Review on Microeconomics - Part 1.pptx

PowerPoint Slides prepared by:
V. Andreea CHIRITESCU
Eastern Illinois University
N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
REVIEW ON
MICROECONOMICS
PART 1: CHAPTERS 1-9
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning
management system for classroom use.
1

N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
Ten Principles of
Economics
CHAPTER
1
2

How People Make Decisions, Part 1
Principle 1: People Face Trade-offs
• Resources are scarce
–To get something that we like, we usually
have to give up something else that we
also like
• When making decisions
–Ask yourselves what you give up, e.g. to
study one more hour, give up one hour of
TV
3

Principle 2: The Cost of Something Is What
You Give Up to Get It
• People face trade-offs; making decisions:
–Compare costs with benefits of
alternatives
–Need to include opportunity costs
• Opportunity cost (the second best)
–Whatever must be given up to obtain
some item
4

Principle 3: Rational People Think at the
Margin
• Rational people
–Systematically and purposefully do the
best they can to achieve their objectives
• Rational decision maker
–Make decisions by comparing marginal
benefits and marginal costs
–Take action only if: MB > MC
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for
use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning
5

Principle 4: People Respond to Incentives
• Incentive
–Something that induces a person to act
–Higher price
• Buyers consume less; Sellers produce more
–Public policy
• Change costs or benefits
• Change people’s behavior
• Can have unintended consequences
6

How People Interact, Part 1
Principle 5: Trade Can Make
Everyone Better Off
• Trade
–Allows each person to
specialize in the activities he
or she does best
–Enjoy a greater variety of
goods and services
“For $5 a week you
can watch baseball
without being nagged
to cut the grass!”
use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved
learning management system for classroom use.
7

Principle 6: Markets Are Usually a Good Way
to Organize Economic Activity
–Through decentralized decisions of many
firms and households
–As they interact in markets for goods and
services
–Guided by prices and self-interest
Ex: Uber/Grab/Be vs traditional taxi
8

Principle 7: Governments Can Sometimes
Improve Market Outcomes
• We need government
–Enforce rules and maintain institutions that
are key to a market economy
–Need institutions to enforce property rights
–Promote efficiency, avoid market failure
–Promote equality, avoid disparities in
economic wellbeing
9

• Property rights
–Ability of an individual to own and exercise
control over scarce resources
• Market failure
–Situation in which the market left on its
own fails to allocate resources efficiently
–Externalities: pollution, noise from karaoke
–Market power: monopoly
10

N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
Thinking Like an
Economist
CHAPTER
2
11

The Economist as a Scientist, Part 3
The role of assumptions
• Assumptions
–Can simplify the complex world and make
it easier to understand
–The art in scientific thinking: deciding
which assumptions to make
• Different assumptions
–To answer different questions
–To study short-run or long-run effects
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved
12

• Economic models
–Diagrams and equations
–Omit many details
–Allow us to see what’s truly important
–Built with assumptions
–Simplify reality to improve our
understanding of it
13

Figure 1 The circular flow
This diagram is a schematic
representation of the
organization of the
economy.
Decisions are made by
households and firms.
Households and firms
interact in the markets for
goods and services (where
households are buyers and
firms are sellers) and in the
markets for the factors of
production (where firms are
buyers and households are
sellers).
The outer set of arrows
shows the flow of dollars,
and the inner set of arrows
shows the corresponding
flow of inputs and outputs.
14

• Production possibilities frontier
–A graph
–Combinations of output that the economy
can possibly produce
–Given the available
• Factors of production
• Production technology
15

Figure 2 The production possibilities frontier
The production possibilities
frontier shows the
combinations of output—in
this case, cars and
computers—that the economy
can possibly produce.
The economy can produce
any combination on or inside
the frontier.
Points outside the frontier are
not feasible given the
economy’s resources.
The slope of the production
possibilities frontier measures
the opportunity cost of a car in
terms of computers. This
opportunity cost varies,
depending on how much of
the two goods the economy is
producing.
16

