Chapter 6

How government policies like price controls and taxes affect

markets

What are Price Ceilings and Price Floors?

Price Ceiling:
o A maximum legal price for a good or service.
o Example: Rent control (to keep housing affordable).
o If the ceiling is below the market equilibrium price → it’s binding
and causes a shortage (too many buyers, too few sellers).
o If it’s above equilibrium → not binding, no effect.
o Imagine:
o Equilibrium rent = $800
o Government sets max rent = $600 → shortage (many
people want apartments, not enough supply)

Price Floor:

o A minimum legal price for a good or service.

o Example: Minimum wage (to protect workers).
o If the floor is above equilibrium → it’s binding and causes a
surplus (too many workers, not enough jobs = unemployment).
o If it’s below equilibrium → not binding, no effect.
o Imagine:
o Equilibrium wage = $6/hour
o Government sets minimum wage = $8/hour → more people
want jobs, but businesses hire fewer = unemployment.

How Do Taxes Affect Markets?

Taxes can be placed on either:
1. Buyers (e.g., sales tax)
2. Sellers (e.g., cigarette taxes for producers)

What happens when a tax is introduced?

o The price buyers pay goes up.
o The price sellers receive goes down.
o The quantity sold in the market goes down.
o A wedge is created between what buyers pay and sellers receive
(the size of the tax).
Example:
o Without tax: pizza sells for $10.
o Tax = $1.50 per pizza.
o Buyers now pay $11.
o Sellers only receive $9.50.
o Fewer pizzas are sold.

Tax Incidence: Who Pays the Tax?

It depends on elasticity:

o If demand is more inelastic (buyers don’t change how much they

buy):

o → Buyers bear more of the tax burden.

o If supply is more inelastic (sellers don’t change how much they

supply):

o → Sellers bear more of the tax burden.

o It doesn’t matter whether the tax is legally on buyers or sellers

the market outcome is the same.

Why This Matters:

Government policies are often meant to help (like rent control or
minimum wage), but they can have unintended consequences:
o Shortages
o Surpluses
o Inefficient resource allocation
 Chapter 7
Consumers, Producers, and the Efficiency of Markets

What is Welfare Economics?

Welfare economics studies how the allocation of resources affects
people's economic well-being (or welfare).

It focuses on three big questions:

o Who consumes what?
o Are the goods going to the people who value them most?
o Who produces what?
o Are the goods being made by the producers who can do it
cheapest?
o How much of each good is produced?
o Is the quantity produced the right amount for society?
o A well-functioning market gets all these answers right it
maximizes total benefit to society.

Consumer Surplus
o Consumer surplus is the difference between what a buyer is
willing to pay and what they actually pay.

Consumer Surplus= Willingness to Pay−Price Paid

It measures how much buyers benefit from participating in the market.

o The demand curve shows the willingness to pay (WTP) of

different buyers.

Example:

o Let’s say you're willing to pay $100 for a concert ticket, and the
ticket costs $80:
o CS=100−80=$20CS=100−80=$20
o You gained $20 worth of benefit (your satisfaction exceeded the
price).

Graphical Representation:
 o On a demand curve, consumer surplus is the area below the
demand curve and above the price line.
o If many buyers are involved, we add up each individual’s surplus
to get the total consumer surplus.

Law of Demand:

o As price falls, more buyers are willing to purchase, and existing

buyers get more surplus.
o So, consumer surplus increases as price decreases.

Producer Surplus

o Producer surplus is the difference between the price a seller

receives and the minimum amount they would accept(which is
their cost).

Producer Surplus=Price Received−Cost

It measures the benefit sellers receive from selling at a price higher
than their cost.

Example:

If it costs a bakery $2 to make a loaf of bread and they sell it for $4:

PS=4−2=$

Graphical Representation:

o On a supply curve, producer surplus is the area above the supply

curve and below the price line.

Law of Supply:

o As price increases, more sellers are willing to produce, and

existing sellers make more surplus.
o So, producer surplus increases as price rises.

