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Microeconomics 1 - Summary - ECON 1101

Microeconomics 1 (University of New South Wales)

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1. COMPARATIVE ADVANTAGE
AND COMPARITIVE ADVANTAGE
COMPARATIVE ADVANTAGE AND THE BASIS
FOR TRADE
 Absolute advantage – when one person is able to produce g&s or perform a task, with less
resources than another person
 Comparative advantage – when one person’s opportunity cost of producing g&s or
performing a task, is lower than another person’s opportunity cost
 Principles of comparative advantage – everyone can do better when each person
concentrates on the activities for which their opportunity cost is lowest (ie comparative
advantage)
PRODUCTION POSSIBLITY CURVE

 Production Possibility Curve (PPC) describes the maximum amount of one good that can be
produced for every possible level of production of another good.
- Assumptions
1. There are only two possible productive activities
2. There are only two individuals
3. There are no transaction costs when trading and no other barriers to trade
- All points on the PPC are called efficient points.
1. Efficient Production Point: currently available resources do not allow an increase in
the production of one good without a reduction in the production of the other
- Inefficient points are points corresponding to situations where inputs are not used efficiently.
2. Insufficient Production Point: currently available resources allow an increase in the
production of one good without a reduction in the production of the other. All the
points below and to the left of the PPC are inefficient.
- However, both efficient and inefficient points are attainable points.
3. Attainable Production Point: can be produced with the currently available resources.
All the points on the PPC or below and to the left of the PPC are attainable.
- In contrast, the points to the right and above the PPC are called unattainable.
4. Unattainable Production Point: cannot be produced with the currently available
resources.
Opportunity Cost: of a given action is the value of the next best alternative to that particular action.

- To calculate the opportunity cost of producing one unit of the good depicted on the x-axis;
divide the vertical intercept (y- axis) by horizontal intercept(x-axis). Vice versa
- Greater the difference between two opportunity costs  greater the gains from specialisation.

PRODUCTION POSSIBILIIES CURVE FOR A MANY-PERSON ECONOMY

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 Shape of the PPC reflects the Principle of Increasing Opportunity Cost ‘the low-hanging fruit
principle’ – in expanding the production of any good, first employ those resources with the
lowest opportunity cost and only afterwards turn to resources with higher opportunity costs.
 The greater the differences among individual’s opportunity costs, the more bow-shaped PPC
will be and the greater the potential gains from specialisation will be.
 The slope of PPC becomes increasingly negative as we read from left to right, this shape is
essentially due to the fact that resources are scarce.

FACTORS THAT SHIFT PPC

 Increase in productive resources; i.e. investment in new factories and equipment

 Increase in population, and so in labour force
 Advancements in knowledge and technology, via education, R&D, IT and communications
technologies

PRODUCTION AND CONSUMPTION POSSIBILITIES AND THE BENEFITS OF TRADE

- Economic welfare of a country doesn’t depend on what it produces, but what it consumes:
where a particular point is on the CPC depends on the needs and wants of the population
Consumption possibilities curve (CPC) is a graph that describes the maximum amount of one good
that can be consumed for every possible level of consumption of the other goods.

- The relationship between the two curves depends on whether the country is open to
international trade or not. Specifically:
 Closed economy (doesn’t trade nationally), PPC and CPC are the same
 Open economy (trades on the international market), the CPC is usually greater than
the PPC because part of what is produced can be traded for other goods and services,
which relieves the restrictions on consumption.
- Since the PPC is always below the CPC, consumption opportunities in an open economy are
always wider than in a closed one.

CRITIQUES TO THE MODEL

 No psychological cost: Having to perform the same activity everyday can generate dissatisfaction
 No transaction cost: No import quotas or tariffs would limit the gains from specialization,
making it pointless beyond a certain level.
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 Specialisation in performing an activity: sunk cost; the needs for goods/activities will change.
 Disregards to preferences or social norms that might prevent trade

2. PERFECTLY COMPETITVE MARKETS

 Market: set of all the consumers and suppliers who are willing to buy and sell a given good.
 Market equilibrium: occurs in a market when all buyers and sellers are satisfied with their
respective quantities at the market price

 Perfectly competitive market is a market in which no individual supplier has any influence
on the market price of the product
 Price taker is a firm that has no influence over the price at which it sells its product
 Externality is an external cost or benefit of an activity incurred by someone who is not
involved in the production/consumption of a given good.

Characteristics of perfectly competitive markets

 Consumers and Suppliers Are Price-takers: A equilibrium, both suppliers and consumers
are not willing/able to affect the market price.
 Homogenous Goods: All suppliers sell exactly the same product. E.g. the wheat market
 No externality: All production costs and benefits are incurred by the supplier of the good;
similarly, all consumption costs and benefits are incurred by the consumer of the good.
 Goods are Excludable and Rival: Suppliers can prevent consumers from consuming a
certain good (excludability) and so that good becomes unavailable to other consumers.
 Full Information: Suppliers and the consumers are perfectly informed regarding the
characteristics of the good, including the quality and the price of a good.
 Full Entry and Exit: Suppliers are free to enter and exit the market

SUPPLY IN A PERFECTLY COMPETITIVE

MARKET
SUPPLY CURVE FOR AN INDIVIDUAL

 Supply Curve: Representation of the relationship between the amount of a particular goods
and services that sellers want to supply in a given time period and the price
 Marginal Benefit: increase in benefits associated with a small increase in level of activity
 Marginal Cost: increase in costs associated with a small increase in the level of activity
(includes Opportunity cost and not just relevant cost)
 Cost-benefit Principle: an individual (firm/society) should undertake a particular action if the
extra benefits of undertaking that action are at least as great as the extra costs
 Economic Surplus: gain from undertaking an action when the benefits outweigh costs
 Quantity Supplied: quantity of a given good or service that maximises the profit of the supplier
 Law of Supply: Describes the tendency for a producer to offer more of a certain good or
service when the price of that good or service increases.
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- This is because supply curves are marginal cost curves and because of the law of diminishing
returns, marginal cost curves are upward-sloping in the short run

The supply curve can be interpreted in two different ways, horizontally and vertically.

