Microeconomics Exam 2 Cheat Sheet
Understand how government interventions like price controls and taxes distort markets, leading to inefficiencies, and how externalities and market failures can be addressed through private bargaining or government policies.
Core Principles
- Binding price controls (ceilings below equilibrium, floors above) create shortages or surpluses, respectively, and lead to deadweight loss by reducing the quantity traded.
- Tax incidence depends on relative price sensitivities (steeper curve bears more burden), not who pays the government; taxes create deadweight loss by reducing quantity traded.
- Externalities cause market failures (overproduction for negative, underproduction for positive) because private costs/benefits diverge from social costs/benefits; the efficient quantity occurs where MSB = MSC.
- The Coase theorem suggests private bargaining can solve externality issues efficiently if transactions costs are low and property rights are clear, regardless of who holds the rights.
- Government policies like Pigovian taxes/subsidies and cap-and-trade aim to correct externalities and achieve efficient outcomes, often more effectively than command-and-control regulations.
- Goods can be classified by rivalry and excludability, leading to market inefficiencies for public goods (free riding) and common resources (tragedy of the commons).
Action Steps
- 1. Determine if a price control is binding by comparing it to the equilibrium price; if not binding, no market effect.
- 2. If binding, identify the quantity traded as the 'short side' of the market (lower of QD or QS).
- 3. Calculate tax incidence by finding the price buyers pay and sellers keep, and determine the burden split based on relative curve steepness.
- 4. For externalities, compare private vs. social costs/benefits to identify over/underproduction and calculate deadweight loss.
- 5. Apply Coase theorem logic: identify parties, rights, and bargaining outcome assuming low transactions costs.
- 6. Evaluate government policies: Pigovian tax/subsidy size equals external cost/benefit; cap-and-trade sets a total limit and allows trading.
- 7. Classify goods based on rivalry and excludability to predict market outcomes (efficient for private, inefficient for others).
Key Terms
- Price Ceiling: Legally determined maximum price; binding only if below equilibrium.
- Price Floor: Legally determined minimum price; binding only if above equilibrium.
- Binding Price Control: A control that prevents the market from reaching equilibrium.
- Shortage: Quantity demanded exceeds quantity supplied at the current price (caused by binding price ceiling).
- Surplus: Quantity supplied exceeds quantity demanded at the current price (caused by binding price floor).
- Deadweight Loss: Reduction in economic surplus due to market not being in competitive equilibrium; caused by price controls or taxes.
- Tax Incidence: Actual division of tax burden between buyers and sellers.
- Excess Burden (of a tax): Loss of surplus not offset by tax revenue; deadweight loss.
- Externality: Benefit or cost affecting a third party not involved in production/consumption.
- Negative Externality: Cost imposed on third parties (e.g., pollution); leads to overproduction.
- Positive Externality: Benefit received by third parties (e.g., education); leads to underproduction.
- Market Failure: Situation where market fails to produce efficient output level (e.g., due to externalities).
- Coase Theorem: Private bargaining leads to efficient solution for externalities if transactions costs are low and property rights are clear.
- Pigovian Tax: Tax set equal to marginal external cost to correct a negative externality.
- Pigovian Subsidy: Subsidy set equal to marginal external benefit to correct a positive externality.
- Tradable Emissions Allowances (Cap-and-Trade): Government sets emission cap, issues allowances, and firms trade them.
- Rivalry: One person's consumption prevents another's.
- Excludability: Non-payers cannot consume the good.
- Public Good: Nonrival and nonexcludable (e.g., national defense); prone to free riding.
- Common Resource: Rival but nonexcludable (e.g., fish in ocean); prone to tragedy of the commons.
- Free Riding: Benefiting from a good without paying for it.
- Tragedy of the Commons: Overuse of a common resource due to individual users ignoring costs imposed on others.
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