Exam 1 Study Guide PDF - Economics

Exam 1: Study Guide Chapter 1: Limits, Alternatives, and Choices in Economics Introduction to Economics Definition of Economics Economics is a social science concerned with making optimal choices under conditions of scarcity.​ Economic wants exceed society’s productive capacity.​ If wants didn’t...

Exam 1: Study Guide Chapter 1: Limits, Alternatives, and Choices in Economics Introduction to Economics Definition of Economics Economics is a social science concerned with making optimal choices under conditions of scarcity.​ Economic wants exceed society’s productive capacity.​ If wants didn’t exceed our productive capacity, everyone could have everything that they ever wanted and this class wouldn’t exist.​ Since we can’t get everything that we want, we have to make choices.​ The choices that we make are the best options available given the circumstances.​ Every choice that is made involves an economic decision.​ Your having chosen to be in this class right now impacts the economy.​ If you were not here, you could be working and helping to produce economic activity. The Economic Perspective Overview of the Economic Perspective A viewpoint that envisions individuals and institutions making rational decisions in their own self-interest by comparing the marginal benefits and marginal costs.​ It considers: ​ Scarcity and choice ​ Opportunity cost ​ Purposeful behavior to increase utility ​ Marginal analysis Scarcity and Choice Resources are scarce - If resources weren’t scarce, we wouldn’t have to make choices.​ Choices must be made. There is no free lunch.​ Because we have to make choices, there is a cost to every choice and that’s called 'opportunity cost.'​ This is where the phrase 'There’s no such thing as a free lunch' comes from.​ What did you give up to be in this class? What would you be doing if you weren’t in class right now?​ It’s important to note that everyone’s opportunity cost will be different. Purposeful Behavior Rational self-interest - Individuals and businesses make rational decisions; decisions that will make them better off, not worse off.​ With rational self-interest, the goal is to maximize utility or satisfaction.​ This does not mean that we are completely selfish or that we can’t make wrong decisions.​ Individuals and utility - We can derive utility by helping others and often when we make decisions, we don’t have all of the information, so wrong decisions can be made.​ Firms and profit - Firms are rational when they make choices about which products to produce in an attempt to maximize their profits.​ Desired outcome - People make decisions with some desired outcome in mind. Marginal Analysis The comparison of marginal benefits and marginal costs, usually for decision making.​ Marginal means 'extra' or 'additional.'​ Every time we make a choice, we are weighing the marginal benefit and cost.​ We will choose to do something if the marginal benefit is greater than the marginal cost because that is rational and will help to maximize utility.​ When people say, 'That’s not worth it,' then they are saying the marginal cost is greater than the marginal benefit. Theories, Principles, and Models The Scientific Method in Economics The scientific method is the procedure for the systematic pursuit of knowledge involving the observation of facts and the formulation of testing hypotheses to obtain theories, principles, and laws.​ It consists of several elements: 1.​ Observe. 2.​ Formulate a hypothesis. 3.​ Test the hypothesis. 4.​ Accept, reject, or modify the hypothesis. 5.​ Continue to test the hypothesis, if necessary. Economic Principles Generalizations - economic behavior that are true for the average person.​ Other-things-equal assumption: The assumption that factors other than those being considered did not change. (Also called the 'ceteris paribus assumption.')​ Graphical expression - In economics, graphs are often used to illustrate the relationship between variables. Microeconomics and Macroeconomics Definitions Microeconomics: The study of the individual consumer, firm, or market.​ Examining the price of a particular product or demand or supply of a particular product’s market is studied in microeconomics.​ Macroeconomics: The study of the entire economy or a major aggregate of the economy.​ Macroeconomics also looks at the basic groups in the economy such as all households, all businesses, all of the government, or the foreign sector.​ All goods and services produced in the economy, or the unemployment rate for the entire labor force, or the inflation rate are all macroeconomics topics. Positive and Normative Economics Distinction Between Positive and Normative Economics Positive economics: Economic statements that are factual.​ Positive economics can be supported or disproved with data. There isn’t any subjectivity.​ Normative economics: Economic statements that involve value judgments.​ Normative economics is what 'ought to be.' This is subjective since people have different opinions about what is desirable. The Economizing Problem Overview of the Economizing Problem The economizing problem: Limited income and unlimited wants.​ The budget line: Attainable and unattainable combinations, trade-offs and opportunity costs.