 Horizontally; At any certain price, the associated quantity on the supply curve is indicative
of how many units the producer is willing to supply at that price.
 Vertically; At a given quantity, the associated price on the supply curve can be interpreted
as the producer reservation price.
 Producer Reservation Price: Denotes the minimum amount of money the producer is willing
to accept to offer a certain good or service

SUPPLY CURVE FOR A FIRM

 Sunk cost: cost that once paid cannot be recovered

 Fixed cost: cost associated with a fixed factor of production
 Fixed cost of production: if a factor of production is fixed, then the cost associated with it
does not vary with the quantity product.
- Suppliers are often firms that need capital and labour to produce their goods.
- The factors of production used by the entrepreneur can be fixed or variable.
- If a factor of production is fixed, then the cost associated with it (the fixed cost) does not
vary with the quantity produced. e.g. machinery, equipment
 Short Run: denotes a period of time during which at least of which at least one production is
fixed.
 Long run: denotes a period of time during which all factors of production are variable.
- A variable factor of production could be labour; producing more units would require hiring
more employees, increasing cost of production
 The short run is the period in which he will have to keep his machinery and pay his
employees
 The long run is the period starting from the point in time where he will be effectively
free to sell the machinery (and the associated loan) or buy one or more new
machineries.
- It is important to distinguish between short run and long run as business decisions might
change depending on the moment in time we are considering.

 Fixed cost is the sum of all payments made to the firm’s fixed factors of production
 Variable cost is the sum of all payments made to the firm’s variable factors of production
 Total cost is the sum of all payments made to the firm’s fixed and variable factors of
production
 Marginal cost is the additional cost of producing one more unit of output. It is the change in
total cost: MC = DTC
Change∈total costs
=
Change∈quantity
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- MC declines, reaches a minimum then rises

- MC declines due to the increasing returns
- MC increases due to diminishing returns

- In order to decide whether to produce the first unit: compare the Marginal cost with
Marginal revenue (Cost-benefit principle)
- Maximum profit the firm can achieve is given by Total Revenue – Total Cost

FIRM’S SHUT DOWN/EXIT CONDITION

 Shut down condition (short run): Shut down if TR – TC (at maximum) < – FC
- By shutting down, the firm will suffer a loss equal to its fixed costs.
- Even when a firm is operating at a loss, it should sill produce – shutting down will yield an
even worse result.

 Exit condition (long run): TR – TC < 0

- There are no sunk costs here; by exiting the industry the entrepreneur gains nothing, but
also loses nothing.
- Hence, the entrepreneur should produce only if the largest profit achievable by doing so is
positive.

DISCRETE TO CONTINUOUS MODEL

What would happen if the labour supply were more flexible, and say the employees were hired for
as many hours the entrepreneur wants?

- The resulting graph would be smooth; this graph is useful as it gives a quick hint on:
 How many units of the good the entrepreneur should produce (expand the quantity
produced until the price line – the marginal revenue – intersects the marginal cost
curve)
 Whether the entrepreneur should shut down (verify whether the price line is below
the minimum point on the Average Variable Cost (AVC) curve – shut down condition
in the short run – or the Average Total Cost (ATC) curve – shut down condition in the
long run).
Why does the average total cost curve fall at first and then rise?

 It falls at first because fixed costs are being spread and the effect of specialisation
 It eventually rises because of the law of diminishing returns
 The firm is using (and paying for) more resources but output is not increasing at the same
rate

Other aspects of the productive problem:

1. Supply curve is equal to the Marginal Cost (MC) curve only for those values of the MC that
are higher than the minimum AVC (in the short run) and higher than the minimum ATC (in
the long run).
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2. The MC curve eventually increases with the quantity produced – the production process is
subject to increasing marginal costs.
3. The MC curve cuts the AVC curve and the ATC curve at their minimum points.
The average remains constant if and only if the marginal cost is equal to the average cost.
Hence, the AVC curve and the ATC curve decrease initially as the MC curve is below them.
They continue to do so until the point where the MC curve touches them. From that point
onward, the MC curve is above them and so they begin to increase
4. In the long run, all costs are variable. E.g. the entrepreneur can decide whether or not to
start a new loan to rent the machinery; the costs varies. If the quantity produced is zero, the
cost of the loan is zero. Hence, the cost of the loan is no longer a fixed cost and the AVC
curve would become identical to the ATC curve as the entrepreneur moves into the long run.

FACTORS SHIFTING THE SUPPLY CURVE

 A change in the market price determines a movement along the supply curve, whereas a
change in some other factors will shift the entire supply curve.

Other factors shifting the supply curve could be:

1. Technology: More advanced technologies reduce the unit cost of production. By using such
technologies, firms can considerably increase the amount of goods they produce.
2. Input prices: A change in the price of inputs will affect the productive capacity of a
firm/industry, which will be directly reflected in the supply. However, the price changes
related to fixed inputs have no effect.
3. Expectations: Expected future price (or future demand) changes will make suppliers adjust
their behaviour to take advantage of the new opportunities.
4. Changes in pricing for other products: If a seller is producing two or more goods, and one
good experiences a surge in demand (and so, price), the seller will shift (as much as possible)
its productive focus to the high demand good.
5. Number of suppliers: The higher the number of suppliers entering a market, the larger the
right shift in the aggregate supply curve.

PRICE ELASTICITY OF SUPPLY

 Price elasticity of supply: denotes the percentage change in the quantity supplied resulting
from a very small percentage change in price.
Measurement of the responsiveness of the quantity supplied of a given good to changes in
its price
∆ Q/Q P 1
 Price elasticity of supply = ∆ P/P = Q × slope
- The price elasticity of supply is usually positive – due to the fact that price and quantity tend
to move in the same direction: Law of supply
Supply is said to be:

1. Elastic if the elasticity of supply is greater than 1

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2. Unit elastic if the elasticity of supply is equal to 1
3. Inelastic if the elasticity of supply is less than 1
- For supply curve, (1/slope) is same at every point but ratio P/Q declines as Q increases –
price elasticity declines as quantity rises
- Price elasticity of supply is equal to 1 at any point along a straight-line supply curve that
passes through the origin, since P/Q is the same at every point – price elasticity of supply is
constant as quantity rises
 Perfectly inelastic supply – supply is perfectly inelastic with respect to price if elasticity = 0,
this occurs when supply curve is vertical
 Perfectly elastic supply – supply is perfectly elastic with respect to price if elasticity = infinite,
this occurs when the supply curve is horizontal

DETERMINANTS OF PRICE ELASTICITY OF SUPPLY

 Availability of raw materials:
o The larger the availability of raw materials, the more elastic supply tends to be.
o On the other hand, if additional raw materials are not available, a firm might be
unable to produce more
 Factors mobility:
o The more mobile the factors of production, the higher the elasticity.
o If a firm can easily divert its factors of production from one good to another, then it
can rapidly increase production of those goods which happen to be in demand.
 Inventories/ Excess capacity:
o The larger the amount of inventories and excess capacity, the higher the elasticity.
o If a firm has a large number of goods in storage (inventories), then it can quickly
increase the amount supplied in the market.
o Excess capacity is a situation where there is relative abundance of fixed factors of
production compared to variable ones.
o A firm that has excess capacity can respond more quickly to an increase in demand.
 Time horizon:
o The longer the time horizon, the higher the elasticity tends to be. If the time horizon
is long enough, producers can search for alternative inputs and revise their
production plans more conveniently.
o It takes time for producers to switch from one activity to another, build new machines
and train additional skilled workers, price elasticity of supply will be higher for most
goods in the long run than in the short run
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DEMAND IN A PERFECTLY COMPETITVE

