Review and Externalities

I. Review

It is time to review the enormous amount we have covered to date, and then apply it.

By now, you would probably agree that there are some very easy aspects of economics, but also increasingly challenging issues. You may feel that you do not understand everything yet. That is OK: it takes time to grasp completely the most difficult concepts in economics.

Let’s divide economics into three categories: Easy, Medium, and Difficult. Make sure you know and can apply everything in the easy category. Then do likewise for the medium category. Finally, learn and appreciate as much of the difficult category as possible.


microeconomics (the study of individual micro market decisions, companies, consumers)

P (price) & Q (quantity or output)

graphing supply and demand curves (with P on y-axis, and Q on x-axis)

supply meets demand: this defines the market price and quantity in a free, competitive market

scarcity: wants exceed free availability. Scarcity is what makes economics meaningful.

opportunity cost

transaction cost

rational economic action


net benefits


firm = company = supplier = seller

marginal benefit of a firm’s output decision:

for producing one more Q: marginal benefit is P (price it is sold at)


price discrimination

Law of Demand: when price goes up, then demand goes down. YOU MUST USE THIS LAW.

supply side

demand side

Do not proceed until you thoroughly understand everything on the above list. Review your notes since the beginning of the course as necessary.

Once you are confident you know and can apply everything on the Easy list, proceed to the Medium (in difficulty) list:




fixed costs (FC) (these are costs that do not vary with a company’s output. E.g., rent payments)

variable costs (VC) (costs that do vary directly with output. E.g., fuel, labor)

average total cost (ATC) (this is all the costs divided by the quantity of output Q)

average variable costs (AVC) (total variable costs divided by the quantity of output Q)

total costs (TC = TVC + TFC)

elastic demand

inelastic demand

price elasticity of demand (percent change in quantity demanded

divided by percent change in price, dropping the negative sign)

marginal cost (MC = change in total cost (TC) due to producing one more unit of output Q)

(note: total fixed costs (TFC) do not change as more is produced, thus MC = change in

TVC due to one more output Q)

marginal revenue (MR)

short run (period when only some inputs are increased in order to increase output; e.g. overtime)

long run (period when any and all inputs are increased to increase output; e.g., build new stadium)

alternative definition of the long run : enough time to adjust all inputs in order to

produce a given Q at the lowest possible cost

variable inputs (inputs that are increased to produce more Q in the short run)

fixed inputs (inputs that cannot be increased in the short run to produce more Q)

returns to scale (increasing, decreasing or constant? Look at whether output Q increases for increase in input I)

income effect

substitution effect

inferior good (a good that sees a decrease in demand when income increases, and vice-versa)

marginal product (increase in output due to additional input: Q = sum MP)

barriers to entry


law of diminishing marginal return

perfect competition (know the conditions for it)

economic point at which firms sell their goods (where MR=MC)

accounting profit (total revenue minus explicit cost)

economic profit (total revenue minus both explicit and implicit costs)

natural monopoly (a company that has increasing economies of scale, such that long-run average

costs of production decrease, like power companies or railroads)

In a perfectly competitive market …

the increase in profit from an additional Q = P – MC

the firm increases Q only if P > MC

the optimal level of Q is where P = MC

the company stays in business in the short run at level Q only if P equals or exceeds AVC

otherwise the company changes Q until it equals or exceeds AVC

if no such Q exists then the company is better off shutting down

In a natural monopoly, there is falling ATC and MC, so ATC > MC.

A monopoly shuts down in the short run if when MR = MC, AVC > P.

A monopoly shuts down in the long run if when MR = MC, ATC > P.

The above list is a bit more challenging, right? Be sure to keep the supply side and the demand side separate in your mind. Which side is marginal product MP on? (The supply side.)

Spend as much time on the Medium list as you can. Look over your notes. Think about which concepts on the Easy and Medium lists you would apply to explain the Nobel-prize winning Coase Theorem and Nash Equilibrium. Review the Model Answers in the course.

You can do well in this course and probably pass the CLEP exam by completely mastering the Easy and Medium lists. That means fully understanding the terms and knowing how to recognize and apply them. For example, perhaps 20% of economics questions on any exam can be answered correcting by proper application of two concepts: MR=MC and the Law of Demand. The other principles listed above cover another 50% or more of all questions you are likely to see. Learn well what you can and make sure you don’t miss any questions on it.

To master the above lists, you’ll want to study the model answers and quiz yourself. Ask yourself why certain goods you buy are priced a certain way. Ask yourself what would happen if Wrigley’s gum company increased the price of gum, for example. Think about the effect of changing the ticket prices for the homeschool dinner we discussed.