​ A budget line is used to illustrate the greatest combinations of two goods that can be purchased with a certain amount of income.​ It reflects the greatest amount of these two goods that can be purchased.​ A budget line is created for a specific level of income so that when income changes, the budget line will shift to show the higher or lower incomes. A Consumer’s Budget Line A graphical representation of the budget line: Quantity of movies 2 4 6 8 10 12 14 Quantity of paperback books Global Perspective Income Variability Among Nations Average income (total income/population) and therefore typical individual budget constraints vary greatly among nations.​ This global perspective shows how average incomes vary greatly among countries.​ If average incomes vary, so will the budget constraints for these nations. Investment in Capital Goods Countries vary widely in the percentage of their respective national incomes that they devote to investments in capital goods ('gross fixed capital formation') rather than on purchases of consumer goods.​ Only the former generates increases in future production capacity. Society’s Economizing Problem Economic Resources For the economy as a whole, the economizing problem exists because resources are scarce.​ Resources refers to inputs that are used in the production of other goods and services. Categories of Economic Resources Land: Includes all natural resources used in the production process.​ Labor: Physical actions and mental activities that people contribute to production.​ Capital (investment): All manufactured aids used in production. Capital refers to anything man-made and used to produce goods and services. Capital is an investment good; it is not the same as money. Money isn’t even considered a resource.​ Entrepreneurial ability: Special human resource distinct from labor. Entrepreneurs are another type of human resource, but is different from labor mainly because entrepreneurs are risk-takers. Functions of Entrepreneurs Roles of Entrepreneurs Employ the other factors of production.​ Take initiative.​ Make strategic business decisions.​ Innovate.​ Take risk.​ Earn profits. Production Possibilities Model Overview An economic model that shows different combinations of two goods that an economy can produce.​ Assumptions: ​ Full employment ​ Fixed resources ​ Fixed technology ​ Two goods ​ Consumer goods ​ Capital goods Production Possibilities Curve Producing anywhere along the blue PPC line means that the economy is producing the maximum amount of pizzas and robots, and this implies that the economy is efficient.​ The economy can produce at any point inside the PPC, but doing so means that the economy is inefficient. This means that the economy has idle resources and/or resources are not being used to their capacity.​ When inside the PPC, it is possible to produce more of both goods by utilizing idle resources, or using resources to their capacity. Increasing Opportunity Costs Law of Increasing Opportunity Costs As more of a particular good is produced, its marginal opportunity costs increase.​ The PPC is concave because of the law increasing opportunity costs. If the opportunity costs were constant, the PPC would be a straight line.​ When the economy is efficient and operating on the PPC, the only way to get more of one good is to give up some of the other because all resources are already being utilized. Optimal Output Marginal Benefit and Marginal Cost The economy decides how much pizza to produce similarly to how a person makes decisions.​ The economy must compare the marginal benefit to the marginal cost of producing pizza.​ The optimal amount of pizza is where the marginal benefit is equal to the marginal cost of producing another unit of pizza. Unemployment, Growth, and the Future Economic Growth and the Production Possibilities Curve Where the economy chooses to produce on the PPC today largely determines the amount of economic growth that they will experience in the future.​ Goods for the future include goods like capital, education, and research and development. When we produce those kinds of goods today, they don’t do anything to satisfy needs and wants today, but they will help to better satisfy future wants and needs by enabling the economy to produce a greater amount of present goods in the future. International Trade Specialization and Production Possibilities International trade enables countries to specialize in the production of goods which they produce more efficiently than other countries.​ With international trade, resources are allocated more efficiently, and it essentially is the equivalent of an increase in resources. This leads to a rightward shift of the production possibilities curve. Last Word: Pitfalls to Sound Economic Reasoning Common Pitfalls Biases​ Loaded Terminology​ Fallacy of Composition​ Post Hoc Fallacy​ Correlation but Not Causation​ Because they affect us so personally, we often have trouble thinking accurately and objectively about economic issues. Chapter 2: The Market System and Circular Flow in Economics Economic Systems Overview of Economic Systems Economic systems are a set of institutionalized arrangements.