MARKET
DEMAND CURVE FOR AN INDIVIDUAL
 Demand Curve: Represents the relationship between the price of a good or service and the
quantity demanded of that good or service.
 Utility: denotes the satisfaction that an individual derives from consuming a given good or
taking a certain action. It is measured in utils per unit of time.
 Marginal utility is the additional utility gained from consuming an additional unit of good in
a given period of time
 Decreasing Marginal Utility: Implies that the utility from consuming an extra unit of a given
good decreases with the number of units that have been previously consumed.
 Quantity Demanded: represents the quantity of a given good or service that maximises the
utility experienced by the individual consuming it

Change in quantity demanded following change in price:

 Substitution Effect: Captures the change in the quantity demanded of a given good following
a change in its relative price.
 Income Effect: Captures the change in the quantity demanded of a given good following the
reduction in the consumer’s purchasing power.
- Substitution effect: always reduces/increases the quantity consumed of a good following an
increase/decrease in its price
- Income effect can go either way.
 For a normal good a decrease/increase in income reduces/increases the quantity
consumed. E.g. expensive wine
Demand curve shifts rightwards when the incomes of buyers increase and leftwards
when the incomes of buyer’s decrease
 For an inferior good a decrease/increase in income increases/decreases the quantity
consumed. E.g. fast food
Demand curve shifts leftwards when the incomes of buyers increase and rightwards
when the incomes of buyer’s decrease
- Even when the good is inferior, the substitution effect is almost always stronger than the
income effect and so an increase in the price of a good tends to reduce the quantity
demanded of that good.
- In general, price and quantity tend to move in opposite directions – Law of Demand; ceteris
paribus
 Law of Demand: Demand curves have the tendency of being downward sloping.
E.g. Exception to the Law of Demand is a Giffen Good for which an increase in price increases
the quantity demanded.
- The demand curve can be interpreted in two different ways, horizontally and vertically.
 Horizontal interpretation: At a certain price, the corresponding quantity indicates
how many units the consumer is willing to buy at that price.
 Vertical interpretation: At a certain quantity, the corresponding price is interpreted as
the consumer reservation price.
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 Consumer Reservation Price: Denotes the maximum amount of money an individual is
willing to pay for a certain good or service.

FROM A DISRETE TO CONTINIOUS MODEL

What happens if demand were much more flexible and the consumer could select the exact amount
of goods wants? Resulting in a smooth graph.
Change in demand following change in price of ‘other’ goods.
 Substitutes: Two goods are substitutes if an increase in the price of one causes an increase in
the quantity demanded of the other
 Complements: Two goods are complements when a decrease in the price of one causes an
increase in the quantity demanded of the other

FACTORS SHIFTING THE DEMAND CURVE

 Changes in demand is a shift of the entire demand curve, whereas changes in the quantity
demanded is a movement along the demand curve that occurs in response to a change in
price
A shift to the left is generated if these factors move in the opposite direction
1. Successful marketing campaign; increase in marginal utility can increase quantity consumed
2. Decrease in the price of supplements
3. An increase in the price of substitutes
4. An increase in income for a normal good
5. A decrease in income for an inferior good
6. A positive shift in consumers’ preferences towards a certain good
7. Population growth

PRICE ELASTICITY OF DEMAND

 Price Elasticity of Demand: Captures the percentage change in quantity demanded resulting
from a very small percentage change in price.
Measurement of the responsiveness of the quantity demanded of a given good to changes in
its price.
∆ Q/Q P 1
 Price elasticity of demand =
∆ P/P
= Q
x slope
- It tends to be more inelastic in the short run than in the long run, because people need time
to adjust to price change
- The price elasticity of demand is almost always negative. This is because price and quantity
tend to move in opposite directions: Law of Demand
- If a demand curve is downward sloping, then its elasticity must be negative.
- Hence, it can be expressed in terms of its absolute (or positive) value.

- Demand is said to be:

1. Elastic if price elasticity of demand is greater than 1

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2. Unit elastic if price elasticity of demand is equal to 1
3. Inelastic if price elasticity of demand is less than 1

- Elasticity will decrease along the demand curve moving from left to right, as the price
decrease and the quantity increases.
- In the mid-point for the demand curve, the elasticity is exactly equal to one.

Price elasticity and the steepness of the demand curve

-
When price and quantity are the
same, price elasticity of demand
is always smaller for the steeper
of two demand curves because
the reciprocal of the slope of the
steeper demand curve is less
- If two demand curves have a
point in common, the steeper
curve must be less elastic with
respect to price at that point
- However, this does not mean that the steeper curve is less elastic
at every point.

Perfectly Elastic and Inelastic demand

 Perfectly elastic: Demand is perfectly elastic with respect to price if price elasticity of
demand is infinite. This occurs when the demand curve is horizontal.
 Perfectly inelastic: Demand is perfectly inelastic with respect to price if price elasticity of
demand is zero. This occurs when the demand curve is vertical.

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

 Availability of substitutes
o The larger the number of substitutes, the more elastic demand tends to be.
o If there are many close substitutes for a certain good, consumers are likely to respond
strongly to an increase in its price – easily switch to similar products.
 Definition of a good
o The broader the definition of a good, the lower the elasticity.
o E.g. Salt as a category has almost no substitutes and so, elasticity is likely to be low

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If you consider a certain brand of salt, then the elasticity for that particular brand is
likely to be high as there are many substitutes.
 Income share
o The larger the share of income required to purchase a good, the higher the elasticity.
 Time horizon
o The longer the time horizon, the higher the elasticity tends to be
o If the time horizon is long enough, buyers can search for alternative substitutes and
revise their consumption plans more easily

DEMAND AND SUPPLY: AN EQUILIBRIUM

ANALYSIS
DEMAND AND SUPPLY AGGREGATION:
- To find the aggregate supply curve you sum the supply curves horizontally
- To find the aggregate demand curve you sum the demand curves horizontally

MARKET EQUILIBRIUM
- Any other price above or below the equilibrium price would either create an excess demand
or an excess supply – either the buyers or the sellers have an incentive to change their
behaviours.

 Excess demand is the amount by which quantity demanded exceeds quantity supplied when
the price of a good lies below the equilibrium price
 Excess supply is the amount by which quantity supplied exceeds quantity demanded when
the price of a good exceeds the equilibrium price
Price has the tendency to move towards it equilibrium level under conditions of either excess supply
or demand.