Figure 3 A shift in the production possibilities frontier
A technological advance in
the computer industry
enables the economy to
produce more computers
for any given number of
cars.
As a result, the production
possibilities frontier shifts
outward.
If the economy moves
from point A to point G,
then the production of both
cars and computers
increases.
17

N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
Interdependence and the
Gains from Trade
CHAPTER
3
18

Absolute Advantage (Adam Smith)
Empty cell Minutes needed
to make 1 ounce
of meat
Minutes needed
to make 1 ounce
of potatoes
Amount of meat
produced in 8
hours
Amount of
potatoes
produced in 8
hours
Frank the farmer 60 minutes per
ounce
10 minutes per
ounce
8 ounces 48 ounces
Ruby the rancher 20 minutes per
ounce
15 minutes per
ounce
24 ounces 32 ounces
– The ability to produce a good using fewer
inputs than another producer
19

Absolute Advantage (Adam Smith)
Empty cell Frank’s meat Frank’s potat
oes
Ruby’s meat Ruby’s potatoes
Production and consu
mption without trade
4 ounces 24 ounces 12 ounces 16 ounces
Production with trade 0 ounce 48 ounces 24 ounces 0 ounces
Trade (5 meat = 18 p
otatoes)
Gets 5 ounces Gives 18 oun
ces
Gives 5 ounces Gets 18 ounces
Consumption with tra
de
Increase in consumpt
ion with gains from tr
ade
Increase of 1 o
unce
Increase of 6
ounces
Increase of 5 oun
ces
Increase of 2 ou
nces
2
0
– Specialization and gains from trade

Comparative Advantage (David Ricardo)
Empty cell Minutes
needed to
make 1
ounce of
meat
Minutes
needed to
make 1
ounce of
potatoes
Amount
of meat
produce
d in 8
hours
Amount of
potatoes
produced in
8 hours
Opportuni
ty cost of
producing
1 ounce
of meat
Opportuni
ty cost of
producing
1 ounce
of potato
Frank the farmer 60 minutes
per ounce
15 minutes
per ounce
8 ounces 32 ounces 4 ounces
of
potatoes/
ounce of
meat
1/4 ounces
of meat/
ounce of
potato
Ruby the rancher 20 minutes
per ounce
10 minutes
per ounce
24
ounces
48 ounces 2 ounces
of
potatoes/
ounce of
meat
1/2 ounces
of meat/
ounce of
potato
21
- The ability to produce a good at a lower
opportunity cost than another producer
- Reflects the relative opportunity cost

Comparative Advantage (David Ricardo)
Empty cell Frank’s meat Frank’s potato
es
Ruby’s meat Ruby’s potatoes
Production and consu
mption without trade
Production with trade 0 ounce 32 ounces 18 ounces (6h) 12 ounces (2h)
Trade (5 meat – 15 po
tatoes)
Gets 5 ounces Gives 15 oun
ces
Gives 5 ounces Gets 15 ounces
Consumption with trad
e
Increase in consumpti
on with gains from tra
de
Increase of 1 o
unce
Increase of 1
ounce
Increase of 1 oun
ce
Increase of 3 ounce
s
2
2
– Specialization and gains from trade

Applications of Comparative Advantage
- Should the U.S. trade with other
SMALL countries?
- Should Serena Williams Mow Her
Own Lawn?
• Serena, in 2 hours
– Mow her lawn, or
– Film a TV commercial, earn $30,000
• Forest Gump, in 4 hours
– Mow Serena’s lawn
– Work at McDonald’s, earn $50
“They did a nice job
with this grass.”
23

N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
The Market Forces of
Supply and Demand
CHAPTER
4
24

Demand, Part 1
• Quantity demanded
–Amount of a good that buyers are willing
and able to purchase
• Law of demand: Other things equal when
the price of a good rises, the quantity
demanded of the good falls
• Demand: Relationship between the price
of a good and quantity demanded
25