​ They serve as a coordinating mechanism.​ Differences in systems exist by degree of decentralized use of markets and prices in decision-making and degree of centralized government control. Laissez-Faire Capitalism Adam Smith – The Wealth of Nations.​ Keep the government from interfering. Assumes markets are self-correcting.​ Power of government needed to: ​ Protect private property from theft. ​ Provide a legal environment for contract enforcement.​ People interact in markets to buy and sell. The Command System The command system is known as socialism or communism.​ Government ownership of resources.​ Decisions made by a central planning board.​ Many countries formerly under communist or socialist control have begun reducing their reliance on central planning and implementing more market-oriented systems.​ Examples: North Korea, Cuba, Myanmar. Laissez-faire vs. Command Economy The market system is a mix of decentralized decision making with some government control.​ Systems found in much of the world.​ Private markets are the dominant force.​ Private ownership of resources.​ Self-interested behavior.​ Monetary rewards are possible but not without some degree of financial risk.​ In the U.S. version of capitalism, the government plays a substantial role. Characteristics of the Market System Private Property and Freedom of Enterprise Private property - Private individuals and firms own most of the private property resources of land and capital.​ Private property, coupled with the freedom to negotiate binding legal contracts, enables individuals and businesses to obtain, control, use, and dispose of this property.​ Private property rights encourage investment, innovation, exchange of assets, maintenance of property, and economic growth.​ Property rights extend to intellectual property through patents, copyrights, and trademarks. Freedom of Choice and Self-Interest Freedom of enterprise means that entrepreneurs and businesses have the freedom to obtain and use resources, to produce products of their choice, and to sell these products in the markets of their preference.​ Freedom of choice means that owners of property and money resources can use resources as they choose, workers can choose the training, occupations, and job of their choice, consumers are free to spend their income in such a way as to best satisfy their wants.​ Self-interest is one of the driving forces in a market system. Entrepreneurs try to maximize profits or minimize losses; resource suppliers try to maximize income; consumers maximize satisfaction. Competition and Market Prices Competition requires two or more independently acting buyers and sellers. This serves to decentralize economic power.​ It also requires freedom to enter or leave the markets.​ Markets and prices reflect the decisions made on each side of the market and determine the set of product and resource prices that guide owners, entrepreneurs, and consumers as they all make choices based on their respective self-interests. Technology, Capital Goods, and Use of Money In the market system, the monetary rewards for creating new products or production techniques accrue directly to the innovator.​ The market system encourages extensive use and rapid development of complex capital goods.​ Money performs several functions, but first and foremost it is a medium of exchange. It makes trade easier. Active, but Limited, Government Although the market system promotes efficiency, it has certain shortcomings.​ There can be an overproduction of goods that have social costs and an underproduction of goods that have social benefits.​ There are tendencies for businesses to increase monopoly power.​ Governments can often increase the overall effectiveness of a market system. The Five Fundamental Questions Overview of the Five Questions These five questions highlight the economic choices underlying the production possibilities model.​ All economies, whether a market system or otherwise, must address these questions: 1.​ What goods and services will be produced? 2.​ How will the goods and services be produced? 3.​ Who will get the goods and services? 4.​ How will the system accommodate change? 5.​ How will the system promote progress? What Will Be Produced? Profit is the difference in total revenues and total costs.​ In a market system, consumers ultimately decide what will be produced through their dollar votes for a product.​ If there are not enough 'votes' for a product, the firm will cease production of that product.​ Businesses must match their production choices with consumer choices or else face losses and bankruptcy. How Will the Goods Be Produced? When firms face competition, the market forces the producers to use the most efficient production techniques, otherwise they will be driven out of business. Production Techniques and Efficiency Determining Production Techniques The combination of technology and the prices of the required resources determines the most efficient production technique.​ Minimize the cost per unit by using the most efficient techniques: ​ Technology ​ Prices of the necessary resources Answering the Question of How to Produce Three Techniques for Producing $15 Worth of Bar Soap​ $2.00 profit Market System Dynamics Who Will Get the Output? A market system is based on the willingness to pay principle which means if the consumer is willing and able to pay, the consumer gets the product.