- Excess supply: sellers would lower price in order to attract buyers.

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- Excess demand: buyers will be willing to pay higher price to get goods.
- This process continues until excess demand/supply is eliminated. No incentive at equilibrium.

 Equilibrium Price and Quantity: The Equilibrium Price (Quantity) represents the price
(quantity) such that the quantity supplied equals the quantity demanded.
 Buyers and sellers are price-takers in the sense that if they were to try to change the price
away from the equilibrium level they would be unable to sell or buy anything.
 Rationing rule: Assumption that buyers who value the good more will be the first to buy it.
- Buyers differ in terms of their reservation price. If the price at which the good is sold is above
the buyer’s reservation price, the buyer will not buy it.
- Sellers also have different reservation prices. If the price at which the good is sold is below
the seller’s reservation price, they will not supply it.
- The reservation prices indicate the Opportunity Costs associated with acquiring (for the
buyers) and producing (for the sellers) the good, measured in dollars.

 Consumer Surplus: Consumer Surplus represents the difference between what a consumer is
willing to pay for a good or service and what she actually pays for that good or service.
 Producer Surplus: Producer Surplus represents the difference between the price a seller
receives for a good or service and what he was willing to receive for that good or service.

CONSUMER AND PRODUCER SURPLUS

 Total consumer surplus: represents the sum of the economic surplus of all consumers
 Total producer surplus: represents the sum of the economic surplus of all producers
 Total surplus: sum of the total consumer surplus and the total producer surplus
Note: The total surplus is maximised exactly at the equilibrium price

- Total consumer surplus is equal to the area below the demand curve and above the market
equilibrium price
- Total producer surplus is equal to the area above the supply curve and below the market
equilibrium price

- In a large market, with a huge number of buyers and sellers, all capable of selling and buying
multiple units, the demand and supply curve can be represented by smooth straight lines.

SHORT RUN (Pareto efficiency)

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 Pareto efficient: situation in which it is impossible to make any individual better off without
making at least one other individual worse off.
 Pareto Improving Transaction: transaction where all parties involved are better off.
- The perfectly-competitive market is Pareto efficient because any attempt to move the price
from its equilibrium level results in a reduction of the total surplus.
- However, efficient outcome does not need to be a desirable one – as it makes no statement
about the overall wellbeing of a society.
- A society should facilitate markets in their quest of maximizing social surplus and achieving
Pareto efficiency.
- But once this objective is achieved (the social pie is maximized), society should consider how
to redistribute the surplus in order to realize other goals, such as equality of resources and
opportunities.

LONG RUN (The Invisible Hand)

 Pushing firms to produce at the lowest possible total cost – likely to happen in the long run; a
period of time where:
1. Existing firms can adjust all their factors of production and perhaps exit
2. New firms can enter the market
- If firms in a market are making positive profits, there is an incentive for new ones to enter
the market.
- An increase in number of firms shift supply curve to the right, reducing equilibrium price and
profit due to change in equilibrium price.
- Note: Firms in a perfectly competitive market are price takers, and so they just take the new
equilibrium prices as given. Hence reduction in profit

Example: all firms have the same productive technology. Therefore, cost curves are also identical.

- In this case, entry will continue until the point where all the firms in the market are making
exactly zero profit.
- Note: at this long run equilibrium price each firm produces a quantity such that the average
total cost (ATC) is minimized. The long run equilibrium price is then just equal to the
minimum ATC.

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- A similar process would occur whenever firms make negative profits – some of the firms
would exit the market.
- The supply curve shifts to the left and the equilibrium price increases, effectively reducing
the loss incurred by the surviving firms.
- This exit process, followed by an increase in price, continues until the firms remaining in the
market make zero profit.

Long Run Supply Curve

- Following the assumption there is a large number of firms all producing the same good and
using the same technology. Hence, in the long run customers can buy as many units as they
want at a price equal to the minimum ATC.
- Hence, long run supply curve for the whole market is going to be a horizontal line, with
vertical intercept equal to the minimum average cost.

- In the short run, if there was an increase in demand; the market would adjust by increasing
equilibrium price, MC goes up
- In the long run, an increase in demand would have no effect on the market – when new
suppliers enter the market, they effectively nullify the pressure on existing suppliers.

- Entry continues and the price remains stable at the level of the minimum ATC.
- What changes is the quantity supplied, which increases more than it would have in the short
run.
- In the short run an increase in the quantity demanded raises the price and the quantity,
whereas in the long run the price is more likely to be stable and all the adjustment occurs via
the quantity offered in the market – suggesting supply is more elastic in the long run.
 The Invisible Hand Principle: individuals’ independent efforts to maximize their gains will
generally be beneficial for society and result in the socially optimal allocation of resources.

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LONG RUN SUPPLY CURVE IN A MORE GENERAL MODEL

- Long run supply curve will only be a horizontal line if all firms have the same identical
productive technology.
- A model with mixed firms would be more complicated and may result in long run supply
curves that are upwards – or even downwards – sloping.
- However, the basic intuition behind the role of the invisible hand on the long run market
equilibrium would still hold.

GOVERNMENT INTERVENTION: THE COST OF

INTERFERING WITH MARKET FORCES
TYPES OF GOVERNMENT INTERVENTIONS IN PERFECTLY COMPETITIVE MARKETS

 PRICE CEILING
Definition: The Price Ceiling represents a maximum allowable price imposed by the government.
 Government concludes that the price consumers are paying is unfairly high, especially for
low-income households.
- Introduction of the price ceiling forces the price down, effectively creating excess demand
- Buyers with the highest willingness to pay can acquire good at a lower price, and so their
surplus increases compared to the surplus they get in absence of the price ceiling.
- Reduction in price means reduction in quantity producers are willing to supply. Hence some
consumers will be unserved; lost in surplus
- The introduction of any price ceiling decreases total surplus – deadweight loss
 Deadweight loss: loss in economic surplus due to fact market is prevented from reaching
equilibrium price and quantity where marginal benefit equals marginal cost.
 Government better off transferring lump sum to low-income households.
Because consumers with highest willingness to pay is most beneficial, this policy is likely to
achieve opposite result: transfer of surplus from poor to rich.
 Rationing assumption: those who value the good are among the first to acquire it.

 PRICE FLOOR
Definition: The Price Floor represents a minimum allowable price imposed by the
government.
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 Government concludes that prices are too low and that producers should be protected by
preventing them from reaching their equilibrium levels.
- Price floors generate an excess supply. Producers who manage to sell their goods benefit
from the higher price imposed by the government.
- Producers who are unable to sell their products experience a sharp decline in surplus.
- Consumers are all disadvantaged.
- The introduction of any price floor unambiguously decreases the total surplus in the
economy. The amount by which total surplus drops after the government imposes a price
floor represents the deadweight loss in the economy.