Table 1 Variables That Influence Buyers
Variable A change in this variable
Price of the good itself Represents a movement along the
demand curve
Income Shifts the demand curve
Prices of related goods Shifts the demand curve
Tastes Shifts the demand curve
Expectations Shifts the demand curve
Number of buyers Shifts the demand curve
This table lists the variables that affect how much of any good consumers choose to buy.
Notice the special role that the price of the good plays: A change in the good’s price
represents a movement along the demand curve, whereas a change in one of the other
variables shifts the demand curve.
26

Figure 4 Shifts in the Demand Curve versus
Movements along the Demand Curve
If warnings on cigarette packages
convince smokers to smoke less, the
demand curve for cigarettes shifts to
the left.
In panel (a), the demand curve shifts
from D1 to D2.
At a price of $4.00 per pack, the
quantity demanded falls from 20 to 10
cigarettes per day, as reflected by the
shift from point A to point B.
27

Supply, Part 1
• Quantity supplied: Amount of a good
sellers are willing and able to sell
• Law of supply: Other things equal when
the price of a good rises, the quantity
supplied of the good also rises
• Supply
–Relationship between the price of a good
and the quantity supplied
28

Table 2 Variables That Influence Sellers
Variable A change in this variable
Price of the good itself Represents a movement
along the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve
This table lists the variables that affect how much of any good producers choose to sell.
Notice the special role that the price of the good plays: A change in the good’s price
represents a movement along the supply curve, whereas a change in one of the other
variables shifts the supply curve.
29

Figure 8 The Equilibrium of Supply and Demand
The equilibrium is found where the supply and demand curves intersect. At the equilibrium
price, the quantity supplied equals the quantity demanded.
Here the equilibrium price is $2.00: At this price, 7 ice-cream cones are supplied and 7 ice-
cream cones are demanded.
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 30

Figure 9 Markets Not in Equilibrium
In panel (a), there is a surplus. Because the market price of $2.50 is above the equilibrium price, the
quantity supplied (10 cones) exceeds the quantity demanded (4 cones). Suppliers try to increase
sales by cutting the price of a cone, and this moves the price toward its equilibrium level.
In panel (b), there is a shortage. Because the market price of $1.50 is below the equilibrium price,
the quantity demanded (10 cones) exceeds the quantity supplied (4 cones). With too many buyers
chasing too few goods, suppliers can take advantage of the shortage by raising the price. Hence, in
both cases, the price adjustment moves the market toward the equilibrium of supply and demand.
31

Table 4 What Happens to Price and Quantity When
Supply or Demand Shifts?
Demand No Change in
Supply
An Increase in
Supply
A Decrease in
Supply
No Change in
Demand
P same; Q same P down; Q up P up; Q down
An Increase in
Demand
P up; Q up P ambiguous; Q
up
P up; Q
ambiguous
A Decrease in
Demand
P down; Q down P down; Q
ambiguous
P ambiguous; Q
down
As a quick quiz, make sure you can explain at least a few of the entries in this table using a
supply-and-demand diagram.
32

N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
Elasticity and Its
Application
CHAPTER
5
33

The Elasticity of Demand, Part 2
• Price elasticity of demand
–Percentage change in quantity demanded
divided by the percentage change in price
• Elastic demand
–Quantity demanded responds
substantially to changes in price
• Inelastic demand
–Quantity demanded responds only slightly
to changes in price
34

• Computing the price elasticity of demand
divided by percentage change in price
–Use absolute value (drop the minus sign)
• Midpoint method
–Two points: (Q1, P1) and (Q2, P2)
]
)/
P
)/[(P
P
(P
]
)/
Q
)/[(Q
Q
(Q
2
2
1
2
1
2
1
2
1
2





demand
of
elasticity
Price
35

• Variety of demand curves
–Demand is elastic
• Price elasticity of demand > 1
–Demand is inelastic
• Price elasticity of demand < 1
–Demand has unit elasticity
• Price elasticity of demand = 1
36