Market Efficiency & Total Surplus

What is Total Surplus?

Total Surplus=Consumer Surplus+Producer Surplus

 o It measures the total benefit that buyers and sellers get from a
market. This is what economists use to judge efficiency.

Efficient Allocation (Ideal Conditions):

An efficient market has these characteristics:

 Goods go to buyers who value them most (highest WTP).

 Goods are produced by sellers who can do it cheapest (lowest
cost).
 Goods are only produced when the value to buyers > cost to
sellers.

This setup maximizes total surplus, meaning society is getting

the most benefit possible from the market.

Market Equilibrium

Equilibrium Maximizes Total Surplus. The equilibrium price and

quantity in a competitive market naturally leads to maximum total
surplus.

At equilibrium:

 Every buyer who values the good more than the price gets to
buy.
 Every seller whose cost is less than the price gets to sell.
 There's no deadweight loss (no wasted resources).

What Happens Outside of Equilibrium?

 If quantity is too low (underproduction): Some buyers who were

willing to pay more than cost don’t get the good → lost surplus.
 If quantity is too high (overproduction): Some sellers produce
goods that cost more than they’re worth to buyers → wasted
resources.

So, any quantity other than equilibrium is inefficient total surplus falls.

Market Failure & Government Intervention

Markets don’t always work perfectly. Sometimes, intervention is

needed.
Reasons for Market Failure:

1. Market Power (like monopolies)

o A seller with too much power can raise prices, reducing
output and causing inefficiency.
2. Externalities
o Negative externalities: e.g., pollution — costs to society
aren’t included in the market price.
o Positive externalities: e.g., education — benefits to others
that aren’t rewarded in the market.

In these cases, the market fails to maximize total surplus.

Role of Government:

o Can regulate, tax, or subsidize to help correct these failures.

o But in general, when markets are competitive and complete,
economists favor a laissez-faire approach letting markets work on
their own.

Evaluating Market Outcomes – Equity vs. Efficiency

Efficiency:

o Refers to maximizing total surplus.

o It's about getting the most benefit from scarce resources.

Equity:

o Refers to how fairly those benefits are distributed.

o Sometimes a market is efficient but not fair for example, if
only the rich can afford something essential.

Policy Trade-offs:

o A government may tax the rich and support the poor (for
equity).
o But these policies can cause deadweight loss or reduce total
surplus (lower efficiency).
 Chapter 13
The Costs of Production

What Is the Cost of Production?

o Firms turn inputs (like labor, land, and capital) into outputs
(goods or services).
o Objective of the firm: Maximize profit.

Key Definitions:

o Total Revenue (TR): Money received from selling output.

o TR = Price × Quantity
o Total Cost (TC): All the money the firm spends to produce goods.
o Profit:
o Profit = Total Revenue − Total Cost

Types of Costs

o Explicit Costs:
o These are direct, out-of-pocket costs (e.g., wages, rent,
materials).
o Implicit Costs:
o These are opportunity costs (e.g., income you gave up to
run your business).
o Example: If you quit your $50k job to start a business, that
$50k is an implicit cost.

Economic Profit vs Accounting Profit:

o Accounting profit = Total Revenue − Explicit Costs.

o Economic profit = Total Revenue − (Explicit + Implicit Costs).

Production Function and Marginal Product

Production Function:
 o Shows how much output a firm produces based on input levels.
o Diminishing Marginal Product:
o As you add more of one input (e.g., workers), while keeping
others fixed, the additional output per unit of input
decreases.

Marginal Product (MP):

o The additional output from adding one more unit of input.

o MP = Change in Output / Change in Input

Total, Marginal, and Average Product Curves

o Total Product (TP): Total output.

o Marginal Product (MP): Increase in output from an additional unit
of input.
o Average Product (AP):
o AP = Total Output / Number of Inputs
o When MP is above AP → AP is rising.
o When MP is below AP → AP is falling.