 TAXATION
Definition: Tax generates tax revenues that can be used to redistribute wealth within a
society.
 Governments set tax to improve the distribution of income and opportunities across
different population groups.
- Assumption: tax is levied on producer; same result applies if tax is levied on consumers.
- Consider a per-unit tax imposed on each of the goods sold in the market.
- From the perspective of a supplier, the effect of this tax is similar to an increase in the
production cost for each unit by exactly the amount of the tax – marginal cost increases by
exactly the tax amount.

- If a tax is imposed in market equilibrium; the equilibrium price must increase following a
shift to the left of the supply curve. Thus, equilibrium quantity will decrease after the
introduction of the tax.
- Effect of the tax is to increase price and decrease quantity exchanged in the market.
- Reduction in surplus for the consumers, due to increase in price.

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How much of the tax burden is imposed on consumers?

- By comparing the initial equilibrium price and the equilibrium price after tax; the difference
between price is $0.5, which is smaller than the $1 per-unit tax.
- Hence, the consumers bear only a fraction of the tax burden because they suffer an increase
in price that is smaller than the full tax amount.
- Remaining part of the tax burden must be borne by the producers.
- Producers have to pay $1 to the government for each unit of the good they sell; hence their
marginal revenue is given by the price at which the good is sold, minus the per-unit tax, $1.
- Hence difference between marginal revenue before/after tax = $0.5. This is the share of the
tax burden that is borne by the producers.
- Since both consumers and producers are worse off after imposing tax: government must be
making tax revenues
- Tax revenue = number of units sold x tax
- The government can use the tax revenues to the benefit of the buyers and sellers. E.g.
 Reduce the taxes imposed on other markets: Even though buyers and sellers
experience loss of surplus caused by imposing tac, they enjoy reduction in the other
taxes they pay.
- However even after other taxes are taken in account, there is still loss in total surplus due to
tax – deadweight loss from taxation
- The deadweight loss from taxation arises because, after imposing a tax, the market reaches
an equilibrium price and quantity where the marginal benefit equals the marginal cost plus
the tax.
- Tax is inefficient: Consumers and the producers (loss from tax) lost more than the tax
revenues accrued to the government (gain). Hence consumers and producers would prefer
to pay the government the exact amount it gained from the intervention in exchange for the
cancellation of the tax – Pareto Improving Transaction.
Conclusion: Tax creates a loss in economic surplus. Should government not tax any market at all?

- Cost-benefit analysis: government offers a number of services (lighthouse, national security,

street lighting) – these services come at the cost of a small deadweight loss; hence society is
better off with a system in place rather than without.

What is the most efficient way of collecting tax?

- Answer depends on how responsive demand and supply are with respect to price changes.

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- The more elastic supply and demand are at the initial equilibrium price, the bigger the
deadweight loss – if supply and demand are highly elastic, even a small tax will determine a
large reduction in the quantity demanded and supplied.
- The larger the departure from the original equilibrium quantity, the larger the deadweight
loss will end up being.
- The larger the reduction in the quantity exchanged, the larger the reduction in tax revenues.
 From diagram: clearly, the more responsive market (Panel A) suffers from a higher
deadweight loss and lower tax revenues with respect to the less responsive one (Panel B)
 If government needs to impose a $1 tax on economy, the most effective way is to apply it to
the market in Panel B (less responsive and generate lower deadweight loss)

 SUBSIDY
- A subsidy is opposite of a tax.
- From previous example: assume a per-unit $1 subsidy is applied to the sellers. This means
the government pays the sellers $1 for each unit sold in the market.
- The marginal cost effectively decreases by $1. The supply curve shits to the right, and the
market experiences a reduction in price and an increase in the quantity exchanged.

- Unlike a tax, a subsidy is a cost for the government (not a revenue). Total cost of the subsidy
is: cost of subsidy x goods
- Total surplus decreases; subsidy creates a deadweight loss
- Governments claim that subsidies are used to make certain goods more affordable for
certain groups of poor consumers – this policy brings about considerable deadweight loss
and is not necessarily optimal.
- An alternative would be a lump-sum transfer from the rich to the poor; the rich would prefer
this kind of solution as long as the transfer is smaller than the deadweight loss they would
suffer under the subsidy.

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INTERNATIONAL TRADE
IMPORTING COUNTRY

 Without trade domestic supply equals domestic demand.

- Consumer surplus is area A, producer surplus is B + E and total surplus is A + B + E
 With trade, if the world price is lower than domestic price, consumers would choose to
purchase at world price.
- The country will need to import in goods to meet consumer demand.
- Consumer surplus is area A + B + C + D, producer surplus is only E, but total surplus is A + B +
C + D + E.
 Hence gains from trade are represented by areas C + D and come from larger surplus
attained by our domestic consumers who buy more and at a lower price.

WINNERS AND LOSERS FROM INTERNATIONAL TRADE

 Although international trade has meant total surplus is higher than without, domestic
consumers lose surplus when their country starts to export good and domestic producers
lose surplus when their countries starts to import.
 However, if the consumers or the producers were influential and powerful enough, they may
be able to organize themselves to lobby the government to restrict free trade.
 Because the gains from trade are thinly spread over many consumers, but losses are felt
most strongly by small group of producers, lobbying is commonly done by domestic
producers wanting to restrict imports.

Other benefits from engaging in trade:

1. Consumers have access to wider variety of goods (Italian soft drinks, Indian movies)
2. Producers may be able to take advantage of economies of scale by selling to a larger market
3. Domestic monopolies or oligopolies might face international competition, reducing their
market power
4. The flow of ideas and technology is faster and easier
TRADE RESTRICTIONS

Two main forms of trade restrictions:

1. Importing Tariffs: represents a tax on imported goods/services

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2. Importing Quotas: represents a quantity limit on the amount of goods or services
permitted to be imported
TARIFFS

- Different to sales tax because it is only applied to goods produced abroad, not to
domestically produced ones.
- Adding tariff means the price of all the products will be word price + tariff.
- This is because domestic publishers can also charge the same price and still have customers
- E.g. If domestic consumers only want 6000 books, domestic producers are willing to sell
4000, and imports fall to 2000 books.
Domestic consumers lose, but domestic producers gain.

- Domestic consumers will lose H + I + J + K because they buy less and at a higher price.
- Domestic producers gain H because they sell more at a higher price.
- The government gains from getting the tariff revenue of area J, paid only on the imported
books
- Overall, consumers lose more than what the producers and government gain – deadweight
loss of the tariff represented by area I + K (lost area I comes from buying from the relatively
expensive domestic producers; area K is lost because total consumption falls).
- Tariff is good for our domestic publishers but bad for our book consumers.

