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UT Knoxville ECON 201 - Exam 2 Study Guide

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Econ 201 1st EditionExam #2 Study Guide Lectures: 12 - 19Lecture 12 (February 6)PricePrices are signals that guide the allocation of society’s resources. The higher the price, the greater the value to sellers and the greater cost to consumers, and vice versa. The value of the price should depend on the amount of meaning and purpose a person places on a particular good. A price ceiling is a legal maximum price a government places on a good while a price floor is a legal minimum price a government places on a good. Price ceilings result in shortages and are advantageous to the consumers. However, price ceilings are only binding below the equilibrium. In the long run, price ceilings tend to flatten demand and supply curves. Price floors result in surpluses and are advantageous to the producers. However, a surplus of goods also results in a surplus of labor, leading to unemployment.TaxesTaxes are the amount that buyers and sellers pay on a specific good sold. The government levies taxes on many goods and services to raise revenue for areas such as national defense and public schools. If a tax increases, the price of the good must also decrease if the sellers want to continue making the same market. A tax on buyers essentially shifts the demand curve down by the same amount of the tax.Lecture 13 (February 9) Tax BurdenTax incidence is defined as how the burden of the tax is shared between sellers and buyers. The more elastic the market curve (the greater flexibility it has with regard to changes in the market) then the less burden it will bear. The lower the value of the slope(and the flatter a curve), the greater the elasticity; likewise, the higher the value of the slope (and the steeper a curve), the lower the elasticity. If the supply curve is more elastic than the demand curve, then the burden of the initial tax will fall on the buyers. Ifthe demand curve is more elastic than the supply curve, then the burden of the initial tax will fall on the sellers.Welfare EconomicsWelfare economics is the study of how the allocation of resources affects economic well-being. Consumer surplus is the amount a buyer is willing to pay minus what the buyer actually pays. This is shown in the equation below.CS=WTP −PProducer surplus is the amount a seller paid for the good minus the seller’s cost. This is shown in the equation below. PS=P−costCost is the value of everything a seller must give up to produce a good (also known as opportunity cost). A seller will only produce and sell the good if the price is greater than or equal to the cost. The cost, then, is a measure of willingness to sell. Lecture 14 (February 11)Total SurplusThe total surplus is the combined total of the consumer surplus and the producer surplus. This value shows the total gains from trade in a market. This can also be calculated by the finding the difference between the value to buyers and the cost to sellers. Government InterventionThe government cannot raise the total surplus in a competitive market. This is reinforcedby the belief of laissez-faire, the notion that the government should not interfere with the market. Effects of TaxesIn the first diagram below, the market does not have a tax imposed upon it. The consumer surplus is equal to the combined areas of A+B+C while the producer surplus is equal to the combined areas of D+E+F. The value of the tax revenue is 0.In the second diagram below, the market does have a tax imposed upon it. Now, the consumer surplus is only equal to the area of A and the producer surplus is only equal tothe area of F. The tax revenue is equal to the combined areas of B+D and the deadweightloss is equal to the combined areas of C+E.Deadweight LossThe deadweight loss is directly dependent upon the size of the tax. The greater the elasticity of a market, the smaller the amount of the deadweight loss. If the tax is doubled, then the deadweight loss increases by approximately four times the amount of the tax. The greater the tax, the greater the deadweight loss, and the lower the revenue.Lecture 15 (February 13)Characteristics of GoodsThere are two main characteristics of goods: excludability and rivalry in consumption. Excludability is when a person can be prevented from using that good by another personconsuming it. Rivalry in consumption is when one person’s use of the good diminishes other people’s use. Examples are in the table below.Rival in Consumption?Excludable? Yes NoYes Private Good (pizza, lattes)Club Good/Natural Monopoly(cable TV, fire protection)No Common Resource(fish in the ocean, environmentalresources)Public Good(national defense, tornado siren)Problems with Public GoodsThe biggest problem with public goods is known as the “free rider” problem. A free rideris a person who receives the benefit of the good but does not pay for it. The result is that this good is not produced, even if buyers collectively value the good more than it costs to produce it. Ultimately, it becomes the role of the government to provide this good. If the benefit outweighs the cost, then the government will provide the good by taxing the people who benefit from it. To understand if the benefit outweighs the cost, the government performs a cost-benefit analysis. A cost-benefit analysis is a study that compares the costs and benefits of providing a public good. At best, this is imprecise anddifficult to evaluate for public goods.Tragedy of the CommonsThe Tragedy of the Commons is an economic parable by Garrett Hardin. In his parable, a medieval village shares land and cattle and everyone uses the land for their cows. If an individual adds another cow to the center, then it is beneficial to them as everyone gets more cattle products while the individual does not have to provide for the upkeep or food of the cow. Just as the benefits of the cow are shared between the people, so the costs are too. The private incentives (using the land for free) outweigh the social incentives (using it carefully). The inevitable result is that the townspeople will have unusable land; they will all buy more cows and ruin their plot. The tragedy is due to an externality (a third person/bystander effect).Solutions to the TragedyThere are a few different solutions to the tragedy. The people could regulate the use of the resources (command-and-control approach). They could impose a corrective tax to internalize the externality. They could auction off permits allowing the use of the resources. Finally, they could


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UT Knoxville ECON 201 - Exam 2 Study Guide

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