Ready now for the Difficult list?


monopolistic competition

perfectly contestable markets


monopsony (a buyer’s monopoly i.e., only one buyer)

cross-elasticity of demand (percent change in demand for good X

divided by percent change in price for good Y)

income elasticity of demand (percent change in demand for good X

divided by percent change in income)

consumer surplus (savings by consumers who would pay more than the market price for a good)

social cost (P-MC summed over the Q not produced due to a monopoly)

indifference curve

law of equiproportional marginal benefit

condition for reducing production (MC>MR)

condition for shutting down (P<AVC in short run or P<ATC in long run)

kinked demand curve model for oligopoly

dominant demand curve model for oligopoly


At Q = 0, TC = TFC

At Q = 1, MC = TVC

At all Q > 0, AVC = TVC / Q

At all Q > 0, AFC = TFC / Q

At all Q, ATC = AVC + AFC

MC = W / MP (where W is wage per unit of labor, and labor is the only input)

TVC = sum of MC

AVC = W / AP when labor is the only input and W is the wage or cost of the labor



TC = Q x ATC

long run average costs (LRAC) are never more than short run average costs (SRAC) for a given Q. Why? See the alternative definition of long run in Medium list above

LRAC = P x (I / Q), where I is input and Q is output and P is price of the input

That is enough for now. I know, some of you view the Difficult list as impossible. It isn’t. Everyone in this course can understand the entire list, and apply it correctly, with some effort. The key is to start with what you do understand, and then build up to the more difficult concepts.

It is like trying to run a marathon. It looks too challenging to everyone at first. But after running a mile, then a few miles, and then building up to runs of ten miles, it does not appear impossible anymore. Learn the easy concepts first, and then build on them until you understand the more challenging ones.

The key to mastering this Difficult list is, as before, to learn to quiz yourself. For example, what happens to MC when MP rises? MC decreases. What happens to MC when MP decreases? MC increases. Look above to the definitions until you fully understand that.

Now let’s apply some of these concepts.

II. Externalities

Externalities are benefits or costs that are external to the seller and buyer of a good or service, for which no compensation is made. That may puzzle you at first. A company produces a good at its expense, and sells to a buyer who pays for it. The buyer bore the cost and received the benefit of the good itself. The seller bore the cost of producing the good, and received the payment for selling it. What else could be going on here?

After all, when you buy gas, you pay the cost and you receive the benefit. It’s a transaction between you and the service station. What cost or benefit does anyone else receive?

Next time you’re traveling in a car, take a look at the exhaust pipe on the car in front of you. Pollution comes out of it. The pollution used to be far greater than it is today, but there still is some exhaust. In some neighborhoods, it’s fashionable for car owners to modify their cars so that the engines consume less gas by producing more pollution. You can smell the difference when you are stuck behind one of those cars. Airport taxicabs are notorious for putting out more pollution than the average car. Airplanes themselves put out substantial pollution at airports as they idle.

The driver of a car or airplane does not bear all of the cost of the fuel. The public is bearing the cost of the pollution. Some people who never drive cars or fly in airplanes bear the cost of the pollution. This is an called a negative externality because it imposes costs on people who did not buy the good.

Car pollution is often unnoticeable. But sometimes pollution can be severe and dangerous. If a company can dump its waste into a river for free, then it is economically profitable for it do so. Those who like to swim or fish in the river will suffer the expense. Either they will have to curtail their activity, interfering with their utility, or they could become sick from it.

There are positive externalities also. These create benefits for the public without requiring some to pay for it. If you happen to live next to an outdoor concert facility, then you may enjoy listening to music without buying an admission ticket. The people paying for the concert receive the benefit they want, but you would receive a benefit free to you as a positive externality.

A public good is something, like music, that provides a benefit to one person without reducing the benefit to others. One listener does not lose benefit by the presence of other listeners. Food, in contrast, is not a public good.

Can you think of other positive externalities? Public transportation, perhaps, where the price of a ticket is less than the true cost? The New York Subway system, where you can go anywhere in all of New York City for a mere $1.50? How about free internet music through peer-to-peer networks like the old Napster?

The internet is filled with activities that create both positive and negative externalities. The positive externality is all the free and useful information posted on websites at someone else’s expense, but available to the public. The negative externality is all the pornography that destroys those who fall victim to it, creating costs for society to bear in dealing with them. FBI agents say that the one common attribute of every criminal residence that they raid is the presence of pornography.