QUOTAS
- An alternative (anti-)trade policy is an import quota, which directly changes the quantity of
imports.

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- To find the equilibrium with the quota, shift the supply curve to the right by the quota
quantity to get total supply.
- E.g. The effect on consumer surplus of this quota is the same as the $10 tariff: it falls by H + I
+ J + K. The surplus of our domestic producers rise by H again.
- The difference is what happens to area J: this is the ‘bonus’ that anyone will receive; they
only pay $15 to the international publishers, but they can charge $25 for the consumers.
- If the government charges a fee to book importing agents, then the government revenue
could be the same as the tariff revenue.

 In terms of total surplus: a quota and tariff can both lead to the same prices and quantities
and generate a deadweight loss of area I + K (if they are set to mimic each other).
 What’s different is what goes on behind the policies.

3. IMPERFECTLY COMPETITIVE
MARKETS
MARKET POWER: MONOPOLY
 Imperfectly competitive markets are those who fail to meet at least one requirement of a
perfectly competitive market.
 Price-taking firms can sell as much as they want at the current market price. However, if they
increase the price, they lose all their sales. This means that the demand curve for the
individual firm is horizontal (perfectly elastic).

 Firms with market power are said to be price-makers (price-setters) in that they have the
ability to set their own prices.
 This means that when the price-setting firm increases the price, it does not lose all its
customers. This means the demand curve for a price-setting is downward sloping.

 A market composed by firms that are price-setters is said to be an imperfectly competitive

market. There are three forms of imperfectly competitive markets:

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1. MONOPOLY: There is only one firm in the market. Hence the firm’s individual demand
curve coincides with the market demand curve.
E.g. Microsoft – Windows, which is essentially the only operating system in the whole
market for personal computers, or Australian Post

2. MONOPOLISTIC COMPETITION: There is a large number of firms, each producing a

slightly differentiated product.
E.g. Restaurant industry: An Italian restaurant offers similar products compared to
Japanese restaurants (i.e. food) but they don’t offer exactly the same type of food. This
provides a measure of market power, where the Italian and Japanese food are not
perfect substitutes.

3. OLIOGOPOLISTIC COMPETITION: There is a small number of firms that sell good that are
close substitutes.
E.g. Banking Sector – ANZ, NAB, Westpac, Commonwealth Bank

DETERMINANTS OF MARKET POWER

 Invisible Hand Theory: simple mechanism that eliminates market power: whenever firms
make profits, some new firms will be willing to enter the market and commence production
of the same good. This entry process will continue until the firms in the market are making
zero profit and are essentially left with no market power.
 If the ability to enter and leave the market is hindered, market power is likely to arise –
barriers to entry.

Major barriers to entry

o Control over Scarce Resources:

If a firm has exclusive control over some key inputs of production, it might be impossible
for other firms to enter the market and compete against it. E.g. OPEC’s market power
comes from control over oil
o Government-Created Barriers:
Governments are sometimes responsible for creating barriers to entry. They do so by
issuing patents, offering copyright protection and granting licenses. E.g. If a
pharmaceutical company holds a patent for a particular drug, then no other company is
allowed to produce the same drug.
Whichever company holds the patent becomes the monopolist in the market for that
particular type of drug for the term of the patent.
o Increasing Returns to Scale:
There are increasing returns of scale (economies of scale) when the average total cost of
producing a certain good decreases with the amount of the good produced. When a firm
experiences economies of scale it also becomes more profitable with size. Hence,

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industries featuring economies of scale tend to be dominated by a small number of large
firms – Natural Monopoly.
E.g. Water supply, electricity and gas
o Network Economies:
They emerge when the customer’s satisfaction with a given product increases with the
number of users. E.g. Facebook.
Similar to Economies of scale because in both cases a company’s market position gets
stronger and stronger as it expands production. E.g. Power companies, wireless
communication companies.

MONOPOLY

 Monopoly: market structure where there is only one firm operating in the market
 A perfectly competitive firm: can sell any number of units at the market price, horizontal
demand curve – the marginal revenue is constant and equal to the market price.
 Monopolist firm: demand curve is same as demand curve for the entire market, and unlikely
to be horizontal. Because the demand curve slopes downwards, monopolists need to reduce
the price in order to increase quantity sold.

∆R
 To compute marginal revenue: MR = ∆ Q ,
where ∆ R represents the change in revenues, and ∆ Q is the change in quantity sold.
 Rule to determine the number of units that maximises the monopolist’s profits: expand
production until the marginal revenue equals the marginal cost.

MONOPOLY AND THE INVISIBLE HAND

What is the socially optimal quantity that maximizes social surplus?

- If the monopolist were to expand production, quantity will also increase.

- While this may lead to the marginal benefit for consumers being higher than marginal cost,
hence increasing total surplus, the monopolist is gaining less profit.
- This shows that what’s great for society is not necessarily great for monopolist.

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Why is there conflict between what the monopolist wants and what the consumers desire?

- This is because in order to sell the extra units of the good and attract new consumers, the
monopolist needs to reduce the price.
- This reduction in price affects every unit that is sold by the monopolist because the
monopolist needs to charge all consumers the same price
- Hence there is an implicit price in increasing the quantity sold, and this leads to an
equilibrium production level that is lower than the socially optimal one.

What is the socially optimal level of production?

- In order to find this, expand production until the marginal benefit is equal to the marginal cost.
- Panel A: socially optimal quantity
- Panel B: the monopoly equilibrium quantity and the deadweight loss for society due to the
fact that the monopolist didn’t select the socially optimal quantity.
 The Invisible Hand Theory does not apply in the case of a monopoly; when the monopolist
maximises its profit the result is not socially optimal.

GOVERNMENT REGULATION

- To solve inefficiencies, competition must be stimulated by encouraging new firms to enter

the market.
- Governments worldwide achieve this by establishing competition laws. The final objective of
these laws is to ensure that consumers are charged the lowest possible prices.
 Competition law: denotes laws intended to foster market competition by regulating anti-
competitive conduct by firms
- However, in the case of a natural monopoly, this government intervention might prove
inefficient. In order to increase the total surplus in the presence of a natural monopoly,
governments often regulate the price at which the monopolist is allowed to sell its products.
 Average Cost Pricing: denotes a policy through which the government forces the monopolist
to set the price and quantity at the intersection of the ATC curve and the demand curve.
- This policy eliminates any positive profit accrued to the monopolist.
 Allocatively inefficient: price asked for the goods produced exceeds their marginal cos
- However, average cost pricing is hard to implement because:
 Government does not know the ATC, it can only estimate them
 Once this policy is in place, firms have no incentive to invest in new technology to
lower production costs – they make zero profits either way
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 When the government uses average cost pricing, the firm’s output is allocatively
inefficient. This is due to the fact that the price usually exceeds the marginal cost.
(In a perfectly competitive market; it is allocatively efficient because in equilibrium
the price equals to the marginal cost).
The government could set a price ceiling equal to the marginal cost – but it might
force the monopolist to make negative profits.