Figure 3 How Total Revenue Changes When Price
Changes (a)
The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. In panel (a), the demand curve is inelastic.
In this case, an increase in the price leads to a decrease in quantity demanded that is
proportionately smaller, so total revenue increases. Here an increase in the price from $4 to $5
causes the quantity demanded to fall from 100 to 90. Total revenue rises from $400 to $450.
(a) The Case of Inelastic Demand
37

Figure 3 How Total Revenue Changes When Price
Changes (b)
The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. In panel (b), the demand curve is elastic.
In this case, an increase in the price leads to a decrease in quantity demanded that is
proportionately larger, so total revenue decreases. Here an increase in the price from $4 to $5
causes the quantity demanded to fall from 100 to 70. Total revenue falls from $400 to $350.
(b) The Case of Elastic Demand
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assword-protected website or school-approved learning management system for classroom use.
38

Figure 4 Elasticity along a Linear Demand Curve
The slope of a linear demand curve is constant, but its elasticity is not. The price elasticity of
demand is calculated using the demand schedule in the table and the midpoint method.
At points with a low price and high quantity, the demand curve is inelastic.
At points with a high price and low quantity, the demand curve is elastic.
39

• Income elasticity of demand
–How much the quantity demanded of a
good responds to a change in consumers’
income
• Divided by the percentage change in income
40

• Normal goods
–Positive income elasticity
–Necessities
• Smaller income elasticities
–Luxuries
• Large income elasticities
• Inferior goods
–Negative income elasticities
41

• Cross-price elasticity of demand
–How much the quantity demanded of one
good responds to a change in the price of
another good
of the first good
• Divided by the percentage change in price of
the second good
42

• Substitutes
–Goods typically used in place of one
another
–Positive cross-price elasticity
• Complements
–Goods that are typically used together
–Negative cross-price elasticity
43

The Elasticity of Supply, Part 1
• Price elasticity of supply
–How much the quantity supplied of a good
responds to a change in the price of that
good
–Percentage change in quantity supplied
• Divided by the percentage change in price
–Depends on the flexibility of sellers to
change the amount of the good they
produce
44

Figure 7 An Increase in Supply in the Market for Wheat
When an advance in farm technology increases the supply of wheat from S1 to S2, the price of
wheat falls. Because the demand for wheat is inelastic, the increase in the quantity sold from
100 to 110 is proportionately smaller than the decrease in the price from $3 to $2. As a result,
farmers’ total revenue falls from $300 ($3 × 100) to $220 ($2 × 110).
45

Figure 9 Policies to Reduce the Use of Illegal Drugs
Drug interdiction reduces the supply of drugs from S1 to S2, as in panel (a). If the demand for
drugs is inelastic, then the total amount paid by drug users rises, even as the amount of drug
use falls.
By contrast, drug education reduces the demand for drugs from D1 to D2, as in panel (b).
Because both price and quantity fall, the amount paid by drug users falls.
(a) Drug Interdiction (b) Drug Education
46

N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
Supply, Demand, and
Government Policies
CHAPTER
6
47

Controls on Prices, Part 1
• Price controls
–Policymakers believe that the market price
of a good or service is unfair to buyers or
sellers
–Can generate inequities
• Taxes
–To raise revenue for public purposes
–To influence market outcomes
48

Controls on Prices, Part 2
• Price ceiling
–A legal maximum on the price at which a
good can be sold
–Rent-control laws
• Price floor
–A legal minimum on the price at which a
good can be sold
–Minimum wage laws
49

Figure 1 A Market with a Price Ceiling
In panel (a), the government imposes a price ceiling of $4. Because the price ceiling is above the
equilibrium price of $3, the price ceiling has no effect, and the market can reach the equilibrium of
supply and demand. In this equilibrium, quantity supplied and quantity demanded both equal 100
cones.
In panel (b), the government imposes a price ceiling of $2. Because the price ceiling is below the
equilibrium price of $3, the market price equals $2. At this price, 125 cones are demanded and only
75 are supplied, so there is a shortage of 50 cones.
50

