ECON101 Study Guide

Unit 4: Markets and Individual Maximizing Behavior

4a. Explain how the maximization assumption helps us understand the behavior of consumers and firms

What principle drives consumer behavior?
What principle drives producer behavior?
What are consumer surplus and producer surplus?
What is the relationship between consumer surplus and value?
What is the relationship between producer surplus and the supply curve?
How does demand represent marginal benefit, and how does supply represent marginal cost?

Let's revisit the familiar demand and supply framework to examine the concept of efficiency. By closely observing the equilibrium between demand and supply, we notice it is impossible to enhance consumer satisfaction without simultaneously impacting producers. Similarly, firms cannot increase their revenue without affecting consumer satisfaction. The equilibrium involves efficiency! (Hint: consider a price above or below the equilibrium and analyze the situation for consumers and producers in terms of efficiency).

Consumer surplus, producer surplus, and the resulting total surplus are valuable tools for assessing market efficiency. They are based on the fact that consumers seek to maximize their utility while firms act to maximize their economic profit. Consumer surplus is defined as the difference between the total amount that consumers are willing and able to pay for a good or service and the total amount that they actually do pay. This measure reflects the extra benefit consumers receive from purchasing a good or service at a market price that is lower than the maximum price they are willing to pay. Producer surplus, on the other hand, is the difference between the total amount that producers receive for a good or service and their total cost of producing it. It represents the additional benefit producers gain by selling a product at a market price that is higher than the minimum price at which they are willing to sell.

Visualizing concepts through diagrams facilitates a deeper understanding of their relationships and applications. Take, for instance, the market for smart speakers shown in the diagram below. How much is consumer surplus (CS), and what does it mean? How much is producer surplus (PS), and what does it mean? Why is a quantity of 10,000 units of smart speakers at a price of $200 per unit an efficient combination? Can consumer surplus increase without decreasing producer surplus? Can smart speaker producers sell the product at a price below $100?

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4b. Apply the concept of consumer surplus, producer surplus, and total surplus to understand the efficient or equitable allocation of resources when there is a change in demand or supply

How is consumer surplus affected by a shift in demand or supply?
How is producer surplus affected by a shift in demand or supply?
How is total surplus (social surplus) affected by market events?

We know the market is dynamically influenced by events that affect demand, supply, or both. We also know how these events affect market prices and quantities (Units 2 and 3). But do we know how they impact efficiency? Yes! We just need to review how shifts in demand, supply, or both impact total surplus (i.e., social surplus) by incorporating the consumer and producer surplus triangles into our demand and supply shift analysis.

This diagram illustrates an increase in demand and allows us to assess the impact on total surplus and revisit concepts and relationships from previous units.

While the resulting increase in price might have led you to think that consumer surplus has decreased, note that the consumer willingness to pay has also increased (from A to E). The diagram shows that both consumer surplus and producer surplus have increased, leading to a larger total surplus.

The efficiency analysis based on changes to consumer and/or producer surplus is very useful for assessing the impact of adopting tax policies, price controls, foreign trade tariffs, etc.

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4c. Apply efficiency analysis to understand the effects of the adoption of price controls

What is a price control?
What are the different types of price controls?
What are the benefits of price controls? Who benefits?
What problems do price controls cause? Who is hurt?
How do price controls affect market efficiency?
What is a deadweight loss?

Free markets create an equilibrium at the point where demand and supply intersect. What happens in a market when the government considers the free market equilibrium price "too high" or "too low"? Governments may implement price controls to attempt to influence the market. For example, in May 2023, UK ministers were reportedly working with supermarkets to voluntarily cap the price of essential food items to alleviate the nation's rising cost of living (with a price ceiling).

The diagram below illustrates the potential excess of demand that a price ceiling could introduce to the milk market. While the deadweight loss (economic inefficiency that results when the allocation of resources is not optimal, such as when supply and demand are not in equilibrium) is not explicitly depicted in the diagram, we can determine it by comparing consumer surplus and producer surplus before and after the implementation of the price control.

Another instance of price controls is the adoption of a minimum wage (a price floor) by governments that consider the wage rate for important jobs "too low", such as when workers do not earn enough to rise above the poverty level. Governments may require businesses to pay a minimum wage to their workers.

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4d. Explain how consumers and firms use marginal benefit and marginal cost to make rational choices

What is the marginal decision rule?
What steps do economic agents follow to determine optimal outcomes?
What is the value of marginal benefit with respect to marginal cost at the optimal level of consumption or production?

To analyze how market participants (consumers and firms) make decisions, we start with the basic assumption that they are driven by rational self-interest and seek to maximize utility (consumers) and profits (firms).

According to the marginal decision rule, consumers and firms compare the marginal benefit or marginal cost of adding one more unit to consumption or production. If the marginal benefit of the next unit exceeds the marginal cost, they should add more units.

Figure: The Benefits and Costs of Studying Economics

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4e. Explain how market failures are caused by externalities and public goods and identify the role of government intervention in alleviating them

What are some examples of market failure?
What are some examples of a public good?
What are some examples of a free rider?
What are negative and positive externalities, and what are some examples of each?
What government policies are used to correct negative externalities?
What is the concept of the tragedy of the commons?

The free market equilibrium is the most efficient point in the market in terms of optimizing total surplus. However, from a society's point of view, the market equilibrium may not always be the best. Sometimes, externalities, public goods, asymmetric information, and market power generate additional costs or benefits that are not considered in the interaction between demand and supply and its resulting equilibrium.