​ The ability to pay depends on income which depends on the amount of resources the person has and the price those resources obtain in the market.​ Consumers with the ability and willingness to pay will get the product. Ability to pay depends on income. How Will the System Change? – The Invisible Hand Changes in consumer tastes​ A market system is a dynamic environment and is able to quickly adapt to changes in consumer tastes and preferences.​ The business firm will find it in its best interest to make the changes reflected in the consumer choices.​ The market system acts like a giant communications system.​ The consumers communicate their preferences through their dollar votes, the business then responds to this by producing more, or less, or none of the product.​ This will soon be reflected in the demand for the resources employed in the production of the product.​ Changes in technology/Changes in resource prices​ When technology and resource prices change, this affects the costs the producer faces when producing the good, changing the amount of the good that will be produced and the price of the good. Progress and Innovation in Market Systems How Will the System Progress? The market system promotes technological improvements and capital accumulation.​ An entrepreneur or firm that introduces a popular new product will be rewarded with increased revenue and profits.​ New technologies that reduce production costs, and thus product price, will spread rapidly throughout the industry as a result of competition.​ Creative destruction occurs when new products and production methods destroy the market positions of firms that are not able or willing to adjust. The Invisible Hand The tendency of competition to cause individuals and firms to unintentionally but effectively promote the interests of society even when each individual firm only attempts to pursue its own interests result in the greatest amount of economic efficiency possible.​ 1776 Wealth of Nations by Adam Smith​ Unity of private and social interest​ Virtues of the market system: ​ Efficiency ​ Incentives ​ Freedom​ The market system guides resources into the production of the goods and services most desired by society.​ It enforces use of the most efficient production techniques while encouraging new production techniques.​ The market system encourages skill acquisition and hard work because you will be rewarded for your efforts.​ Entrepreneurs and workers are free to make choices based on their own self-interest. Command Systems and Their Failures The Demise of Command Systems Command systems fail to produce adequate amounts of goods and services.​ Examples: Soviet Union, North Korea, and pre-reform China​ The coordination problem: Must correctly set output targets for all goods and services.​ Failures along the supply chain were common because one factory’s output was another factory’s input.​ A failure at any step along the way would cause a chain reaction. This became more difficult as the economies grew.​ The incentive problem: There were no indicators of success like in a market system where we have profit or loss to indicate how successful the business firm is.​ There were no price signals to indicate more or less of a product was desired resulting in surpluses and shortages. The Circular Flow Model Overview of the Circular Flow Model The circular flow diagram is a simple economic model showing a private closed economy in which there is only a private sector consisting of households and businesses who interact with each other in the markets.​ The real flow consists of resources flowing from households and used in producing products that flow from businesses.​ The money flow facilitates the workings of the economic system. Components of the Circular Flow Model Private closed economy: ​ Households ​ Businesses ​ Sole proprietorship ​ Partnership ​ Corporation​ Product market and the resource market​ The real flow and the money flow The Circular Flow Diagram RESOURCE MARKET​ Households sell​ Businesses buy​ Costs​ Money income (wages, rents, interest, profits)​ Resources​ Land, labor, capital, entrepreneurial ability​ BUSINESSES buy resources​ sell products​ HOUSEHOLDS sell resources​ buy products​ Goods and Services​ Goods and Services​ PRODUCT MARKET​ Businesses sell​ Households buy​ Consumption expenditures​ Revenues Risk Management in Market Systems How the System Deals with Risk (1 of 2) In a market system, businesses all face risks.​ Profitability of the firm will depend on how well risk is managed.​ Profits flow to the owners as their reward for bearing the risk of losses.​ On the other hand, employees and suppliers to the firm do not face any risk, they get paid regardless of how well the firm is doing. How the System Deals with Risk (2 of 2) Business owners and investors face risk: ​ Losses due to input shortages ​ Changes in consumer tastes ​ Natural disasters that affect the supply chain​ Employees and suppliers have security: ​ Paid whether the firm makes a profit or not​ The market system will experience better economic outcomes over time since owners bear responsibility for their own management decisions.