Rent control in the short run and the long run,
Part 1
• Price ceiling: rent control
–Local government places a ceiling on
rents
–Goal: to help the poor
• Making housing more affordable
–Critique
• Highly inefficient way to help the poor raise
their standard of living
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning
51

Figure 3 Rent Control in Short Run and in Long Run
Panel (a) shows the short-run effects of rent control: Because the supply and demand curves for
apartments are relatively inelastic, the price ceiling imposed by a rent-control law causes only a
small shortage of housing.
Panel (b) shows the long-run effects of rent control: Because the supply and demand curves for
apartments are more elastic, rent control causes a large shortage.
52

Part 4
• Adverse effects in the long run
– Rationing mechanisms
• Long waiting lists
• Preference to tenants without children
• Discriminate on the basis of race
• Bribes to building superintendents
• People respond to incentives
– Free markets
• Landlords – clean and safe buildings
• Higher prices
53

Part 5
• People respond to incentives
–Rent control
• Shortages and waiting lists
• Landlords lose their incentive to respond to
tenants’ concerns
• Tenants get lower rents and lower-quality
housing
• Policymakers – additional regulations
–Difficult and costly to enforce
54

Figure 4 A Market with a Price Floor
In panel (a), the government imposes a price floor of $2. Because this is below the equilibrium
price of $3, the price floor has no effect. The market price adjusts to balance supply and
demand. At the equilibrium, quantity supplied and quantity demanded both equal 100 cones.
In panel (b), the government imposes a price floor of $4, which is above the equilibrium price of
$3. Therefore, the market price equals $4. Because 120 cones are supplied at this price and
only 80 are demanded, there is a surplus of 40 cones.
55

Figure 5 How Minimum Wage Affects Labor Market
Panel (a) shows a labor market in which the wage adjusts to balance labor supply and labor
demand.
Panel (b) shows the impact of a binding minimum wage. Because the minimum wage is a price
floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded. The
result is unemployment.
56

Taxes, Part 1
• Government uses taxes
–To raise revenue for public projects
• Roads, schools, and national defense
• Tax incidence
–Manner in which the burden of a tax is
shared among participants in a market
57

Figure 6 A Tax on Sellers
•When a tax of $0.50 is levied on sellers, the supply curve shifts up by $0.50 from S1 to S2. The
equilibrium quantity falls from 100 to 90 cones. The price that buyers pay rises from $3.00 to
$3.30. The price that sellers receive (after paying the tax) falls from $3.00 to $2.80. Even
though the tax is levied on sellers, buyers and sellers share the burden of the tax.
58

Figure 7 A Tax on Buyers
•When a tax of $0.50 is levied on buyers, the demand curve shifts down by $0.50 from D1 to
D2. The equilibrium quantity falls from 100 to 90 cones. The price that sellers receive falls from
$3.00 to $2.80. The price that buyers pay (including the tax) rises from $3.00 to $3.30. Even
though the tax is levied on buyers, buyers and sellers share the burden of the tax.
59

Taxes, Part 7
• Elasticity and tax incidence
–Very elastic supply and relatively inelastic
demand
• Sellers bear a small burden of tax
• Buyers bear most of the burden
–Relatively inelastic supply and very elastic
demand
• Sellers bear most of the tax burden
• Buyers bear a small burden
60

Figure 9 How the Burden of a Tax Is Divided, Part 1
•In panel (a), the supply curve is elastic, and the demand curve is inelastic. In this case, the price
received by sellers falls only slightly, while the price paid by buyers rises substantially. Thus,
buyers bear most of the burden of the tax.
61

Figure 9 How the Burden of a Tax Is Divided, Part 2
•In panel (b), the supply curve is inelastic, and the demand curve is elastic. In this case, the
price received by sellers falls substantially, while the price paid by buyers rises only slightly.
Thus, sellers bear most of the burden of the tax.
62

Taxes, Part 8
• Tax burden
–Falls more heavily on the side of the
market that is less elastic
–Small elasticity of demand
• Buyers do not have good alternatives to
consuming this good
–Small elasticity of supply
• Sellers do not have good alternatives to
producing this good
63