FIRST DEGREE PRICE DISCRIMINATION

- One of the reasons why the monopolist does not produce enough – produce less than
socially optimal – is that it needs to set the same price for all consumers.
What happens if the monopolist could set a different price for different consumers?

 First Degree Price Discrimination: describes a situation in which the monopolist knows the
reservation price of each consumer and is able to charge each consumer his marginal benefit
(or reservation price).
- Assume first degree price discrimination is allowed.
- Marginal revenue is hence equal to the marginal benefit. This is because selling more units in
a new country does not require the monopolist to reduce the price on all of the units sold in
the other country.
- Cost Benefit Principle suggests that the monopolist should expand production until the
marginal revenue is equal to marginal cost.
- Results: quantity sold is same as perfectly competitive market.
- Hence, a monopolist engaging in first degree price discrimination is also selling socially
optimal quantity.
- However, although social surplus is maximised, the distribution of surplus across the society
is very uneven: the monopolist charges consumers exactly their marginal benefit.
- The monopolist is the one who accrued all the surplus available in the market.

OTHER FORMS OF DISCRIMINATION

There are situations where a monopolist cannot engage in first degree price discrimination.

- This might be due to existing laws that prevents the monopolist to do so

- Monopolist’s inability to learn each consumer’s reservation price
- To prevent consumers with low price (from the monopolist) reselling goods at a higher price
to consumers with high reservation price.

When first degree price discrimination fails, there are other forms of price discrimination:

1. Second degree Price discrimination

The monopolist charges different prices depending on the quantity demanded by each
consumer; Bulk discount. By offering ‘discounts’ the monopolist manages to distinguish
between high and low reservation price, without having to know what information in
advance.
2. Third degree Price discrimination
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The monopolist charges different prices depending on observable consumers’ attributes such
as location.
Hence, the monopolist maximises its profits when it serves all consumers. Moving from first
degree price discrimination to third degree price discrimination does not affect the number
of consumers that are served – however the distribution of surplus changes.
The monopolist makes less profit, and consumers are better off because some of them pay a
lower price. The rest of the consumers pay the same price as before.
Overall, there is a shift of surplus from monopolistic to the consumers.

MARKET POWER: OILIGOPOLY

 Oligopoly: market structure that features a small number of firms.

- In these types of markets, the actions of one firm have a direct impact on the other
firms, vice versa
- Strategic interactions among firms: in making its own decision, a firm tries to anticipate
what the other firms are about to do (Game theory)

PRISONER’S DILEMMA GAME

- Firms (or individuals) might decide not to cooperate even though doing that would be
beneficial to both of them. E.g. whether to increase spending on advertising or not
- If two firms choose ‘not to advertise’, they each earn equal profit
If they both choose to ‘advertise’, their consumer bases will remain the same, as the
advertising efforts nullify each other, essentially leaving the market condition unchanged.
However they earn less profit, due to advertising expense.
- Therefore, collectively it would be optimal for both to choose to ‘not advertise’ – maximum profit
- However, it might be difficult for both to cooperate and agree to ‘not advertise’, as both have the
temptation to violate the agreement and gain profit.
- By acting according to their self-interest, the firms obtain a profit that is lower than if they had
cooperated
- If we assume that advertising has no social value itself, then the outcome would not
satisfy Pareto Optimality, as advertising would be a wasteful activity.
- Producer surplus would have been larger if firms cooperate and not advertise, and
consumer surplus would remain unchanged.
- The Invisible Hand Theory does not apply in this case; hence showing that the individual
quest for profits might not translate into the socially optimal allocation of resources

CARTEL GAME

- Because of the nature of oligopolistic markets, collusions, private and secret agreements
are more prone to occur – cartel

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 Cartel: represent private agreements aimed at increasing the profit of the cartel members by
reducing competition in the market.
- They are aimed at increasing the profit of the cartel members by reducing competition in the
market, done by controlling prices or preventing new competitors from entering the market.
- Private cartels are prohibited under competition law – law intended to foster market
competition by regulating anti-competitive conduct by firms. Key objective is to ensure
consumers are charged the lowest possible prices.
- A cartel is established to keep the market price above a certain level. Members of the cartel
are instructed to avoid price cuts.
- If there were two firms, choosing to ‘price cut’ would be the non-cooperative behaviour and
would violate the agreement. By choosing ‘price cut’ a firm steals customer (and profits)
from the other cartel member, by choosing a lower price.

- There is only one likely outcome: Both firms choose to ‘price cut’.
- The strategy recommended by the cartel would end up with the outcome of ‘price cut’. This
is because both firms would end up increasing their profits by changing their strategy and
engaging in a price cut, if the other cartel member selects ‘no price cut’.
- By making cartels illegal, anti-trust authorities make it hard for firms to collude and
ultimately promote a market equilibrium that benefits the consumers and increases social
surplus by closing up the price gap between perfectly competitive markets and oligopolistic.

COORDINATION GAME

- Characterised by multiple possible outcomes, they capture situations where the players
benefit from coordinating their decisions.
- Battle of the sexes: players differ with respect to which activity they would prefer to engage
in, but they still prefer engaging in the same activity over going alone.
- Firms select the activity they wish to perform without communicating with each other.

- If firms decide to engage in different activities, they get zero utils. If both firms engage in the
same activity they obtain a positive amount of utils, but each gets more if they had
performed a certain activity.
- When both firms perform different activities, they will have an incentive to deviate, and so it
is only when they both unilaterally perform the same will they have no incentive to change.
 Nash Equilibrium: no player can benefit from unilaterally changing her strategy.
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EXTERNALITIES
POSITIVE CONSUMPTION EXTERNALITY
Positive Consumption Externality: represents a benefit accrued to someone who is not involved in
the consumption of a given good.

- An individual’s demand curve is derived from the marginal benefit obtained from obtaining
different quantities of a good
- By applying the cost benefit analysis: expand quantity until your marginal benefit is equal to
marginal cost, the external effect on others are underestimated.
- To find the social demand curve, add up the private marginal benefit and the marginal
external benefit for each unit of good.
- The resulting curve is parallel to the private demand curve, where the vertical distance
between the two is equal to the marginal external benefit.