​ Compare this to the command and control system where no one bears any responsibility for bad management or loses any money if they make bad decisions. They receive the same salary regardless. Case Study: Venezuela Last Word: Hasta La Vista, Venezuela The problems in Venezuela have been well publicized over recent years.​ Dealing with the collapse of their oil industry and the subsequent hyperinflation caused by government mismanagement, the people are feeling the brunt of the problems.​ The average Venezuelan lost an average of 24 pounds of body weight in 2017, and inflation in 2018 was estimated at 1.3 million percent.​ Is it any wonder that over 3 million Venezuelans have fled the country seeking greener pastures elsewhere?​ Venezuela’s economy is on the verge of collapse. 90% of Venezuelans now live in poverty. Chapter 3: Demand, Supply, and Market Equilibrium Markets Competitive Markets In this chapter, the focus is on markets that are competitive. This requires large numbers of buyers and sellers acting independently.​ Interaction between buyers and sellers. Competitive Markets may be: ​ Local – farmer’s market ​ National – real estate ​ International - NYSE​ Price is discovered in the interactions of buyers and sellers. LO3.1 Demand Demand Definition A schedule or curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during specified periods of time.​ Demand schedule (table) or demand curve (graph)​ Amount consumers are willing and able to purchase at a given price assuming: ​ Other things equal (ceritis paribus) ​ Individual demand ​ Market demand – add up all individual demand curves​ LO3.2 Law of Demand Law of demand: Other things equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls (inverse relationship, constrained income)​ LO3.2 Explanations of Law of Demand Price acts as an obstacle to buyers - it makes sense that with a limited income, consumers will buy more at lower prices.​ Law of diminishing marginal utility - Diminishing marginal utility refers to the decrease in added satisfaction that results as one consumes additional units of a good or service.​ Income effect and substitution effect – ​ The income effect occurs as a lower price increases the purchasing power of money income; this enables the consumer to buy more at a lower price (or less at a higher price) without having to reduce consumption of other goods. ​ The substitution effect is when a lower price gives an incentive to substitute the lower-priced good for the now relatively higher-priced goods.​ LO3.2 The Demand Curve Inverse Relationship​ The downward slope indicates a lower quantity (horizontal axis) at a higher price (vertical axis), and a higher quantity at a lower price, reflecting the law of demand. Changes in Demand Changes in the demand for corn will be brought about by a change in one or more of the determinants of demand.​ An increase in demand is shown as a shift of the demand curve to the right, as from D1 to D2.​ A decrease in demand is shown as a shift of the demand curve to the left, as from D1 to D3.​ Caution: These changes in demand are to be distinguished from a change in quantity demanded, which is caused by a change in the price of the product and is shown by a movement from one point to another point on a fixed demand curve. Determinants of Demand (1 of 2) Change in consumer tastes and preferences – ​ Determinants are those things that can shift the entire demand curve causing demand to change. ​ When most consumers experience the same change in tastes for a particular good, the demand for the good will change.  ​ If there is a preferable change in tastes, demand will increase. On the other hand, if there is an unfavorable change in tastes, demand will fall.​ Change in the number of buyers ​ If there are more buyers in the market for a good, demand will increase, whereas when there are fewer buyers in the market for a good, demand will decrease.​ Change in income: ​ Normal goods - Normal goods are goods that we buy more of as our incomes increase. Most of the goods that we buy are normal goods. We buy fewer normal goods when our income decreases. ​ Inferior goods - Inferior goods are goods we buy more of as our income decreases. We buy fewer inferior goods if our income increases. LO3.2 Determinants of Demand (2 of 2) Change in prices of related goods ​ Complementary good - Complementary goods are goods that we consume jointly. It isn’t beneficial to have one without its complement. When the price of one complement increases, the demand for the other complement decreases. When the price of one complement decreases, the demand for the other complement increases. Some examples are cell phones and cell phone service, tuition and textbooks. ​ Substitute good - Substitute goods are goods that we use in place of another. A perfect substitute is a good that we use in place of the other without any loss of satisfaction. If the price of one good increases, the demand for its substitute increases. If the price of one good decreases, the demand for the other substitute decreases. Some examples are Colgate and Crest toothpaste, Nike and Reebok shoes.