AP Microeconomics Review #4 Rixie April 27, 2017

Resource Markets Derived Demand; Determinants of Resource Demand; Perfectly Competitive Labor Market; Monopsony; Least-Cost Hiring Rule

Derived Demand The demand for the factors of production (resources) exists due to the demand for the product

Determinants of Resource Demand Change in demand for the product Higher demand for lemonade would increase the demand for lemons Change in efficiency The more efficient a resource is, the more valuable it is to a business (increase in MRP) Change in the price of a substitute resource Firms demand more of the cheaper resource Change in the price of a complementary resource If one resource gets cheaper, firms will demand more of the complementary resource as well

MRP & MRC MRP (marginal revenue product) represents the additional income that an additional resource brings to the firm In perfectly competitive markets: MRP = Price x Marginal Product (MP) MRC (marginal resource cost) is the SAME THING as MFC (marginal factor cost), and represents the additional cost of hiring/purchasing one more of a resource In perfectly competitive resource markets: MRC = wage

Using the MRP = MRC rule The profit-maximization rule for hiring A firm should hire the quantity where these two curves intersect on a graph. When given data instead of a graph: Choose the quantity of the resource where MRP = MRC, or until they are close as can be before MRC > MRP

Perfectly Competitive Labor Market = MRC

Perfectly Competitive Labor Market Firm’s demand curve = MRP (downward sloping) Firm’s supply curve = MRC = wage (horizontal) The firm’s wage cannot change unless the market wage changes Ex: the supply of labor in the industry changes (see next slide) Ex: the government sets a minimum wage (price floor on the market graph will increase S=MRC=Wage on the firm’s graph) A shift in the firm’s demand for the resource (MRP) will affect their profit-maximizing quantity of labor

Decrease in market supply of labor

Market Minimum Wage (price floor)

Monopsony Labor Market Only one firm hiring (the market IS the firm) Demand curve = MRP (downward sloping) Still use MRP = MRC rule to find the profit- maximizing quantity of labor Wage is found on the supply curve (upward sloping) MRC (or MFC) is upward sloping & above the supply curve MRC does NOT equal wage!

Monopsony Labor Market Find the profit-maximizing quantity of labor where MRP = MFC. Then, find the wage on the supply curve at that quantity. To compare to perfect competition (PC) – a PC market would hire where MRP & supply intersect, and pay that wage Monopsony pays a lower wage & hires fewer workers than PC

Least-Cost Hiring Rule Marginal product per dollar (MP / P) Allows us to compare the amount of additional product gained from differently priced resources (putting in “like terms”) To minimize costs, find the combination of quantities that satisfies both conditions: The ratios of MP / P for each of two resources must be equal. The firm’s budget must be spent without going over, OR the exact amount of total product must be produced

Externalities Graphing & Interpreting Positive & Negative Externalities

Market Failures When the free market fails at providing the socially optimal amount of something Spillover costs – cause negative externalities; additional costs to society from the production of a good or service Ex: the health costs associated with second-hand smoke Spillover benefits – cause positive externalities; additional benefits to society from the production of a good or service Ex: the benefits to society from providing affordable education (highly skilled workers, less crime)

Negative Externality P & Q are the free market price and quantity whereas as P1 and Q1 are socially optimal Problem: The free market produces too much of a good (over-allocation of resources) Solution: The government can place a per-unit tax on producers to shift the Marginal Private Cost curve to the left, so it becomes equal to Marginal Social Cost curve, eliminating DWL DWL

Positive Externality P & Q are the free market price and quantity whereas as P1 and Q1 are socially optimal Problem: The free market produces too little of a good (under-allocation of resources) Solution: The government can subsidize consumers to shift the Marginal Private Benefit curve to the right, so it becomes equal to Marginal Social Benefit curve, eliminating DWL DWL

The Role of the Government Public & Private Goods; Income Distribution; Taxation

Public Goods Private Goods Must be non-excludable & non-rival Non-excludable: no one has to pay to use this good/service Non-rival: multiple people can benefit from/consume the good or service at the same time Examples: national defense, NASA, fire/police departments Are either excludable (must be paid for directly by the consumer) or only one person can consume at a time (or both apply) Examples: a restaurant meal, a symphony ticket, clothing

Free-rider problem Public goods often result in the free-rider problem: Since people aren’t required to pay for public goods to receive the service, many wouldn’t voluntarily help pay for them Ex: A neighborhood association provides night-time security and asks residents to chip in. Some residents may refuse to, since they could argue that they don’t want the service (though they’ll still benefit from it). The solution could be a required fee to the neighborhood association to help cover public goods. The government solution to this problem is usually different types of taxation.

Income Distribution All countries have some degree of income inequality, which is “the extent to which income is distributed in an uneven manner among a population” (source: http://inequality.org/income-inequality) Reasons for inequality: Natural ability (skill) Education & training Discrimination Preferences of amount & type of work (motivation) Market power held in the hands of a few (such as monopolies) Luck and connections

Lorenz Curve The 45 degree line represents perfect income distribution (60% of the population receives 60% of the total income) The Lorenz curve represents the extent of income inequality – the more curved/farther away from the equality line it is, the more inequality the nation is experiencing (ex: 60% of the population receives only 20% of the total income)

Gini Ratio (or Gini Coefficient) Another method of measuring income distribution The closer this ratio is to zero, the more equal the distribution The closer it is to one, the more unequal the distribution Ex: a Gini ratio of .25 for one country suggests that it has a much more equal distribution of income than a nation with a ratio of .85

Types of Taxation Progressive: People get taxed different rates (percentages) according to their income level Ex: federal income tax brackets (the more money you make, the higher the bracket is that you’re in, and the higher the rate that you pay) Regressive: The tax rate (percentage of total income) decreases as income increases Ex: a given sales tax is the same for everybody, but it will have a greater impact on somebody with a smaller income, because it consumes a higher overall percentage of their total income

Types of Taxation Proportional: the tax rate stays constant regardless of income level (whether you make $30K a year or $150K a year, you get charged, say, 15% of your income) Many argue that proportional taxation is a type of regressive taxation, and therefore contributes to income inequality; others say it’s just fair