Who pays the luxury tax?, Part 1
• 1990, Congress adopted a new luxury
tax
–On yachts, private airplanes, furs,
jewelry, expensive cars
–Goal: to raise revenue from those who
could most easily afford to pay
–Luxury items
• Demand is quite elastic
• Supply is relatively inelastic
64

N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
Consumers, Producers,
and the Efficiency of
Markets
CHAPTER
7
65

Consumer Surplus, Part 1
• Welfare economics
–The study of how the allocation of
resources affects economic well-being
• Benefits that buyers and sellers receive from
engaging in market transactions
• How society can make these benefits as large
as possible
• In any market, the equilibrium of supply and
demand maximizes the total benefits received
by all buyers and sellers combined
66

Consumer Surplus, Part 2
• Willingness to pay
–Maximum amount that a buyer will pay for
a good
–How much that buyer values the good
• Consumer surplus
–Amount a buyer is willing to pay for a good
minus amount the buyer actually pays
–Willingness to pay minus price paid
67

Figure 3: How Price Affects Consumer Surplus
•In panel (a), the price is P1, the quantity demanded is Q1, and consumer surplus equals the
area of the triangle ABC.
•When the price falls from P1 to P2, as in panel (b), the quantity demanded rises from Q1 to Q2
and the consumer surplus rises to the area of the triangle ADF. The increase in consumer
surplus (area BCFD) occurs in part because existing consumers now pay less (area BCED) and
in part because new consumers enter the market at the lower price (area CEF).
68

Producer Surplus, Part 1
• Cost
–Value of everything a seller must give up
to produce a good
–Measure of willingness to sell
• Producer surplus
–Amount a seller is paid for a good minus
the seller’s cost of providing it
–Price received minus willingness to sell
69

Figure 6 How Price Affects Producer Sur
•In panel (a), the price is P1, the quantity supplied is Q1, and producer surplus equals the area of
the triangle ABC.
•When the price rises from P1 to P2, as in panel (b), the quantity supplied rises from Q1 to Q2 and
the producer surplus rises to the area of the triangle ADF. The increase in producer surplus (area
BCFD) occurs in part because existing producers now receive more (area BCED) and in part
because new producers enter the market at the higher price (area CEF).
70

Market Efficiency, Part 1
• The benevolent social planner
–All-knowing, all-powerful, well-intentioned
dictator
–Wants to maximize the economic well-
being of everyone in society
• Economic well-being of a society
–Total surplus
–Sum of consumer and producer surplus
71

• Total surplus = Consumer surplus +
Producer surplus
• Consumer surplus = Value to buyers –
Amount paid by buyers
• Producer surplus = Amount received by
sellers – Cost to sellers
• Amount paid by buyers = Amount received by
sellers
• Total surplus = Value to buyers – Cost to
sellers
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom
use.
72

• Market outcomes
1. Free markets allocate the supply of
goods to the buyers who value them
most highly
• Measured by their willingness to pay
2. Free markets allocate the demand for
goods to the sellers who can produce
them at the least cost
73

Figure 7 Consumer and Producer Surplus in the
•Total surplus—the sum of consumer and producer surplus—is the area between the supply
and demand curves up to the equilibrium quantity.
74

• Market outcomes
3. Free markets produce the quantity of
goods that maximizes the sum of
consumer and producer surplus
• Market equilibrium
–Efficient allocation of resources
• The benevolent social planner
–“Laissez faire” = “let people do as they
will”
75

Figure 8 The Efficiency of the Equilibrium
•At quantities less than the equilibrium quantity, such as Q1, the value to buyers exceeds the
cost to sellers.
•At quantities greater than the equilibrium quantity, such as Q2, the cost to sellers exceeds the
value to buyers.
•Therefore, the market equilibrium maximizes the sum of producer and consumer surplus.
76

Should there be a market for organs? Part 1
• “How a mother’s love helped save two
lives”
–Ms. Stevens - her son needed a kidney
transplant
–The mother’s kidney was not compatible
–Donated one of her kidneys to a stranger
–Her son was moved to the top of the
kidney waiting list
77