In the presence of market failures like externalities and public goods, markets may fail to allocate resources effectively. Externalities arise when consumption or production has an unintended effect (positive or negative) on a third party. The pleasant piano music played by your neighbor's son is an example of a positive externality, whereas the unpleasant smoke emanating from the restaurant downstairs represents a negative externality.

Public goods, like national defense, are non-rivalrous and non-excludable, meaning everyone benefits without paying, leading to underproduction. Government intervention, such as taxes or subsidies, can address market failures.

The tragedy of the commons refers to a situation where a shared resource is overused and depleted because individuals, acting in their self-interest, exploit the resource without considering the long-term consequences for the collective (the free rider problem). While some public goods are common resources, not all public goods are.

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4f. Apply marginal benefit and marginal cost analysis to show how society can achieve efficient solutions to environmental problems

What are some negative externalities that pollution creates?
What government policies are used to correct negative externalities?
How do policymakers use marginal analysis to tackle environmental problems?

Many economic activities generate environmental problems, such as pollution, which results in external costs that market prices do not take into account. Economists' assessments of the marginal benefit and marginal cost of economic activities that impact the environment can help governments make informed decisions regarding resource allocation for environmental control.

For example, governments may implement a pollution tax, raising costs for businesses that pollute. When determining the potential structure of this tax, policymakers should compare the marginal cost of the tax (such as the additional deadweight loss the tax caused) to its marginal benefit (the additional reduction in polluting activities).

Governments can also provide funding to encourage businesses to develop and use clean technologies. To determine the appropriate funding level, policymakers should weigh the marginal cost of the subsidy (the additional government financial outlay) against its marginal benefit (additional benefit society receives from clean technologies, such as health benefits, clean rivers, etc.).

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4g. Explain how the Lorenz curve and Gini coefficient give insight into a country's distribution of income and income inequality

What is income inequality?
Why has income inequality increased around the world?
How do we measure income inequality using the quintile distribution?
How do we measure income inequality using the Lorenz curve?
How do we measure income inequality using the Gini coefficient?

Income inequality (the uneven distribution of income and economic resources among individuals, households, or different groups within a society) is a growing problem in many countries, including the United States. Shifts in wage distribution and changes in households' composition partially explain the increase in inequality.

Common methods used to measure income inequality include:

Quintile distribution: This method divides all households into five equal groups, called quintiles, based on their income. The first quintile contains the poorest 20 percent of households, the second quintile contains the next 20 percent, and so on. Economists calculate the share of income each quintile receives.
Lorenz curve: This curve on a graph shows the cumulative share of the population on the horizontal axis and the cumulative percentage of total income received on the vertical axis. The closer the Lorenz curve is to the 45-degree line, the more equal the income distribution.
Gini coefficient: This is a number between zero and one that measures the overall level of income inequality. A Gini coefficient of zero indicates perfect equality; a Gini coefficient of one indicates perfect inequality.

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4h. Distinguish between relative and absolute measures of poverty and explain the major factors that cause and prevent poverty in the United States

What is the poverty line?
What is the difference between poverty and income inequality?
What is the difference between the absolute and the relative income tests?
What are the poverty rate and the poverty trap?
Can governments avoid the poverty trap?

Poverty and income inequality are related yet distinct economic concepts. We determine poverty by the number of individuals who fall below a specific income threshold (the poverty line). Using the poverty line, we can distinguish between absolute and relative income tests. An absolute income test sets a specific income level and defines a person as poor if their income falls below that level. For a relative income test, people are considered poor when their income falls at the bottom of the income distribution.

The poverty rate measures the percentage of the population that is below the poverty line in any given year. The concept of a poverty line raises many tricky questions. For example, should there be a national poverty line in a country as vast as the United States? Should the government adjust the poverty line to account for the value of non-cash assistance programs such as Medicaid and food aid?

While government assistance programs and subsidies may seem like an effective way to address poverty, they can inadvertently create a poverty trap. This occurs when the additional earnings from working are offset by reductions in government support, disincentivizing individuals from seeking employment. Review the measures suggested in the readings to avoid the poverty trap.

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4i. Illustrate how discrimination in the labor market affects the labor demand and labor supply curves

What is the wage rate?
What is employment discrimination?
Why does discrimination persist?
How can we identify employment discrimination in the labor market diagram?

In Unit 2, we introduced the concept and functioning of the labor market. With workers supplying labor and firms demanding labor, the labor market functions in the same way as any other market for goods or services, with the price on the y-axis determined by the wage rate (the amount of compensation individuals receive in exchange for performing labor or services).

Even at the equilibrium point, an efficient labor market can discriminate against specific sectors of society. Employment discrimination occurs when workers with the same skill levels receive different pay or have different job opportunities due to their gender, race, or religion. Make sure you review Gary Becker's model of discrimination in the workplace and the relevant diagram.

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Unit 4 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

absolute income test
consumer surplus
deadweight loss
employment discrimination
externalities
free rider problem
Gini coefficient
income inequality
Lorenz curve
marginal decision rule
negative externality
positive externality
poverty
poverty line
poverty rate
poverty trap
price ceiling
price control
price floor
producer surplus
public good
quintile distribution
relative income test
tragedy of the commons
wage rate