Professor Lawrence Lessig is a champion of the commons on the internet. The commons is a term from medieval England, when anyone could bring their sheep to graze on public land. Ultimately, all the grass was eaten and then the commons was not of much use, so the story goes. Professor Lessig supports free books, music, etc., over the internet. He took a case to the U.S. Supreme Court fighting long copyright extensions (Eldred v. Ashcroft). In the end, some Justices seemed worried about the impact on private property of his theories, and he lost.

Illegal drugs create perhaps the largest negative externality. The transaction is between the drug dealer and the drug addict, but when that drug addict runs out of money due to his habit then he is going to turn to crime. Soon he will be robbing and even killing people to obtain money to feed his addiction. The victims of this crime bear the negative externality.

What is the cause of positive and negative externalities? It is desirable to eliminate the negative externalities, so that sellers bear all the costs of their production and sales. How can they be required to pay all of their costs, rather than pushing those costs onto the public?

Taxes are the typical way. Government imposes a gasoline tax, supposedly to pay for the costs imposed on society by cars. For positive externalities, government subsidies are a way to make the public to pay for benefits that it receives, and support the firm providing the benefit.

The problem is, politicians are known to maximize their own interests in setting tax policy rather than maximizing public interests. Public choice theory recognizes that self-interested politicians can act contrary to public interest.

Remember Ronald Coase? He would say that the reason for externalities is transaction costs. If it were practical to give everyone a right to be free from pollution, and then allow them to sell it without incurring transaction costs, then the negative externality of pollution would disappear. People would accept small payments from Exxon and other oil companies in exchange for allowing the gas to add a little pollution to their lives, if transaction costs weren’t larger than the payments. We would not need additional taxes on gasoline by an inefficient government.

III. Antitrust Laws

The response of government to externalities and to the very different problem of monopolies is regulation. Regulate the polluters; police the trading of music over the internet; and break up the monopolies like Standard Oil, AT&T, and perhaps Microsoft (which barely avoided a break-up by the skin of its teeth!).

Negative externalities and monopolies become popular targets for politicians from time to time. It can be expected that John Kerry will campaign on a platform of increasing regulation to protect the environment against big business. Don’t let companies pollute your lake and streams. A hundred years ago, President Teddy Roosevelt broke up big monopolies and cartels and became immensely popular for it.

There are more poor consumers who vote than wealthy businessmen, and many politicians think the road to election is paved with appeals to consumer interests. As long ago as 1890, the Sherman Antitrust Act was passed to prohibit combinations, trusts and conspiracies that restrict trade and prohibit cartels. The Clayton Act of 1914 went further and even prohibited price discrimination if not justified by cost differences. Accordingly, the term price discrimination is rarely used by businesses, because it sets off alarm bells of illegality. But in practice, virtually every business does engage in price discrimination in some form.

Sometimes the pendulum swings the other way. Ronald Reagan became president by ridiculing the vast amounts of regulation of free enterprise. Get the government off the back of businesses and the people. He sought less government. He would tell stories of senseless regulations, like one requiring American Indians working on high bridges to wear life-preservers in case they fell. First of all, the life-preservers were unbearably hot and of doubtful value even to those who fall. Second of all, the regulations applied even when there was no water below!

In the free market, change is nearly instantaneous to new developments. When a company announces it is bankrupt, its stock value drops to near $0 within minutes. However, it can take the government months or years to adjust to a new development. Louis Freeh, director of the FBI for eight years, was so far behind technologically that FBI agents had to use their more advanced personal computers at home in order to exchange large files! This was recently disclosed in congressional hearings.

An additional problem with regulations has arisen in the past ten or twenty years. Big businesses have learned how to influence regulators by holding out the possibility of hiring them. Fifty years ago, large companies had policies against hiring those who regulated them. But today, regulatory capture is pervasive. Regulators curry favor with the companies they regulate in order to obtain jobs at twice their government salary. The regulators end up helping the large companies at the expense of smaller companies and the public. The regulators have been effectively captured by big companies. The fox ends up guarding the chicken coop.

Finally, imagine a regulator imposing price controls on a natural monopoly. Forcing P = MC for a natural monopoly, however, would require a subsidy by the government because ATC > P. Without a subsidy, the company shuts down. Alternatively, if regulators set P = ATC for the natural monopoly, it does not need a subsidy but it is not producing an optimal output Q. Government price controls are almost never desired from an economic perspective. However, they may be popular politically.