumption by someone else.
Government can solve free riders by
1. Punishing them, although it might not be a public good anymore
2. Taxing everyone
Example Chart:
06.04 The Effects of Government Intervention in Different Market Structures
Government Intervention and Elasticity:

This is a perfectly inelastic supply and demand graph.

Whoever has the lower elasticity will pay more for a tax and benefit more from a subsidy.
Supply= Suppliers, Demand= Consumers
If supply is more elastic, consumers pay more of the tax; if demand is more elastic, suppliers
pay more for the tax.
The graph shows how much consumers and producers pay.

A per-unit tax affects MC and ATC because it is an additional cost for each unit.
Lump-Sum tax: Only affects ATC because it is a once-off payment.
Anti-Trust Policy: A type of government regulation that restricts monopolistic behaviour of
firms in the market, which limits the ability to consolidate/increase market power.
Monopoly Regulation
- Problem: Market power means output is less than the socially optimal quantity. (Lack
of competition)
- Solution: Antitrust policy increases competition (number of firms) in the market OR a
price ceiling shown below which lowers DWL.
Natural Monopoly Regulation
- Problem: Long-run economies of
scale
- Solution: Regulate price with a
price ceiling
In the example on the right, a price ceiling
at the socially optimal level would be
below the ATC which means they would
be losing money, so to get normal profits
they would set a price ceiling at the fair
return level.
Monopsony Regulation
- Problem: Labor market power
means fewer workers are hired than socially optimal.
- Solution: Effective minimum wage increases the quantity of labour hired.
In this graph, the DWL get lowered from
the purple + grey section to only the grey
section, because it produces at the MFC
min= MRP.
06.05 Inequalities
2 Types of Economic Inequality:
Income Inequality: Looks at how annual earnings are distributed
Wealth Inequality: Looks at how assets are distributed.

Use a Lorenz Curve to graphically

represent income inequality.
Gini Coefficient: Numerical measurement
of income inequality.

A: Area between perfect equality and Lorenz

curve.
B: Area under the Lorenz curve.
- Calculated as a number between 0&1, where 0 =
Perfect Equality and 1 = Perfect Inequality.

3 Types of Tax Structure

● Regressive
○ A person pays a lower percentage of their income the more they earn.
● Proportional
○ A person's tax is proportional to their income level; the percentage rate is the
same for everyone regardless of income.
● Progressive
○ A person pays a higher percentage of their income the more they earn. (Ex-
Tax Brackets)
*Within a progressive tax system, a person's total average tax rate will always be lower than
their marginal rax rate.