• Questions
–Trade a kidney for a kidney?
–Trade a kidney for an expensive,
experimental cancer treatment?
–Exchange her kidney for free tuition for
her son?
–Sell her kidney for cash?
78

• Current public policy
–Illegal for people to sell their organs
–Government has imposed a price ceiling
of zero: shortage
• Large benefits to allowing a free market
in organs
–People are born with two kidneys
• Usually need only one
–Few people – no working kidney
79

• Current situation
–Typical patient waits several years for a
kidney transplant
–Every year, thousands of people die
because a kidney cannot be found
80

• Allow for kidney market
–Balance supply and demand
• Sellers get extra cash in their pockets
• Buyers get to live
• No more shortage of kidneys
• Efficient allocation of resources
81

• Critics: worry about fairness
–Benefit the rich at the expense of the poor
• Current system: is it fair?
–Some people have an extra kidney they
don’t really need
–Others are dying to get one
82

N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
Application:
The Costs of Taxation
CHAPTER
8
83

Deadweight Loss of Taxation, Part 4
• Economic welfare
–Buyers: consumer surplus
–Sellers: producer surplus
–Government: total tax
revenue
• Tax times quantity sold
• Public benefit from the tax
“You know, the idea of
taxation with
representation doesn’t
appeal to me very much,
either.”
84

Figure 2 Tax Revenue
The tax revenue that the government collects equals T × Q, the size of the tax T times the
quantity sold Q. Thus, tax revenue equals the area of the rectangle between the supply and
demand curves.
85

Figure 3 How a Tax Affects Welfare
A tax on a good reduces
consumer surplus (by
the area B + C) and
producer surplus (by the
area D + E).
Because the fall in
producer and consumer
surplus exceeds tax
revenue (area B + D),
the tax is said to impose
a deadweight loss (area
C + E).
Empty Cell Without Tax With Tax Change
Consumer Surplus A + B + C A Negative left parenthesis
B + C right parenthesis
Produce Surplus D + E + F F Negative left parenthesis
D + E right parenthesis
Tax Revenue None B + D Positive left parenthesis B
+ D right parenthesis
Total Surplus A + B + C + D + E + F A + B + D + F Negative left parenthesis
C + E right parenthesis
86

Determinants of Deadweight Loss
• Price elasticities of supply and demand
–More elastic supply curve
• Larger deadweight loss
–More elastic demand curve
• Larger deadweight loss
• The greater the elasticities of supply and
demand
–The greater the deadweight loss of a tax
87

Figure 5 Tax Distortions and Elasticities (a, b)
In panels (a) and (b), the demand curve and the size of the tax are the same, but the price
elasticity of supply is different. Notice that the more elastic the supply curve, the larger the
deadweight loss of the tax.
88

Figure 5 Tax Distortions and Elasticities (c, d)
In panels (c) and (d), the supply curve and the size of the tax are the same, but the price
elasticity of demand is different. Notice that the more elastic the demand curve, the larger the
deadweight loss of the tax.
89

Figure 6 How Deadweight Loss and Tax Revenue
Vary with the Size of a Tax (a, b, c)
The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount
of the tax multiplied by the amount of the good sold.
In panel (a), a small tax has a small deadweight loss and raises a small amount of revenue.
In panel (b), a somewhat larger tax has a larger deadweight loss and raises a larger amount of
revenue.
In panel (c), a very large tax has a very large deadweight loss, but because it has reduced the
size of the market so much, the tax raises only a small amount of revenue.
90

Figure 6 How Deadweight Loss and Tax Revenue
Vary with the Size of a Tax (d, e)
(d) From panel (a) to panel (c),
deadweight loss continually increases
(e) From panel (a) to panel (c), tax
revenue first increases, then decreases
Panels (d) and (e) summarize these conclusions.
Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger.
Panel (e) shows that tax revenue first rises and then falls. This relationship is called the Laffer
curve.
91