Total Cost (TC), Fixed Cost (FC), Variable Cost (VC)

o Fixed Costs (FC):

o Don’t change with output (e.g., rent, insurance).
o Variable Costs (VC):
o Change with output (e.g., raw materials, wages).
o Total Costs (TC):
o TC = FC + VC

Marginal Cost and Average Costs

o Marginal Cost (MC):

o Cost of producing one more unit of output.
o MC = Change in TC / Change in Quantity
o Average Total Cost (ATC):
o Total cost per unit of output.
o ATC = TC / Q
o Average Fixed Cost (AFC) and Average Variable Cost (AVC):
o AFC = FC / Q
 o AVC = VC / Q

Cost Curves:

o MC typically falls first then rises due to diminishing marginal

product.
o ATC is U-shaped.
o MC always intersects ATC and AVC at their lowest points.

Efficient Scale and Cost Curve Shapes

o Efficient Scale: The quantity that minimizes ATC.

o Why U-shaped ATC?
o Falling AFC (spreads fixed cost).
o Rising AVC (due to diminishing marginal product).

Short Run vs Long Run

o Short Run:
o Some inputs (like capital) are fixed.
o Firms face diminishing returns.

o Long Run:
o All inputs are variable.
o Firms can change plant size, machinery, etc.

Economies and Diseconomies of Scale

o Economies of Scale (Increasing Returns to Scale):

o As you increase output, ATC falls.
o Reasons: specialization, bulk buying, efficient capital use.
o Diseconomies of Scale:
o As output increases, ATC rises.
o Reasons: communication problems, management
inefficiencies.
o Constant Returns to Scale:
o ATC stays the same as output increases
 Chapter 14
Firms in Competitive Markets

What is a Perfectly Competitive Market?

A market is perfectly competitive if it has:

o Many buyers and sellers (no one controls the market).
o Identical products (goods are the same across sellers).
o Free entry and exit (new firms can enter, and current ones can
leave without restriction).

o Price Taker: Because of these conditions, each firm is a price

taker it must accept the market price.

The Firm’s Revenue

o Total Revenue (TR) = Price × Quantity
o Average Revenue (AR) = TR / Q = Price
o Marginal Revenue (MR) = Change in TR from selling one more
unit
In a competitive market: MR = Price
o Because firms can sell as much as they want at the market price.

Profit Maximization Rule

To maximize profit, a firm compares MR (revenue) to MC (cost):

o If MR > MC → produce more

o If MR < MC → produce less
o If MR = MC → profit is maximized
Golden Rule: Produce where MR = MC

The Supply Curve of a Firm

 o The MC curve (marginal cost curve) above AVC (average variable
cost) is the firm’s short-run supply curve.
o It tells us how much the firm will produce at different prices.
Shut Down vs. Exit
o Shutdown (Short-Run): Temporarily stop production, but still pay
fixed costs.
o Exit (Long-Run): Permanently leave the market and pay no costs.

Decision Rules:

o Shut down if: Price < AVC

o Exit if: Price < ATC (average total cost)
o Fixed costs are sunk costs in the short run they should NOT
affect shutdown decisions.

Long-Run Decisions
o Enter the market if: Price > ATC (you’ll make profit).
o Exit the market if: Price < ATC (you’ll lose money).
o The long-run supply curve is the part of the MC curve above
the LRATC (long-run average total cost).

Measuring Profit and Loss

o Profit per unit = Price – ATC
o Total Profit = (Price – ATC) × Quantity
o On a graph: Profit is the area between the price line and
ATC curve (for quantities sold).
o If ATC > Price, the firm makes a loss.

Long-Run Equilibrium
In the long run:
o Firms enter when profit is positive → supply increases → price
falls.
o Firms exit when there’s loss → supply decreases → price rises.
o Eventually, firms earn zero economic profit:
o Price = ATC = MC
o Firms cover all their explicit and implicit costs.
o There’s no incentive to enter or exit.
This is called the zero-profit condition.