- By making consumption decisions without accounting for their external benefit, maximum
social surplus is not achieved. The deadweight loss is due to the presence of positive
consumption externalities.
- Limitation of Invisible Hand Principle: action that maximises own satisfaction does not
translate in the optimal amount of consumption for society as a whole

- Private negotiation occurs: offer to consume extra units at the price equal to the external
benefit associated.
 Coase Theorem: If trade in an externality is possible and there are no transaction costs,
bargaining will lead to an efficient outcome regardless of initial allocation of property rights.
- Private negotiation doesn’t involve any transaction cost and allows trading in the externality
by requesting a subsidy for each extra unit you consume above your preferred amount.
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Other examples of positive consumption externalities:

1. Fitness activities: reduces the health care costs incurred by society.

2. Vaccinations: reduces the likelihood that others get infected.
3. Bike to work: reduces traffic congestion and pollution
4. Education: positive impact on society overall in the form of increased productivity.
5. Social networking: potential to enrich the experience for other members of the network
6. Fire protection services: reduces the likelihood that a fire originated in his or her place
may spread to other homes.

NEGATIVE PRODUCTION EXTERNALITY

 Negative Production Externality: represents a cost incurred by someone who is not involved
in the production of a given good.

- Similarly, a firm ignores the external effects on others, creating a negative production
externality.
- To find the social supply curve add the marginal external cost to the private marginal cost for
each unit.
- Making production decisions without accounting for their external costs does not maximise
social surplus (deadweight loss created)

- When social marginal cost equals the marginal benefit, that is when the quantity maximises
social surplus
- Private bargaining; offering to decrease the production in exchange for the price equal to the
external cost.

Other examples of negative production externalities:

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1. Harmful production activities: firms impose a cost on society by increasing air, water, and
noise pollution.
2. Excessive risk-taking: banks can kickstart global financial crises that have the potential to
affect thousands of people
3. Over-fishing: firms run the risk of depleting the stock of fish in the ocean

EXTERNALITIES IN LARGE MARKETS

- Socially optimal price and quantity occur where the social curves intersect. There is
deadweight loss associated with equilibrium.
- In presence of externalities in a large market (smooth private demand and private supply
curves), Coase’s conditions no longer apply.
- The number of buyers and sellers create high transaction costs as those involved in the
market struggle to negotiate with all relevant parties.
- Government intervention is therefore necessary to fix what the market cannot handle on its
own – via policies such as taxes and subsidies.

SUBSIDY

- A subsidy equal to the marginal external benefit would shift the private demand curve to the
right to the point where the new private demand curve is identical to the social demand curve.
- The government can affect the market so that the socially optimal quantity is realized.
TAX

- A tax equal to the marginal external cost would shift the private supply curve to left to the
point where the new private supply curve intersects the private demand curve.

NEGATIVE CONSUMPTION EXTERNALITY

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 Negative Consumption Externality: represents a cost incurred by someone who is not
involved in the consumption of a given good.
- A positive consumption externality can still result into a negative consumption externality.
- Private negotiation is again used.
Other examples of negative consumption externalities:

1. Smoking: imposes a health cost on the people surrounding him or her.

2. Alcohol abuse: an individual increases the health care costs incurred by society.
3. Driving: an individual increases traffic congestion and pollution.

PUBLIC GOODS
NON-RIVALRY AND NON-EXCLUDABILITY
- Private goods are rivalrous and excludable
- Public goods are neither rivalrous and excludable
 Non-Rivalry: One individual’s consumption of the good does not impede another individual
from consuming it as well: the marginal cost of providing the public good to an additional
individual is equal to zero.
 Non-Excludability: No one can be excluded from consuming the good.
- Non-rivalry is related to the marginal cost of production: unlike a private good, the marginal
cost of providing the public good to an additional user is zero.
 Pure Public Goods: Pure Public Goods represent goods that are perfectly non-rivalrous and
non-excludable. E.g. lighthouse
 Impure Public Goods: Impure Public Goods represent goods that are non-rivalrous and non-
excludable only up to a point. E.g. motorway

AGGREGATING INDIVIDUAL DEMANDS: MARGINAL SOCIAL BENEFIT AND EFFICIENCY

- To construct the aggregate demand for a public good you have to sum the individual
demands vertically
- Because of the non-rivalry nature of public goods, when one individual pays for a good, the
other also enjoys the benefits generated.
- As long as the marginal social benefit is greater than the marginal cost, the action should be
taken out.
- Efficient quantity: marginal social benefit = marginal cost.
 Marginal Social Benefit: The Marginal Social Benefit is the vertical sum of the individual
marginal benefits.
 Samuelson Condition: The Samuelson Condition states that the efficient quantity of a public
good is found by setting the sum of the individual marginal benefits equal to the marginal
cost.

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MARKET PROVISION AND FREE-RIDING

- In a free market, individuals will individually and independently decide on the quantity. As
one individuals’ marginal benefit will always be below the marginal cost, they will decide not
to take the action.
- However, public goods are non-excludable, and so that individual will gain the same benefit
for free by free-riding under someone’s public good’s provision.
 Free-Riding: denotes the action of enjoying a good without paying for it.
- Consequently, that good is under-provided i.e. less than the efficient quantity is produced –
creating a deadweight loss associated with the market provision of a public good.
 Lindahl prices: sharing the marginal cost of providing a public good according to the
individual marginal benefits
- This does not work as the non-excludable nature of the public good means that the
individual will always prefer to free-ride (consumer surplus is greater free-riding).

PUBLIC GOODS AND EXTERNALITIES

- A public good is an extreme case of positive externality – the benefits accrued to those who
enjoy the public good does not depend on who is providing it.
- When deriving marginal social benefit, both positive externalities and public goods have
similar graphs – they are both also under-provided by the market.

MARKET, GOVERNMENT, AND TAXATION

- Markets are not well equipped to provide public goods.

- Because of non-rivalry, each individual can benefit from someone else’s public good
provision; and because of non-excludability, he/she cannot be stopped from enjoying the
benefits.
- Hence, there is a need for government intervention; i.e. why governments interfere with free
markets and impose taxation in order to provide public goods, such as national defence,
education and infrastructure.
- Unlike a free market, a government can impose taxation because it possesses coercive power
- The power to impose taxation would be enough to provide the efficient level of public good
provision. I.e. Tax individuals on their Lindahl prices. However, an individual’s marginal
benefits are not known by others and hence, realistically not perfect.
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- As individual demands, in reality are unknown, taxation tends to follow two fairness
principles:
1. Governments tax according to people’s ability to pay: richer people should provide
more: progressive taxation; income tax rate is higher the more one earns
2. They tend to tax according to a pay-as-you-go principle; e.g. tolls of bridges and
tunnels

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