N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
Application:
International Trade
CHAPTER
9
92

Figure 1 Equilibrium without International Trade
When an economy cannot trade in world markets, the price adjusts to balance domestic
supply and demand. This figure shows consumer and producer surplus in an equilibrium
without international trade for the textile market in the imaginary country of Isoland.
93

The Determinants of Trade Part 2
• Allow for international trade?
–Price and quantity sold in the domestic
market?
–Who will gain from free trade; who will
lose, and will the gains exceed the
losses?
–Should a tariff be part of the new trade
policy?
94

• World price
–Price of a good that prevails in the world
market for that good
• Domestic price
–Opportunity cost of the good on the
domestic market
95

• Compare domestic price with world price
–Determine who has comparative
advantage
–If domestic price < world price
• Export the good
• The country has comparative advantage
–If domestic price > world price
• Import the good
• The world has comparative advantage
96

Figure 2 International Trade in an Exporting Country
Once trade is allowed, the domestic
price rises to equal the world price.
The supply curve shows the quantity of
textiles produced domestically, and the
demand curve shows the quantity
consumed domestically.
Exports from Isoland equal the
difference between the domestic
quantity supplied and the domestic
quantity demanded at the world price.
Sellers are better off (producer surplus
rises from C to B + C + D), and buyers
are worse off (consumer surplus falls
from A + B to A). Total surplus rises by
an amount equal to area D, indicating
that trade raises the economic well-
being of the country as a whole.
Empty Cell Before Trade After Trade Change
Consumer Surplus A + B A -B
Producer Surplus C B + C + D + (B + D)
Total Surplus A + B + C A + B + C + D + D
The area D shows the increase
in total surplus and represents
the gains from trade
97

Figure 3 International Trade in an Importing Country
Once trade is allowed, the domestic
price falls to equal the world price.
The supply curve shows the amount
produced domestically, and the
demand curve shows the amount
consumed domestically.
Imports equal the difference between
the domestic quantity demanded and
the domestic quantity supplied at the
world price.
Buyers are better off (consumer
surplus rises from A to A + B + D),
and sellers are worse off (producer
surplus falls from B + C to C). Total
surplus rises by an amount equal to
area D, indicating that trade raises the
economic well-being of the country as
a whole.
Empty Cell Before Trade After Trade Change
Consumer Surplus A A + B + D +(B + D)
Producer Surplus B + C C -B
Total Surplus A + B + C A + B + C + D + D
The area D shows the
increase in total surplus
and represents the gains
from trade
98

Winners and Losers from Trade Part 7
• Tariff
–Tax on goods produced abroad and sold
domestically
• Free trade
–Domestic price = World price
• Tariff on imports
–Raises domestic price above world price
• By the amount of the tariff
99

Figure 4 The Effects of a Tariff
A tariff, a tax on imports,
reduces the quantity of
imports and moves a market
closer to the equilibrium that
would exist without trade.
Total surplus falls by an
amount equal to area D + F.
These two triangles represent
the deadweight loss from the
tariff.
Empty Cell Before Tariff After Tariff Change
Consumer Surplus A + B + C + D + E + F A + B - (C + D + E + F)
Producer Surplus G C + G + C
Government
Revenue
None E + E
Total Surplus A + B + C + D + E + F +
G
A + B + C + E + G - (D + F)
The area D + F shows
the fall in total surplus
and represents the
deadweight loss of the
tariff.
100

Arguments for Restricting Trade Part 3
• The infant-industry argument
–“New industries need temporary trade
restriction to help them get started”
–Difficult to implement in practice
–The “temporary” policy is hard to remove
–Protection is not necessary for an infant
industry to grow
101

Arguments for Restricting Trade Part 4
• The unfair-competition argument
–“Free trade is desirable only if all countries
play by the same rules”
–Increase in total surplus for the country
• The protection-as-a-bargaining-chip
argument
–“Trade restrictions can be useful when we
bargain with our trading partners”
–The threat may not work
102

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