Externalities - failure to recognize all costs and benefits. Externalities are the side effects, or spillover effects, of an action between two parties that influences the well being of other individuals. The presence of externalities means that decision-makers do not have the proper cost and price information on which to make decisions.

Public goods – difficult for the market to provide: Public goods are goods consumed by the public as a whole. Police protection and sponsored medical research are examples of public goods.

Potential information problems: When individuals are unable to evaluate the quality of products properly, the makers of poor quality products thrive and the makers of high quality products have low or negative profits. For example, few individuals are capable of evaluating the safety features built into cars.

c: Discuss the differences and similarities between market action and collective action in seeking economic efficiency.

Competitive behavior is present in both the market and public sector.

Public-sector organization can break the individual consumption-payment link. With government, there is no direct link between the size of the payment and the amount of consumption. Some pay little in taxes and receive large benefits and vice versa.

Scarcity imposes the aggregate consumption payment link in both sectors. As in the private sector, aggregate consumption equals aggregate payment (there is no free lunch). Someone must pay for everything provided by the government.

In the private sector, individuals make choices with mutual gain as the foundation. In the public sector, the “majority” makes decisions, which generates some winners and some losers.

When collective decisions are made legislatively, voters must choose among candidates who represent a bundle of positions on issues.

Income and power are distributed differently in the two sectors. Success in the market place depends on one’s ability to provide products at a reasonable price.

d: Discuss the role of government in attempting to correct the shortcomings of the market.

Recall that the invisible hand of market forces generally provides individuals with the incentive to work hard to create value. There are four important factors that can limit the ability of the invisible hand to do this, which creates a potential need for government productive action.

Lack of competition. Competition is vital to the proper operation of the pricing mechanism. When there are only a few firms in the industry, the competition from new entrants can be restrained. Sellers may, thus, be able to rig the market in their favor.

Externalities - failure to recognize all costs and benefits. Externalities are the side effects, or spillover effects, of an action between two parties that influences the well being of other individuals. The presence of externalities means that decision-makers do not have the proper cost and price information on which to make decisions.

Public goods – difficult for the market to provide: Public goods are goods consumed by the public as a whole. Police protection and sponsored medical research are examples of public goods.

Potential information problems: When individuals are unable to evaluate the quality of products properly, the makers of poor quality products thrive and the makers of high quality products have low or negative profits. For example, few individuals are capable of evaluating the safety features built into cars.

2.A: Demand and Consumer Choice, including addendum Consumer Choice and Indifference Curves

a: Explain consumer choice in an economic framework.

As consumption increases, the marginal utility (that is the benefit derived from consuming that next unit) decreases. For example, your twelfth consecutive beer does not taste nearly as good as your first beer. This is known as the Law of Diminishing Marginal Utility. The law of diminishing marginal utility helps determine the shape of an individual’s demand curve. The height of the demand curve at any point is the marginal benefit to the customer (the maximum price the consumer would pay for an additional unit).

Marginal utility and consumer choice: Given a fixed income and price schedule, consumers will maximize their satisfaction (total utility) by ensuring that the last dollar spent on each item yields an equal degree of marginal utility.

Price change and consumer choice:

The substitution effect: If a good becomes cheaper relative to other goods, you will consume more of that good and

The income effect: As the price of a good drops, your real income rises, you will consume more of that good (and other goods).

Time cost and consumer choice: Time, like money, is scarce to the consumer. Thus, a lower time cost, like a lower money price, makes a product more attractive.

b: Identify, describe, and calculate the determinants of price and income elasticity of demand.

Price elasticity of demand indicates the degree of consumer response to variation in price. It is determined by the % change in quantity demand divided by the % change in price.

Example: If the price of product A is increased from $1.00 per unit to $1.10 per unit, the demand will decrease from 5.0 million units to 4.8 million units. What is the price elasticity of demand for product A? Is product A an elastic good?

% change in quantity = [(4.8 - 5.0)] / [(5.0 + 4.8) / 2] = - 0.2 / 4.9 = -0.041 or -4.1%

% change in price = [(1.10 - 1.00)] / [(1.10 + 1.00) / 2] = 0.10 / 1.05 = .095 = 9.5%

Price elasticity of demand for product A = -4.1% / 9.5% = -.43. Because the price elasticity of demand is below 1.0, product A is inelastic.

Price elasticity of demand is determined by:

Availability of substitutes: Many substitutes indicate elastic demand. The most important determinant of the price elasticity of demand is the availability of substitutes. When good substitutes for a product are available, a price rise induces many consumers to switch to other products and

Share of budget spent on product: Goods that occupy a relatively small portion of your budget will tend to be price inelastic.

Income elasticity is the sensitivity of demand to change in consumer income. It is determined by the % change in quantity demanded divided by the % change in income.

An inferior good has negative income elasticity. As income increases (decreases), quantity demanded decreases (increases). Inferior goods include such things as bus travel and margarine. The opposite type of good, a normal good, has positive income elasticity meaning that, as income increases (decreases), demand for the good increases (decreases). Normal goods include things like bread and tobacco.

Generally, normal goods have low income elasticities (absolute values between 0 and 1) are considered necessities. Normal goods with high-income elasticities (absolute values greater than 1) are generally considered luxury goods.

Example: Suppose that your income has risen by $10,000 from a base rate of $50,000. During this period, your demand for bread has increased from 100 loaves per year to 110 loaves per year. Given this information, determine whether or not bread is a necessity or a luxury good.

The percentage change in income is (60,000 - 50,000) / 50,000 = 20%, while the percentage change in the quantity of bread demanded is (110 - 100) / 100 = 10%. Hence, the income elasticity of bread is 10 / 20 = .50. This good is a necessity.

c: Explain why the price elasticity of demand tends to increase in the long run.

The effect of time on elasticity: In general, when the price of a product increases, consumers will reduce their consumption by a larger amount in the long run than in the short run. Thus, the demand for most products will be more elastic in the long run than in the short run. This is sometimes called the second law of demand.

Total revenue, total expenditures, and price elasticity of demand: An important application of price elasticity is to estimate how total consumer expenditures on a product change when the price changes. There are three ways to do this: (a) Consider an individual’s elasticity of demand, (b) Consider the combined elasticity of demand for all consumers of the product, and (c) Consider the elasticity of demand for an individual business that produces the product.