​ Change in consumer expectations ​ Future prices - If consumers expect the future price of a product to be higher, they increase their current demand for the product. If consumers expect the future price of a product to be lower, they decrease their current demand for the product. ​ Future income - If consumers expect their future income to rise, they increase purchases now. If consumers believe their future income will be less, they reduce their demand for some products. Supply Supply Definition A schedule or curve that shows the various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specified period of time.​ When creating supply, we are assuming that the only factor that causes firms to produce more or less is the price of the good.​ It is assumed that all other factors that influence the amount that firms will produce are constant.​ Supply schedule or a supply curve​ Amount producers are willing and able to sell at a given price​ Individual supply​ Market supply – add all individual suppliers together​ LO3.3 Law of Supply Law of supply: Other things equal, as the price rises, the quantity supplied rises and as the price falls, the quantity supplied falls.​ Explanation: ​ Price acts as an incentive to producers. Higher prices mean higher profits. ​ At some point, costs will rise - Beyond some level of output, producers usually encounter increasing costs per added unit of output. The Supply Curve Direct Relationship Other things equal, producers will offer more of a product for sale as its price rises and less of the product for sale as its price falls. Changes in Supply A change in one or more of the determinants of supply causes a change in supply.​ An increase in supply is shown as a rightward shift of the supply curve, as from S1 to S2.​ A decrease in supply is depicted as a leftward shift of the curve, as from S1 to S3.​ Caution: These changes in supply are to be distinguished from a change in quantity supplied, which is caused by a change in the price of the product and is a movement from one point to another point on a fixed supply curve. Determinants of Supply A change in resource prices: If resource prices (input prices) go up, supply decreases. If resource prices (input prices) go down, supply increases.​ A change in technology: If technology increases, supply increases. If we adopt, or use, less efficient technology, supply decreases.​ A change in the number of sellers: If the number of sellers increases, supply increases. Economic profits in the market draw producers from less profitable markets into this market. If the number of sellers decreases, supply decreases. Economic losses in the market cause producers to leave market. Additional Determinants of Supply A change in taxes and subsidies: If taxes are increased on a specific product, supply decreases. If taxes are decreased, or eliminated on a specific product, supply increases. If subsidies are increased on a specific product, supply increases. If subsidies are decreased on a specific product, supply decreases.​ A change in prices of other goods: If the price of another good that the producer could produce with the same resources rises, the supply decreases for the product the producers are currently producing. If the price of another good that the producer could produce with the same resources falls, the supply increases for the product the producers are currently producing.​ A change in producer expectations: If producers expect that the price of the product they are producing will be higher in the future, they cut back on current supply and supply will decrease. If producers expect the price of the product they are producing will be lower in the future, they increase current supply to take advantage of the currently higher price. Equilibrium Price and Quantity Market Equilibrium Equilibrium occurs where the demand curve and supply curve intersect.​ At prices above this equilibrium, note that there is an excess quantity supplied, or a surplus.​ At prices below this equilibrium, note that there is an excess quantity demanded, or shortage. Efficient Allocation Productive efficiency: Producing goods in the least costly way, using the best technology, using the right mix of resources.​ Allocative efficiency: Producing the right mix of goods, the combination of goods most highly valued by society. Rationing Function of Prices The ability of the competitive forces of demand and supply to establish a price at which selling and buying decisions are consistent.​ Prices are the best tool for eliminating market shortages and surpluses. Changes in Demand and Supply Changes in Demand and Equilibrium D decrease: P, Q​ D increase: P, Q Changes in Supply and Equilibrium S increase: P, Q​ S decrease: P, Q Complex Cases Effects of Changes in Both Supply and Demand​ Complex Cases Explained Government Set Prices Price Ceiling Price ceiling: Set below equilibrium price, rationing problem, set on goods that are considered necessities, black markets.​ When price ceilings are placed on a good, this creates a chronic shortage which makes it difficult to determine how to ration the limited output for all of the consumers who are willing and able to buy the good. The shortages often lead to black markets where the good is sold at a higher price than the price ceiling. Price ceilings distort the efficient allocation of resources. Example is rent control/credit card rates. Price Floor Price floor: Prices are set above the market price, chronic surpluses. Example is the minimum wage law. Last Word: Pandemic Prices Economic Effects of the Pandemic The most obvious economic effect of the pandemic initially was empty store shelves. Consumers rushed to stock up on certain commodities, causing shortages. With retail prices remaining largely fixed, shortages resulted as demand far exceeded supply. Additional Pandemic Economics A crash in stock prices​ A spike in the price of used cars​ Increased demand for housing in suburban and rural areas​ Widespread labor shortages Chapter 4: Market Failures: Externalities and Asymmetric Efficiently Functioning Markets Market Failures Markets fail to produce the right amount of the product.​ Efficient outcome requires:​ Market demand curve must reflect full willingness to pay of every person in the market.​ Market supply curve must reflect all costs of production.​ Total Surplus = Consumer Surplus + Producer Surplus Consumer Surplus Difference between what a consumer is willing to pay for a good and what the consumer actually pays. (PMC)​ Extra benefit from receiving a higher price.​ Think about being the seller of a car; you probably have an idea of the lowest possible price that you will accept. If you receive a price that is higher than this lowest possible price, then you have received an extra benefit that is called your producer surplus. Total Surplus and Efficiency Productive efficiency is achieved because competition forces producers to use the best available technology and best combination of resources available.​ Allocative efficiency is achieved because the correct quantity of product is produced relative to other goods and services.​ When the market achieves efficiency, the maximum combined consumer and producer surplus is achieved. Efficiency Losses Efficiency Losses from Underproduction Efficiency losses (or deadweight losses) are reductions of combined consumer surplus and producer surplus.​ Quantity levels that are either less than or greater than the efficient quantity, Q1, create efficiency losses. Efficiency Losses from Overproduction Efficiency losses (or deadweight losses) are reductions of combined consumer surplus and producer surplus.​ Quantity levels that are either less than or greater than the efficient quantity, Q1, create efficiency losses. Externalities Definition and Types of Externalities An externality is a cost or benefit accruing to a third party external to the market transaction.​ Positive externalities occur when a third person, or persons, is affected by the transaction in a positive way. Positive Externalities Good architecture. Choosing a beautiful design for a building will give benefits to everybody in society.​ Buying flowers for front garden gives benefits to others who walk past.​ Education or learning new skills. With better education, you are more productive and can gain more skills. But also, the rest of society benefits from your new skills.​ Getting a vaccination provides a benefit to other people in society because you do not spread infectious diseases.​ A decision to stop smoking causes benefits to other people in society who longer suffer passive smoking.​ Switching from conventional farming to organic farming helps the environment as there are fewer chemicals in the environment.​ Picking up litter makes the environment nicer for everyone. Negative Externalities Negative externalities occur when a third person, or persons, external to the transaction is affected from the transaction in a negative way.​ The good is overproduced, and the equilibrium output will be greater than the efficient output. Understanding Externalities Negative Externalities The good is overproduced, and the equilibrium output will be greater than the efficient output.​ This is because the producer, who is not bearing the full cost of production, will be able to produce more at a lower price than the efficient level, which would exist if true costs were reflected in the production decision.​ Loud music. If you play loud music at night, your neighbour may not be able to sleep.​ Pollution. If you produce chemicals and cause pollution as a side effect, then local fishermen will not be able to catch fish. This loss of income will be the negative externality.​ Congestion. If you drive a car, it creates air pollution and contributes to congestion. These are both external costs imposed on other people who live in the city.​ Building a new road. If you build a new road, the external cost is the loss of a beautiful landscape which people can no longer enjoy.​ Burning coal for energy creates pollution destroying the ozone layer.​ Producing conventional vegetables with pesticides causes carcinogens to get into the environment.​ Consuming alcohol leads to an increase in drunkenness, increased risk of car accidents and social disorder.​ Consuming cigarettes causes passive smoking to others in the vicinity.